© cumming & johan (2013)venture capital and private equity contracting venture capital and...

© Cumming & Johan (2013) Venture Capital and Private Equity Contracting

Venture Capital and Private Equity Contracting:An International Perspective

Douglas CummingB.Com.(Hons), M.A., J.D., Ph.D., CFA York University Schulich School of Business

Sofia JohanLL.B., LL.M., Ph.D.York University Schulich School of BusinessTilburg Law and Economics Centre (TILEC)

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Materials

• Textbook:– Cumming, D.J., and S.A. Johan, 2013. Venture Capital and

Private Equity Contracting: An International Perspective, 2nd Edition, Elsevier Science Academic Press.

• Web:– http://booksite.elsevier.com/9780124095373/

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Chapter 1 Objectives

Introduction Venture Capital & Private Equity

Main Issues Addressed in this courseSummary

• Introduction

• Venture Capital and Private Equity Definitions

• Issues addressed in course and textbook

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Sources of Funds for Entrepreneurial Firms



Sources of fundsWhat do VC/PE Managers Do?Possible Misconceptions?

• There are various sources of funds

• Characteristics of other sources are very briefly provided on the next slide

• Our focus in this course is on Venture Capital (VC) and Private Equity (PE)

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Table 1.1. Greatly Oversimplified Typical Characteristics of Funds Providers

SourceInvestment Motivation

Focus of Attention

Cash Typically Available

Source of Funds

Biggest Drawbacks

Biggest Advantages

Security Required

Subject to Market Conditions?

Internal Operations Reinvestment Execution Unlimited Earnings Slow Non-Dilutive None Some

Founders Ambition Varies $100,000 Savings Personal Risk Non-Dilutive None Little

Friends and Family Relationships Support $250,000 Savings Relationships Easy Sell None Some

Private ‘Angel’ Investors The Entrepreneur Varies$500,000 to

$1.5MPrevious Successes

Varying Commitment

Brings Credibility None Considerable

Venture Capital FundsBusiness Plan, Team, Market,

Trajectory

Contracts, Liquidity Event,

Valuation$1M to $20M

Limited Partners,

Institutions

Time Consuming, Expensive

Brings Help, Credibility

Contractual Terms and Conditions

Greatly

Private Equity FundsMezzanine, Buyout,

Turnaround

Contracts, Liquidity Event,

Valuation

$20M to $500M

Limited Partners,

Institutions

Time Consuming, Expensive

Brings Help, Credibility

Contractual Terms and Conditions

Greatly

Commercial Banks (& Venture Banks)

Risk versus ReturnTwo Repayment

Sources80% of A/R, 50% of inv.

DepositsRegulatory Agencies

Advice, Clean, Straight-forward,

Businesslike

A/R, Inventory, IP

Little

Bridge Funds Risk versus Return Low Risk $500K to $5MLimited Partners,

InstitutionsWarrants

Speed (5 days to get a loan)

All Assets Including IP

Greatly

Leasing Companies Risk versus ReturnLiquidation

Values80% of value

Company Treasury

CostlyCheaper than

EquityVaries Little

Factors (buy your A/R) Risk versus Return Collections 80% of A/RCompany Treasury

~5% over PrimeCheaper than

EquityVaries Little

Asset Lenders Risk versus Return Balance Sheet80% of A/R, 60% of inv.

Company Treasury

ExpensiveCheaper than

EquityPersonal

GuaranteeLittle

Partner CompaniesWhat You Can Do

For ThemSynergies Varies

Company Treasury

May Preclude Other Opportunities

2-Way Economics, Low Pricing

PressureLittle Some

Government Agencies MandatesRegulations,

WarrantsVaries Taxes

Paperwork, Oversight

Inexpensive, No Recourse

Little or None Little

Investment Bankers at IPO Fees Stock Market Unlimited PublicCosts,

Underpricing, Public Disclosure

Advice, Public Exposure

Escrow, Lock-in

Extreme

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Figure 1.1. Venture Capital Financial Intermediation

Investors

Venture Capitalist

Entrepreneurial Firm

Returns Capital

Equity, Debt,Warrants, etc. Capital

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What Do Venture Capitalists (VCs) Do?




• Due Diligence– Screening– 1 to 2 deals out of >1000

• Value-added– Monitoring, Networks, Expertise– Legal, Financial, Accounting, Suppliers, Buyers,

Boards of Directors, Human Resources, Strategic, Marketing, other

8


Possible Misconceptions (?!)




