New Venture Finance
Case Study:  Twinoptic

Executive Summary
The business plan for Twinoptic presents an early stage 
first round deal, but which seeks to raise $5 million.  They 
have a potentially good idea, and a few good people, but no 
major design work done yet.  The founders propose to build a 
read/write CD-ROM drive, similar to Sony's Minidisk system, 
but which uses the standard 4.72" CD-ROM format.  They feel 
that Sony has underestimated the inertia of the larger form 
factor, which is selling 50 million audio discs a year and 
which holds four times as much information as the smaller 
Minidisks. Their projected market is for around 5 million 
units per year.  Being able to be both compatible and price 
competitive with CD-ROM drives are critical assumptions that 
they make. They plan to design the drive themselves, 
manufacture prototypes, and license manufacturing overseas.  
They want to create a partnership with a peripheral 
manufacturer, who will also be a major investor in the 
company.  

The company team appears to be made up of three very 
qualified people, who have held executive positions at 
companies in the same industry.  It is clear that there is 
probably a significant market for the technology they 
propose. If the founders can develop the technology for the 
amount of money that they propose, this could be a 
significant opportunity.  

However, their financials are wildly optimistic.  The 
company will probably need significantly more money than 
they have projected, the drives will not be as price and 
performance competitive as they claim, and their sales will 
be much lower than they claim.  In particular, the critical 
factors of price competitiveness and performance 
competitiveness appear to be significantly overstated.  
Their ability to create this technology with low technical 
risk, and on a $5,000,000 budget, should also be carefully 
questioned.

The biggest danger is that this appears to be a standards 
play in a commodity market.  Twinoptic will be attempting to 
take market share from multi-billion dollar peripheral 
manufacturers, who will quickly attempt to retaliate.  As a 
small company, unless they grow very big very quickly, they 
will not be able to generate the economies of scale 
necessary to survive.  They are basically repackaging 
existing technology, so it is doubtful they will be able to 
get sufficient patent protection to prevent entry.  Unless 
they can keep all other manufacturers out, they are going to 
need to drive a standard to allow interoperability.  This 
will open them up to very fierce competition.  Since they do 
not play to build any manufacturing infrastructure, it is 
unclear that they can sustain their competitiveness.  They 
may still be able to make significant short term profits by 
selling their designs, but it is unclear that they can 
succeed in the long run.  However, this may well be 
sufficient for a profitable exit strategy for the investors.

A number of key questions are raised in the next section.  
There is enough of a potential opportunity with this company 
that these should be carefully reviewed and answered.  These 
questions raise major doubts about the attractiveness of 
this proposal.  However, if the dangers and issues raised in 
these questions are sufficiently dealt with, this company 
should be financed with around $2,000,000, for the founders 
to build a proof of concept, at a pre-money, pre-dilution 
valuation of $1,500,000 to $2,500,000.  If the founders are 
able to bring the major corporate partner in to this round, 
more money should be raised ($3,000,000 to $4,000,000) at a 
proportionally higher valuation.
Strategy
There are a lot of key questions about the feasibility of 
this plan.  In regards to their proposed product, the most 
important are:
n Can they design what they say they can, for as little 
money as they claim?  They claim that this product will 
require no technology breakthroughs, but this is unclear.  
They have no major design work done yet.  A good number 
to discover would be how much Sony spent developing the 
Minidisk player.  They claim their product will cost $4 
to $5 million, over 18 months, to develop.
n It seems surprising that they can be fully compatible 
with existing CD-ROM drives.  Is this feasible?
n Which generation of CD-ROM drives will their data 
transfer rates be similar to?  The current generation or 
the generation that will exist when they start shipping?

