1©Twoeyes 2011

Equity Marketing for the Savvy Entrepreneur

The Blueprint for raising money at the highest price, with minimal loss of ownership and control.

Conor McKenna

©Twoeyes 20112

The most important sale a high-growth venture can make is the sale of its shares to an equity investor. After a well-planned Equity

Marketing campaign, the savvy entrepreneur should be in the position to close the deal at the highest price and with minimal loss of

ownership and control.

What is Equity Marketing?

Equity Marketing is the systematic process developed by Twoeyes that helps entrepreneurs prepare and position their company to

raise milestone-based venture funding through the sale of shares to a series of equity investors, with each investment round priced at

a premium, on terms that are most favourable to existing shareholders.

What is Involved?

The Equity Marketing process is defined by a strategic sequence of 5 key stepping-stones, with each stepping-stone comprising a set

of integrated milestones that can be individually measured, monitored and costed.

The 5 key stepping-stones are:

1. Venture Planning

2. Deal Preparation

3. Equity Marketing

4. Transaction Completion

5. Post-investment Fulfillment.

For the purposes of clarity, this booklet follows the same logical sequence.

Who is Equity Marketing for?

The Equity Marketing Process can be applied at any stage of enterprise growth. It is designed for Entrepreneurs, Business Owners,

Boards and CEO’s of companies of high-value potential that are seeking to raise growth and expansion funding from equity investors.

Who Benefits?

Equity Marketing has one specific goal – to maximise the wealth position of existing shareholders.

www.twoeyes.com

Copyright © Conor McKenna 2011

All rights reserved. This publication may be reproduced, stored in a retrieval system or transmitted in any form by any means for personal use without the permission of the copyright owner. This publication may not be sold or resold for any fee, price or charge without the permission of the copyright owner.

Every effort has been made to ensure that this book is free from error or omissions. However, the Author shall not accept responsibility for injury, loss or damage occasioned to any person acting or

refraining from action as a result of material in this book whether or not such injury, loss or damage is in any way due to any negligent act or omission, breach of duty or default on the part of the Author.

3©Twoeyes 2011

INTRODUCTION

THE GOLDEN RULE

Raising venture funding and investing for equity has been called “the great financing game”. It’s a game whose rules of engagement,

playing conditions and plan of attack – and usually the final score – are dictated by the money.

As an early investor of mine said to me as he withheld critical funding to force me off the Board of the company I founded, “It’s the Golden

Rule, mate – he who has the gold makes the rules”.

If entrepreneurs and business leaders want to raise money, maximise their ownership position and get rich through the eventual sale

of their company, they need to become proficient in the way equity investors play the game.

There are two teams of players in this game of high drama – entrepreneurs and business owners on the one side all working

diligently to build and grow a successful business. On the other are wealthy private investors, professional investment managers

of Venture Capital and Private Equity funds and senior executives of large corporates looking for investment opportunities -

commonly known as Angels, VC’s and strategic corporates.

Blowing whistles on the field and waving the flags on the sidelines are the array of accountants, lawyers, investment bankers and other

professional advisors who get involved at various stages of the game and whose fingerprints are all over the documents and invoices

surrounding an equity transaction.

As the majority of entrepreneurs are cash-strapped and have never experienced the capital raising process before, they face little

alternative but to play the game on a field that’s been market-out by the investors and their side-kicks and henchmen.

Serious investors have honed and matured their investing skills through years of deal-making and the experiences gained from the

accumulation of great wealth. Able to afford the best and brightest stars from the deep ranks of professional advisors, they are the

ones with the experience, resources and networks.

Novice entrepreneurs are at a huge disadvantage the moment they start to play the game – like David was when he fronted the biblical

giant, Goliath. In most equity deals, the underdog entrepreneur gets out-smarted, screwed over or simply crushed by the sheer power

and size of the opponent.

However, like David, it is still possible for an entrepreneur to cast a slingshot and fell the bigger foe, using skill and mastery over brawn

and size.

Savvy entrepreneurs can beat the money at their own game by getting smarter about the rules, studying match-winning tactics and

rehearsing their moves before they ever venture into the fray.

As the old saying goes, “If you can’t beat them, join them”.

Understanding Equity Capital

The main reasons that businesses require new equity are to commercialise new products and services; to commence commercial

operations; to finance a growth strategy; to change the ownership structure; to restructure the business, or to change the capital

structure of the business (“recapitalise’).

According to the Australian Venture Capital Guide, the venture capital industry classifies Equity Capital by different business stages

according to these entrepreneurial needs. The main stages of Equity Capital are:

Seed Capital: This is funding for a pre-revenue venture to support business formation, complete adequate business planning for

subsequent stages, reinforce technology/product uniqueness and develop and prove new products and services to a commercial-

ready stage.

©Twoeyes 20114

The seed stage starts with the idea to form a new business and ends when it is ready for its first commercial sales and revenue.

This stage is typically funded by the entrepreneur, through investments and loans from friends, family and ‘the faithful’, as well as

through government grants and angel investment. Although largely funded by the entrepreneur’ own resources, some Angel investors

participate in this stage. Unless the technology or product is so compelling and is in a very large and global market with a clear exit

strategy within 3-5 years, it is most rare for Venture Capital firms to invest at this stage.

Start-up Capital: This is funding to commence commercial business operations. Start-up refers to commercial start-up: when the new

business starts taking and fulfilling commercial orders but is yet to make profit.

This stage is typically funded by winning more government grants and raising further rounds of Angel investment. It is common for a

large corporate with a strategic interest in the new technology, product or service to aid in its development and commercialisation for

a promised future benefit. In the current funding environment, it is also rare for Venture Capital firms to get involved at this early stage.

Early Expansion Capital: This is growth funding for a relatively new business that is making sales but no profits. Where the venture has

a compelling value proposition or a unique technology solution, Angel investors would tend to be very attracted to investing at this

stage. It would not be uncommon to see groups or syndicates of Angels coming together to pool their capital, knowledge and other

resources and spread their risk. While it is not unusual for Venture Capital firms to invest at this stage, it is likely too early for the larger

funds to be interested.

Expansion (or Development) Capital: This is growth funding for an established company that is making sales and requires capital for

further growth and expansion. The company is likely to have made operating profit at this stage but is unable to generate sufficient

cash to fund major expansions, acquisitions or other investments. This may be a period of rapid growth and the company will usually

require several rounds of capital injection as it achieves the investment milestones set in the business plan. Venture Capital firms

typically invests at this stage, when the entrepreneur has proven the viability of the business, has a track record of sales and some

profits and is seeking expansion finance to expand or restructure operations, develop new and/or export markets or finance a

significant acquisition.

Value

Gestation

Expansion

Rapid growth

Rollout

Prototype

Inception

Venture Capital Firms &Strategic Corporate Investors

Banks, Private Equity Firmsand MBO/MBI

Angel FinancingFounders

IPOAcquisition

Maturity

TimeFamily

The Venture Pathway

5©Twoeyes 2011

Vision

Mission

Values

Follow-on

Fu

ndin

gCam

paign

Exit Strategy• IPO• Trade Sale• D

ivestment

• MB

O/M

BI

• Succession

Strategic Plan• Key Steppin

g Stones

• Fun

ding Plan

• KPIs

Operation

s PlanK

PIs

PeoplePlanK

PIs

Finan

cial PlanK

PIs

SalesPlanK

PIs

Marketin

g PlanK

PIs

Equity

Marketin

g

Mileston

e Perform

ance

Review

Investment

Tranch

e 2Post-investm

ent Fu

lfillment

Equity

Marketin

g Strategy• Produ

ct• Price• Place • Prom

otion

Equity

Investment

Bu

siness Plan

Investor In

formation

M

emoran

dum

Investor Briefin

g D

ocum

ent

Elevator Pitch &

Investor Presentation

Deal Preparation

InvestorD

ue D

iligence

Shareh

olders’ A

greement

Post-mon

ey Valu

ationTran

saction

Completion

Negotiation

s

Investor Presentation

s &

Meetin

gs

Term Sh

eet &

Strike Price

Investment

Tranch

e 1

Liquidity Event

• IPO• Trade Sale• D

ivestment

• MB

O/M

BI

Reverse D

ue D

iligence

Checklist

Value-en

han

cing

Mileston

es

CapitalA

llocation

Table

Draft Term

Sh

eet

Confidentiality

Agreem

entTem

plate

Draft

Shareh

olders’ A

greement

Company

Constitu

tion

Pre-mon

ey Valu

ation

Company

Constitu

tionPost-m

oney

Valuation

Capitalisation

Table

Ventu

re Plan

Twoeyes Equity Marketing Blueprint

©Twoeyes 20116

Management Buyout (MBO): This is funding to enable the current management team to buy-out the existing owner(s) of a business.

Private Equity firms are typically most active in this section of the market.

Management Buyin (MBI): This is funding to enable a new management team to buy into a business. Private Equity firms are typically

most active in this section of the market.

Leveraged Buyout (LBO): This is a buyout that is funded with both equity and debt. LBOs include but need not be MBOs and MBIs.

CHAPTER 1 VENTURE PLANNING

VISION, MISSION, VALUES

The most vital role the entrepreneur must play is to see the future first, creating the Strategic Vision of his business as it will be when

it is fully developed.

When it comes to planning for a significant liquidity event in the future, my advice to the entrepreneur is to always “Start with the

end in View”. Binocular vision is needed here – one eye needs to clearly see the future potential of the business at a commercial level,

while the other eye needs to be on the prize – a significant liquidity event that provides a profitable exit for current and future investors

within a reasonable and realistic timeframe.

As well as providing a clear strategic focus for the business, a well-crafted Strategic Vision is a powerful selling tool, able to inspire key

stakeholders: the market in general, customers, employees, suppliers, current and future investors, etc.

A compelling Vision can also whet the appetite of potential suitors – most likely strategic corporates seeking a bolt-on acquisition and

who share the vision for the unlocked potential in the business.

A strong Strategic Vision starts with a well considered Vision Statement which should be short and pithy – a one-line “Grab” is ideal and

once conceived, should remain unchanged unless approved by the Board of the company.

A good example is from Kid Sense Child Development, a South Australian paedeiatric services organisation that works with kids with

developmental challenges. Kid Sense’ vision is summed up in one line: “Creating the most trusted brand in child development, globally”.

Another example is Equity Club’s, the South Australian initiative to develop a more formalised and informed venture community: “Stimulating

the Capital of South Australia”.

The company’s Mission statement should be derived from the Vision Statement and should be a short and direct summary of the

company’s Strategic Plan over the next 5 – 10 years.

It should include strategic stepping stones made up of a number of key milestones and quantifiable targets and dates. Effectively the

Mission Statement is the short version of the company’s Strategic Plan. As such, it is a very important section and should be written

diligently and updated regularly.

A checklist of things to include in the Mission Statement is as follows:

General Characteristics:

• Targetdate(yearstocompletion)

• Thebusinessyouareinandyourproductsandservices

• Companysize(annualsales,annualprofits,companyvalue,numberofemployees)

• Companygrowth(sales,profits,production)

• Geographicscope(locations,markets)

• Marketpositioning,targetmarkets(s)

• Basisofcompetition(price,quality,service,etc.)

