The Central Bank in Brazil is launching a new set of banknotes after 15 years with the launch of Real. They are good looking. I can’t wait to have all of them.

You can read more about the launch here.

Kwedit is a strange name for a payment company. This is a startup that offers a new form of payment to social and interactive games that allows people to buy virtual goods. The strange thing is that it allows people to “promise” to pay for a virtual good and the user can pay the promise later with a bar code in a 7eleven store.

Even though this seems to be a great innovation, the idea of printing a bar code and pay it in a retail store is nothing new to date. The strong differentiator of Kwedit is the idea of promising to pay later. I wonder what would happen if everybody promises to pay but none of the actually pays anything. I believe that the CFO of the company would be scare of the increase in the account payable of the balance sheet.

This type of payment for virtual goods reminded me of Habbo Hotel. Habbo is a Finnish company that started its virtual goods operations before the internet boom. It is probably the first company to have a business model based on selling virtual goodies to users. Interesting enough, Habbo targeted in a very narrow market segment. Its targets on teenagers that love to chat in pixel-lated environment.

Habbo and its many forms of payments.

Habbo offers 7eleven payments too. OK, they sell pre-paid cards and Kwedit doesn’t.

In my humble opinion, Sulake could have grown much more if it had focused on the virtual good market as a whole market instead of just that niche teenager segment. It could have created a strategic plan of reaching all types of games and services based on virtual goods. Well, other companies grew upon this model and they are newer than Habbo. C’est tant pis.

The Science of Managing Search Ads

There is an amazing article about Google AdWords from the New York Times.

It illustrates the management of an online campaign in AdWords for a company called Tiny Prints. This company advertisers on Google and gets a substantial part of its revenue and customers from AdWords. The company has stopped advertising for a day, trying to decrease its acquisition cost, but it ended up losing customers and allowing competitors to grow. Its management team decided to advertise again and it started to manage its campaign more closely, balancing the ads spending, competitors’ bids and profits.

The article gives an accurate view of how advertisers live with AdWords. To have success in that platform, you need to have quick decision, money and knowledge to use this powerful tool.

Read more here: The Science of Managing Search Ads

Canada - USA - Niagara Falls

People in the venture capital industry know that the VC industry is not going well in Canada. That is why it is even more important to know the situation in a quatitative point of view.

The SME Financing Data Initiative is a government website that publishes quarterly reports about the venture capital industry in Canada. The summary is that the level of investment and funding is the lowest since 2003.

VC investment and fundraising, Q1 2008 and Q1 2009

There is an increase in the number of investment in the seed stage startups. However, all other stages of deals fell.

VC investment by stage of development, Q1 2008 and Q1

Also, you can see better how the distribution deals in Canada per provinces is.

Number of companies receiving VC by province, Q1 2008 and Q1 2009

I haven’t added all the number, but the impression that I have is that the venture capital activities in Canada is decreasing significantly. You can read the whole report here: http://www.sme-fdi.gc.ca/eic/site/sme_fdi-prf_pme.nsf/eng/h_02156.html

I took the report from the Money Tree Report from PriceWaterHouseCoopers and there is a lot of interesting results.

According to the report, the number of deals remained flat but the value increased slightly compared to Q1. But if we compared to Q2 2008, the value of investment drop 48.6%. In this perspective, Canada is not doing that bad at all.

Number of deals in US

Another interesting fact is that the number of seed stage investment increased as in Canada.

Seed investing increasing

This is actually good news. The more we invest in early stage company, the more growth we can expect in 3 – 5 years. So, those who want to gain fast money should not get into the venture capital industry now. But, it is important to get into this industry now to invest in new companies and expect a good exit in 3-5 years; this is the average needed time for a company to mature for an IPO.

The current situation in the VC industry is not good. But, actually, this is a good opportunity to have a readjustment in the industry, lower the valuations and we may have a better return from the portfolio companies in the next 3 -5 years.

Koenigsegg's car with Saab logo

I’ve been following many news related to the GM’s sale of Saab to Koenigsegg and I’m very curious about the outcome of this situation.

I searched Google to see if there was any news of small companies buying big companies and I couldn’t find any results to that, instead I found many news of big companies buying smaller firms.  Then, I made some changes in my query and I still didn’t get any results of small companies buying a bigger one. However, I’m sure that there are a bunch of history of small companies buying big troubled ones or at least their brands.

Two examples:

• Infogrames buying Atari, read more at Wikipedia.
• Rackable Systems buying Silicon Graphics, read more at Wikipedia.

