Venture capital funds

Motivation
Most entrepreneurs are capital constrained so they seek external funding for their projects. Entrepreneurial firms with limited collateral (i.e., tangible assets), negative earnings, and large degree of uncertainty about their future have very limited access to external funding. Lack of outside funding hampers growth of new businesses in many countries around the world.

Potential funding sources

1) Bootstrap (owner equity) insufficient when the firm grows above a certain threshold 2) Angel investors (wealthy individuals) limited due diligence, less thorough in their negotiations since reputational concerns are less important, dont actively monitor their investments 3) Banks Reluctant to lend to firms that burn cash and offer little or no collateral. Also, entrepreneurial firms value flexibility and thus are not very fond of bank loan covenants. 4) Corporations a way for corporations to beat their competitors

What is a VC fund?
1. is a financial intermediary, collecting money from investors and invests the money into companies on behalf of the investors 2. invests only in private companies. (Question: What is a private firm?) 3. actively monitors and helps the management of the portfolio firms (Question: How do VCs help their portfolio firms?) 4. mainly focuses on maximizing financial return by exiting through a sale or an initial public offering (IPO). (Question: So, what are the necessary conditions for the development of the VC sector in a country?) 5. invests to fund internal growth of companies, rather than helping firms grow through acquisitions.

Institutional features
VC firms are organized as small organizations, averaging about ten professionals.

VC firms might have multiple VC funds organized as limited partnerships with limited life (typically 10 years).
General partners (GPs) of the VC fund raise money from investors referred to as limited partners (LPs). GPs are like the managers of a corporation and LPs are like the shareholders. LPs include institutional investors such as pension funds, university endowments, foundations (most loyal), large corporations, and fund-of-funds.

LPs promise GPs to provide a certain amount of capital (committed capital) and when GPs need the funds they do capital calls, drawdowns, or takedowns.
During the first 5 years of the fund (investment period) GPs make investments and during the remaining 5 years they try to exit investments and return profits to LPs.

Flow of funds in the VC cycle

Prominent VC-backed companies

Microsoft, Google, Intel, Apple, FedEx, Sun Microsystems, Compaq Computer etc. Some of these investments resulted in incredibly high returns for VC funds:
During 1978 and 1979, for example, slightly more than S3.5 million in venture capital was invested in Apple Computer. When Apple went public in December 1980, the approximate value of the venture capitalists investment was $271 million, and the total market capitalization of Apples equity exceeded $1.4 billion.

There are also big disappointments though. What the VC funds are doing is to try to find the next Microsoft, Google, Apple, which might help offset the losses associated with 100 other investments.

What do VCs do?

1. Investing:
Screen hundreds of possible investment and identify a handful of projects/firms that merit a preliminary offer Submit a preliminary offer on a term sheet (includes proposed valuation, cash flow and control right allocation) If the preliminary offer is accepted, conduct an extensive due diligence by analyzing all aspects of the company. Based on findings in the due diligence, negotiate the final terms of to be included in a formal set of contracts; and closing.

2.

Monitoring:
Board meetings, recruiting, regular advice

3.

Exiting:
IPOs (most profitable exits) or sale to strategic buyers

The investment process of a typical VC fund

Screening (vague)
Preliminary due diligence Term sheet Final due diligence Closing

100 to 1,000 firms

10 firms 3 firms 2 firms 1 firm

Screening
Takes a big chunk of the VCs time:
Search through proprietary private firm databases Deal flow from repeat entrepreneurs Referrals from industry contacts Direct contact by entrepreneurs

Reputable VCs have easier time identifying better companies because of their big networks and entrepreneur's willingness to work with them. Most investments are screened using a business plan prepared by the entrepreneur. Two major areas of focus in screening:
Does this venture have a large and addressable market? (market test) Does the current management have capabilities to make this business work? (management test)

Market test
Main focus: Possibility of exit with an IPO within 5 year with a valuation of several hundred million dollars The market for the firms products should be big enough
A company developing a drug to treat breast cancer is likely to have a bigger market than a company developing a drug for a disease with only 1,000 sufferers

Barriers to entry should not be too high in the firms market

A company that developed a new operating system for PCs does not have much chance against Microsoft.

Sometimes, there is no established market for the firms products and services (e.g., eBay, Netscape, Yahoo). In such cases, spotting potential winners is more of an art than science.

Management test
Ability and personality of the entrepreneur and the synergy of the management team is examined Repeat entrepreneurs with track records are the easiest to evaluate An often spoken mantra in VC conferences is that: I would rather invest
in strong management with an average business plan than in average management with a strong business plan. Do you think this makes sense?

Due diligence
Pitch meeting: The meeting of VC with company management
Management test

For firms that successfully pass the pitch meeting, the next step is preliminary due diligence
If other VCs are also interested in the firm, preliminary due diligence is short Due diligence is on management, market, customers, products, technology, competition, projections, partners, burn rate of cash, legal issues etc.