7©Twoeyes 2011

Distinctive Characteristics:

• Brands,Product/Servicelines

• Marketing

• Behaviourofemployees

• Presence(look,sound,feel)

• Operations

• Systems&Procedures

Using Kid Sense as an example once again, the following is their Mission statement:

“On 31 December 2018, operating profitably& efficiently in a strategy-focused, systems-driven, people-friendlymanner from a

growing portfolio of purpose-built, company-owned Child Development Centres strategically located across Australasia, Kid Sense

ChildDevelopmentCorporationisamulti-nationalorganisationwithstrategicpartnersinNorthAmerica,UK&Ireland,Europe&Asia

Pacific and is recognised by its target market as ‘the most trusted brand in child development, globally’.

Headquartered in Adelaide, the core focus for our operations are in the major Australian cities, with long-term licensing arrangements

in place with well-established strategic partners in selected North American, European and Asian cities, particularly in USA, Canada,

Ireland,UK,NewZealand,China,HongKong&Singapore.

‘Developing a Brighter Future’

‘Constant And Never-ending Improvement’

STRATEGIC PERSISTENCE‘Stick to plan’

‘Never, never, never give up’‘There’s always a better way’

STAKEHOLDERS

PROMOTION

PROCESS

PLACE

PRICEPE

OPL

E

PRODU

CT

‘Be brilliant at the basics’

‘Do the Right things right’

‘Start as you mean to finish’

INTEGRITY O

F PURPO

SE

‘If it

’s no

t mea

sure

d, it

’s no

t man

aged

’

‘Focu

s on

the

3 th

ings

that

mat

ter m

ost’

‘Sta

rt w

ith th

e en

d in

view’

CLAR

ITY

OF

VISI

ON

©Twoeyes 20118

By this time:

• weownandoperateapproximately15purpose-built,premium-brandedChildDevelopmentCentresacrossAustralia,eachcentre

being strategically located in the metropolitan area that best matches its target market demographic.

• wepartnerlocallywithapproximately150multi-disciplinaryprofessionals,andoperationalsupportpersonnel,whoarerecognised

as expert in their field.

• AustralianrevenuesexceedAU$50Mannually”.

• Wearepositionedasanattractiveacquisitiontargetbyastrategiccorporatebuyer.

Values

Corporate Values are usually a collection of motherhood statements that don’t mean much and are largely passed over. In my view, not

enough strategic thought is given to establishing a strong set of values for a venture before it grows into a large organisation.

After more than 2 decades in commercial ventures, I have learnt that successful business boils down to 2 things – People and

Communication. All else is commentary.

Hiring the key people with the right mix of Ability, Attitude and Vision is without question one of the hardest - and potentially most

rewarding - challenges. How they comport themselves and the basis for the decisions they make while engaged by the business is a

fundamental issue of communication.

The business needs to have a clear set of values – or Guiding Principles – against which its representatives and operatives can turn to

for direction on what is accepted and expected behavior, both internally and externally.

Using Kid Sense again as an example, the following is the Values Wheel that was developed by the core management team and is

clearly displayed on the website, in the printed Company Profile and is prominently displayed in the Guest Lounge for clients to see.

The importance of crafting a clear and focused vision cannot be understated. It is the job of the entrepreneur to develop a vision that

is deep and compelling enough to attract and assemble a team of passionate and committed stakeholders who collectively can work

with you and for you to plan and execute a strategy that will deliver profitable growth through strong marketing and innovation, while

mitigating key risks in the eyes of the next round of investor.

When it’s done, everyone has a clear sense of direction and goals – a target for the future, a basis for decision making, planning and

business development activities.

But it’s not enough for you, the entrepreneur to have a vision – that is just the first step. You have to give it life, communicate it keep it

growing and vibrant, alive in the minds of everyone in the company and keeping the company moving towards it.

It Works. Just ask Tom Watson, the Founder of IBM. Here’s what he had to say about it:

“IBM is what it is today for 3 special reasons:

The first reason is that, at the beginning, I had a very clear picture of what the company would look like when it was finally done. I had

a model in my mind of what it would look like when the dream – my vision – was in place.

The second reason was that once I had that picture, I asked myself how a company which looked like that would have to act. I then

created the clear picture of how IBM would act when it was finally done.

The third reason IBM has been so successful was that once I had a picture of how IBM would look when the dream was in place and how

such a company would have to act, I realised that, unless we began to act like that way from the very beginning, we would never get there.

From the onset, IBM was fashioned after the template of my vision. And each and every day we attempted to model the company

after that template. At the end of each day, we asked ourselves how well we did, discovered the disparity between where we were and

where we had committed ourselves to be, and, at the start of the following day, set out to make up for the difference”.

9©Twoeyes 2011

Once you start with the end in view, you can focus on what is needed to get there, recalibrating regularly to ensure you change.

But the converse is true - when a company becomes unfocused, it loses its inherent power. When an entrepreneur becomes unfocussed,

they lose their balance and start the death spin.

The successful business will focus like a laser on its Strategic Vision, clearly defining its Strategic Targets over the next 3-5 years. The

Board and CEO should agree just 3 corporate objectives for the next 12 months and develop a detailed plan of action for each objective,

reviewing progress daily, weekly, monthly, quarterly and annually. And it will communicate a clear set of values to guide its stakeholders

about how the company must comport itself.

From Clarity comes Focus. From Focus comes the Power to Act.

Exit Strategy

The entrepreneur or business owner needs to develop a Strategic Plan that describes the Vision and Mission of the company and

includes a high-level growth strategy and funding plan over the next 5 – 7 years as well as a strategy-driven operational plan over the

next 3 – 5 years.

The growth strategy should lead to a number of realistic avenues for exit, with each potential exit opportunity being big enough for

early investors to get a 10 to 20 times multiple return on their investment.

Known as the Exit Strategy, this is the point at which a significant liquidity event occurs in the form of an Initial Public Offering (IPO) on

a Stock Exchange, a sale to a corporate buyer (a Trade Sale) or a leveraged buyout by the existing – or new – management (MBO/MBI).

With IPO’s reserved for only the very few companies, the most common exit strategy is a strategic sale of the company and/or its assets

to a corporate buyer.

The savvy entrepreneur will seek to sell the strategic and unlocked potential of their company rather than value it on historical financial

performance and projected earnings through a Discounted Cash Flow (DCF) approach.

According to serial entrepreneur, equity investor, author and presenter, Dr Tom McKaskill, “very few companies can choose the timing of their

acquisition. Most are forced into a sale by external events or through poor management. A smaller number are approached by a potential

buyer and take the opportunity to sell. Only a very few control the timing of their acquisition by taking the initiative to find – and prepare the

company to strategically fit - a buyer when they are not under pressure to sell.

When it comes to the strategic sale process, a businesses that creates perceived value by enabling a large corporation to exploit a

significant future revenue opportunity through the combination of the two companies, builds value by developing strategic assets and

capabilities which the large company will go on to exploit.

In a strategic acquisition, a small business can often provide the means by which a large corporation can quickly generate many times

the purchase price by leveraging its own assets and capabilities alongside those being acquired.

Positioned strategically, such acquisitions are made - not on the basis of the historical profits - but on the value that can be generated

within the combined entity.”

In short, when it comes to a strategic sale, it’s not past profits that matter - it’s the potential future profits that count.

The key to the strategic sale is to create the right strategic opportunity for a targeted, pre-qualified buyer. To do this, it is necessary to

move away from the balance sheet and the income statement and focus on the buyer’s opportunities and threats.

By focusing on these key areas, the size of the opportunity and/or threat becomes the metric against which an acquisition price is

negotiated rather than on the seller’s net worth.

©Twoeyes 201110

Strategic Plan

Much strategic thinking is needed in developing a plausible exit strategy – with options – in order to prepare the company for equity investment.

All investors will need to clearly see how the entrepreneur plans to provide them with an opportunity to harvest their investment within a

reasonable – 3 to 5 year – timeframe.

The planned development of the venture over the next 5 or so years should be broken down into three to five key strategic stepping

stones on the way to the ultimate prize.

The best strategic stepping stones are the ones the company can point to with hard evidence and that demonstrate real momentum

in the progress of the business.

This handful of strategic stepping stones should become the funding blueprint for the business: a high level funding plan linked to the

achievement of each stepping can be developed. By allocating expenditure to stepping stones along the way, the funding plan should

indicate how invested monies will be spent and value created at each stage.

START UP EARLY PRODUCT MARKET ENTRY MARKET PENETRATION TRADE SALE

AngelFunding-$500K SeriesA-$2M SeriesB-$3M SeriesC-$4M SeriesD-$1.5M

Develop Business Plan Hire 10 Technologists 2 Development

Partners

Proven Sales Economics

(Margins)

MarketSize$XM

Alpha Product Beta Product Limited Product

Release&Early

Revenues

Aggressive Market

Rollout

Position of Market

Leadership

Raise$2M Hire experienced CEO Full team build out Internationalisation Four to six potential

buyers of the company

Series A Investment $2M

Family & Angels $500K

Series B Investment $3M

Series C Investment $4M

Series D Investment $1.5M

Stepping Stone: Q1 11

Stepping Stone 2: Q2 12

Stepping Stone 3: Q4 13

Stepping Stone 4: Q4 14+

TIME

VALUE

Start Up

Early Product

Market Entry

Market Penetration

Trade Sale

11©Twoeyes 2011

According to Dermot Berkery, an Irish Venture Capitalist, this concept of building a valuable business through multiple staging posts,

each of which is financed separately, is the core tenet underpinning entrepreneurial finance.

In his excellent book, ‘Raising Venture Capital for the Serious Entrepreneur’, Berkery goes on to say that each strategic stepping stone

represents an integrated set of value-enhancing commercial milestones for the company. The milestones might relate to intellectual

property protection, product development and completion, reference sales and the acquisition of key customers, new market entries,

moves to thwart competitors and recruitment of key hires, as well as the associated investment round to finance all the activities on

the way to meeting the milestones.

Funding Strategy

The series of strategic stepping stones should seamlessly match the funding strategy for the business. If the entrepreneur has

established a workable set of say 4 strategic stepping stones over 5 or 6 years and if the management team executes the plan well, the

company will raise about four rounds of investment in the course of its development. In the parlance of Venture Capital, these rounds

are called Series A, B, C, and D.

The Series A funding round should be big enough to get the company to Stepping Stone 1 (with some margin for error since plans

generally take longer to execute than expected).

Some entrepreneurs might be tempted to raise enough money to take the company to Stepping Stone 2 and beyond – if it can find a

willing investor. However, this misses the point.

At the start-up, the company will likely be at its lowest valuation of its existence. Therefore, if it raised the capital to get it all to

Stepping Stone 2 and beyond, initial shareholders would suffer far more dilution in their ownership percentages than is necessary.

The savvy entrepreneur will raise just enough capital in the Series A round to complete on Stepping Stone 1 and raise more later at a

higher valuation based on this success and the risks of the growing business have been progressively stripped away.

This is the essence of the early-stage venture game – raising just enough to get to the next stage of development of the company

(with a reasonable margin for error) in the hope and expectation of raising more capital at a higher price per share and on much more

attractive terms later.