As in this little research, most companies bought the troubling ones because of the brand. It is quite hard to see a small company buying a larger one because usually, small companies do not have capital to buy any company at all.

That is why it is fascinating to see the merger of Koenigsegg and Saab. Koenisgsegg sold only 20 cars around $1.2 million each last year. Meanwhile, Saab sold over 5o,000 cars units during the same period. Koenisgsegg is receiving many many support to acquire Saab. First, it has $600m loan from the European Investment Bank guaranteed by the Swedish government, and a dowry from GM in the form of platforms, powertrains and about $500m in cash and other assets.

Then, Saab’s Creditors agreed to write down 75% of their debt!

This merger looks more like this: GM and the Swedish Government “hired” Koenisgsegg to clean up or infuse a new life into the company.

I would love to see how successful this ‘marriage’ will be. Some cars enthusiasts’ sites say that it would be great to have Koenigsegg technology and hype infused into the Saab products. I wonder what Koenigsegg is thinking about this. Maybe, it would be great for them to have a platform where they can mass produce their extremely cool cars to the world.

However, there are many risks for this strategies. How could Koenigsegg adapt its designs into the production line of Saab and how the small Koenigsegg’s team can hope to manage the bigger and fatter Saab management and company’s structure?

I wish them luck!

News related to Saab and Koenigsegg sale:

Unstable Storm – Economist.com
Saab’s Creditors Agree to Sharply Write Down Debt
Koenigsegg buys Saab: The automotive gods may smile upon us once again
Google News: Saab & Koenigsegg
512-HP Koenigsegg Quant Solar-Electric 4-Seater To Enter Production
Geneva 2009: NLV Quant by Koenigsegg

A new study by the Ewing Marion Kauffman Foundation, Right-Sizing the U.S. Venture Capital Industry, states that venture capital industry’s return is under performing because of the current size of the industry. It says that by reducing the it, this industry may increase its return.

The logic is that the VC firms won’t have that much money to make high valuations in startups, so the return will be higher naturally.

Kauffman says The US VC industry must shrink

This report is in tune with what I am reading from The Money of Invention, How Venture Capital Creates New Wealth: Paul A. Gompers, Josh Lerner. Josh Lerner’s book states clearly that if the supply of money from limited partner is high, while the demand of investment from startups is the same, the consequence is lower return.

This is incredible.

You can read more about the Kauffman’s paper here: http://www.kauffman.org/newsroom/venture-capital-industry-must-shrink-to-be-an-economic-force-kauffman-foundation-study-finds.aspx

Wow, this is increadible. 

Facebook is receiving $ 200 million for 1.96%!
 To calculate the post valuation, we just need to do this:

X = post-valuation
X = 200 million / 0.0196 = 10 204 million = $ 10 billion roughly.

Amazing how this company is able to draw more investment. 

Read more news about this event here:

Russian firm invests $200 mln in Facebook
What Is Facebook Actually Worth?
Why Facebook needs DST in Russia

Private equity is a medium to long-term finance (10 years). Private equity firms provide money to companies in exchange of equity and control.

Venture capital funds are a type of private equity investment. The main specialty of a VC firm is in early stage companies.

Usually PE funds do leveraged buyout. These firms purchase all or a significant portion of the stock or assets of a company (public or private). They usually use debts from huge banks to buy the companies. That is why some of the operations are called leveraged buy-outs. Then, they try to improve the companies’ operational and financial performance and after a couple of years, they release the companies’ stocks to the market, expecting to get profit from it.

Most PE funds focus on firms with stable cash flow, high market share, undervalued shares and known industries.

Typically, a private equity fund life cycle is defined as:

- 0 to 1 year: Raise Capital
- 1 to 5 years: Investing in distress or interesting companies
- 5 to 10 years: Liquidation of the investments.

The liquidation can be done by the IPO of the private company.
As you can see, Private Equity investment is quite similar to Venture capital investment.

In general, private equity does not have liquidity, ownership is concentrated, valuation is difficult and finance is accompanied by control and mentoring. However, public equity has liquidity (people exchange equity for money easily), ownership is dispersed, valuation is relatively easy and finance is often separated from control and mentoring.

Material about Private Equity from the Internet:

Private equity - Wikipedia

PowerPoint Presentation about Private Equity
Private Equity.ppt
Presentation – Pvt Eqy – 2008 – Kalpana Jain
FundsRaisedStrcturedJan04
NYC Investment Fund-David Bowe.ppt
PowerPoint Presentation About Private Equity
Selling to private Equity.ppt
Legal Aspects of Private Equity- FINAL.ppt
 

In a academic view, we could define venture capital as those firms that invest in early stage startups and private equity are firms that invest in later stage companies or public companies. However, both have the same investment style. They invest in companies in exchange for equity of a company. Also, venture capital is a subset of private equity investment. Private equity investments include leverage buyouts, distressed investments and mezzanine capital. With the economic crisis, venture capital firms  are more conservative, so a lot of venture capitalists are investing more in later stage companies which the risks are lower.

