Lectures 1 and 2

1. Week 1 Introduction

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 cannot borrow from banks.

An alternative to banks is wealthy individuals (e.g., businesspeople, doctors, lawyers)referred to as angel investors. However, these investors are widely dispersed and amount they contribute is small.

Lack of outside funding hampers growth of new businesses in many countries around the world. Venture capital is a means to overcome capital constraints.

is afinancial intermediary , collecting money from investors and invests the money into companies on behalf of the investors

invests only inprivatecompanies.( Question : What is a private firm?)

actively monitors and helps the management of the portfolio firms( Question : How do VCs help their portfolio firms?)

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?)

invests to fund internal growth of companies, rather than helping firms grow through acquisitions.

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

VC firms might have multiple VC funds organized aslimited partnershipswith limited life (typically 10 years).

General partners (GPs)of the VC fundraisemoney from investors referred to aslimited 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 docapital calls ,drawdowns , ortakedowns .

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.

Investing:

Screenhundreds of possible investment and identify a handful of projects/firms that merit a preliminary offer

Submit apreliminary offer on a term sheet(includes proposed valuation, cash flow and control right allocation)

If the preliminary offer is accepted, conduct an extensivedue diligenceby 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; andclosing.

Monitoring:

Board meetings, recruiting, regular advice

Exiting:

IPOs (most profitable exits) or sale to strategic buyers

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 thanS3.5 millionin 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.

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.

Mezzanine:

Very late stage venture capital by VCs, banks, insurance cos etc.

Subordinated debtwithwarrantsattached (typically used inLBOs ).

Similarities :

Both VCs and hedge funds are organized aslimited partnerships .

Fund manager (GP: general partner)compensationstructure at both types of firms are very similar. (we will talk more about this later)

Differences :

VCs invest inprivatebut hedge funds typically invest inpublic firms .

Hedge funds often invest in financial assets of a company for quick financial returns, while VCs often help structure or restructure the firm. In other words, hedge funds areshort-term tradersand private equity firms arelong-term investors .

The investments of hedge funds aremore liquidthan the investments of private equity firms.

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?

The contracts share certain characteristics, notably:

(1)stagingthe commitment of capital and preserving the option to abandon,

(2) usingcompensation systemsdirectly linked to value creation,

(3) preserving ways toforce 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.

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)

Management fees

typically 2.5%/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 aslifetime fees

Investment capital = Committed capital Lifetime fees

Carried interest (or carry)

typically equals to 20% of thebasisor funds profits (source: Bible-Genesis 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

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.

Some projects have high personal returns for the entrepreneurbut 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.

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.

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?

Lectures 1 and 2

Economy & Finance

Transcript of Lectures 1 and 2