6 VC PE Investment Process

Entrepreneurial Finance
Module 6
Venture Capital and Private Equity:

The investment process
Chair of Entrepreneurial Finance

Prof. Dr. Reiner Braun
Entrepreneurial Finance Summer Term 2015
Page 1
Updated Schedule
Financing
young
companies
Venture
Capital &
Private Equity
Venture
Valuation
Page 2
Financing relationships of a VC/PE firm

Investors
Success
participation
Refinancing
relationship
Money
(Fundraising)
PE / VC firm
Return on
investment
Financing
relationship
Portfolio company
Source: Based on Schefczyk (2006)

Page 3
Investing
smart money
(Equity & Help)
The investment process
Investors
Investor Relations
Fundraising
Investment
Origination
Investment
Due
Diligence
Investment
Structuring
Investment
Development
Portfolio Companies
Source: Fingerle, C. (2004): Smart Money - the Influence of Venture Capitalists on Portfolio Companies
Page 4
Investment
Exit
Distribution
of Returns
Agenda
6.1 Investment Process
6.2 Investment Development
6.3 Investment Exit
Page 5
Content of the Structuring Phase
VC/PE firm
Negotiations
Portfolio Company
about contractual agreements

financial instruments
additional investor rights
Legally non-binding term-sheet: actual financial & legal terms related to a transaction
These terms are finally included in various legal documents such as

the shareholders agreement,
the articles of association,
the bylaws of the management team and supervisory board and
the employment contracts of the management team.
Page 6
Financial Instruments (1/3)
Equity
Common stock
Shareholders share the same level of risk and return

Additional rights can be given by shareholders agreement
Preferred stock
Additional investor rights directly linked to ownership of stock

Usually issued as convertible preferred stock
Page 7
Debt
Senior debt
Subordinated debt
enjoys higher priority than other loans or equity stock in

case of a liquidation of the asset or company
has a lower priority than a senior loan in case of a

liquidation of the asset or company
Page 8
Mezzanine
Convertible debt
Silent Partnerships
Allows lender to exchange debt for common shares at a

preset conversion ratio
Silent partner participates in profit and losses

(maximally with amount of investment)
German tax law differentiates between:
typical silent partnership
atypical silent partnership (rather comparable to an
equity investor)
according to the degree of entrepreneurial risk, return
and participation rights attributed to the silent partner
Page 9
Financing an MBO/LBO Transaction
Financing requirements for a buyout consist of
Purchase price (company value)

Net financial debt to be taken over
Necessary investments
Transaction costs
Financing secured by various capital forms
Equity
Debt (A, B, C Senior, Junior)
Hybrid financing instruments (Mezzanine)
Source: Deloitte
Page 10
But
Where is the M of the Management Buy Out?
1) All
Page 11
exits
Whats expected from the management?
Equity investment of 1 times annual salary
Negotiable
Depends on institution
Envy factor
Considerable upside reward for success
Total commitment to the project
Page 12
And now
The L of the Leveraged Buyout!
Page 13
What are bankers looking for?
Strong positive cash flow
Equity contribution of 30% to 40%
Repayment of Senior A typically within 7 years
First charge over assets as security
Financial and other covenants

Interest coverage of 2.5 to 3 times
Leverage of 3.5 up to 8 x EBITDA
Cash cover of at least 1
Source: Deloitte
Page 14
Additional Investor Rights - Overview
1. Information Rights
2. Control Rights
7. Disinvestment Rights
Additional
Investor Rights
6. Preemptive Rights
3. Management Covenants
5. Cash Flow Rights
4. Milestone Agreements
Page 15
1. Information Rights
Information Rights
define the extent to which the VC/PEs have access to

information of the portfolio company
Many rights already defined by statutory regulation (e.g. 51a GmbHG for
GmbHs, 131 AktG for AGs)
Ability to react on happenings within the company
VC/PEs define a catalogue of information (financial statements, budgets, nonfinancial information regarding company development)
Information provision in regular intervals, usually monthly
Reduce post-contractual information asymmtries
Page 16
2. Control Rights (1/3) - Voting Rights
Voting Rights
measure the percentage of votes that shareholders have to

effect corporate decisions.
Usually VC/PE firms hold a certain class of preferred stock and ask for a
class voting right:
Only holders of this type of preferred stock are allowed to vote on changes
regarding the status of their class of stock without other investors having the
right to intervene
Page 17
2. Control Rights (2/3) - Veto Rights
Financial aspects
Introduction of
corporate pension
schemes
Sale of a business
division
Capital increase
Taking on
additional debt
Annual budget
Changes in
the shareholder
structure
Contracts with
other
shareholders
Issue of charges
over the companys
asset
Appointment of
directors
Creation of
subsidiaries
Organizational aspects
Investment and respectively

disinvestment aspects
Merger with
or acquisition of
companies
Contracts of
other major
related party
Management
contracts
Alteration of
company statues
Page 18
Contracts of material
influence
2. Control Rights (3/3) - Board Rights - Definition
Board Rights
Board rights define membership in the supervisory board.

