Venture Capital and Private Equity Investing

Venture Capital and Private Equity Investing Cumming & Johan (2013, Chapter 10) 1

Figure 1.1. Venture Capital Financial Intermediation Investors Part II: Chapters 4-9 Returns Capital Venture Capitalist Equity, Debt, Warrants, etc. Capital Part III: Chapters 10-13 Entrepreneurial Firm 2

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Chapter Objectives • This chapter overviews issues considered in Chapters 10-14, and provides supplementary issues dealing with venture capital and private equity investment activities • Due diligence (screening potential investee firms) • Selecting the stage of entrepreneurial firm development at which to invest (the various stages were indicated in Chapter 1) and industry in which to invest (e.g., biotech, computers, etc.) • Staging (number of financing rounds) • Valuation • Syndication (number of investors) • Board seats • Contracts between the fund and its investee firms, which includes decisions over matters that include, but are not limited to: • Security (debt, preferred equity, common equity, etc.) • Control rights (such as the right to replace the founding entrepreneur as the CEO, among other rights) • Veto rights (such as over asset sales and purchases) 3

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary 1. Due Diligence: How do VC’s choose investments? Kaplan and Stromberg (2004 Journal of Finance) “Characteristics, Actions and Analyses: Evidence from Venture Capital” 4

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Data • 67 Investments from 11 U.S. limited partnerships • Specific details introduced here that have previously been ‘unknown’ outside the venture capital funds themselves 5

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Criteria for Deciding to Invest A. Opportunity: Market Conditions, Product, Strategy and Competition • Large market size and growth • Attractive product and/or technology • Attractive business strategy/model • High likelihood of customer adoption • Favourable competitive position 6

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Criteria (continued) B. Management: Quality and Previous Experience 6. Quality of management 7. Favourable performance to date 7

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Criteria (continued) C. Deal Terms: Valuation, Contractual Structure, syndicate and portfolio considerations 8. Low valuation 9. Contractual structure that limits risk 10. Positive influence of other investors 11. Good fit in VC investment portfolio 8

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Criteria (continued) D. Financial and Exit Conditions 12. Financial market conditions and exit opportunities 9

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Large Market Size and Growth • Examples: • Two very important and visible market opportunities, which should both be over $1B with an few years • Large market amenable to rapid growth • Very large market in which incumbents can earn high profit margins • Virtually unlimited market potential in the long run • Large and growing market with favourable demographic and privatization trends • Company could dramatically impact the evolution of the computer industry • Dramatic shifts in business favour the company’s product 10

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Attractive Product and/or Technology • Examples: • Late stages of product development (first product launch planned in 15 – 18 months) • Superior technology with large market potential • Revolutionary new technology • Has developed excellent product • Has built a robust, scalable system that can meet the current market demands • Best product on the market • Well tested technology/product • Early stage company with post-beta product with competent/experienced technology team 11

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Attractive Business Strategy/Model • Examples: • Company significant reduces costs while maintaining quality • Compelling business strategy. Presence or likelihood of validating corporate alliances • Attractive and demonstrated profitability of business model • Excellent new concept • Dinstictive strategy • High value-added, high margin strategy for very little upfront capital • “Lean and mean” operation with few employees and good customer focus • Pure play / focused 12

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary High Likelihood of Customer Adoption • Examples: • Conceptual acceptance by professional community • Beta arrangements with large customers • Solid base of customers who regularly renew • Increasing popularity of approach among customers • Company has very interesting beta sites, who have been enthusiastic about product • Major corporations are customers and are positive regarding the capabilities of the product and the management team • Attractive customer value proposition 13

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Favorable Competitive Position • Examples: • Company has intellectual property rights to all significant research findings using this technology, not very threatening competitors • Company is targeting a significant segment that is underserved by incumbents • Early mover advantages from being pioneer of this concept and largest player • Highly fragmented industry, which makes the industry ripe for consolidation • No competitors • Early entrant • Very few effective alternatives available, and none currently targeting all three target segments • First-mover advantage, similar to Amazon and AOL • Given the large market, there is more than enough room for several competitors • Strong proprietary and patent position • Potential for large market share with early penetration – meeting clearly unaddressed needs 14

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Quality of Management • Examples: • Comfortable with the management team • Management team is of the highest quality in the industry • Experienced management team which is critical driver of success • VC is investing because of quality of management team, who is believed to be good in science, and at raising and conserving money • Experienced, proven and high-profile CEO competing in a market where execution is key • Very good CFO just hired • Known CEO for a long time • CEO / founder is one of the few managers in the industry capable of attracting necessary employees. Has developed excellent product while consuming only modest amounts of capital. 15

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Quality of Management (continued) • Examples (continued): • Experienced managers out of successful venture backed company • Strong CEO/founder with very high marks from existing investors • Current management team has extensive internet and website management experience • Key members of management team has industry experience. Team is well-balanced, young and aggressive • Highly sought-after entrepreneur/founder, who co-founded successful company that subsequently went public. Strong board • Excellent CEO joining company • CEO is frugral and will not spend capital unwisely • Executive team has acquired a significant level of penetration an relationships in a fairly short time. 16