National Venture Capital Association (NVCA) reported that venture capital performance showed positive returns across all investment horizons 3 years and longer for the period ending December 31, 2008.

As you can see in the table, venture returns across all horizons outperformed public market indices, NASDAQ and the S&P 500, through December 31, 2008.

Venture Capital Funds Return Are Still High Compared to NASDAQ or S&P 500

You can read more from NVCA website:

http://www.nvca.org/index.php?option=com_docman&task=doc_download&gid=424&Itemid=93

Hard Math from Flickr

In my last post – Venture Capital Method: Valuation Considering Granting Stock Options to Management Team: http://www.chimkan.com/2009/05/05/venture-capital-method-valuation-considering-granting-stock-options-to-management-team/

I showed how to calculate the needed number of share if we give at least 15% of stock options to the management at the end of 5 years.

Remember the imaginary story from John and Ada from the last post?

John Doe is an entrepreneur who wants to raise $ 10 million so he can launch his clean energy product for the energy industry. He conservatively analyzed that the net income will be 10 million in five years. Also, the price earnings ratio is 15X in comparable companies.

Ada Li, Dream Capital, loved Doe’s plan, but she recommended that the management team should be rewarded at least 15% share of the company at the end of 5 years. Also, she needs a rate of return of 40%.

Now, Ada and John think that they will need another round of financing at the beginning of the third year. John probably will need another $ 4M.  Ada still wants to keep her rate of return at 50%, but she believes from her experience that the second round of investors will requires only a 30% of rate of return because of the progress made in the company. Keep in mind that Ada still wants to reserve 15% share of the company to the management.

• Ada wonders what the share she needs today is.
• On the other hand, what will the second round investor look for?

To answer these questions, let’s do some step-by-step work:

Steps 1 – 8 were taken from the last post:

Step 1 – John’s company has currently 1,000,000 shares.

Step 2 – John needs $ 10 M

Step 3 – Value of the company in 5 years: $ 10 M X 15 = $ 150 M

Step 4 – Ada wants a rate of return of 40% = $ 10M(1.5)^5 = $ 53.78M

Step 5 – Ada wants that the management has 15% of the company in 5 years: 15%

Step 6 – Given that at the end of five years, the management will have 15% of the shares, so this left $ 22.5 M for the management and the remaining value to John and Ada, which is $ 127M.

Step 7 – Ada hopes to receive $ 53.78M regardless of the 15% given to the management.

Step 8 – So, she decides that she needs to own: 42.18% of the company. [Calculation: $53.78M/$ 127M = 42.18%]

Step 9 – What is the amount of ownership the round 2 investors needs? (They need a rate of return of 30% for 3 years and investing $ 4M) >>> $ 4M*(1.3)^3 = $ 8.78M

Step 10 – Remember, that we need to give 15% of the company to the management, so the required share for round 2 investors are based on this: $ 8.78M/$127M = 6.9%

Step 11 – What is the percentage Ada needs to keep her investment fine knowing that her equity will be diluted by the next round of investors and the management?

42.18%/(1-6.9%) = 45.3%

Instead of 42.18%, Ada will need 45.3% percent of the company now.

Step 12 – John will need to issue …

X(1,000,000 + X) = 45.3%

0.55X = 453,000

X = 823,636 shares

Price per share >>> $ 10 M/823,636 shares = $12.14/share 

Step 13 - Let’s add John’s and Ada’s number of shares = 1,000,000 + 823,636 = 1,823,636 shares

Step 14 - Round 2 investors will need:

X/(1,823,636+X) = 6.9%

0.931X = 125,830

X = 135155 shares

Step 15 – The new investors will need to pay…

$4M/135155 shares = $ 29.6/share

The answer:

Ada wonders what the share she needs today is.

A: Ada will need 823,636 shares at $12.14/share

On the other hand, what will the second round investor look for?

A: Round 2 investors will need 135,155 shares at $29.6/share

The next post will show further dilution of John’s equity if the something goes wrong with the company.

I was searching for more news about venture capital industry and I found out this bad news from Boston.com.