Exemplary responsibilities:
Hiring, evaluating and firing senior management
Advising senior management on general corporate strategies and
decisions and ratifies them
Page 19
3. Management Covenants (1/2)
Affirmative covenants
Non-compete clauses
Define correct behavior of the companys management.

For example,
management promises to maintain adequate insurance
to pay corporate debts and taxes in accordance with
normal terms
If a founder leaves the firm, he cannot work in the same

profession for a couple of years and geographical location
Page 20
3. Management Covenants (2/2)
Vesting
Representations &
warranties
Founders will forfeit granted shares or options

if they leave the employment of the company before vesting
periods expire (time vesting) or
if certain milestones are not met (performance vesting).
The company is required to make representations and

warranties on:
its good standing,
the ownership of its technology and other assets,
full disclosure of all material information needed to make
an informed investment decision,

Page 21
4. Milestone Agreements - Overview
Milestones
Contracts may specify measures to be taken contingent on certain

predefined events - these so-called milestones define important
steps in the development of the company.
Financial nature
e.g.
Reaching certain sales
and profitability numbers
Registration for an IPO
Technical nature
e.g.
Completion of design
Pilot production
Introduction of a second
product
Page 22
Conclusion of contracts
e.g.
Acquisition of key customer
Conclusion of licensing
R&D contracts
4. Milestone Agreements Most Relevant Milestone Agreements (1/2)
Earn-out
Ratches
VC/PE firm pays certain amount on top of the price it

initially paid for its stake if the company manages to achieve
pre-specified, mostly financial criteria within a time period.
Ratchet-down agreement:
transfer of shares from management to VC, if management
fails to meet a performance target within a specified time
Ratchet-up agreement:
transfer of shares from VC to management, if management
timely meets a performance target
Page 23
4. Milestone Agreements Most Relevant Milestone Agreements (2/2)

Staging
capital needs are met through several financing rounds
additional financing only if pre-specified milestones are achieved
if company fails to reach its milestones, the VC/PE firm is typically released from its
contractual obligation to provide further finance.
Adverse Selection
Moral hazard
Hold-up
Staging lowers amount of capital at risk

resolve uncertainty about companys characteristics
next stage financing with less information asymmetries
Threat that VC/PE firm may stop financing creates incentives for the
entrepreneur to exert high effort and avoid high risks.
By keeping the initial financing rounds as small as possible the

potential payoff of a hold-up strategy is reduced drastically.
Page 24
5. Cash Flow Rights Liquidation Preference Definition
Liquidation Preference
Liquidation preferences specify the amount and the order in which holders
of different classes of securities get paid in the event the company is sold or
liquidated.
Page 25
5. Cash Flow Rights Liquidation Preference Implementation

Liquidation preference - Basic structure
VC/PE firm receives its initial investment back

before other investors receive any payments
Additional elements
Participating preferred stock

The venture capitalist
Preferred dividends are of some

specified percent that will be accrued on
the preferred stock and paid before any
dividend can be paid to holders of
common stock.
first receives the par value of the

preferred stock (plus the accumulated
dividend, if present) and then
participates in the remaining
payments with the common stock as
if he had converted.
Cumulative preferred dividends not

have to be paid out during normal
business operations but accumulate and
are added to the liquidation claim of the
VC/PE firm.
Page 26
5. Cash Flow Rights Dividend Preference Example Participating Preferred Stock
Common Stock
VC/PE firm investment in

convertible
Participating preferred stock

with cumulative dividend
2m EUR (50% of common stock)
Trade sale after 5 years
5m EUR (100%)
Cumulative dividend (10%)
0 EUR
1m EUR
Repayment of investment
0 EUR
2m EUR
Pro rata repayment of

remaining assets
2.5m EUR
1m EUR
Total repayment to VC/PE firm
2.5m EUR
4m EUR
Total repayment to VC/PE firm

as % of trade sale
50%
80%
Page 27
5. Cash Flow Rights Antidilution Protection

Antidilution rights
protect the shareholdings of the VC/PE firm
against share and price dilution
Share dilution/percentage based

