Venture Law Exam

Name: Anthony Njau

Student Number: 140535

Acronyms
VC
LP
GP
ATDC
ADP
CVC

Venture Capital (firms)

Limited Partner
General Partner
Advanced Technology Development Center
Anti-Dilution Provisions
Corporate Venture Capital

M e m o r a n d u m
To: Bruno Francois, Cycloramic
From: Anthony Njau
Date: 20th March 2015
Re: Issues in Capital rising from Venture Capital firms
1.0
SUMMARY
This memo concerns issues arising the capital raising process of the startup Egos Ventures,
covering aspects of selection criteria of VC, the differentiation of traditional VCs and corporate
VCs and the future prospects of the venture, including exit considerations.
As part of the memo, a concrete framework is provided towards the founder in selecting the best
VCs that add value, and also the key considerations and pros / cons in raising capital from CVC,
as well as an analytical discussion of Egos Ventures future not only as a going concern but also
on the disadvantages and advantages involved in any potential exit for Mr. Francois.
2.0
FACTS
Cycloramic, an iOS and Windows-Phone hands-free panorama app, founded in 2012 by Bruno
Francois in a startup called Egos Ventures, as part of a business incubation program at ATDC
(Advanced Technology Development Center) in Georgia.
In its first year of operations, Cycloramic managed to gain around 660,000 downloads, with
income (after expenses and iTunes charges) at around $175,000, roughly a net profit margin of
27%.
This changed in Year 2, where after airing on Shark
Tank on January 2014, an American program where
investors listen to and invest in startups, they raised
$500,000 from two equal stake investors at 7.5%
each, for a post-money valuation of $3,333,333. This
television appearance boosted downloads to
8,000,000, the apps selling price from $0.99 to $1.99
and raising the apps ranking on iStore to Number 1.
Interestingly, Mr. Francois originally sought $90,000
for a 5% equity stake offer. The show helped boost
the firms sales and margins.

In interviews with media after Shark Tank finance round, Mr. Francois remarked that before the
show, it was difficult to make contact with good potential partners and that this was their first
round of external financing. He also remarked the Shark Tank financing round took a long time,
with initial interviews with the shows producers starting the previous year, April 2013.
The strongest remark of this round of financing, is the investors, Mark Cuban and Lori Greiner .
Mr. Cuban has experience in the technology field, with investments in several outfits, and his
advice could include how Mr. Francois could exploit his utility patent on the rotating app
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technology to other uses. Ms. Greiner, is a self-proclaimed wizard at television marketing and
picking winners in general. As a successful shark, she has a strong reputation and network which
would help Mr. Francois, at better terms than the other sharks on the show.
Mr. Francois successfully managed to select investors who add value to his technology firm,
through their insight and networks, but also at the highest valuation for such an early startup.
3.0
ISSUE
What this memo is not about, is the valuation, types of investment securities, dilution and ADP.
This memo is about VC selection and exit prospects.
I.
II.
III.

How can Mr. Francois distinguish VCs that add value?

Should Mr. Francois accept corporate venture capital?
What are Egos Ventures future prospects?