If the results of the preliminary due diligence is positive, the VC prepares a term sheet that includes a preliminary offer.

VC Investments by stage
Early stages:
Seed: Small amount of capital is provided to the entrepreneur to prove a concept and qualify for start-up capital (no business plan or management team yet). Start-up: Financing provided to complete development and fund initial marketing efforts (business plan and management in place, ready to start marketing products after completing development). Other early-stage: Used to increase valuation and size. While seed and start-up funds are often from angel investors, this is from VCs.

Mid-stage or expansion:
At this stage, the firm has an operating business and tries to expand.

Late stages:
Generic late stage: Stable growth and positive operating cash flows Bridge/Mezzanine: Funding provided within 6 months to 1 year of going public. Funds to be repaid out of IPO proceeds.

VC investment share by stage

100% 80% 60% 40% 20% 0% Late Expansion Other Early Seed/Startup

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

VC investments by industry
Industrial/Energy Business/Financial Media/Retail Other Healthcare Biotech Hardware Semiconductors Softw are Communications
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

postboom boom preboom

How to value investments?

Cash flow
Free (after-tax) cash flow from operations = EBIT (1-tax rate) + Depreciation CapEx NWC Also called unlevered free cash flow

No financing related cash flows (e.g., interest payments) are included

Free cash flow to the firm does not consider tax benefits of debt. Applicable tax benefits, if any, need to be separately considered.

Discount rate

Discount rates and leverage

Valuation approaches (1)

Valuation approaches (2)

3. Venture capital (or comparable firms) methodology Back out the valuation of your company using the ratio (e.g., P/E) for a comparable publicly traded firm Suppose a publicly traded firm that is almost identical to the firm you are trying to value has a P/E ratio of 20. If the company that you are trying to value has earnings $0.50/share, the value of each share of this company is approximately $10 (=20 x $0.5)

4. Capital cash flow approach Similar to APV, the only difference is you discount tax shields with required return on assets rather than required return on debt.

Which method to use?

For young firms with great deal of uncertainty about future cash flows, use the venture capital approach. When valuing a later stage firms, if you want a DCF-based valuation estimate, whether you should use the WACC or APV approach depends on your assumptions about future debt levels: If you assume that the firm has a constant debt ratio target, use WACC because APV is computationally difficult

If you assume that the firm has a constant dollar debt amount target, you cannot use WACC, you must use APV

VC partnerships and legal issues

VCs are organized as limited partnerships. Tax advantages:
Not subject to double taxation like corporations; income is taxed at the LP level. Gain or loss on the assets of the fund are not recognized as taxable income until the assets are sold.

Conditions to be considered a limited partnership for tax purposes:

(1) Pre-specified date of termination for the fund (2) The transfer of limited partnership units is restricted (3) Withdrawal from the partnership before the termination date is prohibited. (4) Limited partners cannot participate in the active management of a fund if their liability is to be limited to the amount of their commitment. (Note, however, that LPs typical vote on key issues such as amendment of the partnership agreement, extension of the funds life, removal of a GP etc.)

While LPs have limited liability, GPs have unlimited liability (they can lose more than they invest): Not critical because VCs dont use debt. 1% of the capital commitment comes from the GPs. Why?

VC contracts
The contracts share certain characteristics, notably:
(1) staging the commitment of capital and preserving the option to abandon, (2) using compensation systems directly linked to value creation, (3) preserving ways to force management to distribute investment proceeds.

These elements of the contracts address three fundamental problems:

(1) the sorting problem: how to select the best venture capital organizations and the best entrepreneurial ventures, (2) the agency problem: how to minimize the present value of agency costs, (3) the operating-cost problem: how to minimize the present value of operating costs, including taxes.

Agency problems between GPs and LPs

Limited partnership status prevents LPs from being involved in the management of the fund, so GPs may take advantage of LPs. Mechanisms to overcome potential agency problems:
Limited fund life Reputation: if the GP steals from me today, I will not invest in his next fund Compensation systems is designed to align the incentives of the GPs and LPs: GPs receive 20% of the funds profits Mandatory distributions (when assets are sold proceeds should be distributed to the LPs, they cannot be reinvested), so no free cash flow problem GPs commit 1% of the capital (could be sizable depending on the GPs wealth) Covenants (see next slide)

Restrictive covenants in VC agreements

Description Covenants relating to the management of the fund: Restrictions on size of investment in any one firm Restrictions on use of debt by partnership Restrictions on coinvestment by organization's earlier or later funds Restrictions on reinvestment of partnerships capital gains Covenants relating to the activities of the GPs: Restrictions on coinvestment by general partners Restrictions on sale of partnership interests by general partners Restrictions on fund-raising by general partners Restrictions on addition of general partners Covenants relating to the types of investments: Restrictions on investments in other venture funds Restrictions on investment in public securities Restrictions on investments in leveraged buyouts Restrictions on investments in foreign securities Restrictions on investments in other asset classes % of contacts 77.8% 95.6% 62.2% 35.6% 77.8% 51.1% 84.4% 26.7% 62.2% 66.7% 60.0% 44.4% 31.1%