dilution provisions
Price dilution/
price based dilution provisions
Trigger
Capital increases, stock dividends and

stock splits
Sales of shares at lower valuations in

downrounds
Intention
Keep the percentage of the venture

capitalists shareholding constant
Adjust the price per share paid by

the VC to a lower level
Design
Preemptive right
Full ratchet and weighted average

ratchet
Page 28
5. Cash Flow Rights Antidilution Protection

If the venture sells shares at a lower price,
the venture capitalist receives
additional shares for free
Full ratchet
Weighted average ratchet
The venture capitalists average cost per

share will then equal the lower price per
share given to the new investor
Free shares =
The venture capitalists average cost per

share will then equal the average price
per share given to all investors
original investment
- old shares
conversion price
Free shares =
original investment
- old shares
conversion price
Conversion Price =
new investment
old price
old price x
outstanding shares + new shares
Conversion Price = New price
outstanding shares+
The lower the valuation in the next financing round, the higher the
dilutive costs of raising additional capital
Page 29
5. Cash Flow Rights Example for Full-Rachet Dilution Protection
Conversion
Price of
Preferred
shares
Shares
Issued
(000s)
Common
Shares After
Conversion
Percent of
Company
Owned
$1.00
7,500
2,500
7,500
2,500
75.00%
25.00%
$1.00
$0.50
7,500
2,500
2,000
7,500
2,500
2,000
62.50%
20.83%
16.67%
Capitalization No Dilution Protection

First Round
Common Shares
Series A Preferred Shares
Second Round
Common Shares
Series B Preferred Shares
Second Round Capitalization Full Ratchet Dilution Protection
Common Shares
7,500
2,500
2,000
$0.50
$0.50
Page 30
7,500
5,000
2,000
51.72%
34.48%
13.79%
5. Cash Flow Rights Example for Weighted Average Anti-Dilution Protection
Conversion
Price of
Preferred
shares
Shares
Issued
(000s)
Common
Shares After
Conversion
Percent of
Company
Owned
Capitalization No Dilution Protection

First Round
Common Shares
Second Round
Common Shares
$1.00
7,500
2,500
7,500
2,500
75.00%
25.00%
$1.00
$0.50
7,500
2,500
2,000
7,500
2,500
2,000
62.50%
20.83%
16.67%
Second Round Capitalization Weighted Average Dilution Protection
Common Shares
7,500
2,500
2,000
$0.917
$0.50
Page 31
7,500
2,727
2,000
61.34%
22.30%
16.36%
6. Preemptive Rights
Requires the portfolio companys management to offer the stock for

sale to the venture capitalist at the same price and terms negotiated
with a third party.
Right of First
Refusal
Right of First
Offer
Limits the liquidity of shares of the management

Goals of the venture capitalist
Option to increase its stake in the company
Possibility to control the composition of the shareholder group
Management must merely define the minimum price and terms it will
accept for the sale of stock to third parties. The venture capitalist
then has the option to purchase the stock at these minimum terms
for a designated period of time.
From the perspective of the venture capitalist, less attractive as it
does not control the shareholder structure as effectively as the right
of first refusal.
Page 32
7. Disinvestment Rights (1/2)
Tag-along right
Right of the VC/PE firm to participate in any sale of stock by the

management (usually on a pro rata basis)
Protection against a sell-out by the companys management
Drag-along right
Requires the management to sell their shares to a third party if

the VC/PE firm sells his shares
Ensures that the management is not capable of upsetting
an exit possibility by not participating in a trade sale
Page 33
7. Disinvestment Rights (2/2)
Entitles the VC/PE firm to sell the stock to the company

Redemption right
The company is required to repay the initial investment plus

a minimum interest rate to the VC/PE firm
Exercisable at the will of the VC/PE firm but usually only
after a certain event has occurred
Registration rights
Entitle VC/PE firms to require their portfolio company to register

its shares for sale to the public.
Mechanism to exit: help the VC/PE firm to realize an

exit where the management still hesitates to undertake an
IPO.
Page 34
Financing an MBO / LBO Transaction