In terms of marketing the product, the most important 
questions are:
n Can they overthrow Sony's Minidisk standard?  This seems 
to be a reasonable thing to do.  While Sony's product's 
smaller size is better for laptop computers, the CD-ROM 
form factor has quite a bit of inertia.  The CD-MO 
product will have at least 4x the capacity of the 
Minidisk, which should be compelling.
n They plan to manufacture the product for $275 and have a 
retail price of $550.  Is this reasonable for this 
market?  I would expect the multiplier to be closer to 4x 
to 5x.
n What will the cost of CD-ROM drives be when the CD-MO 
product is released at $550?  This price might be 
competitive at the time the plan was written, but the 
founders do not seem to be taking in to account the fact 
that prices may drop by up to 50% and performance 
increase by up to 100% during the 18 months that they 
will probably need to release their product.  By that 
time, a CD-ROM drive will probably be $350 less than 
their product, rather than the claimed $75-$150 
difference.
n Can they truly build a sustainable company with this?  
This area is a commodities market, and very large 
competitors will enter very quickly.  There do not seem 
to be very good barriers to entry, and they will not be 
able to establish large economies of scale.
n Who owns the manufacturing capability they will be using 
for their product?  If it is primarily other peripheral 
manufacturers, this could pose a much larger danger than 
if a significant share is independent of these companies.
n Will the company be making a standards play with this 
technology?  It appears that they have to in order to be 
interoperable.  This makes the total market size larger, 
but will truly turn it in to a commodity market.
n They project that they will acquire 10% of the CD-ROM 
market.  This seems very high (2-3% might be more 
reasonable), because it does not take in to account 
competitors' reactions.
n They project that the CD-ROM drive market will be at 
least 50% bigger than the industry estimates they quote.  
Why is this?
n Will large companies continue to license their design for 
very long?  Since they are not building the manufacturing 
capability, this will be critical.  In particular, their 
corporate partner is going to want to be able to 
manufacture drives for a very small royalty.

The management team seems capable.  They claim 75 years of 
experience between the three primary founders.  However, it 
is unclear how large some of the companies are that they 
have executive experience in.
Financial Requirements
Twinoptics' financial projections appear wildly optimistic. 
Some of the problems include:
n They project to generate more than $1 billion in revenues 
in their third full year of shipping product, although 
75% of this goes to their manufacturing costs, which they 
have out-sourced.  
n For the three full years that they are shipping products 
for, sales and marketing is less than 2.5% of their total 
revenues.
n As pointed out above, these sales numbers seem to be 
based on the two incorrect assumptions that competition 
will not arise and that the price of CD-ROM drives will 
not decrease before they start shipping product.
n They only budget a total of $500,000 to sales and 
marketing for the two years before major product sales 
start.

The company is trying to raise $5,000,000 in the first round 
of financing, to pretty much cover the entire costs of 
development.  They do not need to raise all of this 
immediately.
Capital Structure
Twinoptics' proposed financing structure plans to raise 
$5,000,000 in the first quarter, $2,000,000 in the year 
after that, $3,000,000 in the second full year, and 
$5,000,000 in the third full year.  

This financing structure is seriously flawed.  Unless the 
company has key patents or major design work they are not 
disclosing, the pre-money, pre-dilution valuation of the 
company is probably betewen $1,500,000 and $2,500,000.  
Raising $5,000,000 for the first round, with 20% of the 
company reserved for employees, the founders will likely 
have less than 25% of the company after the first round!  
However, if they are able to attract a major corporate 
partner and investor for this first round, they may be able 
to get a significantly higher valuation and be able to 
afford more money.

A more reasonable financing structure would bring in 
$2,000,000 for the first round, $5,000,000 in the second 
round, and perhaps $10,000,000 in the third.  This would be 
augmented by venture leasing to finance their equipment and 
furniture.  

The first round milestones would include building a proof of 
concept, putting the rest of the management team in place, 
and developing the necessary strategic alliances.  The 
second round milestones would include finishing the product 
development and starting sales.  The third round would fuel 
company expansion, and a mezzanine round or public offering 
would probably be required soon after, if they are to 
sustain the type of growth they have planned.

Twinoptics' business plan leaves many major questions to be 
answered, and appears to have some fundamentally flawed 
assumptions.  If all of these can be dealt with 
satisfactorily, a reasonable initial offering would be for 
$2,000,000 at a pre-money, pre-options pool valuation of 
$2,000,000.  Assuming a 15% options pool and 5% for warrants 
for the venture leases, this would leave the founders and 
the investors each with 40% of the company.  This assumes 
that they are not able to immediately form a partnership 
with a corporate partner.  Giving this partner certain 
rights to license the technology they develop would enable 
significantly more money to be raised this round.