One advantage of the stepping stone approach is that only the jump to Stepping Stone 1 needs to be costed out to a very low level of

detail. This is the part that the Series A investor will be asked to finance.

The Series A investor will need to be convinced that it will get an economic return for financing the jump to the first stepping stone. In

practice, this means that the Series A investor will need to be convinced that the company will be attractive to new investors if it gets

to the first stepping stone and that the Series B investor will pay a price per share that is perhaps two to four times greater than the

price the Series A investor pays.

If good commercial milestones are met that are attractive to investors, the company can raise additional investment capital at a good

price. If good milestones are met that the investors do not value, the company is in trouble – it won’t be able to raise new funds, or if it

does, it will raise new funds at a punitive price.

The best path for the entrepreneur, therefore, is the one with clearly defined strategic stepping stones containing milestones that are

attractive to investors and that will boost the price per share at each stage. (If a few valuable milestones can be met quickly and at a

low cost, it might make sense for the entrepreneur to raise a small amount of capital up front and raise more at a higher price later.

Alternatively, if a lot of capital is available at a good price, it might make sense to take it).

The best strategic stepping stone for an early stage company is the one that allows it to capture the necessary funding in the next

investment round at the highest price and with the least loss of ownership and control.

The true art of entrepreneurial finance is to pinpoint the smallest number of achievable, yet valuable, milestones to overcome in the

©Twoeyes 201112

upcoming stage, cost them out accurately with enough margin of error and to seek to raise that amount at the highest realistic price

possible, with the least amount of dilution and on the best terms.

Venture Plan

In addition to the Strategic Plan, there are an additional 5 Key Plans to be developed:

• MarketingPlan,whichanalysesthemarketopportunityandtheexistingandpotentialcompetitionanddevelopsamixofProduct,

Price, Place (distribution) and Promotion to exploit the opportunity, generate high quality leads and beat the competition.

• SalesPlan,whichdetailstheprocessforconvertingleadsintosalesandhowcustomerrequirementswillbefulfilledandhow

customers will be retained.

• OperationsPlandetailinghowthecoretechnologywillbedevelopedandcurrentandnewproductsdeveloped,howexisting

products will be produced and delivered.

• OrganisationalPlandetailingtheorganisationalstructurefromtheBoardofDirectorsandCEO,throughtothecoremanagement

team and the broader employee base. New hires planned in the future are also listed, as are any Advisory Groups.

• FinancialPlanProvidesaProfit&Lossprojectionforthenext3years,aBalanceSheetandarollingcashflowbudgetforthenext

12 months.

Combined, these 6 plans form the Venture Plan, a robust Strategic Operational Business Plan that clearly describes the venture in its

current and projected state. This will become a pivotal document when it comes to the capital raising process and will be examined

intensely during the Due Diligence phase.

CHAPTER 2 DEAL PREPARATION

Due Diligence

Companies intending to market some or all of their equity in order to raise growth capital should be prepared for the significant

amount of Due Diligence that an Angel, Venture Capital or Private Equity investor and their advisors may require before consummating

an equity financing.

A broad definition of Due Diligence is an investigation into the financial, legal, commercial, marketing and operational activities of a business

in connection with a proposed investment - or acquisition - of the business, so that the acquiring party enters into the investment with full

knowledge of the facts.

A Due Diligence exercise is carried out to validate strategic ideas and to provide an independent review and support for assumptions

underlying the investment appraisal. It identifies negotiation points and can help determine practical solutions for the tactical

implementation of a strategy. It may also form the basis of the Terms Sheet. As such, the “DD” process will usually run parallel with

Terms Sheet negotiations.

The investor and its lawyers and accountants will usually undertake Due Diligence according to a pre-defined checklist and will likely

cover the following areas.

• Corporate: A review of the company’s corporate structure including any subsidiaries, business names, constituent documents,

shares issued and debt securities convertible into shares.

• Assets: A review of assets owned by the company including real property, intellectual property, contractual rights and intangibles,

including a list of who owns the assets and any mortgages or charges over them.

• Intellectual Property: Ownership of the intellectual property including Trade Marks, Patents, Domain Names and Business Names,

will be verified.

• Financial Statements: The financial statements and accounts of the company will be reviewed extensively to assess the past

performance and prospects of the business.

• Material Contracts: A review of the company’s key contractual relationships with suppliers and customers, key employees, strategic

alliances, licensing agreements, etc.

13©Twoeyes 2011

• Employees: The company’s standard employment agreements, relationships with key employees, employee option plans, staff turnover

levels and the history of disputes.

• Litigation: Any actual or threatened litigation or dispute in which the company has been or is currently involved.

Due Diligence establishes the level of risk inherent in an investment. According to Chris Golis in his excellent book, Enterprise and

Venture Capital, there are seven risks investors should analyse when carrying out Due Diligence:

1. Development Risk – can the product be developed?

2. Manufacturing Risk – can the product be commercially produced?

3. Market Risk – will there be adequate sales for the product?

4. Management Risk - can the entrepreneur create and run a profitable business?

5. Financing Risk – will the company be able to raise follow-on funding?

6. Valuation Risk – has the investor paid too much for the investment?

7. Exit Risk – can the investor exit the investment within three to five years?

Knowing that potential investors will complete formal Due Diligence before any investment will be considered, the savvy entrepreneur

would have commenced ‘Reverse Due Diligence’ in preparation. This should be done concurrent to developing the Venture Plan.

Akin to a pre-game warm up, Reverse Due Diligence is where the management team gathers, prepares and collates internal

documentation and records. They will also asks of themselves the same type of questions an investor would ask when they come to

examine the risks and realities of the opportunity during the Due Diligence process.

While by no means exhaustive, the following is a list of typical questions an entrepreneur should have answers to before engaging

with equity investors:

Company:

• Whatdoyoubetterthananyothercompany?

• Whatelsedoyouhavebesidestechnology?

• Isthisaproductorabusiness?

• Whatisyourorganisation’suniqueness?

• Whatdoyouconsidertobeyourcompany’sgreatestweakness?

• Whatareyourunfairorsustainablecompetitiveadvantages?

• Whatdoyouhavethatwillenableyoutoshiftgearsifthemarketisalotdifferentthanyouplanon?

Opportunity:

• Whoistheventure’scustomer?

• Howdoesthecustomermakedecisionsaboutbuyingthisproductorservice?

• Towhatdegreeistheproductorserviceacompellingpurchaseforthecustomer?

• Howwilltheproductorservicebepriced?

• Howwilltheventurereachalltheidentifiedcustomersegments?

• Howwillthemuchdoesitcost(intimeandresources)toacquireacustomer?

• Howmuchdoesitcosttoproduceanddelivertheproductorservice?

• Howmuchdoesitcosttosupportacustomer?

• Howeasyisittoretainacustomer?

©Twoeyes 201114

Customers:

• Whoisyourrealcustomer?[Whoreally“cares”?]

• Whycan’ttheylivewithoutit?

• Howwilltheventurereachalltheidentifiedcustomersegments?

• Howwillthemuchdoesitcost(intimeandresources)toacquireacustomer?

• Howlongbeforethecustomersendsthebusinessacheck?

• Howmanywidgetsdoyouneedtoselltobreakeven?

• Whatarethekeycustomertangibleandintangiblefactorsthatanyonehastoprovideinordertosucceed?[Whatisthe“whole

product”?]

• Whatareyourcustomer’svalues?

• Howarepricingdecisionsmade?

• Whatarethebarrierstoentry?

• Whatarethestrengthsandweaknessesofyourcompetitors?

• Whathasthekeymanagementteamaccomplishedinthepast?

• Whoelseneedstobeontheteam?

• Whatindustrygroupsaretheydrawnfromandwhataretheoveralltrends?

• Howaretheydoingittoday?

• Why/howwilltheyuseyourproduct?

• Whatdoesthemarketwant?

• Whatpainissohighthattheyarewillingtocometoyou?

• Howintenseisthepain?

• Whatmotivatesyourcustomertobuy?

• Whatareyourcustomer’svalues?

• Whoareyourearlyadoptersandwhy?

• Whoisyourmainstreammarket?

Sales & Channels:

• Howwillcustomersbuyyourproduct?

• Howwillcustomersbecomeawareofyourproduct?

• Whowilltheycallfortechnicalsupport?

• Howlongdoesthepurchasedecisionprocesstake?

• Whatarethekeyvariablesinthebuyingdecision?(price,service,features,reputation,creditterms,deliveryspeed,orrelationship

with Salesman)?

• Arebuyingdecisionsaffectedbyadvertisingorsalespromotion?

• Whatisthedegreeofbrandloyaltyamongcustomers?Howisitmeasuredordetermined?

• Whatmethodsareusedtolockcustomersin?

• Whatwouldberequiredtopersuadetheuserofacompetitiveproducttoswitchandhowmuchwouldthiscost?

• Howimportantispersonalsellingtothiscustomer?

• Howgooddoesthesalespersonhavetobe?

15©Twoeyes 2011

The Whole Product:

• Whatotherproducts/accessorieswillcustomersbuytocompletelyfulfilltheirneeds?

• Whatareyourcustomer’sintangibleneeds?

• Whatisthe“wholeproduct”?

• Howistheproductpriced?

• Whataretheexpectedfuturepricetrends?

• Howarepricingdecisionsmade?

• Isqualitythekeytothesaleoftheproduct?

Competition:

• Whoarethemajorcompetitorsatpresent?

• Arethereanyexpectednewentriesorotherpotentialcompetitors?

• Whatisthefinancialstrengthofthepresentcompetition?

• Whatistherelativeeaseofentryintothefield?

• Whatistheimportanceofintangiblessuchasleadtime,goodwill,patents?

• Whatarethebarrierstoentry?

List all of the major industries in which this product is sold:

How does the company compare with competition in each of the following categories?

- product features

- market share

- marketing capability

- production capability

- financial resources

- financial management

-R&Dcapability

- Overall management strength

People:

• Wherearethefoundersfrom?

• Wherehavetheybeeneducated?

• Wherehavetheyworked-andforwhom?

• Whathavetheyaccomplished-professionallyandpersonally-inthepast?

• Whatistheirreputationwithinthebusinesscommunity?

• Whatexperiencedotheyhavethatisdirectlyrelevanttotheopportunitytheyarepursuing?

• Whatskills,abilities,andknowledgedotheyhave?

• Howrealisticaretheyabouttheventure’schancesforsuccessandthetribulationsitwillface?

• Whoelseneedstobeontheteam?

• Aretheypreparedtorecruithigh-qualitypeople?

• Howwilltheyrespondtoadversity?

©Twoeyes 201116

• Dotheyhavethemettletomaketheinevitablehardchoicesthathavetobemade?

• Howcommittedaretheytothisventure?

• Whataretheirmotivations?

Cash Flow:

• Whendoesthebusinesshavetobuyresources,suchassupplies,rawmaterials,andpeople?

• Whendoesthebusinesshavetopayforthem?

• Howlongdoesittaketoacquireacustomer?

• Howlongbeforethecustomersendsthebusinessacheck?

• Howmuchcapitalequipmentisrequiredtosupportadollarofsales?

Competition:

• Whoarethenewventure’scurrentcompetitors?