Example for deal structuring of a MBO
The effect of various types of finance on the eventual return to the investor
Company Data
Management is seeking to execute an MBO
Vendor is prepared to accept a price of EUR 20 mil
Business turns over EUR 30 mil and achieves a profit after tax of EUR 2 mil
Business has no existing debt or cash
Management believes that the company will be able to make profits after
tax of EUR 4 mil in five years time when the company will have cash of
EUR 16 mil and in total will be worth EUR 56 mil
They have told the potential investors that they

are able to invest EUR 250.000
want to own 40 % of the company
Page 35
MBO Company
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
2.0
2.4
2.8
3.2
3.6
4.0
0.0
0.0
0.0
0.0
0.0
0.0
Tax
0.0
0.0
0.0
0.0
0.0
0.0
Earnings after interest and tax
2.0
2.4
2.8
3.2
3.6
4.0
Cash Balance
0.0
2.4
5.2
8.4
12.0
16.0
Earnings before interest and tax

Interest
Value of the Company

(10 times earnings before interest and tax)
Plus cash
Cost of acquisition
20.0
40.0
0.0
0.0
20.0
56.0
Proceeds available on exit
Page 36

Example for deal structuring of an MBO: OPTION A
The effect of various types of finance on the eventually return to the investor
Investors accept terms and invest EUR 19.75 mil in return for 60% of the
company
In five years time they will receive back 60% of EUR 56 mil = EUR 33.6 mil
IRR = 11% per annum
Management then converts EUR 250.000 into EUR 22.4 mil
Option A
Investors ordinary equity
Managements ordinary equity
Total Option A
Cash
(in mil)
IRR
(in %)
Proceeds
19.750
60
11.2
33.600
0.250
40
145.7
22.400
20.000
100
Page 37
56.000

Example for deal structuring of a MBO: OPTION B
Investors do not accept terms and pay the same price as the management
for the ordinary shares otherwise the risk that management makes profit
on the investment and investors make substantial losses, is too high
(e.g. if company was worth only EUR 30 mil after five years, then
management would receive 12 mil for a profit of EUR 11.25 mil, while
investors would receive 18 mil for a loss of EUR 1.75 mil)
Hence, if management pays EUR 250.000 for 40% of common shares, the
investors should pay EUR 375.000 for 60% making a total of common stock
of EUR 625.000. The investors could then invest the remaining EUR 19.375
mil in preferred shares, which must be redeemed at the time of the sale of
the company
When company is sold for EUR 56 mil, investors would receive back EUR
19.375 plus 60% of EUR 56 mil less EUR 19.375, which is in total EUR
41.35 mil management would receive EUR 14.65 mil
Now investors would have a return of 16%, which is still too low
Page 38
Financing an MBO / LBO Transaction: OPTION B
Option B
Investors preference shares

Investors total
Total Option B
Cash
(in mil)
IRR
(in %)
19.375
0.375
Proceeds
19.375
60
19.750
0.250
40
20.000
100
Page 39
21.975
15.9
41.350
125.7
14.650
56.000

Example for deal structuring of a MBO: OPTION C
In addition to the option B version, a coupon to the preferred shares (10%

p.a.) is added
Now investors would have a return of 18%
Option C
With 10% cumul. dividend
Investors total
Total Option B
Cash
(in mil)
IRR
(in %)
31.205
19.375
0.375
Proceeds
60
19.750
0.250
40
20.000
100
Page 40
14.877
18.5
46.082
108.8
9.918
56.000

Example for deal structuring of a MBO: OPTION D
Another possibility is to introduce debt to the transaction
With pre-tax profits of EUR 3 mil by year 2, the company could afford to pay
interest in around EUR 10 mil of debt and still covers the interest around
three times (profit is three times interest rate)
Lender will ask for a covenant that interest is always covered more than
twice
IRR would turn to over 25%, as investors would only have to pay EUR
9.375 mil instead of EUR 19.375 mil
Page 41
Financing an MBO / LBO Transaction: OPTION D
Option D
Bank debt (10% cum. Interest)
Cash
(in mil)
IRR
(in %)
Proceeds
10.000
16.105

With 10% cumul. dividend
9.375
15.090
0.375
Investors total
9.750
0.250
40
20.000
100
Total Option B
60
Page 42
14.883
25.2
29.973
108.8
9.922
56.000
Contingent Structure of Venture Capital/Private Equity Contracts
Financial and control