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Favorable Performance to Date • Examples: • Attractive and demonstrated profitability of business model • Rapid growth: over 40% last four years • Company has a manageable cash burn rate and is expected to be cash-flow break-even with 12 months • Company has good reputation in industry • Company has been successful to date and has made substantial improvements during last two years • Significant sales growth momentum • Has developed product, well positioned to achieve revenue target • Company is operationally break-even • Year one sales of $3.2M, profitabe so far • Cash flow positive 17

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Low Valuation • Examples: • Low valuation 5-year IRR of 46% in conservative case • Very profitable unit model (60% IRR over 10 years) • Valuation is attractive and should give high returns if successful • Exit multiples are shooting up • VC only has to invest $1m at a $2m pre-money valuation 18

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Contractual Structure that Limits Risk • Examples: • The participating preferred should protect the VC in the case of mediocre performances • Unique investment structure: only have to put in money if milestones are met; combination of cumulative non-convertible preferred stock and regular convertible preferred has benefit that VC will be paid back most of investment out of IPO proceeds • Equipment can be funded with debt • Gives investors ability to control growth • Successfully structured investment to minimize downside, by only providing limited funds until milestones met • VC commitment will be invested over time. If initial (Chicago) launch no successful, VC has option to cut back • Cash-efficient early stage thanks to future company acquisitions with stock • New investor has the benefit of reduction in VC pro rata investment if more funds needed • Limited risk for VC: will only own 4.4% of company • Can take company to leading industry position with minimum amount of capital 19

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Positive Influence of Other Investors • Examples: • Investing partners include investors who previously invested in some extremely successful companies • Former CEO of US industry involved as active chairman and interim CEO, as well as investor • Main reason that VC is investing is that it is required to get a new individual investor which has the benefit of (1) reduction in VC pro rata investment if more funds needed, and (2) the skills of the investor and the interim “turnaround” CEO that he is getting company 20

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Good Fit in VC Investment Portfolio • Examples: • Adds additional breadth to VC portfolio with this market segment • VC is strong in this geographic region • Participation in the rapidly growing market • Good strategic fit with VC • VC has board seat on company in complementary business, with which VC could facilitate marketing partnership • Represents new market segment for the funds, which should stimulate some additional opportunities (assuming a positive outcome) • Potential for )Non-California) VC to lead a Silicon Valley deal 21

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Financial Market Conditions and Exit Opportunities • Examples: • If successful, possibility for early exit or acquisition • Expect to have access to both debt and equity in public markets in attractive terms • Quick flip potential for the investment • Many strategic buyers available • Recent public market enthusiasm for e-commerce companies might enable public equity financing to mitigate future financing risks • Given the size of the market opportunity and company’s strategy, capital markets will be receptive given that company achieves business plan. Also, a consolidation trend should emerge in industry as more companies enter market 22

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary NDAs? • Non-disclosure agreements • Rarely considered by VCs • Why?! 23

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Diversification? • Venture capital funds typically have around 10 investees in their portfolio. • Why not more investments (diversify risk)? • This issue is studied further in Chapter 18 24

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary 2. Stage of Development Cumming, Fleming and Schwienbacher (2005 Financial Management) “Liquidity Risk and Venture Capital Finance” 25

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Exit Conditions in Stock Markets Affect VC/PE Markets • Relationship between IPOs and Early Stage Investments • Inverse relation… early stage investments take a while to bring to fruition (Chapter 19) • Can delay exit requirements by investing early stage, hence early stage activity is counter cyclical relative to IPO market conditions 26

Figure 10.1: Importance of New Early-Stage Investments and IPO Volume in the United States from 1985 to 2004. The bold line (with left-hand Y-axis) gives the ratio of new early-stage investments over all new expansion-stage and later-stage investments in each year. The IPO volume (right-hand Y-axis) is shown by the dashed line and represents the number of initial public offerings (IPOs) as reported by Ritter and Welch (2002). It refers to IPOs on the NASDAQ, NYSE and AMEX. Source: Cumming et al. (2005b). 27

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary 3. Venture Capital Staging Gompers (1995 Journal of Finance) "Optimal Investment, Monitoring, and the Staging of Venture Capital" 28

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Tradeoff • Agency Costs versus Monitoring Costs • This tradeoff enables us to make predictions regarding the duration and size of venture capital investments 29

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Typical Monitoring • Gorman and Sahlman (1989) • Monitoring is costly and can’t be done continuously • Between financing rounds, on average inside VCs visit the entrepreneurial firm once per month and spend 4-5 hours at the firm per visit • On average outside VCs visit the firm once a quarter for an average of 2-3 hours • Checks between financing are designed to limit opportunistic behaviour by entrepreneurs between performance evaluations for new capital commitments 30