4.0

DISCUSSION

4.1
Selecting the VC
On the first issue, Mr. Francois is faced with the
issue of which VC to enter into terms with. In the
Universe of VC, Information Technology forms
a large percentage, as much as 30% (2012 PWC
/NVCA Report). This makes raising VC funds
relatively easier due to the amounts allocated
towards this sector, but also relatively
competitive, given the need for VC to identify
the next blockbuster app or firm.
In the discussion of how to select a VC to go
with, Mr. Francois is focusing on the next rounds
of financing, having allocated Series A on the
Shark
Tank
round.
However,
the
recommendations from empirical evidence as to
which characteristics of the VC, Mr. Francois should focus on would have been as applicable to
the Shark Tank round as to future rounds.
According to Park and Vermeulen (2015), a set of reasons can determine whether a VC can be
successful, and hence beneficial to their portfolio of companies. These indicators can be
intangible but quantifiable, and are in respect of the VC to either their investors or their portfolio
companies, with the expectation that the . These are:
1. Visibility and Leadership
This means that the VC should be known, with access to contacts and deal flow. The
leverage of social media (twitter, blogs etc) in influencing the sector which the VC is
involved in can help increase added value to entrepreneurs like Mr. Francois.
A simile to this would be the shark tank effect, which is a term explaining the revenue
boosting effect of appearing on a shark tank episode on the entrepreneur. This is also
increased by the continued media appearances and social media promotion that investor
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celebrities like the shark tank panel can exercise. Another example would be the stock
market effect of social media posts by founders like Elon Musk or by investors like Carl
Icahn in respect to his tweet concerning Apple.
Leadership is affiliated to visibility but concerns those VC that actively sourcing deals
and leading the investment rounds, which allows them to exercise additional influence
and also attract best in class resources, human and capital.
2. Hyperactivity and Risk Appetite
This combines the indicator of whether the VC engages with seed and startup funding or
angel investments, that are more risky, but tend to lead to higher payoffs. This translates
to experience in selecting and supporting early stage startups.
3. Disruptive Leanings
This broad term according to the 2015 paper, encompasses examples of VCs that take
innovative steps to differentiate themselves, decisions including making the term sheets
more investor (LP) friendly including sharing rights like board representation and control,
voting rights and pro-rata rights.
This indicator is supported by the work of McCahery and Vermeulen (2013), which
identified the increasing importance of co-investments, separate account arrangements
and the decline of 2% management fee and 20% carried interest rule. This study
documents the disruptive tendencies of private equity funds.
And as referred to in the work by Dittmer, McCahery and Vermeulen (2013), this change
in the standard venture capital model is also motivated by fundamental changes in the
industry, including increased competition from non-standard fundraising platform
including crowd funding and the need for and increased collaboration between VCs and
industry partners.
4. Exit Performance
This looks at the past performance of a VC as a potential forecast of future performance,
also reflecting experience and the guidance of moving the startups towards profitable
exits.
Additional methods of distinguishing VC that add value to their portfolio companies include:
1. Make use of data analytics
Mr. Francois needs to make use of data analytics from sources like Pitchbook and
Crunchbase, in order educate themselves on the investment performance and feedback,
especially from other founders, in selecting the best VC.
Other factors to look out for include the corporate governance treatment of the VC on
their portfolio companies and also by analyzing the term sheets of previous investments in
order to
2. Co-investment with fund / Skin in the Game
As part of disruptive leanings, co-investment is a separate point for the founder, in
examining the extent to which the VC has skin in the game. This helps align their interests
and also provide motivation on the part of the VC to better and actively support the
startup towards success.
3. Capital syndication as a signal
The founder can also look at the extent of syndication on the part of the lead investor VC,
in order to measure the confidence of the VC in the venture. The greater the syndication
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the lesser the problem of adverse selection, as was documented in the work of Douglas
Cumming (2006).
It can also be argued however that increased syndication can lead the double adverse
selection problem where the issue of free rider can arise with VCs in a given round
leaving it up to others to deal with monitoring and advising the firm.
4. VC Characteristics
This includes the geography of the fund, where the geography bias can help or hinder the
level of value added services that he VC can provide. Another characteristic is the amount
of financing required, the specialization of the fund e.g. early stage or expansion stage
financing required.
Lastly, an important entrepreneurs survey study documents and iterates the selection criteria that
are important to entrepreneurs in selecting the VCs, and is the work by D. Gordon Smith (1999)
and include:
1. Valuation (Price)
Founders care about the post money valuation being provided, however, this does not
guarantee the quality and amount of value addition that the VC can offer. It does provide
a tenuous link, that the greater the valuation, the greater the interest of the VC and
potential downside and hence the mutual interest in ensuring that the venture performs
well.
2. Value added services
These services of monitoring and advising the venture are what portfolio companies need
as much as the actual financing. These services can be quiet broad, but there are a few key
tasks performed by VC that can influence the decision of which VC to accept financing
from, and on the other hand, whether the VCs investment will be helpful towards the
startup.
3. VC reputation
This argument is similar to that of Park and Vermeulen and is important for the founder as
not only in terms of future fundraising and exiting contexts, but also in terms of getting
deal flow, access to human resources and network effects, the VC reputation, not external
but also internally in terms of point 2 above, Value added services, is very important.
4. Venture Capitalist Attributes
The last criteria are the characteristics of the VC him or herself, in terms of criteria such
as the specialization of the industry or the number of years of operation of the fund or VC.
All these point back to signals towards the founder, of the potential best fit between the
founder and the VC, and potentially of the value additions.
Therefore Mr. Francois, can make use of these criteria in selecting the best VC that can add
value. This framework, can be simulated by comparing in a simplistic manner, how the Shark
Tank panel, compares to each of these criteria which have been summarized.
The first step is to analyze the panel, in a high-level way, to see whether they fit within the
model:
1. Daymon John- Successful businessman, motivation speaker, with focus in fashion and
textile manufacturing. Successful run on Shark tank with several investments which have
had good performances, and partnering in some other deals. Few deals as lead investor,
mainly in his own sector.
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2. Kevin OLeary- known as the real shark, prefers disruptive investment structures such as
royalty basis or reducing stake in company once a certain repayment multiple of initial
investment has been reached. Focus is on technology and software industry with great
previous performance. Very active on twitter, with around 60,000 followers.
3. Steve Tisch- media entrepreneur which stakes in sports arena, the New York Giants, and
production of movies. Very wealthy with a significant net worth but little to no
experience in venture capital or angel investing.
4. Lori Greiner- A successful marketer, including a long running show on QVC, a
television order platform. Long experience on Shark Tank with several homeruns in many
investments. Motivational partner to portfolio companies, with above average stakes and
required ownership. Focus is on marketing, advertising, sales and all things television.
Less wealthy than the other investors on the panel, but also considers more risky
investments for higher stakes. Can invest based on gut instinct or emotion.
5. Mark Cuban- Very wealthy IT and software investor, with investments including a
basketball team. Has a unique investment philosophy and only invests in companies he
can add value or commit time. Lead investor in many projects on shark tank, and sole
investor in many more, very active on social media, including 1,25 Million followers on
twitter, and an active following on his blog.
The panel is then scored, from 1 3, based on the strength on each criteria.
Criteria
Daymond
Kevin
Steve Tisch
Lori Greiner
John
OLeary

