Introduction au Capital Risque André Tartar

The Death Valley

Motivation Most entrepreneurs are capital constrained so they seek external funding for their projects. Entrepreneurial firms with limited tangible assets, negative earnings, and large degree of uncertainty about their future cannot borrow from banks. An alternative to banks is wealthy individuals (e.g., businesspeople, doctors, lawyers) referred to as angel investors. However, these investors are widely dispersed and amount they contribute is small. Lack of outside funding hampers growth of new businesses in many countries around the world. Venture capital is a means to overcome capital constraints.

A Venture Capitalist: 1.is a financial intermediary, collecting money from investors and invests the money into companies on behalf of the investors 2.invests only in private companies. (Question: What is a private firm?) 3.actively monitors and helps the management of the portfolio firms (Question: How do VCs help their portfolio firms?) 4.mainly focuses on maximizing financial return by exiting through a sale or an initial public offering (IPO). 5.invests to fund internal growth of companies, rather than helping firms grow through acquisitions.

Terminology VC firms are organized as small organizations, averaging about ten professionals. VC firms might have multiple VC funds organized as limited partnerships with limited life (typically 10 years). General partners (GPs) of the VC fund raise money from investors referred to as limited partners (LPs). GPs are like the managers of a corporation and LPs are like the shareholders. LPs include institutional investors such as pension funds, university endowments, foundations, large corporations, and fund-of-funds. LPs promise GPs to provide a certain amount of capital (committed capital) and when GPs need the funds they do capital calls. During the first 5 years of the fund (investment period) GPs make investments and during the remaining 5 years they try to exit investments and return profits to LPs.

Flow of Funds in VC Cycle

What do VCs do? 1.Investing:  Screen hundreds of possible investment and identify a handful of projects/firms that merit a preliminary offer  Submit a preliminary offer on a term sheet (includes proposed valuation, cash flow and control right allocation)  If the preliminary offer is accepted, conduct an extensive due diligence by analyzing all aspects of the company.  Based on findings in the due diligence, negotiate the final terms of to be included in a formal set of contracts; and closing. 2.Monitoring:  Board meetings, recruiting, regular advice 3.Exiting:  IPOs (most profitable exits) or sale to strategic buyers

VC Investments by Stage Early stages:  Seed: Small amount of capital is provided to the entrepreneur to prove a concept and qualify for start-up capital (no business plan or management team yet).  Start-up: Financing provided to complete development efforts (business plan and management in place).  Other early-stage: Used to increase valuation and size. While seed and start-up funds are often from angel investors, this is from VCs. Mid-stage or expansion:  At this stage, the firm has an operating business and tries to expand. Late stages:  Generic late stage: Stable growth and positive operating cash flows  Bridge/Mezzanine: Funding provided within 6 months to 1 year of going public. Funds to be repaid out of IPO proceeds.

MONEY RAISED IN 2015 PIPE: Private Investment in Public Equity 3 billions VC

VC contracts with LP

The contracts share certain characteristics, notably: (1) staging the commitment of capital and preserving the option to abandon, (2) using compensation systems directly linked to value creation, (3) preserving ways to force management to distribute investment proceeds.

GP Compensation in VCs 1.Management fees  typically 2.5%/year of committed capital during the investment period and declines later…  used to pay salaries, office expenses, costs of due diligence  the sum of the annual management fees for the life of the fund is referred to as lifetime fees  Investment capital = Committed capital – Lifetime fees 2.Carried interest (or carry)  typically equals to 20% of the basis or fund’s profits.  allows the GP participate in the fund’s profits (incentive alignment role)

VC contracts with companies

Staged Capital Infusions in Companies Rather than giving the entrepreneur all the money up front, VCs provide funding at discrete stages over time. At the end of each stage, prospects of the firm are reevaluated. If the VC discovers some negative information he has the option to abandon the project. Staged capital infusion keeps the entrepreneur on a “short leash” and reduces his incentives to use the firm’s capital for his personal benefit and at the expense of the VCs. As the potential conflict of interest between the entrepreneur and the VC increases, the duration of funding decreases and the frequency of reevaluations increases.

Other ways to control entrepreneurs VCs may discipline entrepreneurs or managers by firing them (VCs often take controlling stakes and board memberships in the firms):  Right to repurchase shares from departing managers from below market price  Vesting schedules limit the number of shares employees can get if they leave prematurely  Non-compete clauses Managers are compensated mostly with stock options, which increases incentives to maximize firm value. This might of course also provide incentives to increase risk, so close monitoring is necessary. Active involvement in management of the firm Should you invest in the jockey or the horse?

