The Nuts & Bolts of Investing in a VC Fund

THE NUTS & BOLTS OF INVESTING IN A VC FUND

Part of the Alternative Investment Basics Series 2015 Series

Premier Date: September 10, 2015


MEET THE FACULTY

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PANELISTSJonathan Friedland Levenfeld Pearlstein, LLC

Craig Mordock Sheppard Mullin Richter & Hampton LLP

Drew Whiting Axia Law


MODERATOR

Christopher Cahill,

Lowis & Gellen, LLP

Practical and entertaining education for business owners and executives, Accredited Investors, and their

legal and financial advisors.

For more information, visit www.financialpoisewebinars.com

DISCLAIMER:

THE MATERIAL IN THIS PRESENTATION IS FOR INFORMATIONAL PURPOSES ONLY. IT SHOULD NOT BE CONSIDERED LEGAL ADVICE. YOU SHOULD CONSULT WITH AN ATTORNEY TO DETERMINE WHAT

MAY BE BEST FOR YOUR INDIVIDUAL NEEDS

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ABOUT THIS SERIES

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The personal investment landscape in the United States is currently undergoing the greatest transformation since the popularization of the mutual fund. The JOBS Act of 2012 lifted the ban that previously prevented private placements from being advertised. As a direct result, for the first time, millions of accredited investors are only now beginning to understand that there are investment options available to them that they never before considered. This webinar series was created for those millions of Americans who meet the federal government’s definition of “accredited investor,” to help them decide if some of their investment dollars should be allocated away from stocks, bonds, mutual funds, and the like and into the asset class that is commonly referred to as “alternatives,” which include PE, VC, Hedge funds, private placements, and hard assets (which include a wide array of things, such as gold, land, and comic books). As with all Financial Poise webinars, each episode in the series is designed to be viewed independently of the other episodes: think sitcom rather than soap opera.

ABOUT THIS EPISODE

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Investing in an IPO is something many people assume is a great opportunity. Many investors, however, have been disappointed when they have been unable to “get into” the IPO. Yet, many IPOs do not do all that well. Venture Capital (and its “younger cousin,” angel investing) are terms that describe investments that are made long before an IPO. If you are an accredited investor (that is, you earn more than $200,000 ($300,000 if married) a year or who have at least $1 million in assets (not including the equity they have in their home), you should know enough about VC and Angel Investing, even if only to make an informed decision that they are not for you.

EPISODES IN THIS SERIES

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(Dates below are premier dates; all webinars also available on demand)

#1 Are you an Accredited Investor, and if you are, so what? 5/7/15

#2 What is the JOBS Act and Why Should You Care? 6/4/15

#3 What is Equity Crowdfunding and Should it Matter to You? 7/9/15

#4 Angel Groups vs. 506(b) Platforms 8/6/15

#5 The Nuts & Bolts of Investing in a VC Fund 9/10/15

#6 The Nuts & Bolts of Investing in Pre-IPO Share 10/8/15

#7 The Nuts & Bolts of Investing in a PE Fund 10/29/15

#8 The Nuts & Bolts of Hedge Fund 11/12/15

#9 Basic Investment Principles- from Asset Allocation to Z Scores 12/3/15

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WHAT DO VCs DO?

• Find investment opportunities

• Pick winners (only some of which will win), plot structure, management, and harvest

• Manage the investment (participate on Board)

• Harvest the investment (get $$, the end game) usually by acquisition of the portfolio company or by IPO

Is VC a Good Investment for YOU

“Dave Swenson, the well-regarded head of the Yale endowment and author of Unconventional Success: A Fundamental Approach to Personal Investment, is famous for pointing out that VC returns are highly dependent on which individual fund you invest in.”Source: Mastering the VC Game by Jeffrey Bussgan

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WHERE DO VC FUNDS GET THEIR FUNDING?

• Insurance companies, educational endowments, pension funds, wealthy persons

• Within investment portfolios, these funders allocate to various classes, including “alternative investments” (maybe 5 – 10%)

• VC is an alternative investment, with potentially high returns

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Before the Jobs Act: onlythrough existing relationships.

Now, they can solicit accredited investors.

How do VC funds find their

accredited investors?