• “Vulture” capital: significant ownership and control rights

• Insufficient funds

• Sell bad investee firms public in initial public offerings (IPOs)

9


Venture Capital and Private Equity



DefinitionsSizeCountries/ Data

Some Definitions

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PROFITS

TIMEValley of Death

BreakEven

Angels, FFF

Seed Capital

(Could include VC)

1st

2nd

3rd

Mezzanine

IPO

PublicMarket

SEO

Early Stage Later Stage

VCs, Acquisitions/MergersStrategic Alliances, etc.

Figure 1.2

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“Venture Capital” vs “Private Equity” (1/3)




• Seed– Financing provided to research, assess and develop an initial concept before a business

has reached the start-up phase.• Start-up

– Financing provided to companies firms for product development and initial marketing. Companies Firms may be in the process of being set up or may have been in business for a short time, but have not sold their product commercially.

• Other Early Stage– Financing to companies firms that have completed the product development stage and

require further funds to initiate commercial manufacturing and sales. They will not yet be generating a profit.

• Expansion– Financing provided for the growth and expansion of a company firm which is breaking

even or trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital.

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• Bridge Financing– Financing made available to a company firm in the period of transition from being privately owned to

being publicly quoted.• Secondary Purchase / Replacement Capital

– Purchase of existing shares in a company firm from another private equity investment organization or from another shareholder or shareholders.

• Rescue / Turnaround– Financing made available to an existing business firm which has experienced trading difficulties (firm is

not earning its cost of capital (WACC)), with a view to re-establishing prosperity.• Refinancing Bank Debt

– To reduce a company’s firm’s level of gearing.• Management Buyout

– Financing provided to enable current operating management and investors to acquire an existing product line or business.

• Management Buyin– Financing provided to enable a manager or group of managers from outside the company firm to buy-

in to the company firm with the support of private equity investors.

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• Venture Purchase of Quoted Shares– Purchase of quoted shares with the purpose of delisting the firm.

• Other Purchase of Quoted Shares– Purchase of shares on a public stock market.

• In practice, sometimes broader categories of definitions are used. For example, – Start-up: sometimes used in practice to refers to Start-up, and Other Early Stage – Expansion: sometimes used in practice to refers to Expansion, Bridge Financing,

Rescue/Turnaround– Replacement Capital: sometimes used in practice to refers to Secondary

Purchase/Replacement Capital, Refinancing Bank Debt– Buyouts: sometimes used in practice to refers to Management Buyout, Management

Buyin, Venture Purchase of Quoted Shares.

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Size of VC and PE Markets?




• VC is a small but important sector of the economy

• Connected to:– IPO markets (stock markets)– Legality: shareholder protection, bankruptcy law, tax– Government programs– Armour and Cumming (2006 Oxford Economic Papers)

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Aus

tria

Bel

gium

Den

mar

k

Finl

and

Fran

ce

Ger

man

y

Irela

nd

Italy

Net

herla

nds

Por

tuga

l

Spa

in

Sw

eden UK

US

Can

ada

Early Stage

Expansion Stage

Total Private Equity

All Dispositions

Fundraising

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

Amounts Averaged1990 - 2003

Relative to GDPExpressed in %

Figure 1.4. Size of Venture Capital and Private Equity Markets Across CountriesSource: Armour and Cumming (2006)

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Figure 1.5. Comparison of VC Amounts by total PE versus GDP and PopulationThis figure shows the differences across countries in terms of amounts of early stage VC / total PE, early stage VC / GDP and early stage VC / population. Amounts are scaled as indicated to enable direct comparisons and show how country rankings for VC amounts change depending on the benchmark used to compare countries. Data are averaged by country for the period 1989-2011. 17


Figure 1.6. Comparison of the Number of VC Investments by total PE versus GDP and Population in EuropeThis figure shows the differences across countries in terms of numbers of early stage VC investment / total PE, early stage VC / GDP and early stage VC / population. Amounts are scaled as indicated to enable direct comparisons and show how country rankings for VC amounts change depending on the benchmark used to compare countries. Data are averaged by country for the period 1989-2011. 18


VC Data




• U.S.: http://www.ventureeconomics.com, http://www.vfinance.com, http://www.v1.com

• The PricewaterhouseCoopers MoneyTreeTM Survey: http://www.pwcmoneytree.com/

• Canada: http://www.cvca.ca, http://www.canadavc.com

• Europe: http://www.evca.com

• Australia: http://www.abs.gov.au/Ausstats/[email protected]/0/bffef2819df68ca2ca256b6b007ab94e?OpenDocument