rights of entrepreneur
VC/PE firm relinquishes

several financial and control
rights
VC/PE firm obtains extensive

financial and control rights
Company performance
Page 43
Effects of Typical Venture Capital/Private Equity Contractual Agreements
Reduce risk of
Effects
managerial
opportunism
competitive
opportunism
unfavorable
decision taking
exit
obstruction
Information rights
Control rights
Management
covenants
Milestone agreements
Cash flow rights
Preemptive rights
Disinvestment rights
Contractual rights
Applicable
Not applicable
Page 44
Literature
Kaplan, S. / Strmberg, P. (2003): Financial contracting theory meets the real world: an empirical
analysis of venture capital contracts, in: Review of Economic Studies, 70 (2), pp. 281-315.
Sahlman, W. (1990): The structure and governance of venture-capital organizations, in: Journal of
Financial Economics, 27, pp. 473-521.
Page 45
Agenda
6.3 Investment Exit
Page 46
Roles of the VC/PE firm in the Investment Development Phase
Monitor
Coach
Protecting the value

of the investment
Enhancing the value

of the investment
Page 47
Approaches towards the Coaching Functions of the VC/PE investors
Hands-off
approach
VC/PE firms do not

interfere with the
decisions of the
management of a
portfolio company and
follow a laissez-faire
policy
VC/PE firms are actively

influencing the
management of the
portfolio company
Involvement of the VC/PE firm
Page 48
Hands-on
approach
Investment Development
FOCUS on VC
Page 49
Certification as Indirect Activity of Venture Capitalists
Venture capital-backed companies benefit from the reputation of their venture capital firms
Transmission of valuable signals about a portfolio company to third parties:
Customers
Suppliers
Investors
Personnel and management
Investment banks
Accountants
Reduction of asymmetric information and transaction barriers

certification
Page 50
Resource Provision Table of Venture Capitalists
Resource provision by venture

capital firms
Resource categories
Technological resources
Financial resources
Managerial resources
Personnel resources
(/ )
Physical resources
Organizational resources
Reputational resources
Social resources
Some resources provided
Source: Fingerle,C. (2004): Smart Capital the Influence of Venture Capitalists on High Potential Companies.
Page 51
No resources provided
Stages and Value Adding Activities
Extent of activity
Financial engineering
Hands-on coaching
Early stage
Later stage
Page 52
Performance and Extent of Involvement
Potential write-off
Living dead
On-track
Page 53
High-flyer
Performance and Extent of Involvement Contrary Opinions
Extent of venture capitalists involvement depending on

performance (prospect theory argument)
low
Potential write-off
high
high
Living dead
On-track
(need for oversight argument)

Extent of venture capitalists involvement depending
on performance
Page 54
High-flyer
low
Prospect Theory
Assumptions
The value function

Utility gain
of venture capitalist
Value is defined in terms of

gains and losses and evaluated
to a reference point (deviations)
Reference point
Value function has a different

shape for gains and losses
Utility gain
Value function is concave for

gains
Value increase
of portfolio company
Value decrease
Utility loss
Value function is convex and

steeper in the area of losses
Utility loss
of venture capitalist
Page 55
Investment Development
FOCUS on PE
Page 56
Different Categorization for Value Drivers in PE Transactions (1/4)
Operative and strategic

value driver
Corporate governance
Financial value drivers
Operative support /
Reduction of agency
Financial arbitrage
restructuring
Strategic orientation
costs
Mentoring
General conditions
Source: Own diagram based on Berg/Gottschalg (2005)

Page 57
Operative and strategic

value driver
Operative support / restructuring through
Cost reduction, efficient management and

increase of margins (outsourcing, cost control,
overhead reduction)
Optimizing capital employment

(working capital management and reduction)
Improving personnel and decision making

processes (increasing productivity and
competence)
Contribution of managerial resources
Operative support /
restructuring
Strategic orientation
Strategic orientation through
Reorientation of markets and products

(price policy, improving customer service,
distribution channels, redefining target groups)
Focus on core competences
Source: Own diagramme based on Berg/Gottschalg (2005)

Page 58
Corporate Governance
Reduction of monitoring costs through
interest alignment (share ownership,

performance-related compensation)
Strict monitoring (reports and boards) and

disciplining effect of debt (preventing empire
building)
Reduction of agency
costs
Mentoring
Mentoring support by private-equity investors

through:
Contribution of industry know-how and

management expertise
Contribution of social and industry networks

Page 59
Financial arbitrage: no value creation

(buy-low and sell-high; leveraging company price
changes due to changes in market prices,
identification and correction of mispricing)
Financial engineering: no value creation but value

shift (often on the account of creditors)
Financial value drivers
Financial arbitrage
Above average proportion of debt
Tax deductibility
Leverage effect
Reduction of agency cost of free cash flow

Page 60
Conflict in Theory: Value Transfer versus Value Creation

Value transfer hypothesis
Basic hypothesis: no creation of new value within a buyout transaction