Mark Cuban

Visibility
and
Leadership
Hyperactivity and
Risk Appetite

Exit Performance

VC characteristics
(specialization in
software)

Valuation
Value
added
services
VC Reputation

2
1

2
3

3
1

3
1

3
3

Tally

12

17

12

15

21

Criteria such as capital syndication as a signal of lack of interest and future monitoring has been
left out, since several deals were offered which were syndicated. In addition, co-investment has
been left out as well since all Shark Tank investors invest their own money. Data analytics has
been removed as these qualified investors are not real VCs.
It is clear from the above, that Mr. Francois made the right decisions and incorporated some or all
of these considerations in selecting the best VC to add value to his app and his firm. He selected
the offer from Mark Cuban, which was syndicated with Lori Greiner. From our simple analysis,
the best partners would have been Mark Cuban and Kevin OLeary. However, Mr. OLearys
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offer consisting of some form of royalty deal and later modifies the deal to an equity ownership
stake that is reduced when a multiple of 1X is repaid back to him.
4.2
CVC as an alternative
As a second issue, this requires the discussion of the value proposition towards Mr. Francois of
raising capital from corporate VCs. The greatest benefits from CVCs are that they provide deeper
pockets of not only resources and expertise, but also better time to market in terms of operations,
given the fact that often CVC invest in related services or business ideas that have better fit with.
According to the work of Henry Chesbrough (2002), CVCs can fail to maximize the potential of
a venture if two criteria are not met:
1. CVC objectives Fail to focus on financial returns
At the cost of strategic aims, financial returns have to be the focus, in order to ensure that
incentives and expectations of startups and the CVC are aligned. The other side of this
coin is that the CVC should be dedicated on maximizing the value of the investment.
2. Alignment of operations with the venture
The CVC need to make sure that they invest within their wheelhouse, and not use CVC as
a form of diversification, which will lead to poorer performance and deconcentration of
efforts.
For Egos Ventures, the route of CVC does provide some pros / cons that Mr. Francois has to
consider, especially considering the rather angel-esque investment from Shark Tank as Series A,
and how this will work together with the interests of the CVC for any future rounds of financing.
This is examined below:
Advantages
A strategic investor: Deep expertise,
industry connections and potential
operating partnerships
Larger amounts available for investment:
cold cash
Benefit also from intangible network
effects like brand value of CVC