VC Industry Participants

VC Firms

Investment Banks

Investors (“Limited Partners”)

Founders

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Organizational Structure

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General Partner(Venture Capital Firm)

Limited Partners (Investors)

Venture Capital Fund(Limited Partnership)

PC PC PC PC

Manages the fund


VC Fund Structure (con’t)“Closed-end” fundsContrast with mutual funds

GP usually commits at least 1% of total capital and balance committed by LPs

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VC Fund Structure (con’t) Commonly structured as a limited partnership owned jointly by a VC firm (GP)

and LPs

GP manages and controls VC fund

10-year life with +1+1 extension

4-6 year investment period

1-2% annual management fee

80-20 profit split, after reaching “hurdle”

LPs need to fund within 2-3 weeks of “capital call”

Investments typically are channeled through a NewCo

Proceeds of capital received by NewCo then used to invest in target

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VC Firm Organization“A VC firm tends to be organized (often

unwittingly) around the thesis of James Surowiecki’s book, The Wisdom of Crowds- that is, no one person can be as smart as a group of informed, independent-minded people. And the best way to make the best investment decisions is to construct a democratic process rather than a hierarchical one.”Source: Mastering the VC Game by Jeffrey Bussgan

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Preferred Returns

Most compensation arrangements include preferred returns, which must be paid to LPs (after return of capital) before carried interest is paid to GP

There are two different ways to apply preferred returns: (a) pure preferred returns and (b) hurdle rates with catch-ups

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Limited Partners

LPs contribute up to 99% of the capital of fund

Yet LPs have little control over fund’s activities

LPs protected by basic covenants in fund documents Restrictions on how much capital can be invested in any one

company Restrictions on type of investment fund can make Cash from portfolio sales commonly must be distributed to LPs

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GP Compensation Management Fee: Usually 1-2% of total capital commitments until end

of a four to five-year investment horizon, then 2% of unreturned funded capital thereafter (declining as investments are sold or realized)

Carried Interest: 20% profit split to GP after Preferred Return is paid to LPs (subject to a Clawback)

Clawback is applied at the liquidation and winding up of a fund that adjusts distortions in compensation to GP

Portfolio Company Fees and Expenses: Paid directly by portfolio companies to VC Firm

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How does a GP spend Her Day? Locating potential investments

Selecting investments

Negotiating and Structuring investments

Monitoring investments

Exiting investments

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Deal Flow

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Deal Screening

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Portfolio Monitoring

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ELEMENTS OF VC FUND INVESTMENT IN PORTFOLIO COMPANY

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• Reverse vesting of founder stock (5 years)

• Full funding at initial closing or in steps upon milestones (technical, commercial, revenue-based)

• Liquidation preferences (VC gets paid upon a liquidation event)

• Redemption (VC forces repurchase of stock by company if no liquidation event or IPO)

• Board size, seats retained by VC, founder veto powers, board management powers

• Conversion of stock classes, anti-dilution provisions

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Typical ly a liquidity

event for theportfoliocompany

How and when do LPs make

money money?


The LP’s ExitLimited partnerships must be dissolved within a certain

time as they need to return capital to LPs

Monetization and realization of “paper” profits

Sale

IPO

Recapitalization

LPs may be able to sell their interests in the secondary market

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MORE ABOUT THE FACULTY

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CHRISTOPHER CAHILL

Mr. Cahill is counsel with Lowis & Gellen LLP, in Chicago, Illinois. He guides secured lenders, creditors, debtors, creditors’ committees, potential purchasers and others through bankruptcy cases, out-of-court workouts, assignments for the benefit of creditors, and receiverships. Mr. Cahill has substantial mega-case experience at national law firms representing very large debtors, and has counseled and litigated on behalf of manufacturers and secured lenders in large and middle-market cases.

Mr. Cahill also publishes frequently and speaks regularly on commercial insolvency issues. He is an executive editor of Commercial Bankruptcy Litigation, 2d Edition (Jonathan P. Friedland, Elizabeth Vandesteeg & Christopher M. Cahill eds., 2015) and is the host of Accredited Investor Markets Radio, a weekly broadcast for investors, on accreditedinvestormarkets.com.


[email protected]

http://www.accreditedinvestormarkets.com/aimkts-radio/

mailto:[email protected]