• Whatresourcesdotheycontrol?

• Whataretheirstrengthsandweaknesses?

• Howwilltheyrespondtothenewventure’sdecisiontoenterthebusiness?

• Howcanthenewventurerespondtoitscompetitors’responses?

• Whoelsemightbeabletoobserveandexploitthesameopportunity?

• Aretherewaystoco-optpotentialoractualcompetitorsbyformingalliances?

The end result of Reverse Due Diligence should be a Corporate Handbook containing all the items required for third party examination and

discovery and a comprehensive set of answers preempting those questions the investor is likely to ask.

As equity investors price perceived risks and value options, Reverse Due Diligence is an important step in ‘de-risking’ the deal before

formal negotiations take place. Done properly, Reverse Due Diligence will shave weeks off the Due Diligence process for a venture

investor and will have a positive impact on valuation.

Venture Packaging

Perhaps the most strategic – and challenging - step in raising venture funding is knowing how to package the deal and market it so that

it appeals to a specific class of investor – think Angel, VC or Strategic Corporate Investor.

The first step here is to price the deal – a valuation of the company is needed before any money is invested – known as the pre-money

valuation. Once the pre-money valuation has been priced, the post-money valuation needs to be determined.

Any serious equity investor – and savvy entrepreneur – will focus on the pre-money valuation of a company. Both pre-money and post-

money are simply valuation measures of companies. The difference between them is simply a matter of timing of valuation.

Pre-money valuation refers to a company’s value before it receives outside financing or the latest round of financing, while post-money refers

to the company’s value after it gets outside funds or its latest capital injection. It is important to know which is being referred to as they are

critical concepts in valuation.

17©Twoeyes 2011

The Basic Maths:

Let me explain the difference by using a couple of examples:

• Inacompanywithapre-moneyvaluationof$5million,a$5millioninvestmentwouldbuya50%ownershipstakeandwouldgive

a$10millionpost-moneyvaluation.

• SupposethatanAngelinvestorislookingtoinvestinanearly-stageventurewithhighgrowthpotential.Theentrepreneurandthe

Angelinvestorbothagreethatthecompanyisworth$1millionandtheinvestorwillputin$250,000.

• Theownershippercentageswilldependonwhetherthis isa$1millionpre-moneyorpost-moneyvaluation. Ifthe$1million

valuationispre-money,thecompanyisvaluedat$1millionbeforetheinvestmentandafterinvestmentwillbevaluedat$1.25

million.Ifthe$1millionvaluationtakesintoconsiderationthe$250,000investment,itisreferredtoaspost-money.

As you can see, the valuation method used can affect the ownership percentages in a very sizable way. This is due to the amount

ofvaluebeingplacedonthecompanybeforeinvestment. Ifacompanyisvaluedat$1million, it isworthmoreifthevaluationis

pre-moneycomparedtopost-moneybecausethepre-moneyvaluationdoesnotincludethe$250,000invested.Whilethisendsup

affectingtheentrepreneur’sownershipbyasmallpercentageof5%,itcanrepresentmillionsofdollarsifthecompanygoestoanIPO

at some future date.

Valuing Early-stage Ventures

Agreeing to a valuation of a young and growing business between the existing shareholders and the potential investor can be one of the most

difficult issues in an equity investment deal.

Valuing a company of any size is never easy but it is especially onerous if that company happens to be a start up or early stage venture

without any operating history. The multiple earnings method is most appropriate for service-based companies with several years of

revenue. The Discounted Cash Flow (DCF) method is more dependable and reliable for companies with actual products and revenues.

However, the DCF method is next to useless to apply to a venture that is pre-revenues so settling on a valuation often involves intense

negotiations.

I once met an experienced VC who admitted to me that he didn’t actually know how to do a Discounted Cash Flow. But he did know

where a deal would likely close at based on pattern recognition.

Arguably, the right way to think about VC valuation is not a finance exercise but a negotiations one. Typically, most Angel and VC rounds are

priced by the market - by supply and demand.

On the investor’s side, the goal is to acquire as large a position in the company and exert as much control as possible while keeping the

entrepreneur sufficiently motivated. On the entrepreneur’s side, the goal is to minimize dilution and maintain a much ownership and

control as possible while bringing in a helpful and motivated investor.

Pre-money Valuation + Invested Capital = Post-money Valuation

Price per Share = Pre-money Valuation/Pre-money Shares

Pre-money Valuation Post-money Valuation

Value Percent Value Percent

Entrepreneur $1,000,000 80% Entrepreneur $750,000 75%

Investor $250,000 20% Investor $250,000 25%

Total $1,250,000 100% Total $1,000,000 100%

©Twoeyes 201118

Calculating the Deal

The essence of an equity capital transaction is that the investor puts cash in the company in return for newly-issued shares in

the company. The company’s value immediately prior to the transaction is referred to as “pre-money,” and immediately after the

transaction “post-money.”

The “pre-money valuation” is the share price times the number of shares outstanding before the transaction:

Pre-money Valuation=SharePriceXPre-moneyShares

The total amount invested is the share price times the number of shares purchased:

Investment=SharePriceXSharesIssued

The shares purchased in an equity investment are new shares, leading to a change in the number of shares outstanding:

Post-money Shares = Pre-money Shares + Shares Issued

Because the only immediate effect of the transaction on the value of the company is to increase the amount of cash it has, the

valuation after the transaction is just increased by the amount of that cash:

Post-money Valuation = Pre-money Valuation + Investment

The portion of the company owned by the investors after the deal will just be the number of shares they purchased divided by

the total shares outstanding:

Percentage Owned = Shares Issued /Post-money Shares

There is also another way to view this:

Percentage Owned = Investment / Post-money Valuation = Investment / (Pre-money Valuation + Investment)

Sowhenaninvestorproposesaninvestmentof$2millionata$3millionpre-moneyvaluation,thismeansthattheinvestorswill

own40%ofthecompanyafterthetransaction:

$2m / ($3m + $2m) =2/5=40%

And if you have 1.5 million shares outstanding prior to the investment, you can calculate the price per share:

Share Price=Pre-moneyValuation/Pre-moneyShares=$3m/1.5m=$2.00

As well as the number of shares issued:

Shares Issued=Investment/SharePrice=$2m/$2.00=1m

19©Twoeyes 2011

The bounds between sufficient entrepreneur motivation and the potential to create an attractive return to an investor is a very wide ZOPA

(Zone of Possible Agreement). Where the deal closes is a function of the relative bargaining power of the players involved. In other words,

are there many other investors seeking to invest in the company (rarely)? Do the Investors have lots of options for where to put their capital

(often).

Remember also that it’s not only about valuation, as a lot of other terms that shape the Terms Sheet that have value. Liquidation

preferences, restrictions on the founder’s shares, option pools, founder liquidity, Board Of Directors seats are just some of the levers

investors use to make up for higher valuations.

Entrepreneurs should definitely read up on these deal terms and become familiar with the language of the deal. If they don’t, they

deserve the Terms Sheet they end up with and shouldn’t moan about it when the dust settles.

That being said, many investors will often base their valuations on management’s own projections and on other deals negotiated in

the industry by other companies. Information about comparable companies which have received venture financing can be useful in

setting benchmarks for valuation. The investor will want to ensure that the valuation is supported by financial and legal Due Diligence

and that the company’s forecasts are reasonable and based on sound assumptions.

Other factors that help form the early investor’s view of value are appraisals of the CEO and management team, novelty of the value

proposition, evaluation of the IP, expected time-to-market, expected path-to-profitability, estimated capital needs and burn-rate,

syndicate risk, sector volatility and deal structure.

The savvy entrepreneur will know that the investor willing to pay the highest price is not necessarily the best one for the business.

Another investor willing to pay a bit less may be a better partner in dynamically growing the business.

As well as determining pre-money and post-money valuations, successful packaging means creating a capital structure with equity

products (convertible debt, preferred stock, options, etc.) that are appealing to the target investor.

This requires the foresight to determine any future equity products a company may offer, how the overall equity may be diluted

and what the potential Internal Rate of Return (IRR) would be for each successive round. This also requires careful accounting of

shareholders’ positions.

Whenitcomestopitchingthedealtoaninvestor,onesizedoesnotfitall.The80/20ruleapplieshere–about80%ofthepackageis

suitablefor100%of3investorsclasses(Angels,VCsandStrategicCorporates)butthecritical20%needstobetailoredtofittheactual

target. Trying to sell a generic deal to hardened investors is like trying to sell a PC to a Mac enthusiast.

Key Documents

Once the venture package has been firmed up, an Equity Investment Business Plan, Investor Pitch and Presentation, Investor Briefing

Document and the all-important 30 second Elevator Pitch need to be distilled from the Venture Plan and then crafted and honed.

This step can take a considerable amount of time and effort to get right, but done properly and presented to the right target, the

investors’ appetite will be whetted and they will be emotionally and cognitively predisposed to a deal.

The Equity Investment Business Plan is a high-level version of the Venture Plan and incorporates aspects relevant to the investment

offer, which is tailored to the target investor.

The Investor Pitch and Presentation is a formal power point presentation and scripted pitch designed to take 15 minutes that tells the

investment story in a compelling and concise manner, opening the door for a question and answer session with the investor.

The Investor Briefing Document is a summary of the deal and is designed to give a quick but detailed snapshot – enough to entice the target

investor to want to investigate the opportunity further. In essence, this is a well-presented sales document, putting forward an enticing and

compelling proposition – the old saying that “you never get a second opportunity to make a first impression” plays out here.

©Twoeyes 201120

The 30 second Elevator Pitch is a short and punchy monologue that presents the value proposition of the deal in the most compelling

manner possible, in the least amount of time and words possible.

While developing the critical deal documentation, it’s also a wise idea to have a Confidentiality Agreement, draft Terms Sheet and draft

Shareholders’ Agreement drawn up that structure the deal the entrepreneur wants to make. (See next chapter).

By presenting potential investors with the company’s set of documents – and not having to react to the ones drawn up by the investor’s

lawyers –entrepreneurs can tilt the balance in their favour and ensure that their team is in the driving seat during negotiations going

forward.

It is also advisable to make sure the company’s Constitution has been reviewed to ensure the entrepreneur is comfortable and familiar

with its contents and that any changes that need to be made are done so before securing investment.

On Confidentiality Agreements, entrepreneurs should refer to the one freely available on the avcal.com.au web site. Investors are

unlikely to sign the majority of Confidentiality Agreements put them by entrepreneurs. At the end of the day, it comes down to trust

and logic – do you really think the investor will steal your idea?

CHAPTER 3 EQUITY MARKETING

As you would with any new product, market testing is an important step: once the venture package has been assembled, it’s important

to test the quality and completeness of the deal before formally offering it for sale.

Working with selected investors, advisory groups, friendly customers, experienced entrepreneurs and seasoned advisors before the

deal is formally introduced establishes advocacy early and identifies the gaping holes that might have been missed.

A most valuable experience is to enter – and ideally win - a business planning competition where panels of ‘friendly’ investors

challenge the entrepreneur’s business plan, investor pitch and investment deal from all angles. (This can sometimes be an ego bruising

experience for the entrepreneur but it is usually well deserved and most valuable).