Venture Capital Returns Internal Rate of Return (IRR) or Value Multiple

Year 1Year 2Year 3Year 4Year 5Year 6Year 7 Investments Portfolio value Total distributions Carried interest0.0 Distributions to LPs Cumulative distributions to LPs Port value after capital returned Management fee4.0 snapshot of a Fund in Year 7 of its 10-year life

VC Investment Process

The investment process of a typical VC fund Screening (vague)100 to 1,000 firms Preliminary due diligence10 firms Term sheet3 firms Final due diligence2 firms Closing1 firm

Screening Takes a big chunk of the VC’s time: –Search through proprietary private firm databases –Deal flow from repeat entrepreneurs –Referrals from industry contacts –Direct contact by entrepreneurs Reputable VCs have easier time identifying better companies because of their big networks and entrepreneur's willingness to work with them. Most investments are screened using a business plan prepared by the entrepreneur. Two major areas of focus in screening: –Does this venture have a large and addressable market? (market test) –Does the current management have capabilities to make this business work? (management test)

Market Test Main focus: Possibility of exit with an IPO within 5 year with a valuation of several hundred million dollars The market for the firm’s products should be big enough –A company developing a drug to treat breast cancer is likely to have a bigger market than a company developing a drug for a disease with only 1,000 sufferers (some counter exapmles) Barriers to entry should not be too high in the firm’s market –A company that developed a new operating system for PCs does not have much chance against Microsoft. Sometimes, there is no established market for the firm’s products and services (e.g., eBay, Netscape, Yahoo). In such cases, spotting potential winners is more of an art than science.

Management Test Ability and personality of the entrepreneur and the synergy of the management team is examined Repeat entrepreneurs with track records are the easiest to evaluate An often spoken mantra in VC conferences is that: “I would rather invest in strong management with an average business plan than in average management with a strong business plan”.

Due diligence Pitch meeting: The meeting of VC with company management –Management test For firms that successfully pass the pitch meeting, the next step is preliminary due diligence –If other VCs are also interested in the firm, preliminary due diligence is short –Due diligence is on management, market, customers, products, technology, competition, projections, partners, burn rate of cash, legal issues etc. If the results of the preliminary due diligence is positive, the VC prepares a term sheet that includes a preliminary offer and serves as an anchor for negotiations between the fund and the entrepreneur

Valuation of VC Investments

Exit Valuation The estimated value of the company at the time of a successful exit (i.e., an IPO or a competitive sellout) Two main approaches to exit valuation: –Relative valuation: Find a set of current companies that are comparable to your company at the time of its (hypothetical) successful exit. Then, use a comparables analysis to estimate the value of your company –Absolute valuation: Typically based on a discounted cash flow (DCF) analysis

Comparables Analysis 1.Identify a set of similar companies (same sector, size, growth rate) 2.Examine the valuation ratios of benchmark firms  Enterprise value to EBIT, EBITDA, Sales, Net Income, Book value of equity etc.  Enterprise value = Market value of equity + Book value of debt – Cash 3.Use the ratios to estimate the market value of your firm’s equity Example: We estimate that Newco would have revenues of $50M six years from now. Public companies in Newco’s industry have enterprise value to revenue ratio of 5. By applying the same multiple we can estimate Newco’s enterprise value as: 5 x $50M = $250M. Issues: –The choice of comparable firms –The choice of valuation multiples

Allocation of Venture Capitalist Time 0% 5% 10% 15% 20% 25% Percent of time Soliciting Business Selecting Opportunities Analyzing Business Plans Negotiating Deals Directing and Monitoring Consulting Recruiting Management Assisting in Outside Relationships Exiting Activity

The Venture Capital Investment Process Development of Fund Concept Secure Commitments from Investors Generate Deal Flow Closing of Fund First Capital Call Year 0 Distributing Proceeds – Cash – Public Shares – Other Harvesting Investment – IPO – Acquisition – LBO – Liquidation 2-3 years or more Value Creation and Monitoring – Board service – Performance evaluation and review – Recruitment management – Assist with external relationships – Help arrange additional financing 4-5 years Screen Business Plans Evaluate and Conduct Due Diligence Negotiate Deals and Staging Additional Capital Calls Invest Funds 2-3 years 7-10 years plus extensions