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JONATHAN FRIEDLAND


[email protected] Friedland is a partner with Levenfeld Pearlstein.Jonathan’s corporate work includes serving as outside general counsel to a number of closely held businesses and their principals, representing private equity funds and others in their M&A activities, and in advising start-ups and their investors. The wide range of corporate issues he advises clients on include: fiduciary duties; structuring issues (between shareholders, members, joint venturers, etc.); credit negotiations; general contract issues; succession planning, employee matters, and litigation. Jonathan is on the editorial board of The Corporate Counselor.Jonathan also leads the firm’s Restructuring & Insolvency Service Practice. He has extensive experience in guiding companies and their constituents through a variety of financially challenging situations. He represents banks, debtors, official and ad hoc creditor committees, buyers, and other stakeholders in bankruptcy cases, assignments for the benefit of creditors, receiverships, and out-of-court workouts. Jonathan is lead author of Strategic Alternatives for Distressed Businesses, an 800 page treatise and Commercial Bankruptcy Litigation, a 1500 page treatise.Jonathan holds the highest possible rating from Martindale-Hubbell (AV® Preeminent™) and AVVO (10/10), has been repeatedly recognized as an Illinois “Superlawyer” in the areas of Business/Corporate Law and Bankruptcy & Creditor/Debtor Rights, and has received several other similar distinctions. Jonathan has been profiled, interviewed, and/or quoted in many publications, including Buyouts Magazine; Smart Business Magazine; The M&A Journal; Inside Counsel; LAW360; Business Week.com; The Bankruptcy Strategist; Dow Jones Daily Bankruptcy Review; Bankruptcy Court Decisions; Dow Jones LBO Wire; and The Daily Deal.Jonathan graduated from the State University of New York at Albany, magna cum laude, in 1991 (after three years of study) and from the University of Pennsylvania Law School in 1994. He clerked for a federal judge before entering private practice. He was an Adjunct Professor of Strategic Management at the University of Chicago’s Graduate School of Business for several years and was the 2006 Clayton Center for Entrepreneurial Law Visiting Professor of Business Law at the University of Tennessee College of Law. Jonathan was a partner with Kirkland & Ellis before joining Levenfeld Pearlstein. Jonathan is also the founder and chairman of DailyDAC, LLC.



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CRAIG MORDOCK


[email protected] Mordock is a partner at Sheppard Mullin, where he maintains a corporate and securities practice with special on private and public securities offerings, corporate governance, and mergers and acquisitions. His corporate finance experience ranges from representing venture capitalists, institutional investors, and start-up companies in early-stage financings to representing issuers and investment banks in public offerings of equity and debt securities. He advises purchasers and sellers of companies in a variety of industries, including software, communications, semiconductors, life sciences, renewable energy, consumer products, and financial services.

Craig has extensive experience representing public companies in connection with disclosure and compliance matters under the Securities Act of 1933 and the Securities Exchange Act of 1934 and provides general corporate and business counseling to several privately held companies. He regularly counsels boards of directors and board committees in connection with their duties under state and federal law as well as their compliance with the rules of self-regulatory organizations such as the New York Stock Exchange and NASDAQ.

Craig has been a speaker at numerous conferences on securities and corporate governance matters and has published articles on various topics in these areas.



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DREW WHITING


[email protected]

Drew Whiting is a partner who focuses his practice on assisting the emerging entrepreneur and growing small business owner achieve their personal and business visions. He approaches each client as a partner and is completely invested in seeing each individual and business reach success.Drew has experience working in the legal departments of National Railway Equipment Co., Porsche Business Services Inc., and in the Corporate Group at Horwood Marcus & Berk, where he gained experience in a wide range of corporate legal matters. More importantly, he was afforded the opportunity to uniquely understand the business of the law from the provider and client perspectives.Drew is actively involved in the start-up community in Chicago and devotes his time to getting to know entrepreneurs and their visions. He has represented many start-ups, from early entrepreneurs to businesses raising capital in the financial, real estate, insurance and technology industries. Drew serves as Secretary of the Small Business Advocacy Council (SBAC) Young Professionals’ Board, an organization committed to improving the environment in which small business operate. He is also a Resident Expert at the University of Illinois Chicago’s Institute for Entrepreneurial Studies, where he counsels small businesses on a wide variety of start-up and growth objectives.Drew is also Cook County Court Appointed Special Advocate (CASA), where he works primarily with the Creating Independent Transitions for Youth (CITY) program, which helps youth develop the skills necessary to lead independent, productive lives into adulthood. Drew kicks off each day by training for boxing and marathons. When the weather is nice, he participates on the city’s most feared kickball team, strives to be a bogey golfer, regularly plays beach volleyball and snaps the ball for a mediocre flag football team. He is a PADI certified SCUBA divers.Drew is a member of the American Bar Association, Illinois State Bar Association and the Chicago Bar Association.


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IMPORTANT NOTE:

THE MATERIAL IN THIS PRESENTATION IS FOR GENERAL EDUCATIONAL PURPOSES ONLY.

IT SHOULD NOT BE CONSIDERED LEGAL, INVESTMENT, FINANCIAL, OR ANY OTHER TYPE OF ADVICE ON WHICH YOU SHOULD RELY.

YOU SHOULD CONSULT WITH AN APPROPRIATE PROFESSIONAL ADVISOR TO DETERMINE WHAT MAY BE BEST FOR YOUR INDIVIDUAL NEEDS.

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