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 sources1) 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, don’t 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 Apple’s 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) 100 to 1,000 firms

Preliminary due diligence 10 firms

Term sheet 3 firms

Final due diligence 2 firms

Closing 1 firm

Screening

• Takes a big chunk of the VC’s 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 firm’s 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 firm’s 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 firm’s 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

0%

20%

40%

60%

80%

100%

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Late

Expansion

Other Early

Seed/Startup

VC investments by industry

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

postboom

boom

preboom

How to value investments?

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 fund’s 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 don’t 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.

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.

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.

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 firm’s 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.

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?