- just a value transfer in favor of the private equity companies.
Consequently, there must be stakeholders that are negatively affected by the

transaction, e.g.
Employees: value transfer due to personnel cost reduction BUT no

empirical confirmation
State: tax saving of portfolio company due to high leverage, yet postbuyout tax payments could be higher and all related buyout parties have to
be considered
Debt providers: due to increased leverage, worse creditworthiness and

increased default risk, yet covenants buffer the risk (change-of-controlclause)
Diverging opinions within scientific empirical research

Source: Lowenstein (1985) and other studies
Page 61
Conflict in Theory: Value Transfer versus Value Creation

Value creation hypothesis
Basic hypothesis: there is a creation of new value within a buyout transaction

Value creations emerge due to improvements within the portfolio company
Among others due to reduction of agency costs, disciplining function of debt
and better monitoring systems (see also slides before)
Or due to increase in entrepreneurial flexibility and reduction of bureaucracy

Majority of empirical studies confirms that buyout transaction are subject
of significant value increases due to an increase in profitability and
productivity
Scientific studies confirm the value creation hypothesis, nonetheless, in

most cases value increases are caused by a mixture of value transfer and value
creation
Source: Meier et. Al. (2006), Wright et. Al. (1996) and others.
Page 62
Evaluation of Value Creation A Practical Approach

Operational effects
Value creation
EBITDA growth
Increase in equity value EBITDA at entry

from a GPs point of view.
compared to EBITDA at
exit.
EBITDA serves as a
basis for valuing a
company (assuming
unchanged EBITDA
multiples).
EBITDA effect can be

further split into sales
effect and EBITDA
margin effect.
Free cash flow (FCF)

effect
Cash flows that are being
generated on a company
level over the holding
period.
EBITDA multiples
represent the enterprise
value as a multiple of
EBITDA.
Amongst others, free cash

flow is used for paying
down debt or for paying
dividends.
Change in EBITDA
multiples between entry
and exit impacts the
enterprise value.
This illustrates the deleverage effect, not the

leverage effect.
Source: Achleitner et al. (2010)

Multiple effect
Page 63
Evaluation of Value Creation Example
Sales Effect
( Sales) x Margin @ Exit
x EV/EBITDA @ Exit
Entry
Sales (m)
4 years
100.0
Exit
150.0
+
Margin Effect
( Margin) x Sales @ Entry

x EV/EBITDA @ Exit
EBITDA Margin (%)
10%
15%
EBITDA Effect
( EBITDA) x EV/EBITDA @ Exit
EBITDA (m)
10.0
22.5
EV/EBITDA (x)
10.0
12.0
Multiple Effect
Enterprise Value (m) 100.0

Net Debt
270.0
70.0
( Multiple) x EBITDA @ Entry
5
FCF (De-leveraging) Effect
Equity
30.0
265.0
Total Value Creation = Equity

Money Multiple = Equity @ Entry / Equity @ Exit
Page 64
( Net Debt)
Literature
Berg, A. / Gottschalg, O.F. (2005): Understanding Value Generation in Buyouts, in: Journal of
Restructuring Finance, 2 (1), pp. 9-37.
Dotzler, F. (2001): What do venture capitalists really do, and where do they learn to do it?, in:
Journal of Private Equity, 5 (1), pp. 6-12.
Easterwood, J. / Seth, A./ Singer, R. (1989): The impact of leveraged buyouts on strategic
direction, in: California Management Review, 32 (1), pp. 30-43.
Lowenstein, L. (1985): Management Buyouts, in: Columbia Law Review, 85 (4), pp. 730-784.
MacMillan, I. / Kulow, D. / Khoylian, R. (1988): Venture capitalists' involvement in their

investments: extent and performance, in: Journal of Business Venturing, 4, pp. 27-47.
Meier, D. / Hiddemann, T. / Brettel, M. (2006): Wertsteigerung bei Buyouts in der Post InvestmentPhase - Der Beitrag von Private Equity-Firmen zum operativen Erfolg ihrer Portfoliounternehmen im
europischen Vergleich, in: Zeitschrift fr Betriebswirtschaft, 76 (10), pp. 1035-1066.
Wright, M. / Wilson, N. / Robbie, K. (1996): The longer term performance of
management buy-outs, in: Journal of Entrepreneurial and Small Business
Finance, 5 (3), pp. 312-334.
Page 65
Agenda
6.3 Investment Exit
Page 66
Exit Possibilities (1/2)
Liquidation
Pros/cons according to perspective
Buyback
Dependent on
IPO
Trade Sale
Secondary Sale
Source: EVCA (2002)