Venture capital sector makes adjustments

Highlights from this news:

- Last year, our industry raised about $28 billion in new investment capital, but VC industry will raise around $8 billion and $12 billion, nationally

- The shrinkage of Boston’s venture capital sector will be tough for the venture capitalists (It was expected anyway, it is losing pace against Silicon Valley and other places)

- The upshot is that venture capital firms will be managing smaller funds, and some firms will go out of business.

- Fewer firms and smaller funds will obviously mean fewer jobs for venture capitalists and the staffers who support them.

 

News about series funding or staged investments from venture capitalists

 In this third post, I’m going to explain why venture capital firms invest in stages and not in a one-time-big-investment and why Facebook is receiving rounds of investments.

Venture capitalists want to have some control in their investments. By staggering their investments in rounds, they can evaluate if the startup should receive more money or not. In this way, the VCs can monitor the entrepreneur’s progress and gather additional information to make a sound investment.

From the book “The Venture Capital Cycle – 2nd edition” on page 173, we have the Apple Computer’s story that illustrates this well:

“Apple Computer received three rounds of venture capital financing. In the first round, venture capitalists invested $518,000 in January 1978 at  a price of $0.09 per share. The company was doing well by the second round of venture financing in September 1978. Venture investors committed an additional $704,000 at a price of %0.28 per share, reflecting the progress the firm had made. A final venture capital infusion of $2.331 million was made in December 1980 at $0.97 per share. At each stage the increasing price per share and the growing investment reflected resolution of uncertainty concerning Apple’s prospects.”

Besides, these rounds of investments may have some names such as Series A round or B or C or even D rounds.

From the entrepreneur’s side, these round of investments may mean that they achieved a milestone event such as breakeven, getting their 1,000,000 customer, having the patent granted, having the drug trial phase IV passed, etc.

Back to the Facebook and Accel example:

“Facebook received its first investment of US$500,000 in June 2004 from PayPal co-founder Peter Thiel.[25] This was followed a year later by $12.7 million in venture capital from Accel Partners, and then $27.5 million more from Greylock Partners.[25][26] A leaked cash flow statement showed that during the 2005 fiscal year, Facebook had a net loss of $3.63 million.”

So, in this little paragraph, we see that Facebook had at least 3 rounds of investments until 2005.

- Peter Thiel: US$ 500,000
- Accel Partners: US$ 12.7 million (Accel invested probably because Facebook achieved some milestone)
- Greylock $27.5 million (Greylock invested probably because Facebook achieved some milestone, but probably it had to pay more for less share)

Much later, we had the Microsoft’s investment of $240 million.

Let’s pick up Accel’s investment and see how its investment increased in value.

“Among venture capitalists it’s a poorly kept secret that Facebook’s valuation came in just shy of $100 million. Assuming that’s true (Mr. Breyer declined to say), Accel paid a little more than $12 million for roughly a 15 percent share.”

Usually, when a company receives a round of fund with increasing value (a higher price-per-share), no previous investors requires more shares of the company. If the company has a “down-round” which means that the price-per-share of the latest round is lower than the previous one, usually the VCs requires more new shares to compensate for their loss in the valuation. I will explain this in other posts.

So, in later reports, Accel still has 11% of the company. This means at the time of Microsoft’s investment, Accel’s investment was valued from US$ 12.7 million to US$ 1.65 billion. That’s an increase of 130 times of their initial investment!

Other VCs and investors invest in Facebook because they hope that their shares will have a similar increase value of their investments.

You wonder if this is the way VC makes money. This is simply the value of their investment; however, they need to “transform” their shares of the company into money.

This transformation is what VCs call “exiting event”.

The “exiting event” can be divided into four types:

- Staying private

- IPO

- Bankrupt

- Acquired / Merger

In the part 4 of this post, I will show what would happen to Accel’s investment for each of the exits. Then, we conclude how VC firms make money.

The news that you saw from the image were taken from these pages:

Twitter Raises $35 Million Series C From Benchmark and IVP

MARINUS PHARMACEUTICALS RAISES $20 MILLION IN SERIES B FINANCING

Wozniak’s storage startup Fusion-io raises $47.5M more

Irvine Chip Startup WiSpry Nabs $10M Funding

Background information:

Accel Partners is a private equity and venture capital firm. It invests in many industries such as Computing, Consumer Internet, Engergy, etc (there are 11 industries).

Increadibly, Accel has invested in 197 companies (I did not count one by one but I use a smarter way to count). It is based in Palo Alto, Californa and it also has in London, China and India. It was created on 1984 and there are some famous companies invested by them, Real Networks, Facebook, Veritas, Comscore, BitTorrent and Macromedia (the creator of Dreamweaver, Flash, etc.)