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Value of Staging • Gather information about the firm • Reduce informational asymmetry between entrepreneur and venture capitalist • Monitor the progress of the firm • Maintain the option to abandon financing 31

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Monitoring Costs • Opportunity costs of generating reports for the VC and entrepreneur • Opportunity costs of visiting an entrepreneurial firm • Contracting costs (legal, negotiating, and other incidental costs) associated with each new financing round 32

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Factors that affect agency costs 1. Asset intangibility and R&D 2. Growth options • Increase in market to book ratios  increasing role of investment opportunities in firm value 3. Asset specificity 4. Firm development stage • No agency costs  irrelevance of financing structure (similar to MM proposition) 33

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Asset Intangibility • Agency costs of debt • E.g., Risk-shifting, under-investment, asset stripping • Value of leverage • Increases with liquidation values and asset tangibility • Asset characteristics that increase the agency costs of debt reduce the value of leverage and make monitoring more valuable • Should also shorten funding duration in staged venture capital investments 34

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Growth Options • Growth options  more scope for the entrepreneur to act in his or her own interest against the interest of the VC(s) • Market to book ratios are indicative of growth options • Shorter investment durations when higher market to book options 35

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Asset Specificity • Assets with high industry-specific and firm-specific value have smaller liquidation values • Greater asset specificity  reduced liquidation values  shorter investment duration  more monitoring 36

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Firm Development Stage • Which firms (start-up, expansion, turnaround, buyout) should be staged and which should have shorter investment durations? 37

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Investment and Liquidity • When more capital is available for investment, will VCs invest more or less per round and more or less frequently in the firms they finance? 38

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Importance of Exit • Do firms that are exited by means of an IPO receive more or fewer rounds of financing and more or less total financing than their counterparts that are exited by an acquisition, secondary sale, buyback or writeoff? 39

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Examples of Staging • Federal Express • $12,250,000 September 1973 $204.17 / share • $6,400,000 March 1974 $7.34 per share • $3,800,000 September 1974 $0.63 per share • Firm went public in 1978 at $6 per share • Apple Computer • $518,000 January 1978 $0.09 / share • $704,000 September 1978 $0.28 / share • $2,331,000 December 1980 $0.97 / share 40

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary What If No Staging? • Entrepreneurs may pursue personally beneficial strategies at expense of VC • Examples: • Risk-shifting • Fame as opposed to fortune • Entrepreneur may invest in negative expected NPV venture 41

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Gompers Data • 794 firms that received VC financing between 1961 and 1992 in the US • Received 2143 rounds of venture capital financing (15% of all VC over the period) • Industry focus (min 70% of annual investments) on high-tech firms (communication, computers, electronics, biotechnology, medical/health) • VCs specialize in investments in which asymmetric information and agency costs are most pronounced 42

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Info on Exits in the Sample • 22.5% IPO • 23.8% merger / acquisition • 15.6% writeoff • 38.1% remain private • Useful contrasts relative to Chapters 20 and 21 43

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary The Duration & Size of Financing Rounds (1/2) • Duration of financing rounds declines for late stage companies • The average amount of financing per round generally rises for late stage companies • Asymmetric information and agency costs decline as investment stage is later • Rate of cash utilization increases as investment stage is later (rate of working capital utilization and investment increases with investment stage) 44

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Independent Variables (2/2) • Dummy variable for stage of financing • Firm age at time of financing (+) • (Tangible assets) / (Total assets) (+) • Size of financing round (insignificant) • Market-to-book ratio (-) • R&D / Sales (also: R&D / Assets) (-) • Amount of $ in VC industry (-) 45

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Regression Analysis Total Financing & # Financing Rounds • Independent variables: • Exit types (IPO +) • (Tangible assets) / (total assets) (insignificant) • Market to book ratio (+) • R&D / Sales (insignificant) • R&D / Assets (insignificant) 46

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Supplementary Issues in Staging • What else may explain the results? • Monitoring costs are not measured • Also, relevant to consider cyclicality of new investments versus follow-on staged investments (next slide) 47

Figure 10.2: Importance of New Investments Compared to Follow-On Investments. The bold line (left-hand Y-axis) gives the proportion of new investments from all investments (new and follow-on) in each year. The dashed line (right-hand Y-axis) gives again the number of IPOs in each given year (IPO volume), as in Figure 2. Source: Cumming et al. (2005b Financial Management). 48

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary 4. Valuation in VC relative to Public Markets Gompers & Lerner (2000, Journal of Financial Economics) "Money Chasing Deals?: The Impact of Fund Inflows on the Valuation of Private Equity Investments 49

Due Diligence Stage of Development Staging Valuation Syndication Board Seats Contract Terms Summary Valuation Issues • How does fund inflows into the VC market affect the pricing of deals? • Is the relation driven by demand pressures or is it related to an improvement in deal prospects? 50

Venture Capital and Private Equity Investing