Entrepreneurial Finance Issues: Entrepreneurship Roundtable

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Entrepreneurial Finance Issues: Entrepreneurship Roundtable. Dr. Michael J. Robinson, CFA, ICD.D Haskayne School of Business The University of Calgary December 5, 2012. Talk Subtitle: What a VC Will Not Tell You. - PowerPoint PPT Presentation

Transcript of Entrepreneurial Finance Issues: Entrepreneurship Roundtable


Entrepreneurial Finance Issues:Entrepreneurship Roundtable

Dr. Michael J. Robinson, CFA, ICD.DHaskayne School of BusinessThe University of CalgaryDecember 5, 2012

1Talk Subtitle:What a VC Will Not Tell YouA venture capitalist (VC) is an institutional investor seeking to maximize their return (either financial or strategic) from investing in private firmsThe VC world is full of unique terms, practices, and behaviours that define the unwritten rules of the gameA VC will not tell you how to play the game, but if you are willing to listen they will help guide you through the pitfalls each developing firm encountersUnfortunately, VCs will invest in only about 1 in 100 firms they encounter so the remaining firms must seek other development capital and guidance

Alberta Private Equity Markets StudyPhase 1 by Elder and Robinson (2007)

3Alberta Private Equity Markets StudyPhase 1 by Elder and Robinson (2007)

4Risk ExerciseThis exercise involves a question I was asked as part of my job interview with the BDC VC division.The question is as follows:You have just made a $3 million investment in an early stage firm. What are the issues about the investment that will cause you to lose sleep at night?

People, Products and MarketsThe risk elements you have identified in the preceding exercise fall into three main categories:People Does the firm have the correct management team in place, and will they behave appropriately?Products Can the firm effectively deliver the described product on time and on budget, i.e. is the product technically feasible?Markets Will customers be willing to purchase the product once it is completed? Are there competing products being developed under the radar that will place the firm at a competitive disadvantage?

More AcademicallyHigh degree of uncertainty in private equity investments creates significant capital market imperfectionsUncertainty has three main dimensions:Information asymmetry and agency risks (People)Technological uncertainty (Products)Market uncertainty (Markets)Risk mitigation practices followed in the public capital markets are less effective in private equity contextDue to above risks, private equity capital is rationed

Extreme Information Asymmetry inPrivate Equity Investment SituationsInformation asymmetry in this investment situation has two dimensions:Adverse Selection Entrepreneurs have private information about the investment which will lead to poor quality firms being overrepresented in the marketMoral Hazard Entrepreneurs will engage in behaviours that are detrimental to investors following an investmentTaken together, these two dimensions of information asymmetry create a high degree of agency risk in the private equity marketplaceEven without explicit wrongdoing on the part of the entrepreneur, a firm can experience agency problems

People Issues on a More Practical LevelA seasoned U.S. early stage investor, Thomas Churchwell (2002) notes that without access to smart early-stage capital, and other experienced advisors, 80% of start-ups will fail. By way of contrast, a more professionally backed start-up will have an 80% success rate. The easiest way to describe the problem is that a new entrepreneur does not know what they do not know. I have been involved with advising several new entrepreneurs and there is a progression that they must work their way through if they are to become successful. Implicit in the preceding statement is the notion that a failure to make this progression will likely lead to significant difficulties for the entrepreneur and his/her firm. A failure to seek advice, and then listen to the recommendations, significantly lowers the chances of a firm succeeding.

Sources of Private Equity FinancingInformal InvestorsRelationship CapitalEntrepreneurs CapitalFriends and Family CapitalBusiness Associates CapitalOpportunity Based CapitalAngel InvestorsNovice AngelsExperienced AngelsFormal InvestorsVenture Capitalists and other Private Equity Investors

Private Equity Market ParticipantsInformal InvestorsTwo types of informal investors are:Wealthy individuals (angels) who wish to invest and add value to the firm through their experience and network of connectionsLess wealthy individuals who wish to invest passively in private firms managed by people they know, or in private firms located close to them Informal investors have less ability to mitigate both market and agency risk than formal investors, but will tend to screen on agency risk

Private Equity Market ParticipantsFormal Investors (Strategic Partners)Institutional investors that specialize in investing in situations with high uncertainty and asymmetric informationThe most common type of formal investor is a venture capitalist (VC) which will specialize in certain industries or investment situationsResearchers note that VCs are more concerned with market risk than agency riskVCs will use stringent screening procedures to mitigate market risk and will use hands-on governance and monitoring mechanisms to manage agency risk

Characteristics of Informal InvestorsSource: A Profile of Angel Investors, Morrissette, The Journal of Private Equity, 2007.