High quality preparation is essential at this stage of the Equity Marketing process: if it turns out that an important feature is missing

from the venture package, it is better to stay home and preserve your one admission ticket to the game than damage your prospects.

Building credibility in the investor market is a slow but important process. A well-timed and strategic ‘word of mouth’ marketing

campaign avoids “shopping” the deal and focuses instead on creating demand for it and favourable momentum in the investor market-

place. (Deal shopping is when too many investors are approached too quickly with an incomplete venture package. As the investor

community is small and tightly knit, word can get around quickly, negatively positioned the deal in their mind before you knock on

their door).

One key rule in dealing with equity investors is to never make an unsolicited approach – sending in a cold email with your business plan

attached is the biggest single mistake a novice entrepreneur can make. Investors work in a close-knit world of colleagues, associates and

advisors where risk and trust are driving forces. Anyone trying to enter their world – especially an unknown, starry-eyed entrepreneur

– is regarded with suspicion. The way to enter is through a referral from a trusted, credible third party.

Market Segmentation

Finding potential investors is not as daunting as one might think. The first place to start is with the amount of investment capital

required.

Angel Investors

The first set of equity investors a rising entrepreneurial venture typically encounters are the Angel Investors – the informal network

of the high net-worth individuals who invest their own money into ventures where they usually have domain knowledge, first-hand

commercial experience and where they can add value over and above the capital they supply. As most Angels are retired entrepreneurs,

business owners or senior executives, many prefer to invest in sectors that are closely related to their own business experiences.

21©Twoeyes 2011

A common feature of Angels is that they like to invest with other likeminded Angels – either informally as a group of ‘mates’ or more

formally through an Angel Group (BioAngels in Adelaide, South Australia is one example of a formal group focused on a particular

industry sector).

Angelstypicallyinvestbetween$50,000and$500,000individuallyalthoughdealsofupto$3millioncanoccur.Astheyinvestatan

earlier,moreriskystagethanVentureCapitalists,AngelstendtoseekahighInternalRateofReturn-usuallybetween30%–40%IRR.

Angels are typically the most patient of investors and their investment horizon is typically between 3 and 7 years.

The Good, the Bad & the Ugly

The ‘good’ angel can be worth their weight in gold as they will have a wide and relevant network of contacts and will strategically and

constructively work with the entrepreneur and management team as a mentor, advisor and director.

Importantly, this type of angel has enough personal wealth to lose the money invested without feeling the pain too heavily. As a

consequence, she typically has enough funds available to invest in further rounds to avoid dilution of her shareholding. There is no

point in attracting investors who can’t afford to “pay to play” in the inevitable follow-on funding rounds – they will just get diluted

down to nothing and blame the entrepreneur as a result.

The ‘bad’ angel is one who can’t really afford to invest – and lose - the money. It’s not unusual for these types to have little or no

commercial experience or value-add. They generally take up a great deal of the entrepreneur’s time answering a constant stream of

unnecessary questions. While it’s tempting to take any money that’s offered, sometimes it’s best to say “No, thank you” and keep looking.

The ‘ugly’ angel is the chap – almost always male – who has more money than he will ever spend and who thinks that money makes

him smarter than everyone else – especially the entrepreneur. This angel has an ego bigger than his wallet and tends to make decisions

emotionally, not strategically. Doing a deal with this type of angel is akin to getting in to bed with a gorilla – the outcome is predictable

and highly unpleasant.

Venture Capitalists

Asageneralrule,formalinvestors–VentureCapitalists–investincompaniesseekingbetween$2M-$5Mandtheyoperatewithinan

investment mandate governing their firm. As a result they tend to have a preference for certain industry sectors (i.e. Life Sciences or

ITC)andwillnotinvestinothers(i.e.Property).Wherethedealisquitelarge(ieover$3m),itiscommonforVC’stosyndicatewithone

or more VC firms to reduce their individual exposure.

Venture Capitalist funds and their investment managers are the professional players on the investment team. Highly formalised, they

willmostlikelybemembersofAVCAL,theAustralianVentureCapital&PrivateEquityAssociationLimited.(www.avcal.com.au)

Venture Capitalist funds – or VC’s as they are commonly known – provide financial capital to early-stage, high potential, high risk

entrepreneurial companies in exchange for a high degree of ownership and control. VC’s also provide added value to the deal by way of

strategic, operational and financial advice, access to follow-on funding and arranging debt facilities, access to a sophisticated network

of contacts and alliance partners and facilitating exit strategies.

Venture Capital Investment Managers are completely focused on the financial return as they have a mandate from their investors –

typically superannuation funds - to deliver as high a return as possible. Their investment horizon is usually between 3 – 5 years and

theymightseekanIRRofbetween35%-45%withatleastoneseatontheBoardandusuallyahighdegreeofcontroloverfinancial

and strategic matters, as well as preferential shareholder rights and Put/Call Options embedded in the Shareholders’ Agreement.

Like Angels, VC’s seek to realise their investment through a Significant Liquidity Event – typically by way of a Trade Sale to a large

corporateorlesscommonlybywayofanInitialPublicOffering(IPO)ofthecompany’ssharesontheAustralianStockExchange(ASX)

or overseas exchanges, such as NASDAQ.

In today’s environment, it is a myth to think that VC’s will fund a start up with little more than a concept or an unproven technology.

With many funds badly burnt by the ‘tech wreck’ in 2000, VC’s tend to enter the investment cycle at a later stage than Angel Investors,

investingbetween$2million-$5millionoveranumberofstages(knownas“tranches”).

©Twoeyes 201122

VC’s tend to specialise in one or more market segments where their core skills can be of most value to their investee companies.

While each fund is different, in general VC seeks to invest in high growth ventures with the underlying potential to develop into well-

rounded companies that:

1. Have an owner-base who are seeking growth and who understand the need to leverage equity to maximise the wealth position

of all shareholders.

2. Have a provable business model with products and services that address a Tier 1 market-need in a potentially global market that is

currently under-satisfied, with the model demonstrating substantial sales potential within 7 years.

3. Can attract high-quality management, staff and board members.

4. Can be leaders in their field.

5. Are in emerging growth markets.

6. Have proprietary technology/IP with compelling and sustainable competitive advantages that is or near market ready.

7. High gross margins and a requirement for modest expansion capital.

8. Have the type of risks that can be mitigated and/or removed during the venture development project.

9. Satisfactory valuation and investment terms

10. Have the potential to attract follow-on venture funding and/or have potential for substantial gains via a trade sale or IPO within

3-5 years.

Stratageic Corporate Investors

Unlike a VC, a Strategic Corporate Investor (SCI) is not solely motivated by financial return. SCIs typically look for technologies, products

and/or business models that either complement existing business units within their group or that can be “bolted in” to their existing

operation as a new strategic business unit.

This means that they may not necessarily be looking to sell them off to the highest bidder but rather to take a strategic stake to make

outright acquisition of the company later on an easier process to control.

While a SCI will generally be interested in the success of the venture, there may be commercial opportunities that the entrepreneur

will be unable to pursue by virtue of a conflict of interest. On the flip side, competitors of the Strategic Corporate Investor – usually key

customers in the market - may not want to deal with an entity controlled (or strongly influenced) by their competitor.

While rare, there is also the real possibility that the SCI is simply making a defensive move to withhold the new technology from the

market in order to protect their dominant position and prevent the venture from winning VC investment which would result in a

greater threat and potentially would cost considerably more to acquire.

With a Strategic Corporate Investor in place early in the deal, the business may be less attractive to downstream VC investment as the

potential for a strategic sale to another large corporate or an IPO on the public market is significantly limited.

Qualifying Investors

Once a list of potential investors has been identified, they need to be qualified. It is helpful to classify them in terms of six primary

factors:

1. formal vs informal

2. local vs distant

3. active vs passive

4. seasoned vs nascent

5. solitary vs syndicated and

6. the amount they tend to invest per deal.

23©Twoeyes 2011

Arranging them in a corresponding grid helps identify the most appropriate potential investor for a particular deal.

Once the general identification and qualification of the investors have been completed, raising venture funding from equity investors

starts with a thorough understanding of the following:

• Howmuchmoneydoyouneed?

• Whatwillitbeusedfor?

• Howlongwillitlast?

• Howmuchmorewillyouneedoncethemoneyisspent?

• Whatexactlyisityouaresellingandwhatareitsfeatures?

• Whatarethefeaturesandbenefitsthatgowiththesale?

Once these basic marketing questions have been considered, an understanding of the potential buyer can be made:

• Whotendstobeabuyeroftheequityyouareselling?

• Whydotheybuyit?

• Howdotheybuy?

• Whattypeofinvestmentshavetheymadeinthepast?

• Whatistheirpreferredindustrysector(s)andwhatwonttheyinvestin?

• Whatistheminimumrequirementsfromaninvestment?

• WhatistheirInvestmentHorizon-whenwilltheyneedtoexit?

While a much longer list of questions can be developed, this “Who, What, Why, How and When” approach – Marketing 101 – is the

basic start of an Equity Marketing Campaign.

Combined with the traditional 4 P’s of marketing – Product, Price, Place and Promotion – they are the keys to raising capital from equity

investors in record time, at the highest price and with the minimum loss of ownership and control.

Features

Like hard products, equity has tangible and intangible features, advantages and benefits that appeal to different types of venture investors.

Tangible features include type of deal; terms of the deal; capital requirements; quality and experience of leadership and management;

intellectual property protection; the industry sector and target market; the product marketing plan; proposed exit strategy/s and the

geographic proximity of the investment to the investor, and so forth.

Intangible features include the offering’s ability to become a market leader or be syndicated as an investment; the origin and credibility

of the referral source; communication mechanisms; learning curves and know how; risk and security and the investor’s general comfort

with the deal as a whole.

Once the Vison, Mission, Values and Strategy have been developed, and the venture package assembled, the most important sale for a

high-growth venture is the sale of its shares to an equity investor.

Unfortunately, most entrepreneurs arrive on the potential investor’s doorstep with their technology or product under their arm and try

to sell them on that instead. As any experienced salesperson will know, using the wrong sales strategy and pitch to the right customer

is a recipe for disaster. You never get a second chance to make a first impression.

Understanding the equity investment market is very difficult because it’s largely an insider’s game, shrouded in intrigue and spoken in

a language that is foreign to the uneducated. Yet the basic tools to marketing and selling any product or service apply to equity.

By diligently preparing the company to raise capital, applying the principles of marketing to the sale of equity, researching the target

investor market and studying the various deal terms and common language used, entrepreneurs can change the rules of the game and

significantly impact their wealth position as a result.

©Twoeyes 201124

CHAPTER 4 TRANSACTION COMPLETION

As mentioned previously, it is important that the entrepreneur develop a Terms Sheet prior to approaching the investor so that their

preferred deal is framed and considered before negotiations start.

The Terms Sheet is perhaps the most important document the entrepreneur can get right. All else falls – or hangs – from it. The Terms

Sheet sets out the basic framework for the deal. It can be a excruciatingly boring document to develop and read – particularly if the

language used is like a foreign tongue. However, the savvy entrepreneur embraces it and gets comfortable with it as her wealth is

secured or lost in this one document.