• Private data sources

• Data and empirical methods summarized in Cumming and Johan (2013, Chapter 3)

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VC Industry in US




• Over 1000 funds• Geographic concentration• Specialized focus• Over $US 100 billion capital under

management• Predominantly Private Limited Partnership

VC Funds

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Figure 1.7.a Capital Overhang for Venture Capital Funds Raised by US Investors Source: Pitchbook

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Figure 1.7.b. Capital Overhang for Private Equity Funds Raised by US InvestorsSource: Pitchbook

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Figure 1.8.a. Average Venture Capital Return Multiples by Vintage YearSource: Pitchbook

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Figure 1.8.b. Average Private Equity Return Multiples by Vintage YearSource: Pitchbook

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Table 1.4. Thomson Financials' Private Equity Performance Index (PEPI)Investment Horizon Performance through 09/30/2006 (expressed in %)

Fund Type 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr

Early/Seed VC 2.9 5.5 -5.4 38.3 20.5

Balanced VC 10.7 12.8 1.8 16.8 14.6

Later Stage VC 27.8 10.5 2.7 9.4 13.9

All Venture 10.8 9.4 -1.0 20.5 16.5

Small Buyouts 11.3 9.4 5.0 6.0 25.2

Medium Buyouts 37.2 12.3 6.1 10.9 15.3

Large Buyouts 23.1 16.4 8.3 8.3 12.4

Mega Buyouts 23.4 16.2 10.1 8.9 11.6

All Buyouts 23.6 15.6 9.2 8.8 13.2

Mezzanine -8.1 4.7 2.9 5.9 8.4

All Private Equity 19.0 13.2 5.9 11.2 14

NASDAQ 5.5 7.8 8.7 7.1 11.4

S & P 500 9.7 9.9 5.2 7.5 9.725


Figure 1.9. Venture Capital Horizon IRR by Fund SizeSource: Pitchbook

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Figure 1.10. IRR Quartiles by Fund Size for Mature Venture Capital FundsSource: Pitchbook

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Figure 1.11. Median 1-Year Rolling Horizon IRR by Fund TypeSource: Pitchbook

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Figure 1.12. Horizon IRR – Private Equity, Venture Capital and Public IndexSource: Pitchbook

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Figure 4.13. US Buyout Returns by Vintage Year

Median, Upper and Lower Quartiles as of December 2006

Source: Kaplan (2007), Venture Economics

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Lower 1/4

Median

Upper 1/4

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Figure 1.14. US versus Non-US Venture Capital Investment by Fund Vintage YearSource: Thompson SDC.

0

2000

4000

6000

8000

10000

12000

14000

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

US Private VC Investment in Seed Early and Expansion

Non-US Private VC Investment in Seed Early and Expansion31


Figure 1.15. US versus Non-US Venture Capital IPO Exits by Fund Vintage YearSource: Thompson SDC

0

200

400

600

800

1000

1200

140019

9019

9119

9219

9319

9419

9519

9619

9719

9819

9920

0020

0120

0220

0320

0420

0520

0620

0720

0820

0920

1020

11

US Private VC IPO Exits Non-US Private VC IPO Exits32


VC Industry in Canada




• The estimated size of Canada’s VC/PE) market: $76 billion at the end of 2013

• Buyout:$53.2 bil.; Mezzanine: $7.6 bil.; VC: $14.9 bil.

• Private indp. Funds: 59% of total funds; $44.6 billion, Institutional captive funds accounted for $20 billionCorporate captives $2.3 billion. Retail funds were $7.6 billion andGovernment owned and -directed $1.8 billion.

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Venture Capital in Australia




Table 1: Amount of Funds Raised by Fiscal Year, Australia (in A$ Millions)

Year Venture Capital Private Equity TOTAL

FY2001 325.50 585.20 910.70

FY2002 55.60 780.40 836.00

FY2003 161.70 521.70 683.40

FY2004 155.30 863.20 1,018.50

FY2005 84.30 2,094.60 2,178.90

FY2006 184.70 3,933.60 4,118.30

FY2007 435.60 4,951.90 5,387.50

FY2008 343.60 5,581.70 5,925.30

FY2013 298.92 1,412.31 1,711.23

FY2010 168.28 1,456.07 1,624.35

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Venture Capital in Europe




• Fundraising by European private equity houses reached €16bn in 2013, 80% below the €81bn raised in 2008

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Main Issues addressed in this Course



[Not a comprehensive list]

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I. Why Do VCs Exist?



