Venture capital .funds ppt

Venture capital funds

• Private investors who provide venture capital to promising business ventures. They typically invest where at least 25 percent annual returns within one to five years are feasible, and often demand 50 percent or more ownership to exercise control over the investee firm to offset their high risk. Often they also provide management and industry expertise andbusiness connections with other firms and venture capitalists. 

• Their objective usually is to bring the business to its initial public offering (IPO) stage so that they can sell their shareholdings to the public at high profit, and get out. See also adventure capitalist and angel investor.

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.

Potential funding sources1) 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, don’t 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

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.

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.

Flow of funds in the VC cycle

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 Apple’s 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.

What do VCs do?

1. 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.

2. Monitoring: Board meetings, recruiting, regular advice

3. Exiting: IPOs (most profitable exits) or sale to strategic buyers

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

Screening

• Takes a big chunk of the VC’s 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)

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 firm’s 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 firm’s 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 firm’s products and services (e.g., eBay, Netscape, Yahoo). In such cases, spotting potential winners is more of an art than science.

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?

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.

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.

VC investment share by stage

0%

20%

40%

60%

80%

100%

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Late

Expansion

Other Early

Seed/Startup

VC investments by industry

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

postboom

boom

preboom

How to value investments?

Cash flowFree (after-tax) cash flow from operations

= EBIT (1-tax rate) + Depreciation – CapEx – ΔNWC

•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.

Discount rate

Discount rates and leverage

Valuation approaches (1)

Valuation approaches (2)3. 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)

4. 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.

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

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 fund’s 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 don’t use debt.

• 1% of the capital commitment comes from the GPs. Why?

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.

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 fund’s 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 GP’s wealth) Covenants (see next slide)

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%

GP compensation in VCs

1. 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

2. Carried interest (or carry) typically equals to 20% of the basis or fund’s profits (source: Bible-

Genesis 47:23-24). Basis typically equals Exit proceeds – Committed (or Investment) capital.

allows the GP participate in the fund’s profits (incentive alignment role) Basis and timing of payments to the GP might vary from fund to fund

Fees and carry

Source: Metrick and Yasuda, 2008, “The Economics of Private Equity Funds”

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.

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 R&D intensive firms as well as firms with fewer tangible assets.

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?

VC investment contracts (1)

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.

2. 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.

3. Most private investment provide for some form of investor control that is often tied to the performance of the venture.

VC investment contracts (2)

4. When evaluating deal terms, be sure to ask the following questions:

(a) How does this term add value?

(b) How will this term limit my flexibility in the future?

(c) Is this term priced correctly in the deal?

5. A poorly structured deal can make even a good company go bad…by limiting its ability to raise funds when things turn out just to be O.K.

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 firm’s 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.

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.

Board rights

Voting rights

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?

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 Apple’s $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 M&A market. Not surprisingly, in countries will relatively less developed equity and IPO markets the VC industry failed to flourish.