Also incredibly, Accel was able to raise almost 1 billing of dollar at the end of 2008, when the Global economic downturn started.

Read more at its website

Facebook is a social network website. Basically, it is a virtual place where people communicate and share their lives in an easy way. It was created by Mark Zuckerberg and his classmates in Harvard University in 2003.

You can read more about Facebook here.

Now we are ready to visualize how a VC firm can make money (I will need to write more than a post for this, be ready).

If you read from the Wikipedia page at the Financials section, you read that:

“Facebook received its first investment of US$500,000 in June 2004 from PayPal co-founder Peter Thiel.[25] This was followed a year later by $12.7 million in venture capital from Accel Partners, and then $27.5 million more from Greylock Partners.[25][26] A leaked cash flow statement showed that during the 2005 fiscal year, Facebook had a net loss of $3.63 million.”

We are not going to focus on the net loss this time. I may discuss this later posts.

Searching a little bit the Internet, we get:

From New York Time, Facebook and Venture Capital Firms

“Among venture capitalists it’s a poorly kept secret that Facebook’s valuation came in just shy of $100 million. Assuming that’s true (Mr. Breyer declined to say), Accel paid a little more than $12 million for roughly a 15 percent share.”

Chim’s comment: I added some other paragraph just to give you a glimpse of what was being discussed there. You can click the paragraph to the news directly.

As you can see, Accel paid, very probably (you can see from the last post that this is almost exactly what Accel had with the Microsoft valuation), $ 12M for 15% of Facebook that time.

“And back in 2006, social-network valuations sky-rocketed accordingly.

There was the $800 million acquisition offer from Yahoo that Facebook reportedly rejected, the $2 billion Facebook wanted and the $25 million in venture capital Facebook got from Greylock Partners in April. In September, RBC Capital markets analyst Jordan Rohan said MySpace might be worth $15 billion in three years. The same month, Google bought video-sharing site YouTube, with is social features such as profiles and friends lists, for $1.6 billion.”

Chim’s comment: Something is impressive here. Big companies, such as Yahoo!, were buying social networks for about $500 – $800 million at that time. This means that the value of social network sites were in this range price. One very interesting thing is the Jordan’s (from RBC Capital) comments “MySpace might be worth $ 15 billion in three years”. He missed, it was Facebook that was going to be valued at $ 15 billing in less than 3 years.

Venture Beat - Facebook and VC firms

“It has never been our intention to sell the company,” said Melanie Deitch, Facebook’s director of marketing, adding that the latest funding puts the rumors of such a sale to rest. Late last month, Business Week reported the company had turned down a buyout offer for $750 million and was looking for as much as $2 billion, citing analysts saying that Viacom, owner of MTV, might make a good match.

David Sze, the venture capitalist who led the investment for Greylock, said earlier statistics from comScore showing a decline in unique visitors in February were an aberration, and that the company’s internal statistics show continued robust growth. Indeed, the March statistics showed resumed growth on this metric too.”

Chim’s comment: As you can think, big companies were trying to buy Facebook for $750 M range. The second paragraph is interesting about the statistics from comScore. It is not the first time that comScore misreport numbers about visitors for a site. Sometimes, misleading news are spread to push negotiation… not in this case, I guess.

WebProNews - Facebook and VC firms

“Venture capital funding provided by Greylock Partners and other firms totaling $25 million placed a value of $525 million on Facebook, which reportedly turned down $750 million from Viacom.”

Chim’s comment: What I really want you to focus is the first paragraph. Greylock Partners and other firms valued the company at $525 million! This number is important to establish the pre-money and post-money valuation. With this info, we are able to estimate the approximate percentage of the company’s equity being sold.

Seattlepi.com - Facebook and VC firms

“New York-based News Corp., whose far-flung media properties include Fox Broadcasting and 20th Century Fox, spent $3.5 million for an undisclosed stake in Mountain View, Calif.-based SimplyHired. It bought MySpace.com last year for $580 million.”

Chim’s comment: So, on 2005, Fox bought MySpace for $580 million. Again, this reinforce the probable value range ($400M – $800 M) of a famous social network site.

At the end, we see that Peter Thiel got XXXX % (I can’t find the info, but this does not matter in our discussion of how a VC firm makes money rfom now) of Facebook with US$ 500,000 in June 2004, Accel Partners invested $ 12.7 million for 15 % (let’s say that New York Times is right) and Greylock Partners invested $27.5 million for XXXXX %.

Tomorrow, I will post the calculation of what is the percentage that Greylock Partners got with $ 27.5 million.