Why do VCs exist?What matters when running a fund?Financial contracting with entrepreneursInvestor Value-AddedHow to Successfully Divest?

• Why not simply borrow from banks?

• What does this imply about any theory / evidence in venture capital?

– Review agency theory in detail because it is paramount to all issues addressed in this course

– Cumming and Johan (2013 Chapter 2)

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II. What Matters in Running a Fund? (1/6)




• What do institutional investors care about?– Return expectations, Reporting, Liquidity

• How does this affect fundraising?• How does this affect specialized fund

mandates, such as socially responsible funds?– Cumming and Johan (2013, Chapter 4)

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• What terms with institutional investors?– Limited partnership agreements– Restrictive covenants– Limited liability– What clauses to use and when to use them– Cumming and Johan (2013, Chapter 5)

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• How to structure compensation?– Fixed fees– Carried interest– Cash versus share distributions– Clawbacks– Cumming and Johan (2013, Chapter 6)


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• Style Drift– Why and when should institutional investors

care?– Why and when does it matter to fund

managers?– Cumming and Johan (2013, Chapter 7)


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• Listed private equity (LPE)– What are the differences between LPE and

limited partnerships?– Who invests in LPE, and when and why?– Cumming and Johan (2013, Chapter 8)


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• What role for government?– Existence of capital gaps?– Economic sources of capital gaps– Legal sources of capital gaps– Direct government investment programs– Legislation– Evidence from US, UK, Continental Europe, Israel,

Australia, Canada– Cumming and Johan (2013, Chapter 9)


44


III. Financial Contracting with Entrepreneurs (1/4)



• Investment process– Due diligence– Stage of development and industry– Location– Staging – Fund flows and valuations– Syndication– Portfolio size / manager– Board seats– Contracts– Innovative activity– Investment duration– Cumming and Johan (2013, Chapter 10)


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• What structure of investment?– Security design

• Warrants• Common equity• Preferred equity• Convertible preferred equity• Convertible debt• Debt

– Other veto and control rights– Cumming and Johan (2013, Chapter 11)



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• Specific veto, control and cash flow rights– Definitions and terms– Role of preplanned exits– Cumming and Johan (2013 Chapter 12)


47





• International differences in contracts, due diligence, board seats, syndication, co-investment– Role of legal systems– Cumming and Johan (2013, Chapter 13)


48


IV. Investor Value-Added (1/4)



• VC and PE Value-Added– Jobs– Total Factor Productivity– Patents– Locusts?– Cumming and Johan (2013 Chapter 14)


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• Do contracts ensure effort?– Advice– Monitoring– Conflicts– When more pronounced– Role for contracts in facilitating effort and

mitigating problems– Cumming and Johan (2013 Chapter 15)


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• Where to invest?– Distance between investor and investee in the

US– Inter- versus intra-provincial in Canada– Implications of proximity and local bias– Cumming and Johan (2013 Chapter 16)


51





• How many investments? • Portfolio size/manager

– Trade-off: • Diversification• Diffusion in effort

– Cumming and Johan (2013 Chapter 17)


52





• Fund size– Scale economies versus limited attention– Cumming and Johan (2013 Chapter 18)


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V. How to Successfully Divest? (1/4)



• Overview of divestment process– Exit vehicle

• IPO, Acquisition, Secondary sale, Buyback, Write-off• Issues with IPOs

– IPO short-term underpricing, long-term overpricing– Impact of venture capital backing– Cumming and Johan (2013 Chapter 19)


54





• Investment Duration– How long to invest– Economic conditions versus fund and investee

characteristics– Cumming and Johan (2013 Chapter 20)


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• Which exit vehicle?– Market conditions– Legal conditions– Fund characteristics– Investee firm characteristics– Allocation of control rights– Cumming and Johan (2013 Chapters 21)


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• Returns, Valuation and Disclosure– Mechanics of valuation– What enhances returns?– How to make adjustments with valuations

based on return expectations?– How to disclose valuations of unexited

investments to institutional investors?– Cumming and Johan (2013 Chapter 22)


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Summary



• VC/PE unique form of financing• Idiosyncratic risk matters• Contracts matter

– Fund structures: relations with limited partners– Public policy and design of statutes– Relations between investors and entrepreneurs– Exits, Returns, Valuations, Disclosure

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