Page 67
Capital market situation
Overall economic conditions
IPO window for

sector/industry
Comparable M&A activity and

number of potential buyers
Exit Possibilities (2/2)
Liquidation
Buy Back
Investee company is bankrupt and the VC/PE firm has to

write off the complete investment.
Repurchase of the VC/PE firms stake by the entrepreneurs.
IPO
Initial Public Offering is the first sale of stocks by a privately

held company to the public. Issued stocks are then traded
on the stock market.
Trade Sale
Purchase of the investee company by another corporation.
Secondary Sale
Sale of the VC/PE firm's stake to another financial investor.
Page 68
VC/PE Firms Role in the Exit Process
Decision on exit route
Advice helping the company to grow in line with exit decision
Selection of key advisers
Validation of expected price
Page 69
Success Factors in an IPO
Speed, co-ordination, and timeliness
IPO team working together to raise the companys public profile

and awareness of the impending flotation
Generation of a perception of scarcity amongst potential

investors
Positive market view of the companys future
Favorable exogenous factors
Source: EVCA (2002), Entrepreneurship Education Course, Modul 8, Exit: IPOs and Trade Sales, p. 9.
Page 70
Evaluation of a Public Sale
Advantages
Disadvantages
Higher exit proceeds
Limited to High Flyers
Lower potential for conflicts
Strong dependence on stock

exchange conditions/IPO
window
Higher reputation
Possible triggering of a takeover
No full investment reduction

possible
Flexible investment reduction

Participation in future value creation
of the portfolio company
Higher costs and time

expenditure
Source: Paffenholz, G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.114

Page 71
Benefits and Downsides of Public Quotation for the Company
Benefits
Downsides
Access to a potentially unlimited source

of capital
Cost/inconvenience of uncertain and

lengthy IPO process
Currency for acquisitions

(the companys own stock)
Ongoing reporting obligations of a public

company
Better reputation - impact on

relationships with all key business
constituents
(employees, customers, suppliers)
Hard to satisfy short/medium-term

market expectations without
compromising the companys long-term
prospects
Financial rewards for the companys

founders and stock option beneficiaries
Exposure to systemic market risks,

which can affect a companys stock
irrespective of its own performance
Unsolicited take-over offers
Source: EVCA (2002)

Page 72
Definition Lock-up
Lock-up
Agreement between underwriters and existing shareholders not
allowing the existing shareholder to sell any shares for a certain
specified period of time.
Page 73
Definition Grandstanding
Grandstanding
Young venture capital firms take their portfolio companies public
earlier than established venture capital firms in order to built up
reputation and successfully raise capital for new funds.
Source: Gompers, P. (1996): Grandstanding in the venture capital industry, in: Journal of Financial Economics, 42 (1), S. 133-156, p. 133
Page 74
Trade Sale
Sale of the portfolio company to
Competitor
horizontal integration
Supplier/customer
vertical integration
As the buyer has a strategic interest in the firm, usually all shares of the company have to be
sold, i.e. the entrepreneurs have to sell their shares alongside the other financial investors.
Acquirer
conflicts of
Probably prefers a complete sale
interest
Page 75
Current
management
team
Might have a strong interest to resist
a trade sale
Phases of a Trade Sale
Internal
Processing
Agreement on
exit strategy
Analysis of
company
If necessary
restructuring
measures
Identification of
Buyers
Identification
and selection of
possible buyers
Initial contact
Distribution of
information
memorandum
Preparation of a
data room
Contribution of
letter of intent
Due diligence
by potential
buyers
Start of
negotiations
Form of
contract and
contact closing
Source: Paffenholz,G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.122.

Valuation/
Negotiations
Page 76
Success Factors in a Trade Sale
Secrecy
Competition
A leak may trigger adverse reactions

from employees, customers or suppliers
If potential purchaser sense that other

parties may be interested, this will help to
Such reactions may spook the

purchaser into seeking to renegotiate or
abandoning the deal
create a sense of urgency
maximize the price

ensure that acquirers remain honest
(i.e. do not continually try to renegotiate)
Other potential buyers have lower

interest in targets widely known to be up
for sale
If sale does not take place, desire to sell

may be seen as indication for vendors
lack of confidence in the business
future, negative spiral
Source: EVCA (2002)