Once an Angel, an Angel syndicate or a Venture Capital firm indicates its intention to invest in a company, there are a number of

important issues to be negotiated. Once agreed, this framework for the investment will be set out in a Terms Sheet which records the

parties understanding of the key issues. Think of the Terms Sheet as a Heads of Agreement.

Key issues to be resolved at this stage include the form of investment, protections to be given to the investors, rights of the investors to

appoint board representatives, control over major decisions, information rights, pre-emptive rights and exit strategies.

The Terms Sheet will govern the investment until such time as Due Diligence is completed by the investor and the parties negotiate

the detailed legal Shareholders and Subscription Agreement. The major benefit of a Terms Sheet is that it focuses the energies of the

parties on the major issues early in the process, saving both time and expense in drafting formal agreements later.

The real issue here is that the Terms Sheet is usually written by the investors’ side of the deal – their lawyers in particular – and they

have done them multiple times and know what protections to put in that best suit the investor at the detriment of the entrepreneur.

Before meeting with the investor, the savvy entrepreneur will have pre-drafted a Terms Sheet with their advisors so that they know what

they want – and don’t want – in the document. Tabling the Terms Sheet first, with value-enhancing milestones that the entrepreneur

feels comfortable in achieving - is usually an interesting ploy to tilting the balance of power and it shows the investor you have done

your homework, are commercially savvy and will not be easily hood-winked.

An issue to bear in mind with the Terms Sheet is that the company is likely to need subsequent rounds of financing. Future investors

are likely to want the same or similar rights as those granted to early round investors, and the company should weigh the impact of

this in negotiating the early rounds.

Depending on how formal the investors are (i.e. less formal Angels versus Professional VC), Nick Humphrey, a VC Lawyer in Sydney

suggests the following issues are likely to arise in the negotiations of the Terms Sheet.

• Pre-money valuation – the value of all share in the company immediately prior the proposed investment.

• The Strike Price - the agreed price per share once the investment deal has been struck.

• Post-money Valuation – The pre-money value of the company plus the investment amount

The form of the Investment Consideration: The consideration for the investment may take the form of ordinary shares, preferen, are

commece shares or convertible notes. Sophisticated investors will generally seek preference shares as they confer additional protection

without leveraging the balance sheet.

Rights attached to Preference Shares include:

1. Preferential rights to dividends

2. Preferential right on a liquidation or winding up of the company

3. Right to convert preference shares into ordinary shares at any time.

• SizeofInvestmentandTranches: The investor may wish to make their investment in stages – known as tranches – with each

tranche conditional upon the company achieving certain milestones.

While mile-stone base funding is a fair approach, it is useful to link milestone-based payment to a pro rata of milestone

25©Twoeyes 2011

achievement–if75%ofthemilestoneshavebeenachievedingoodfaith,then75%ofthepaymentshouldbemade.Thereis

nothing worse than the entrepreneur working hard to reach the milestone and just falling short with the investor using this as a

way to punish the entrepreneur with more punitive terms like withholding the critical funds unless certain actions are taken. This

is sometimes a ploy used to force the founder off the board or even out of the company.

• Number of Directors: Investors will want to oversee and control the progress of their investment. In order to do this, they will seek

to appoint a certain number of Directors to the Board and tailor the matters which must be considered by the Board:

• Protection against Dilution:

There are two types of anti-dilution protection:

1. Restructures - protection against share dividends, share splits, reverse splits and similar recapitalizations occurs by adjusting the

conversion price or preference shares to ensure that the number of share of ordinary shares issued on conversion represents the

same percentage of ownership; and

2. Price Protection - if the company issues shares at a discount to the shares bought by an investor, the conversion ratio is

adjusted to ensure the number of ordinary shares issued on conversion represents the same percentage of ownership.

• Redemption: Venture Capitalists may seek the right to force the company to realise the value of the investment at some point in

the future by requiring the company to buy back or redeem their shares if an IPO or trade sale has not occurred by a certain date.

• Facilitation of Sale of all Issued Shares: Investors may also require a “Drag along” clause which compels all shareholders to sell

theirsharesifmorethanaspecifiedpercentageofshareholders(usually75%)acceptathirdpartyoffer.

• Standstill for Founding Shareholders: Investors may also require that the founding shareholders agree to a standstill provision

which prevent them from selling their shares in the company for a period of time.

• Executive Service Agreements: Key executives may be required to sign appropriate Executive Service Agreements usually linked to

the company’s performance-based milestones.

• Information rights: Investors may want the right to receive certain information, such as monthly financial statements, annual

audited financial statements and the annual business plan and budget approved by the Board.

• Intellectual property rights of the company: Investors may want assurances that the company has sole legal and beneficial

ownership of the intellectual property rights.

• Pre-emptive Rights: Investors may require a preemptive right to invest in future issues of shares in preference to a third party.

• Exit Strategy for Investors: Equity investors – in particular VCs – are driven by the need to realise the value of their investment and

may seek to impose a provision enabling them to force a trade sale or IPO if such an event has not occurred with 3 or 4 years of the

investment.

• Additional Management Members: Investors may require the company to recruit additional executives – typically a CEO or CFO –

to the management team.

• Exclusivity Period: Investors may seek a period of exclusivity after signing the Terms sheet, typically in the region of 30 to 60 days,

where the investor has the right, but not the obligation to invest.

Assuming the Due Diligence process has not uncovered major issues relating to the prospects or current management of the business, the

parties will then prepare and sign formal documentation which sets out the detailed mechanics for the issues set out in the Terms Sheet.

Referencing Nick Humphrey once again, in most cases the legal documentation will include the following:

• Subscription Agreement: This document sets out the subscription details such as number of shares, price of shares, the number

of tranches and dates of subscriptions. It will also contain detailed warranties about the company, rights attaching to shares, and

any conditions which have to be satisfied before the investment is made.

• Shareholders Agreement: The Big Brother to the Terms Sheet, this is the important document in the deal process and sets out

the ongoing relationship between the new and existing shareholders and the company as agreed in the Terms Sheet. It will be a

robust, mind-numbingly boring document with many ‘standard’ legal clauses in addition to those agreed in the Terms Sheet.

Despite it being hard work, the savvy entrepreneur will go through this document with a fine tooth comb, become familiar with each

clause and get independent legal advice on its content. This is your Marriage Contract and you live or suffer by the clauses you agree to.

©Twoeyes 201126

• Intellectual Property Acknowledgement Deeds: Acknowledgement by other parties that they have no rights in any intellectual

property which they developed and assign all such creations to the company. Remember that IP rights should be assigned to the

company by employees and third parties like brand designers and web site developers – anyone who has ‘created’ something of

value in the future.

• Executive Service Agreements: Binding “key” employees to the company for a period (usually two or three years) and will set out

the employees terms of service, remuneration and bonus entitlements.

CHAPTER 5 POST-INVESTMENT FULFILLMENT.

Once the dust has settled on the transaction and the Terms Sheet and Shareholders’ Agreement has been signed by both parties, the

first tranche of monies should be forthcoming from the investors. It is now time for the entrepreneur and the management team to

shift their focus from capital raising mode into a strategic operational mode.

Board of Directors

A good Board has a balance between representatives of the founders, the investors and external, non-aligned third parties. Post

investment, a new board needs to be established with new directors appointed as representatives of the new investors. It is usually a

good idea to introduce a formal Code of Conduct for Directors that each director to required to sign, in order to set the clock and culture

of the board going forward and clarify what is acceptable and expected behavior and what is not.

When appointed to the board, each director has the fiduciary duty to pursue the best interests of all shareholders, not to represent any

particular shareholder, even if that shareholder has been instrumental in having that director appointed to the board.

It is likely that in the Shareholders’ Agreement there will be a stipulation of how many board seats will be given to the new investors

and who will be chairperson.

Ideally the board will be composed of the CEO, at least one director representing the founding shareholders and one director

representing the new investors, with an independent and suitably qualified and experienced person as chairperson, who will have a

casting vote in the event of a tied dispute.

A good deal of thought should have gone into identifying and selecting the chairperson as they will be needed to give the board

balance and unity and ensure that decisions are made in the best interests of the company – and not just one group of shareholders.

They will also need to be of strong character to stand up to the investors as and when needed to prevent the “money making the rules”,

(as in ‘The Golden Rule’).

The entrepreneur and his team should expect a good deal of hand’s on activity from the directors, especially from the one representing

the new investors. As long as it is constructive, this input should be appreciated by the other board member’s and management team

as this value-add should have been one the key reasons the investor was selected to join the company in the first place.

Caution is need here though to ensure that the members of the board are not crossing the line between strategy and operations and

they let management get on with doing their job – guidance and strategic input is fine, meddling is not.

Execution

The Plan of Action to be executed by the board and management team lies in the set of strategic stepping stones and integrated

milestones put forward by the entrepreneur and signed off on by the investors under the Shareholders’ Agreement.

The focus of the board and management team is to deliver on the first strategic stepping stone and performance milestones, in full,

on time, within budget. Any slip in milestone performance will jeopardise the next tranche of funding being injected by the investors.

In order to keep management focused on achieving the target milestone, Key Performance Indicators (KPIs) should be monitored and measured

daily, weekly, monthly and quarterly and investors should be provided with regular updates, particularly at monthly Board meetings.

27©Twoeyes 2011

It is especially important at this stage for management to demonstrate a judicial use of cash, with any capital spending to be in line

with the funding plan for the strategic stepping stone and set of milestones.

Inevitably there will be internal and external events that cause milestone slips. These should be communicated to the Board and

investors early and in an open and forthright manner. Trust needs to be earned and, when it comes to managing investors’ expectations,

honesty is certainly the best policy. “Bad news early” is also a good rule to follow.

Once the target milestones have been successfully achieved within budget, the investors will be required to inject the next tranche of

monies into the company’s coffers. The Board should be respectful but firm with investors to ensure that this payment is made in full

and on time, as per their contractual obligations.

CEO

The CEO will be held personally accountable by the board to achieve the strategic stepping stone and milestones that underpin it. In

new investee companies, it is not unusual that the CEO is replaced by the Board post-investment. This is particularly the case where the

founding entrepreneur is the inaugural CEO. It is very rare that the one individual has the skill set – and mind set – to take a company

from concept through the various stages of growth, as each stage demands a different set of skills and experiences.

I was once sitting at a US Venture Capital seminar where the speaker advised every VC to approach each board meeting with one

question in mind – “Do I fire the CEO today and if not, how can I help him?” At the same session, statistics were presented that showed

more than half the CEO’s of new investee companies in the USA were terminated within six months of investment.

Before raising venture financing, the savvy entrepreneur should ask himself if he really has the skill set and qualities needed to grow

the company through the next stages. If he can honestly – and courageously answer the question in the negative, the best thing to do

is to seek to replace himself with an experienced CEO, tying this in as one of the initial milestones upon which funding will be based.

Once replaced by someone more experienced and equipped, the founding entrepreneur can assume a senior role more suited to

his skill set – like Chief Technical Officer or Director of Marketing. This avoids the inevitable blood-bath later on and protects the

entrepreneur’s position.

Follow-on Funding

Concurrent to working in the business to achieve the next target milestone and ultimately the first strategic stepping stone, the board

and management team needs to work on the business to prepare for the next stage of capital raising to finance achieving the second

strategic stepping stone.

