Venture capital funds

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Venture capital funds
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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.

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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

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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.

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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.

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Flow of funds in the VC cycle
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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.

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What do VCs do?

• 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.
• Monitoring
• Board meetings, recruiting, regular advice
• Exiting
• IPOs (most profitable exits) or sale to strategic
  buyers

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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
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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)

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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.

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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?

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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.

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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.

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VC investment share by stage
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VC investments by industry
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How to value investments?

•  

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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.

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Discount rate

•  

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Discount rates and leverage
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Valuation approaches (1)

•  

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Valuation approaches (2)

• 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)
• 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.

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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

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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?

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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.

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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)

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

• 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
• Carried interest (or carry)
• typically equals to 20 of the basis or funds
  profits (source Bible-Genesis 4723-24). 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

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Fees and carry
Source Metrick and Yasuda, 2008, The Economics
of Private Equity Funds
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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.

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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
  RD intensive firms as well as firms with fewer
  tangible assets.

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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?

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

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VC investment contracts (2)

• When evaluating deal terms, be sure to ask the
  following questions
• How does this term add value?
• How will this term limit my flexibility in the
  future?
• Is this term priced correctly in the deal?
• 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.

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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.

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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.

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Board rights
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Voting rights
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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?

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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 MA market. Not surprisingly, in countries
  will relatively less developed equity and IPO
  markets the VC industry failed to flourish.