Entrepreneurial Finance

Lecture 8: Professional Venture Capital

(and Other Financing Alternatives)

Jacek Przybyszewski, Department of Finance

November 26, 2018
Lecture outline

i. Recap, previous lecture

ii. Professional venture capital (see references)
iii. Other financing alternatives (LM, ch. 13)

References:
LM ch. 12-13
Metrick & Yasuda (2011a), ch. 1-7
Metrick & Yasuda (2011b)
Gompers, Gornall, Kaplan, Strebulaev (2017)
Recap, previous lecture

・ Pre-money/post-money valuation
・ Absolute/relative valuation
・ The VC method
i) Valuation if successful
ii) Target multiple of money
iii) Expected retention
iv) Investment recommendation
Valuation

・ Pre-money: Value of firm excluding investment

・ Post-money: Value of firm including investment (often in VC method)
・ Absolute: Valuation using explicit DCFs
・ Relative: Valuation using comparables, e.g. P/E ratio
The VC method

i) Valuation if successful (TVT)

ii) Target multiple of money (M)
iii) Expected retention (R)
iv) Investment recommendation (S ≥ S*)

Simple back-of-envelope method – no account for complex structures!

VC method, example

TV6 = 100M, I0 = 5M, RV = 15%, P = 0.30, R = 67%

・ M = (1+0.15)6/P = 11.6
・ S* = M×I0/R×TV6 = 86.3%

I0: investment, TVT: terminal value, RV: required return

R: retention, P: probability
M = target multiple, S = target equity
Professional Venture Capital
Professional venture capital

i. What is a VC fund?
ii. Organization of VC funds
iii. Overview: The VC landscape
iv. Overview: VC returns
v. Overview: Research on VC funds
What is a VC fund?
What is a VC fund?

・ Subclass of broader, institutional asset class; private equity

・ Financial intermediary and activist investor
・ Limited partners, LPs (e.g. pension funds)
・ General partners, GPs (fund managers)
・ Porfolio firms, PFs (entrepreneurs)
・ GPs invest in PFs on behalf of LPs
Private equity, fund types and overlaps (MY-2011)
VC investment by stage (MY-2011)
VC funds’ investing cycle
Limited partners
General partners

・ Characteristic of GPs in 15 VC firms, Wieland (2009)

・ Science/business degree – industry experience – manager/entrepreneur
・ 60% B.Sc. in science/engineering, 62% MBA
・ 78% experience in IT or health care industries
・ 37% prior entrepreneurs, 38% prior managers
Organization of VC Funds
Typical VC fund

・ VC firms raise consecutive funds (every 3-5 years)

・ Limited partnership (GP/LP)
・ Typically 10 year life cycle
・ Investment phase
・ Growth and harvesting phase
・ Compensation: Management fees and carried interest (2:20 shops)
Partnership, terms of agreement (MY-2011)
General partners, organization structure (MY-2011)
Money structure

・ Investment capital = Committed capital – Fees

・ Capital called in investment phase
・ Distributions paid in harvest phase
・ Total distributions = Portfolio value – Carried interest
・ Value multiple: Total distributions/Committed capital
・ Hurdle rates, claw-backs
Money structure, example

Commit’d capital: 100; 2% annual fee; 20% carry; 10y fund; PF10 = 150
・ Investment capital = 100 – 0.02×100×10 = 80
・ Carried interest: 0.20×(150-100) = 10
・ GP, Gross Value Multiple: 150/80 = 1.9
・ LP, Net Value Multiple: (150-10)/100 = 1.4
・ Net IRR = 1.41/10 –1 = 3.4%
Example, Kleiner Perkins (MY-2011)
Overview: The VC Landscape
Brief history of VC funds

・ 1946: American Research and Development (ARD)

・ 1953: Small Business Administration (SBA)
・ 1958: Small Business Investment Companies (SBICs)
・ 1979: Prudent Man Rule
・ 2001: Dot.com bubble
VC investment since 1985
Large performance spread (time and intra-industry)
The economics of VC investment
Global differences in VC activity (VC % of total)
VC % of GDP (OECD)
Entrepreneurial ecosystems, agglomoration
Major drivers of differences

i. Exit markets
ii. Entrepreneurial ecosystem
iii. Law and corporate governance
iv. Country risk

Abundance of policies but few success stories:

Silicon Valley, Tel Aviv, Singapore
Overview: VC returns
Life cycle of PF investments
Returns and exit routes
Returns of first round investment
Returns of later investments
VC returns, in general

・ Difficult topic in research (privacy, data limitations)

