CASE STUDY: THINK PAD INC. (a VC firm's investment process)

Venture Financing: Process and Selection Criteria

The following is a case study describing a fictional VC firm's investment process.

Ralph has worked as an Associate at New Money Ventures, L.P. for the past two years. He has sourced nearly 1,000 leads of which his firm selected one for investment. This investment provided a 5-to 6-time return on investment (ROI) for New Money Ventures, L.P. In venture-speak, a 5-to 6-time ROI is considered "a double." If Ralph keeps hitting doubles, he will do well in the venture business; however, his ambitious nature drives him to want to be one of the very best in the industry.

To be a premier venture capitalist, one must "hit a home run." If a company that a venture capitalist invests in has a return on investment anywhere from 20 to 100 times (or more), then the deal can be considered a "home run." Venture-backed companies like Apple, Microsoft, Novell, and Federal Express are a few good examples of "home run" deals.

Like most Associates, Ralph attends quite a few trade shows. One fortuitous day, Ralph decided that he should attend the Propeller-Head Trade Show. After a couple hours of walking the trade show floor, Ralph left with his standard five or six trade show leads. One lead was unusually intriguing. A company that he had never seen before, Think Pad, Inc. (TPI), had an extremely interesting, soon-to-be-released product called ThoughtProcessor 1.0. The ThoughtProcessor product enabled users to access all of the functions of a computer merely by thinking. With it one could write a document in a word processing program or create a spreadsheet without having to type a single letter on a keyboard. Although the 1.0 version of the product had a few bugs, it had the potential to stimulate a paradigm shift in the computing industry.

While at the trade show, Ralph introduced himself to the CEO of TPI, Mr. Herman I. S. Slick. Ralph pointed out to Slick that a partnership with New Money Ventures, L.P. could be beneficial. In addition to providing TPI with the financing to finish their R&D work, New Money could add credibility to their board, help recruit a strong management team, and aid the company in making strategic decisions throughout the delicate process of growing a company and taking it public. Slick had declined many VC firms' advances lately because he had not been convinced that they could offer much value beyond money. However, he was intrigued by Ralph's proposition and by New Money's previous success in the software industry. He considered the idea of a start-up/first round of financing with New Money.

A few days after their meeting at the Propeller-Head Show, Ralph called Slick at TPI's headquarters in Seattle. Ralph and Mr. Slick talked about TPI's product line, market, distribution channels, sales model, and management team. Mr. Slick projected that within three years Think Pad could be a $100 million (gross annual revenue) company. Over the last two years, Ralph had encountered hundreds of entrepreneurs who thought that their products could produce annual revenues of $100 million. He remained skeptical. Even with his conservative mindset, however, he was impressed both by the background of the management team and by Snail's quick mind, technological expertise, and market understanding. Ralph asked Slick to send him the ThoughtProcessor product and a business plan.

Venture Financing: Key Documentation To Be Prepared by the Entrepreneur

The following day Ralph received a FedEx package from TPI. Ralph read the plan and then loaded the ThoughtProcessor software into his computer. Ralph put the special infrared panel onto his monitor and fixed the infrared goggles on his head. Once the software was running, Ralph looked at the screen and thought "Open Microsoft Word." Microsoft Word began to load. He then thought "Open New Document." A new document appeared. As he composed a letter in his head, his thoughts appeared in type on the screen. Ralph was impressed.

Ralph brought the business plan and product to Reginald Eugene Xavier, New Money Venture's Managing General Partner, who was known in the venture community as Bob. After a brief demonstration, Bob made arrangements to fly to Seattle.

The following day Bob met with Slick and Henry, the VP of Technology who was the genius behind the creation of the ThoughtProcessor product. Impressed by their story and confident of Snail's willingness to work with New Money, Bob returned to Boston and began the due diligence process. He and Ralph called everyone who knew about Slick, Henry, Think Pad, and ThoughtProcessor 1.0 and they spoke with industry analysts who had tested a beta version of the product.

Once Ralph and Bob completed their due diligence checks, Bob was ready to hammer out the details of the investment. After a little negotiation between Bob and Slick, they both agreed to a deal structure where New Money Ventures, L.P. acquired a 25% equity stake in TPI for $2 million. Upon completion of the investment, Bob joined TPI's board.

In the ensuing months, Bob helped Slick recruit a VP of Marketing and a VP of Sales. While they had planned to raise an additional $10 million in a second round of financing to fund their major sales and marketing push, the strategic marketing relationship that Bob had helped Slick establish with Microsoft eliminated the need for a large sales force and provided TPI with enough cash flow to prosper.

Two years later, TPI went through the rigorous process of going public. Bob coached Slick and Henry for the road show -- an intense series of meetings with industry experts and investment bankers. These meetings provided TPI with an opportunity to educate the investment community about their story and to gain support for their public shares.

All the hard work paid off. TPI went public with 10 million shares outstanding at $20/share. Within three months, the stock shot up to $40/share, providing New Money Capital, L.P. with a 50 times ROI.

Thanks to New Money Ventures, L.P., TPI was able to turn their technology into an extremely profitable business. Thanks to TPI, Bob and Ralph "hit a home run."

A word to the wise. When your stock restrictions finally come off, you may see a big drop in your stock's price just a few days before. This drop in price is caused by the professionals shorting your stock, because they know that you will want to cash in a few shares to celebrate. Just wait three weeks or so and the stock will recover.

A personal friend, whose company is now worth over $300 million, lost big dollars in this way and asked us to pass on the advise. You have been warned. Pass it on.