Page 77
Evaluation of a Trade Sale
Advantages
Disadvantages
Higher exit proceeds, but also

possibility to exit in case of a
moderate development
High potential for conflicts
Immediate and complete exit

possible
Obligation to accepted non-cash

or payment by installments
Easier, quicker and cheaper

transaction (compared to an IPO)
Obligation to grant guaranties
Limited number of potential

buyers
Source: Paffenholz,G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.120

Page 78
Influence of Exit Strategy on Growth Strategy
IPO
Trade Sale
Company needs to be well-rounded and

capable of thriving as an independent
entity
Build an IPO-ready mentality
Main requirements are
quarterly budgets and forecasts
accounting standards for public
companies
disclosure standards for public
companies
public relations
conference tour
Company does not have to be a

complete firm and may lack entire
functions
Purchaser may only be interested in one
function
At least one aspect of the company
should be directed to achieve the
best in class
Source: EVCA (2002)

Page 79
Mini Quiz
?
Would you as investor prefer a trade sale or an IPO as exit route?
Page 80
Evaluation of a Secondary Purchase
Advantages
Disadvantages
Possibility to exit even if portfolio

company is still immature
Low potential for high returns
Reservation of potential buyers
Low potential of conflicts
Small number of market

participants
Simple and quick transaction

Rarely problems to identify relevant
potential buyers
Source: Paffenholz,G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.124

Page 81
Recommendation Readings
Brian Burrough and John Heylar (1990): Babarians at the Gate: The fall of RJR Nabisco.
Sebastian Mallaby (2010): More Money than God: Hedge Funds and the Making of a New Elite.
Daniel Schfer (2006): Die Wahrheit ber die Heuschrecken. Wie Finanzinvestoren die Deutschland AG umbauen.
Paul Jowett and Francoise Jowett (2011): Private Equity: The German Experience.
Stephan Eilers, Nils Koffka, and Markus Mackensen (2012): Private Equity: Unternehmenskauf, Finanzierung,
Restrukturierung, Exitstrategien.
Eli Talmor and Florin Vasvari (2011): International Private Equity.
Page 82

6 VC PE Investment Process

Caricato da

Informazioni sul documento

Descrizione originale:

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

6 VC PE Investment Process

Caricato da

Copyright:

Formati disponibili

Entrepreneurial Finance

Venture Capital and Private Equity:

Chair of Entrepreneurial Finance

Entrepreneurial Finance Summer Term 2015

Entrepreneurial Finance Summer Term 2015

Financing relationships of a VC/PE firm

Source: Based on Schefczyk (2006)

The investment process

6.1 Investment Process

6.2 Investment Development

6.3 Investment Exit

Entrepreneurial Finance Summer Term 2015

Content of the Structuring Phase

about contractual agreements

These terms are finally included in various legal documents such as

Entrepreneurial Finance Summer Term 2015

Financial Instruments (1/3)

Shareholders share the same level of risk and return

Additional investor rights directly linked to ownership of stock

Entrepreneurial Finance Summer Term 2015

Financial Instruments (2/3)

Entrepreneurial Finance Summer Term 2015

enjoys higher priority than other loans or equity stock in

has a lower priority than a senior loan in case of a

Financial Instruments (3/3)

Allows lender to exchange debt for common shares at a

Silent partner participates in profit and losses

Entrepreneurial Finance Summer Term 2015

Financing an MBO/LBO Transaction

Financing requirements for a buyout consist of

Purchase price (company value)

Financing secured by various capital forms

Where is the M of the Management Buy Out?

Entrepreneurial Finance Summer Term 2015

Whats expected from the management?

Equity investment of 1 times annual salary

Considerable upside reward for success

Total commitment to the project

Entrepreneurial Finance Summer Term 2015

The L of the Leveraged Buyout!

Entrepreneurial Finance Summer Term 2015

What are bankers looking for?

Strong positive cash flow

Equity contribution of 30% to 40%

Repayment of Senior A typically within 7 years

First charge over assets as security

Financial and other covenants

Additional Investor Rights - Overview

5. Cash Flow Rights

Entrepreneurial Finance Summer Term 2015

define the extent to which the VC/PEs have access to

Reduce post-contractual information asymmtries

Entrepreneurial Finance Summer Term 2015

2. Control Rights (1/3) - Voting Rights

measure the percentage of votes that shareholders have to

Entrepreneurial Finance Summer Term 2015

2. Control Rights (2/3) - Veto Rights

Entrepreneurial Finance Summer Term 2015

Investment and respectively

2. Control Rights (3/3) - Board Rights - Definition

Board rights define membership in the supervisory board.

Entrepreneurial Finance Summer Term 2015

3. Management Covenants (1/2)