・ Data: Cambridge Associates, fund level (net returns)
・ Data: Sandhill Econometrics, PF level (gross returns)
・ Intuitively, net returns < gross returns
・ How to measure annual returns?
・ How to measure annual risk-adjusted returns?
Gross fund returns, r = 12.8%
Net fund returns, r = 16.2%
Risk-adjusted returns, simple CAPM
Risk-adjusted returns, Fama-French + liquidity
Overview: Research on VC funds
Research on VC funds

・ Research on VC markets ≈ Research on VC funds

・ Typically based on US data, but generally applicable
・ Metrick & Yasuda (2011b)
・ Gompers, Gornall, Kaplan, Strebulaev (2017, WP)
Metrick and Yasuda (2011b)

”Venture Capital and Other Private Equity: A Survey”

・ Literature survey; synthesis of existing research, theoretical/empirical
・ Why do VCs exist?
・ What do VCs do?
・ Performance
・ Contracts (Lecture 9!)
Why do VCs exist?

・ VC market characterized by asymmetric information

・ Agency conflicts: adverse selection and moral hazard
・ Bank debt generally not feasible
・ VCs specialize in mitigating agency conflicts
・ VCs match ent’eurs with no funds – to investors with no ideas
Agency conflicts, in general

・ Agent – Agent relation (or Principal – Agent)

・ Asymmetric information
・ Insufficient monitoring
・ Misaligned incentives
・ Adverse selection and moral hazard
・ Solutions: Screening, monitoring, contracting
What do VCs do?

i. Screening
ii. Monitoring (and contracting)
iii. Value-adding activities (exit orchestration)
i) Screening criteria (LM ch. 12)

i. VC requirements; familiarity, geography, control, cash-out potential

ii. Characteristics of proposal
iii. Characteristics of entrepreneur/team
iv. Nature of proposed industry
v. Strategy of proposed business
i) Screening criteria; jockey or horse?

・ Frequent CEO TO in VC-backed firms, Hellmann (1998)

・ Business more important than team (CEO TO), Kaplan et al. (2009)
・ Scalability more important than profitability, Zarutskie (2010)
・ Jockey seems to be less important than the horse...?
ii) Monitoring activities

・ Board representation
・ Contingent control rights
・ Staged, contingent financing
・ Complex contracting – incentive alignment
(covered in lecture 9)
ii) Monitoring activities (cont’d)

・ Higher agency costs (R&D) imply higher monitoring, Gompers (1995)

・ Board representation higher with greater distance, Lerner (1995)
・ VC-backed firms have more independent boards, Hochberg (2003)
・ Staged funding aligns incentives and bargaining, Inderest et al. (2007)
・ More CEO-turnover in VC-backed firms, Kaplan et al. (2009)
・ Widespread use of complex contracts (lecture 9)
iii) Value-adding activities

・ VCs often considered ’smart money’

・ Leverage industry experience
・ Leverage professional network
・ Facilitate recruitment of key employees
・ Experience in orchestrating exits
iii) Value-adding activities (cont’d)

・ More experienced VCs achieve better IPO pricing, Barry et al. (1990)
・ VC-backed firms more professionalised, Hellmann & Puri (2002)
・ VC-backed firms more innovative, Kortum & Lerner (2002)
・ More experienced VCs perform more activities, Botazzi et al. (2008)
Performance in VC markets

・ Controversy whether VCs outperform market on average

・ Diffucult to estimate consistent risk-adjustment (𝛽 ∈ 1.0 – 3.7)
・ Performance persistence widely observed at fund level
・ If fund I outperforms, more likely that funds II and III will outperform
Performance persistence at fund level

・ Difficult to scale up good performance in VC – why?

・ Difficult to increase fees (2:20 surprisingly stable) – why?
・ More experienced VCs get better firms on average (reputation effect)
・ More experienced VCs get better deals on average (bargaining effect)
Performance persistence: Top-tier funds (US)
How smart is smart money?

・ VC-backed firms generally perform better (e.g. higher IPO rate)

・ Do VCs improve business – or do they just invest in good business?
・ Classical problem: Selection or treatment?
・ Sørensen (2007), Selection: 40% – Treatment: 60%
Contracts (more on this in lecture 9)

・ Preferred equity, participating preferred equity, warrants, options

・ Vesting of founder stocks
・ Contingent control rights
・ Board seat and vote allocation
・ Covenant restrictions
・ Staged financing and tranching of capital
Gompers, Gornall, Kaplan, Strebulaev (2017)

”What do Venture Capitalists Do?”