Reduced focus on ROI over strategic

concerns allows less profitable NPV
startups to get funding and with longer time
horizons

Disadvantages
Potential conflict of business interests
between venture and CVC

CVC tend to have slower deal flow,

meaning time to market may be reduced
Increased bureaucracy may be possible,
especially with non spin off CVC, where the
parent company can exercise pressure on the
venture in making decisions
Lack of focus or priority on exits in some
CVC investments may detract some
founders, since strategic considerations may
restrict options such as a profitable trade sell
in order for the CVC to maintain market
leadership or suppress competitors

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Opens the investment universe as

traditional VCs traditionally focus on
narrow sectors like Biotech and Software.
As long as there is a corporate, CVC is
possible
Stability of funding (own sources from
massive cash balances or cheaper financing
due to larger size of multinationals) of CVC
is stronger compared to traditional VCs,
especially where financial stability of
economy is at issue
Investing at Mid to late stage means that
at the time of accepting CVC, the founder
can create better terms since most of the
risk is expired.

Mixed objectives (i.e. strategic over

financial) can lead to minimization of the
value addition possible from CVC to
startups

Potential problem of CVC co-investing in

competitors of own portfolio startups due to
the betting nature of some CVC investments

Difficult corporate governance not only

from underlying agency issues but also due
to less independent CVC fund structures in
traditional i.e. non spinoff or Direct VC
compensation CVC investments, lacking
the limited partnership and

The considerations above therefore provide a framework again for Mr. Francois to consider when
contemplating the decision to accept funding from a CVC, which in summary include:
.1 Aligned interests (operational and sector wise) of potential CVC with Egos
Ventures
.2 Select CVC from prism of entrepreneurial maximizing decisions and terms, so that
Mr. Francois can select a veritable partner and collaborator
.3 Better negotiation in future series with CVC for better corporate governance and
decision making structures to maintain Mr. Francois voting and control rights and
to minimize the potential disadvantages of misaligned interests
In analyzing the software sector that Egos Ventures first app is focused on, should Mr. Francois
decide to seek and accept CVC funding, the CVC software segment has been increasing in terms
of deals and valuations, and has a broad universe of not only mid-stage but also some early stage
tech CVC investors prominently such as Google Ventures and In-Q-Tel as seen below from a
CBInsights 2014 study:

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5.0
Egos Ventures future prospects
The last issue in the memo regards the future prospects of Egos Ventures, especially relating to
the potential to exit, i.e. a decision analysis of whether to remain private, go public or execute a
trade sale in the future.
All the alternatives, are dependent on a successful Egos
Ventures, the level of whose variation can determine the
suitability of either option. For instance, since Egos Ventures is
post revenue, with an income of around $175,000 in Year 1,
boosted in Year 2 by the Shark Tank media appearance effect, to
roughly $2,2000,000, at a 27% net profit margin, the prospects
i.e. going concern value of Egos Ventures on a real options
model analysis based on expected payoff is far exceeding the
initial investments of roughly $500,000 (Shark Tank Investors)
and $485,000, as seen, and as well on the pre-money valuation of $3,000,000 of Egos Ventures,
as calculated below:
Pre-Money Valuation: $Post Money Valuation - $Investment
$3,333,333 - $500,000 = $2,833,333
The investment on the part of Mr. Francois is imputed based on the difference between revenues
of roughly $650,000 in year one from 660,000 downloads at $0.99 per download and remaining
income of $175,000. The costs of starting Cycloramic, as Egos Ventures as assumed to be the
investment on the part of Mr. Francois.
This payoff model is made on the assumptions that Shark Tank invests in common shares, or if
preferred, with the more common 1X liquidation preferences, and no additional payoffs such as
dividends and common shares splits payments.
The problem of software companies, especially one such as Cycloramic, which is dependent on:
1. Number of new downloads
2. In-app Purchases or some form of advertising monetization
This makes it more tricky to predict the future value of the venture based on discounted cash
flows, especially if the cyclical nature of app innovation means that a new app could easily
replace Egos Ventures app on the iStore market, meaning reduced or little new revenues and
hence income.
What can be said, is that based on the revenues model and going concern approach, remaining
private may not be as profitable as the premium that can be paid to a trade sell or by going public,
when the time comes.
Further assumptions can be made on the Gordon Dividend growth model on Cycloramic, on the
assumption that, revenues increase at a modest 2% growth rate (for entertainment software
companies) and a discount rate of roughly 8% indefinitely, as sourced from Damodaran Online
data. For Dividend, we use FCFF, based on net profit margin in Year 2 of roughly $2,200,000.
Value = $2,200,000 / (8% - 2%)
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= $36,666,667
The estimated valuation of roughly $40 Million is based on weak assumptions, but highlights that
the maximum payout from this investment is potentially significant on a going concern basis, and
on the division of profits (taxable income as dividends).
However, it is very much possible to see Egos Ventures, especially with future innovative apps,
patents and marketing premiums in a trade sale or IPO to achieve greater returns. According to
CBInsights, the average IPO returns for tech firms in 2014 was around $101 Million, even with
some variation, on an ex-ante basis and based on the Egos Ventures current performance, we can
say that an IPO or trade sale would be preferable.
In order to analyze the 3 options, we compare the advantages and disadvantages of each one as
seen below, based on a -1/1 matrix for whether the disadvantages or advantage respectively is
present, to tally the most attractive options:
Criteria
IPO
Trade Sale Remaining Private
1.
2.
3.
4.
5.
6.

Regulatory compliance: US Securities and Exchange Act

Reporting disclosures as a burden
Increased tax burdens
Dilution and potential loss of control
Real up-front transactional costs
Moral Hazard and adverse selection of transaction
partners and advisors
7. Under pricing or leaving money on the table
8. The importance of Correct timing, problem of not
maximizing the amount of expected payoff from exit
9. Intangible benefits like prestige, reputation, visibility and
status of Egos Ventures post transaction
10. Increased liquidity of Egos Ventures Shares for the
benefit of common shareholders and option holders
11. Intangible costs including maintain the going concern of
the company
12. Additional benefits such as making the equity of Egos
Ventures into a currency for Mergers or Acquisitions
Tally

-1
-1
-1
-1
-1
-1

1
1
1
1
1
-1

1
1
1
1
1
-1

-1
-1

-1
-1

-1

-1

-1

-1

-1

-1

-1

-6

In a pure comparison of advantage to disadvantage, we can see that operationally, the decision to
remain private has stronger incentives for Mr. Francois, with the option to trade sale being more
preferable to an IPO.
The analysis above, however crude, fails to highlight the importance of amount of returns on exit,
and the nature of a potential exit. Remaining private extends this time for the possibility of
maximizing the return on either a sale or an IPO, however, this may come at a cost to the amount
to be raised as investors at a later stage will look at:
1.
2.
3.
4.

Extent of revenues and future cash flows of Egos Ventures

Protection by patent of this future revenues
Competition
And other factors
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RECOMMENDATIONS
In concluding this memo, and in consideration the three issues, we are able to provide the
following recommendation towards Mr. Francois regarding current and future considerations of
Egos Ventures:
1. In raising funds from VCs, employ a consistent framework in selecting VCs that will help
maximize the added value towards the startup at every stage of its development. This
model is presented in the discussion of issue 1.
2. In deciding to approach and raise funding from CVCs, then Mr. Francois should at best
make sure that both their strategic and financial objectives and their operational interests
are aligned in order to ensure long term partnership that add value to Egos Ventures.
3. In deciding on what next to do for Egos Ventures, Mr. Francois should remain private for
now, but should review this position as often as possible, in order to maximize the
expected payoff of greater than $40 Million, based on its current operations and patent of
Cycloramix

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