Preparation is the key to successful capital raising – ensuring the company has everything ready and in place before interacting with

investors. Starting this process early will ensure the company is in a strong position – with cash in the bank from the initial fundraising.

The Venture Plan needs to be updated across all 6 of its component parts, taking in to account changes in the external operating

environment as well as developments in the internal operations. The Reverse Due Diligence process also needs to be revitalised to

ensure that everything is in place for investor Due Diligence.

It is important for the entrepreneur to have prepared a Capitalisation Table that details existing shareholdings and the price paid per

share. A similar table should be developed that forecasts possible shareholdings with future fundraisings, which are done in stages as

per the key strategic stepping stones laid out in the Strategic Plan.

The objective of the next equity marketing campaign is to have a significant step up in value per share based on the value created – and

risks mitigated – by successfully achieving the first key strategic stepping stone.

Valuing the business after the first round of investment is straightforward - the post-money valuation of the first round simply becomes

the pre-money valuation of the second round.

©Twoeyes 201128

Equity Dilution Factor

The key number that should be front of mind for the savvy entrepreneur is the equity dilution factor. This is the percentage of equity

that is owned by the previous holder(s) of equity. The equity dilution factor is how value is created for shareholders and how the CEO

achieves his most important Key Performance Indicator – to make the company more valuable.

Using a scenario developed by Venture Capitalist, Chris Golis, over a five year period a typical fund raising campaign might go like this:

• Year1:Thecompanyisfoundedwithseedcapitalof$100,000,

• Year2Angelsputin$500,000forone-thirdofthecompanyvaluingitat$1.5million.

• Year3VCinvestor1putsinamillionfor25%ofthecompanyvaluingit$4million.

• Year4Another3VCsputinamillioneachfor20%ofthecompanyvaluingitat$15million.

• Year5ThecompanydoesanIPOthebusinessraising$10millionfor20%valuingthecompanyat$50million.

As stated previously, the key number is the equity dilution factor. This is the percentage of equity that owned by the previous holders of equity.

Inthefirstroundforexampleitis67%,inthenextrounditis75%,80%inyear4and80%inyear5.

SoforthefounderstheamounttheyholdattheIPOis100%x67%x75%x80%x80%or32%.VC1holds16%.Theangelsholdalsohold

16%.

What happens (hopefully) is that:

1. For each round the valuation rises.

2. The founders raise new capital from new investors. If one investor ends up with a majority stake, the entrepreneurs become

employees.

3. The current shareholders with a new capital raising, get diluted but hopefully the increase in valuation more than compensates.

Pre-emptive Rights

Invariably the Shareholders’ Agreement will stipulate that existing shareholders have pre-emptive rights on any future share offers –

meaning the company must offer all shareholders the opportunity to acquire the new shares on a pro rata basis before offering them

to third parties.

By exercising their pre-emptive rights, existing shareholders will prevent dilution to their shareholding when new shares are issued.

What commonly occurs is that the founding shareholders – the entrepreneur, the ‘friends, family and faithful’ and initial Angel

investors – do not have the funds available to ‘pay to play’ and will see their shareholding diluted down. While not pleasant, this should

be palatable as long as the value of the share has increased.

Down Rounds

Real problems can be encountered when there is a ‘down round’, where the price per share is lower than in the previous round. Those

who do not participate financially in the round suffer dilution as well as seeing their share value decrease. There is nothing that will

make shareholders more disgruntled than seeing value stripped from their investment.

There is potential for conflict of interest when pricing the next round as it is not in the investors’ financial interest to have a higher price

per share, particularly when the value was increased on the back of the cash they initially invested. This is where strong leadership from

the board – and especially the independent Chairperson, is required.

If the company has experienced difficulties, such as milestone slips and is running low on cash, an internal round of funding – by the

existing shareholders – might need to be undertaken. There will be at least three camps in this discussion: those investors willing to

invest more, those investors unwilling or unable to invest more and management who needs the cash to run the company.

29©Twoeyes 2011

A severe down round – with the share price halved or more - is often the proposed solution resulting in the re-investors owning a very

large share of the company, and causing severe dilution of those not willing or unable to “pay to play”. When it comes to making a

decision about such a down round, each of the parties will feel tension between their fiduciary duty as a director and the strict interests

of the shareholder group they represent. However, at the board table, fiduciary duty must predominate.

Exit Strategy

As well preparing to raise the next round, the board should be strategically focused on the exit strategy. While many dream of the

fabled IPO, the most likely exit strategy is a trade sale to a larger corporate.

It is essential that exit planning starts early, with a number of potential acquirers identified and profiled. This should be the job of

both the board and CEO and should not be left to chance. After all, a significant liquidity event in the form of a profitable exit is why

all investors are there in the first place.

When formulating the capital raising plan for the next round, careful thought and consideration should be given to who the next round

of investment comes from. Whoever the target is, their presence should advance the company towards a profitable exit downstream.

©Twoeyes 201130

Angel/Angel

investor

A high-net worth individual who makes investments in entrepreneurial companies using their own capital,

rather than that of an institution or fund. Angel investors usually invest at the early stage of a company’s life

cycle, such as the seed or early expansion stage. Angel investors are typically successful entrepreneurs who

have become wealthy, often as a result of a trade sale in a technology-related industry.

Angel Financing Capital raised for a private company from independently wealthy investors. This capital is generally used as

seed or early expansion funding.

Angel Groups Organisations, syndicates and networks of angel investors formed for the specific purpose of facilitating angel

investments instart-up&/orearly-stagecompaniesfor investorswithacommoninterest.Bypoolingtheir

capital and spreading their risk,, angel groups make collective investments in entrepreneurial companies.

Anti-dilution

Provisions

Contractual measures that allow investors in convertible preferred shares to an automatic reduction in the

conversion price, meaning more common shares on conversion, if a subsequent round is a “down round,”

thereby mitigating down round dilution. (See Full Ratchet and Broad Based Weighted Average).

AVCAL Australian Venture Capital and Private Equity Association Limited.

Bolt-on

Acquisition

An acquisition by a company, typically backed by private equity or venture capital investors, where that

company acquires another entity or business operating in the same industry as the company.

Bootstrapping Means of financing a small company by employing highly creative ways of using and acquiring resources

without raising equity from traditional sources or borrowing money from the bank.

Broad-Based

Weighted

Average Ratchet

A type of anti-dilution mechanism. A weighted average ratchet adjusts downward the price per share of the

preferred shares of investor A due to the issuance of new preferred shares to new investor B at a price lower

than the price investor A originally received (a “down round”). Investor A’s preferred share is repriced to a weight

average of investor A’s price and investor B’s price, taking into account the significance of the new round and it

dilutive impact. A broad-based ratchet uses all ordinary shares outstanding on a fully diluted basis (including

all convertible securities, warrants and options) in the denominator of the formula for determining the new

weighted average price.

Business Angel See Angel.

Burn Rate The rate at which a company expends net cash over a certain period, usually a month.

The Language of Equity Investing

31©Twoeyes 2011

Business Plan A document that describes the entrepreneur’s idea, the market problem, proposed solution, business and

revenue models, marketing strategy, technology, company profile, competitive landscape, as well as financial

data for coming years. The business plan opens with a brief executive summary, most probably the most

important element of the document due to the time constraints of venture capital funds and angels.

Buy-in

Management

Buyout

A form of a buyout incorporating characteristics of a management buyout as well as a management buy-in,

whereby members of a company’s existing management team undertake a buyout of the company alongside

new managers.

Call Option The right to buy a security from another shareholder , exercised at the discretion of the purchaser, for a pre-

agreed price (or a price calculable from a pre-agreed formula) triggered by the occurrence of a particular event

or within a specific time period.

Capitalisation

Table

Also called a “Cap Table”, this is a table showing the total amount of the various securities issued by a company

and how much was paid for that stock.. This typically includes the amount of investment obtained from

each source and the securities distributed -- e.g. ordinary and preferred shares, options, warrants, etc. -- and

respective capitalisation ratios. A capitalisation table gives a quick snapshot of the total ownership and equity

of a company.

Carried Interest Thesubstantial share,oftenaround20%,ofprofits thatareallocatedto thegeneralpartnersofaventure

capital partnership.

Channel Partner A company’s distributors and resellers.

Confidentiality

Agreement

A statement formally acknowledging that the confidence of information provided in private will be respected.

The use of these documents is declining due to difficulty and impracticality of enforcement in an environment

where VC’s routinely see many very similar business opportunities. Also referred to as a Non Disclosure

Agreement (NDA).

Convertible Note A short term debt investment instrument. Typically used when it is difficult or inappropriate to agree agreed

valuation.Pricingmaybesetinreferencetothenextprofessionalrounde.g.a10%discounttothenextround

or may be fixed at the time of the investment. The type of security that note converts into is also agreed ahead

of time.

Conversion Ratio The number of shares that a convertible security may be converted into. The conversion ration equals the par

value of the convertible security divided by the conversion price.

Conversion

Rights

The right of a shareholder to convert preferred share into ordinary shares. Usually, one has this right at any

time after making an investment. Company may want rights to force a conversion upon an IPO; upon hitting of

certain sales or earnings’ targets, or upon a majority or supermajority vote of the preferred shares. Conversion

rights may carry with them anti-dilution protections

Co-investment The syndication of a private equity financing round, or an investment by Angel investors, alongside a lead

investor.

Constitution The charter of rules which govern the conduct of the business and corporate affairs of a company. A constitution

has the effect as a contract between the company and each shareholder, the company and each director and

secretary and as between each member. In absence of a formal constitution the “Replaceable Rules” under the

Corporations Act 2001 will apply.

©Twoeyes 201132

Conventional

Convertible

Preferred Shares

A type of preferred share that can also be referred to as “Non-Participating Preferred Shares”. This preferred

share typically receives a liquidation preference prior to Ordinary Shares, and does NOT participate on an “as if

converted basis” with ordinary shares in any remaining proceeds of a defined “liquidation” event. Upon such

a “liquidation” event, holders of Conventional Convertible Preferred Shares must choose whether to receive

their liquidation preference or convert their shares to Ordinary Shares in order to participate in the pro rata

distribution of assets.

Dilution The reduction in the percentage size of one’s shareholding through the issue of new capital.

Down Round A round of financing where investors purchase stock from a company at a lower valuation than the valuation

placed upon the company by earlier investors. Down rounds cause dilution of ownership for existing investors.

This often means the company’s founders stock or options are worth much less, or even nothing at all.

Due Diligence The process whereby an investor investigates the attractiveness of an opportunity, assesses the quality of the

management team, and assesses the key risks associated with an opportunity. Due diligence starts on initial

inspection of an opportunity and ends when an investment is completed.

Earn Out Part of the price of a transaction, which is conditional on the performance of the company following the deal.

ESOP Employee Share Option Plan. The term sheet will typically stipulate the upper limit on the size of the option

poolexpressedasapercentageoftheissuedcapital,typically10%to20%.Theseoptionswillbeusedtoattract

key hires, retain and motivate staff.

Exclusivity Period An agreement whereby a company agrees to give an investor the first right of refusal on an investment for an

agreed period of time. An exclusivity period is a requirement of most terms sheets.