GP compensation in VCs
1. Management fees
typically 2%/year of committed capital during the investment period and declines later used to pay salaries, office expenses, costs of due diligence the sum of the annual management fees for the life of the fund is referred to as lifetime fees Investment capital = Committed capital Lifetime fees

2. Carried interest (or carry)

typically equals to 20% of the basis or funds profits (source: BibleGenesis 47:23-24). Basis typically equals Exit proceeds Committed (or Investment) capital. allows the GP participate in the funds profits (incentive alignment role) Basis and timing of payments to the GP might vary from fund to fund

Fees and carry

Source: Metrick and Yasuda, 2008, The Economics of Private Equity Funds

The sorting problem

How to filter out good funds from bad funds? VCs can signal their quality by agreeing to GP compensation tied to fund performance and committing to better governance standards. VCs can build reputation over time. Then, reputational capital will deter them from taking actions against the interests of their LPs.

The nature of incentive conflicts between VCs and entrepreneurs

Some projects have high personal returns for the entrepreneur but low expected payoffs for shareholders.
A biotechnology firm founder may choose to invest in a certain type of research that brings him great recognition in the scientific community but provides lower returns for the VC. Because entrepreneurs stake in the firm is like a call option, they might choose highly volatile business strategies, such as taking a product to the market while additional tests are warranted.

Entrepreneurs like control, so they will avoid liquidating even negative NPV projects. The incentive conflicts are more severe and so funding duration is shorter for high growth and R&D intensive firms as well as firms with fewer tangible assets.

Contracting issues
Information problems: How do I know what the project is worth? Agency problems: How can I provide incentives the entrepreneur to work in my interests?

VC investment contracts (1)

1. Virtually all private investments are structured as convertible preferred with redemption features and often include warrants to acquire additional shares.
The convertible preferred allows private investors to have a priority claim while sharing in the upside. This structure can increase the size of the cash flow pie by controlling agency problems and reducing information asymmetries.

2.

Virtually all venture investments involve staged commitments. Staged commitments add value by creating an option to abandon (a put option).
Staged commitments also give the venture capitalist the option to revalue and expand their investment at future dates.

3.

Most private investment provide for some form of investor control that is often tied to the performance of the venture.

VC investment contracts (2)

4. When evaluating deal terms, be sure to ask the following questions:
(a) (b) (c) How does this term add value? How will this term limit my flexibility in the future? Is this term priced correctly in the deal?

5. A poorly structured deal can make even a good company go badby limiting its ability to raise funds when things turn out just to be O.K.

Staged capital infusions

Rather than giving the entrepreneur all the money up front, VCs provide funding at discrete stages over time. At the end of each stage, prospects of the firm are reevaluated. If the VC discovers some negative information he has the option to abandon the project. Staged capital infusion keeps the entrepreneur on a short leash and reduces his incentives to use the firms capital for his personal benefit and at the expense of the VCs. As the potential conflict of interest between the entrepreneur and the VC increases, the duration of funding decreases and the frequency of reevaluations increases.

Control mechanisms
Most venture contracts defined triggers for cash flows, voting, and other control rights. In general the better the performance the less VC control. Corporate control mechanisms.
Private investors typically get at least a few board seats. Voting control is based on the percentage ownership: Often times a particular issue votes as a block (even though there may be a number of individual shareholders). Control is often tied to targets i.e. sales or operating targets when reached increase entrepreneurial control.

Board rights

Voting rights

Other ways to control entrepreneurs

VCs may discipline entrepreneurs or managers by firing them (remember VCs often take controlling stakes and board memberships in the firms that they invest):
Right to repurchase shares from departing managers from below market price Vesting schedules limit the number of shares employees can get if they leave prematurely Non-compete clauses

Managers are compensated mostly with stock options, which increases incentives to maximize firm value. This might of course also provide incentives to increase risk, so close monitoring is necessary. Active involvement in management of the firm Should you invest in the jockey or the horse?

Exit strategies
Most VC-backed firms fail before they see the light of the day. Therefore, VC investments are very risky. However, VCs constantly search for the next Microsoft, Apple, Google, or Intel whose VC funds made enough money to offset losses from hundreds of failed deals. For example, in 1978 and 1979, VCs invested $3.5 million for 19% of Apple Computer. After Apples $1.4 billion IPO in December 1980, the VCs stake was worth $271 million (a more than 7000% return).

Most successful VC-backed firms eventually become publicly listed with an IPO. Depending on market conditions, the VC may prefer to sell its stake in the M&A market. Not surprisingly, in countries will relatively less developed equity and IPO markets the VC industry failed to flourish.