2. 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 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.
3. A VC
- 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.
4. Terminology
- 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.
5. Flow of Funds in VC Cycle 6. What do VCs do?
-
-
- 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.
-
-
- Board meetings, recruiting, regular advice
-
-
- IPOs (most profitable exits) or sale to strategic buyers
7. Some VC-backed companies you might recognize
- 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.
8. VC Investments by Stage
-
- 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.
-
- At this stage, the firm has an operating business and tries to
expand.
-
- 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.
9. VC investment share by stage 10. VC investments by industry
11. VC vs. Other Types of Private Equity
- Very late stage venture capital by VCs, banks, insurance cos
etc.
- Subordinated debtwithwarrantsattached (typically used inLBOs
).
Mezzanine Venture Capital Buyout Distress Private Equity Hedge
Funds 12. VCs vs. Hedge Funds
-
- 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)
-
- 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.
13. 14. 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?
15. VC contracts
- 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.
16. Agency problems betweenGPs 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:
-
- 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)
17. Restrictive Covenants inVC 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% 18. GP Compensation in
VCs
-
- 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
19. Data: Fees and Carry Source: Metrick and Yasuda, 2008, The
Economics of Private Equity Funds 20. 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.
21. The nature of incentive conflicts between VCs and
entrepreneurs
- 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.
22. 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.
23. 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
- 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?