Exit Strategy The method by which a investor intends to get out of an investment that he or she has made in the past.

In other words, the exit strategy is a way of “cashing out” an investment. Examples include an initial public

offering (IPO) or being bought out by a larger player in the industry (also known as a trade sale or acquisition).

Exit strategy is also referred to as a “harvest strategy” or “liquidity event”.

Full Ratchet An anti-dilution provision that, for any shares of common stock sold by a company after the issuing of an

option (or convertible security), applies the lowest sale price as being the adjusted option price or conversion

ratio for existing shareholders.

Full-ratchet anti-dilution protection allows an investor to have his or her percentage ownership remain the

same as the initial investment.

Forexample,aninvestorwhopaid$2persharefora10%stakewouldgetmoresharesinordertomaintainthat

stakeifasubsequentroundoffinancingweretocomethroughat$1pershare.Theearlyroundinvestorwould

havetherighttoconverthissharesatthe$1price,therebydoublinghisnumberofshares.

Information

Memorandum

A document prepared for potential investors, outlining the business and investment opportunity.

Intermediary Individuals or organisations that introduce deals, frequently working with investee companies to assist them

in preparing their business plans , refining their strategies and getting prepared for investment.

Investment

Syndicate

Angels and VC’s may co-invest to diversify their risk and to reduce the future funding risk of a business.

33©Twoeyes 2011

ICM Information, communication and new media: a descriptor for a segment of the high technology sector.

IPO Initial Public Offering, floating a stock on a Stock Exchange.

IRR: Internal Rate

of Return

The discount rate often used in capital budgeting that makes the net present value of all cash flows from a

particular project equal to zero. Generally speaking, the higher a project’s internal rate of return, the more

desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is

considering. Assuming all other factors are equal among the various projects, the project with the highest IRR

would probably be considered the best and undertaken first. IRR is sometimes referred to as “economic rate of

return (ERR).

Legals The process of converting a mutually agreed terms sheet into formal documentation typically a Shareholders’

Agreement, a Subscription Agreement, Service Contracts and Warranties.

LBO:

Leveraged

Buy Out

The buyout of a company’s existing ownership using borrowed funds. The funds borrowed by the investors

purchasing the target company are generally secured by the assets of the target company.

MBI:

Management

Buy In

Where an outside manager or management team purchases an ownership stake in the first company and

replaces the existing management team.

MBO:

Management

Buy Out

Where management of the target company desires to acquire ownership of the company.

Milestone A business event that indicates progress towards successful execution of a business plan.

NDA Non-Disclosure Agreement. See Confidentiality Agreement.

Option The right, but not the obligation, to buy or sell a security at a set price (or range of prices) in a given period.

Post-money

Valuation

The product of the price paid per share in a financing round and the shares outstanding after the financing

round.edit

Preference Shares These are non-equity shares. They rank ahead of all classes of ordinary shares for income and capital. Their

income rights are defined and they are usually entitled to a fixed dividend (e.g. 10 per cent fixed). The shares

may be redeemable on fixed dates or they may be irredeemable. Sometimes they may be redeemable at a fixed

premium (e.g. at 120 per cent of cost). They may be convertible into a class of ordinary shares.

Preferred

Ordinary Shares

These may also be known as ‘A’ ordinary shares, cumulative convertible participating preferred ordinary shares

or cumulative preferred ordinary shares. These are equity shares with preferred rights. Typically they will rank

ahead of the ordinary shares for income and capital. Once the preferred ordinary share capital has been repaid,

the two classes would then rank pari passu in sharing any surplus capital. Their income rights may be defined;

they may be entitled to a fixed dividend (a percentage linked to the subscription price, e.g. 8 per cent fixed) and/

or they may have a right to a defined share of the company’s profits - known as a participating dividend (e.g. 5

per cent of profits before tax). Preferred ordinary shares have votes.

Pre-money

Valuation

The product of the price paid per share in a financing round and the shares outstanding before the financing

round.

©Twoeyes 201134

Ratchets A structure whereby the eventual equity allocations between the groups of shareholders depend on either

the future performance of the company or the rate of return achieved by the venture capital firm. This allows

management shareholders to increase their stake if the company performs particularly well.

Secondary

Offering

An offering of shares that are not being issued by the firm, but rather are sold by existing shareholders. The firm

consequently does not receive the proceeds from the sales of these shares.

Seed Capital A source of funding for the early stages of a start up venture where the product, process, or service is in its

conceptual or developmental phase. Angel Investors are the usual source of seed capital.

Shares

Outstanding

The number of shares that the company has issued.

Staging The provision of capital to entrepreneurs in multiple installments, with each financing conditional on meeting

particular business targets. This helps ensure that the money is not squandered on unprofitable projects.

Start Up Funding Earliest stage of business, typically no operating history. Investment is based on a business plan detailing the

management group’s backgrounds along with the defined market and financial projections. It is the first stage

in the maturity of a business. It encompasses the point of initial concept upon which the business is founded,

and typically is considered to span through the point the business has a product or service in place and is

beginning to generate revenue from operations. The company is poised to launch into its marketing plan and

a capital infusion is required. This phase may be considered to run even as far as the second or third year of

operations. The usual sources of risk capital are Angel Investors. See also Seed Capital.

Terms Sheet A non-binding letter of offer to invest, subject to Due Diligence, which stipulates the terms and conditions the

investor is proposing including valuation, board positions, conditions precedent, minority protection rights, etc.

Trade Sale The sale of a company’s shares to another company, typically in the same industry sector.

Tranching An arrangement whereby the investment capital is split into a number of stages with the size of tranche and

valuation pre-agreed. Investment of subsequent tranches is subject to attainment of agreed milestones.

Warranties A series of legal statements whereby the principals of the investee company attest to the accuracy and

completeness of the information provided during the due diligence process.

35©Twoeyes 2011

Conor McKenna is Managing Director of Twoeyes. He is Lead Advisor for Twoeyes’ Strategic Advisory services and is

the Director of Twoeyes’ growing portfolio of investee companies.

Conor is a specialist in the areas of strategic operational planning and preparing companies for growth and capital

raising. When providing advisory services to private, public and not-for-profit organisations, he calls on broad

experience, proven entrepreneurial and executive skills, high-level Business and Venture Capital qualifications &

an international network of business leaders, private equity investors, Government officials & service providers.

Founder of Twoeyes, a company he established in 2000, Conor is a patented inventor, a venture-backed entrepreneur, a multiple business

ownerandanequityinvestor.Heisalsoanon-executivedirectorof,andadvisorto,anumberofprivatecompanies,Governmentbodies&not-

for-profit organisations.

Duringhis20+yearcareer,Conorhaslived&workedinIreland,England,USA,Canada,Italy&Australia.Hisbusinessandconsultingexperiencespans

manyindustries,includingmanufacturing,distribution,retail,professionalservices,internet,multimedia,glass&plasticpackaging,winemarketing,

waterdesalination,venturecapital,medical&alliedhealthservices,corporatetraining,eventmanagement,disabilityservices,aswellasthe

infrastructure, building and home improvement industries. Within these industries, Conor has worked with start-ups, spin-outs, family businesses,

smalltomedium-sizedenterprises,largecorporates,not-for-profitorganisationsaswellasGovernmentboards&agencies.

Thefounder&drivingforceofmultipleventures,Conorhasbroadoperatingexperience:fromthefirstemployeeinastart-upinthewater

desalination industry to a management role with the Australian subsidiary of a Fortune 500 American multi-national, where he was

responsiblefora$50Mbudget&reportedon1Bunitsin‘JustinTime’supplytotheAustralianwineindustry.

In 1999, Conor invented ZORK, a patented wine sealing technology that now forms the basis of a successful global product innovation. The

companyhesubsequentlyfoundedsuccessfullycommercialisedthetechnology&raisedmulti-milliondollarsinventurefundingbeforebeing

acquired by a US multinational in 2011.

Conor is the co-owner and Chairman of Kid Sense Child Development Corporation, one of South Australia leading private providers of

paediatric Allied Health services.

Conor holds a Master of Business Administration (Advanced) Degree; an Executive Diploma in Business Planning; a Graduate Diploma in

Business Administration and a Bachelor of Arts (Literature). He has completed the Venture Capital and Private Equity Executive Program at

Harvard Business School and the Foundation Course in Venture Capital from the Australian Venture Capital Association Limited (AVCAL). He

has also completed the Company Directors Course from the Australian Institute of Company Directors (AICD).

Conor McKennaBA GDBA MBA (Adv) MAICD | Churchill Fellow 2009

Managing Director & Lead Advisor

Making Companies More Valuable

©Twoeyes 201136

About Twoeyes

Founded in 2000, Twoeyes is a boutique venture investment and strategic advisory firm based in Adelaide, South Australia.

Our business purpose is to help Entrepreneurs, Business Owners, Boards and CEO’s make their company more valuable.

As a venture investor, Twoeyes actively develops an equity portfolio of investee companies at various stages of development.

As a strategic advisor, Twoeyes brings together a ‘virtual’ team of highly experienced business, commercial and investment

specialists who provide outstanding clarity to help private, public and non-profit organisations reach their potential.

By combining the principles of Venture Capital, Private Equity and Strategic Operational Planning with first-hand

entrepreneurial and senior executive experience, Twoeyes offers clients a unique approach to business consulting and the

delivery of special projects.

While Twoeyes preferred approach is a flat-rate fee or retainer arrangement, from time to time, we may take success fees and/

or minority equity investments as a fee for advisory work or to assist emerging entities and non-profit organisations.

Where we can help

From clarifying strategy to preparing for strategic sale, Twoeyes can help make your company more valuable.

For a confidential, obligation-free meeting to explore your business needs or brief a special project, please contact:

Twoeyes Investee Companies

www.zork.com.au

Conor McKenna BA GDBA MBA (Adv) MAICD | Churchill Fellow 2009

Managing Director & Lead Advisor

Twoeyes Pty. Ltd. - Making Companies More Valuable

90 Unley Road, Unley, South Australia

PO Box 1133, North Adelaide SA

Telephone (08) 8272 7522

Facsimile (08) 8272 4823

Mobile 0402 26 46 70

Email conor@twoeyes.com

Web twoeyes.com

• Newventuredevelopment

and structuring

• Technologycommercialisation

• Newproduct/servicedevelopment

and launch

• Businessplanningandrisk

assessment

• Operationalreviewandrisk

assessment

• Strategicoperationalplanningand

implementation

• Strategyworkshopsand

presentations

• Strategicmarketingplanning

• CorporateIdentity

• Branddesign&realisation

• Brochures&AnnualReports

• Websitedevelopment

• Integratedon-line/off-linemarketing

communications strategies

• Boardbuilding

• Teamrecruitmentanddevelopment

• Performanceappraisal

• Executivecoaching&mentoring

• Corporateandsalestraining

• Familybusinessconsulting

• Successionplanning

• Companysalesanddivestments

• Mergersandacquisitions

• Buyside/sellsideDueDiligence

• Equityprocurement,including

private equity, venture capital

and angel funding

• Governmentgrantfunding

• R&DTaxConcessions

• Debtprocurement

• SpecialProjects

©Twoeyes 2011