Estimates from the US suggest that there are approximately 400,000 business angels investing $50 billion in capital each year in over 50,000 firmsThis is estimated to represent approximately 70% of the capital being provided to new US ventures

Characteristics of Informal InvestorsAverage age of an angel investor is 47-50 yearsDistribution of ages is as follows:Under 35 years old 11%35-44 years old 33%45-54 years old 31%55-64 years old 19%Over 65 years old 6%

Characteristics of Informal InvestorsAverage investment size is about $75,000 with one study finding the following distribution:Investment under $25,000 20%Investment between $25,000 and $99,000 - 40%Investment between $100,000 and $250,000 - 25%Investment over $250,000 15%Most angels have three deals in their portfolio and make an investment every 18-24 monthsMost angels prefer to invest close to home (within one or two hours driving time)

Characteristics of Informal InvestorsExtent of Due Diligence is minimal and based on informed business judgment and an assessment of the quality of the entrepreneurInvestment structure tends to be simple (common stock)Angel likes to provide hands-on advice to the entrepreneurInvestment horizon is typically five years or moreAnnual ROI expectations are typically between 20%-30%Like to co-invest (80-90% of deals have multiple angels)

Histogram of PrivateEquity Financing in Alberta

17Histogram of Investments by Individuals

18Informal Investors Usage of Exemptions

Non-Individual Investors Exemption Usage

Conclusions of StudyThe study documented a series of behaviors followed by angel investors: The study results provide support for: Angel investors prefer to invest close to home (lowers their monitoring risk)Angel investors prefer to invest in industries they understand (lowers their market risk)Angel investors prefer to invest in firms with more tangible assets (lowers market and agency risk)There are other significant informal investors who can provide capitalWhere to find angel investors?Angel investors tend to like to work togetherThere is a formal angel network in Alberta called the Alberta Deal Generator (http://www.dealgenerator.com/)There is an affiliation of angel investors in Canada called the National Angel Capital Organization (http://www.nacocanada.com/)



Possible Trouble with AngelsBeware the one-hit wonderSee the business model that gave them success in the past as the correct one in all situationsBeware the Angel looking to steal the firmWill fund with debt knowing you will not attract any more equity capital and try to take you over when you are in troubleBeware the disgruntled deep-pocketed AngelSue him for sportImplication for entrepreneur and his/her family members

Overview of VC Financing IssuesWhy do VC firms exist?VCs operate in environments characterized by high agency costs and high uncertaintyIn these situations, a VCs relative efficiency in selecting and monitoring investments gives them a comparative advantage over other investorsVCs are more active in industries where there are high information costs, e.g. software/biotechnologyVCs will also tend to specialize in certain types of industries, or investment situationsEven within their area of specialization, many VCs prefer more mature investment opportunities

How Venture Capital WorksVC investment fills a void between corporate and government sources of funds for innovation, and the money an innovator can raise from the informal equity marketsVC funds are not typically targeted to basic research, but more to commercializationMost VC funds are structured as 10 year limited partnerships with capital provided by institutional investorsWith a 5-7 year investment horizon for early-stage firms, this means the VC must make these investments in the first few years of the life of their fundThe last 2-3 years of the life of a fund are spent on harvesting the investmentsThe J-Curve reflects how VCs deploy their capital over time

How a VC Spends their Time(After 4-5 deals the VC is fully committed)Soliciting Business 10%Selecting Opportunities 5%Analyzing Business Plans 5%Negotiating Investments 5%Serving as Directors and Monitors 25%Acting as Consultants 15%Recruiting Management 20%Assisting in Outside Relationships 10%Exiting Investments 5%

How Do VC Firms Operate?VC firms perform extensive due diligence to reduce information asymmetry between the entrepreneur and th