・ Questionnaire survey, 885 active VCs (US and abroad)
・ Issue 1: Sample selection (Stanford, Chicago, Harvard, Kauffman)
・ Issue 2: Self-selection (Successful more likely to respond)
・ Issue 3: Self-reporting
・ Interpretation: Study of best practices in VC industry
Sample median splits (subsamples)

・ Stage: Early – Late

・ Industry: IT – Health
・ IPO rate: High – Low
・ Fund size: High – Low
・ Location: California – Other US – Foreign
Gompers, Gornall, Kaplan, Strebulaev (2017)
How do VCs source deal flow?
How do VCs source deal flow?
Deal funnel similar to findings in MY (lecture 1)
Deal funnel similar to findings in MY (lecture 1)
Deal funnel similar to findings in MY (lecture 1)
Important qualities in ent’ial team
Methods used in valuation
Methods used in valuation
Use of complex contracts
Use of complex contracts
Use of complex contracts
Other financing alternatives:
Equity (LM ch. 13)
Informal investors vs. VC funds

Informal investors

€3.90 bn.

€5.46 bn.

€0.61
bn.
Angel networks
Angel groups

VC funds Visible angels Invisible angels

EBAN (2016)
Invest Europe (2017)
Business angels

・ Similar profiles to VC managers (prior entrepreneur/manager)

・ Invest primarily own funds (no LPs)
・ Invest primarily in seed and start-up stages
・ Not forced to liquidate investments (longer horizon than VC)
・ Typically straight equity and board seat (less complex deals)
Incubators, Accelerators

・ Private/public institutions for promoting entrepreneurial ventures

・ Seed/survival stage
・ Equity investment or grants (depends on private/public)
・ Guidance, councelling
・ Denmark: Public-private partnership (innovationsmiljøer)
Differences across firms that receive IN/BA/VC funds

Incubators Business Angels VC Funds

Employees 1.9 2.8 4.5

Founders 2.6 2.6 2.4

Firm age 1.3 2.0 2.1

Equity share 0.087 0.141 0.185

First investor 0.029 0.931 0.067

Corporate VC

・ Corporations also invest in entrepreneurial ventures

・ Often strategic incentives (competition, integration)
・ Longer time horizon, different incentives from VC funds
・ Account for less than 5% of VC investments (understudied)
Other financing alternatives:
Debt
Other financing alternatives: Debt

i. Traditional bank debt

ii. Venture lending
iii. Small business lending programs
iv. Receivables (factoring/lending)
v. Customer models
vi. Grants
vii. Crowdfunding
i) Traditional bank debt

・ Generally, not possible

・ No collateral, no history of financial metrics
・ Owner-debtholder agency conflict (debt overhang)
・ Incentive for risky behaviour when close to default
・ Credit card roll-over (personal debt, owner is liable)
ii) Small business lending programs

・ Government guarantees (part of) approved loans

・ Exist in most countries (e.g. Innovationsfonden)
・ Agency problems not solved (owner-debtholder)
・ Officials often not competent to assess loan applicants
・ Numerous examples of failed programs (Lerner, 2011)
iii) Venture lending

・ Bridge gaps between equity rounds; A, B, ...

・ Often equity component (warrants)
・ Similar to preferred equity, skewed towards debt
・ Collateralize patents and IP rights
・ E.g. Silicon Valley Bank
iv) Leasing, venture leasing

・ Similar to owning the assets (assets obsolete by end of lease)

・ Asset leasing: pay leasing fees
・ Capital leasing: pay installments/arrears
・ Often some tax advantages
・ Venture leasing: similar to venture lending (lend assets, use warrants)
v) Receivables lending/factoring

・ Factoring; receivables sold as short-term assets

・ Specialized factoring markets (mostly seasoned firms)
・ Often sold at discount but still liable in default
・ Lending; Receivables used as collateral in traditional debt
・ Depends on type of industry and collection history
vi) Customer models

・ Advance payments
・ Partial financing (often equity component)
・ Subscription models (pay upfront for services received over time)
・ Intermediation models, e.g. airbnb, hotels, uber, etc.
vii) Government grants

・ Most governments subsidize innovation in various forms

・ Grants often approved for R&D heavy projects
・ Often pure subsidy (no debt/equity involved)
・ DK: Innovationsfonden, Markedsmodningsfonden, Fonden for
Entreprenørskab (micro grants)
viii) Crowdfunding/direct offerings

・ Recent development, long-term impact unknown

・ Crowd equity
・ Crowd lending
・ Crowd donations
・ Crowd non-equity
・ More on crowdfunding in lecture 10
Landscape, Denmark

・ 20 VC investments per year

・ 1.000 business angel investments per year
・ 4 government incubators
・ Accelerators, innovation centres, grants, etc.
・ inno-overblik.dk
Questions?
Thank you!