Private Equity and Venture Capital in the UK Melanie Perkins 17 March 2015

What we will cover: The private equity market The deal process The business plan Business angels Deal structure High Tec start ups/Early Stage Deals How investments are managed

What is private equity? Unquoted shares Private company Permanent/semi permanent capital Risk capital Return achieved through exit proceeds and yield

Venture Capital …Is a type of private equity capital typically provided to early stage, high potential growth companies

Why Private Equity? Private Equity gives higher returns, but at higher risk Stability possible due to Private Equity’s long term outlook and ability to adapt to changing market conditions

Current Issues for the Industry Banks unwilling to lend Difficulty in raising new funds Additional government support available Pricing starting to increase again Another Tech bubble? Good opportunities Rescue finance

Some deal terms Start-up What is Private Equity used for: Start-up Growth Capital – working capital, acquisitions MBO – Management Buy Out – the existing management of the company buy the company MBI – Management Buy In – incoming management buy the company BIMBO – combination Buy out and Buy in - strengthen the team LBO – Leveraged Buyout – can be any of the above IBO – Institutional Buy Out – a PE company buys the company and then puts in the management of its choice P to P – Public to Private (i.e. de-listing) Buy and Build – the PE company makes an investment in order to buy more companies in that sector and put them together to make something big and profitable

Sources of private equity funding Private equity firms VCTs EIS SEIS Funds Government Pension funds/Insurance companies Corporate investors Private individuals – ‘Angels’ Other – e.g. Academic, Family Trusts/Offices Either direct or via ‘Funds of Funds’ BVCA

Targeting the most promising funds More experienced managers perform better No. of previous funds raised is significantly associated with performance Past success predicts future success Investing in earlier rounds is a good thing Investing in ICT generated the highest historical returns Funds £50M - £250M performed better (neither too small or too big) Nesta Research

Co Investment Why matched funding: Gearing up other monies Encourages investment Completes investment rounds Goes further Invest in areas without specific expertise

Co Investment Sources of matched funding: Government EU/other public bodies Charitable organisations Family offices

The ideal private equity deal gives a high return (cash-to-cash and IRR) for a low risk Given the huge amounts of money in the industry, the ideal private equity deal is very big! Can we make money on this?

Understanding private equity deals Price/Buy the company at value / under-value Price will be based on DCF, comparative multiples (EBIT or EBITDA), recent PE deals, surplus asset availability and the level of competition Finance as much as possible by debt - gearing Incentivise the management by giving them more equity than their cash investment merits Grow the business / make it more efficient Sell it at a profit

What interests private equity companies? – Pointers to Success Good management Growth prospects (in bottom line) Cash generation – strong and predictable USP/Barriers to entry e.g. brand names / strong market position Deal price Not hostile Transaction angle - e.g. a ‘buy and build’, or an individual to bring into the business Readily separable assets A clear exit strategy

Deal terms will include… A structure to give an acceptable IRR Memorandum & articles Shareholders’ agreement / Investment Agreement Details of the investment and the terms attached to each of the securities – e.g. votes, vetoes, covenants, rights on exit, conversion terms … Drag along and tag along rights Pre-emption rights Board representation rights Fees Representations and warranties Service contracts Banking agreements

How they make their money By selling out at a higher P/E By selling parts of the business separately By improving the business at an operational level By using gearing to create equity value (and to create focus on the need for cashflow so that debt can be paid down quickly)

Sourcing Deals Marketing Research Financial Advisers Co Investment Partners PR Word of Mouth/Recommendation

The deal process

Choosing professional advisers Reputation Experience Depth Location Fee structure Chemistry Comfort

The venture capital process Prepare business plan Approach venture capitalist with plan Initial evaluation by VC Initial meetings and enquiries Heads of Terms Due diligence Final negotiations and completion Monitoring Exit It will take longer than you think!

What would an investor want to see in a business plan?

The business plan Executive Summary History and background to the deal Market/Competition People Financial history Financial projections Plans for growth Exit Strategy Assumptions behind projections/Sensitivity SWOT

Preparing the plan - who does what? Entrepreneur Explanation of the concept Words Assumptions for financials Adviser Structure of plan Financial models Review for completeness and acceptability Prepare a Summary plan too – a ‘taster’

Preparing the plan - who’ll read it? VCs spend about 10 – 15 minutes on initial screening of proposals. Angels spend about 9 minutes. VCs, angels and bankers all look for different things in business plans Debt is looking at risk; equity considers growth Bankers place a lot more emphasis on the financials VCs emphasise financials and market issues about equally; the entrepreneur and the strategy are also very important Angels also emphasise financials and markets, but focus more on the entrepreneur than do VCs Angels also emphasise investor fit/chemistry Bankers and VCs tend to be more consistent in their views than do angels

Initial evaluation by venture capitalist Does it fit investment criteria? You can check this on BVCA.co.uk Amount Stage Industry Geographical area Does it seem commercially feasible? Is it interesting? How much other work do we have on?

Legal – e.g. IP, contracts, AML Due diligence People Business Market Competition Customers Financial Legal – e.g. IP, contracts, AML

Governance Risk Committee Legal Sign Off Finance Sign off Investment Committee Level of approval authority Independent members? Quorum

Process Offer letter Subscription Agreement Memorandum & Articles Conditions Precedent Legal Completion

Monitoring Board representation VC or a representative? Salary? Shareholding? Information Covenants Review – align shareholder objectives

Exit Sale Float/IPO Buy back Insolvency The preferred method and timing of exit should be discussed at the start of the deal

Deal Structuring

Risk and Reward Big risks generate big financial returns The financial risk is generated by financial engineering

Deal structuring Different VCs have different preferences No right or wrong answers What we are trying to achieve maximise returns minimise risk

Buy-outs vs Technology Investments Low growth Cash positive Low risk Low return High growth Cash negative High risk High return To maximise returns (IRR) on buy-outs we need to introduce gearing

But ….. Gearing does increase the risk Be prudent - every business should have a financial structure it can service Good structuring can improve returns but will not make a bad company a good investment Higher fixed costs due to servicing debt Allow for some contingency funding Will the bank be supportive?

A structuring model Two basic models:- ‘Newco’ Buyback

Instruments Used Preferred Ordinary Shares Preference shares Warrants Mezzanine Debt Secured Debt Guarantees

Instruments Used Fixed & redeemable elements are split: VC fixed equity matched to management fixed equity e.g.. if… Mgt Ords £1m 20% then… VC Ords £4m 80% Balance is subordinated loan/preference shares

Envy Ratio ‘The ratio of management’s capitalisation to PE’s capitalisation (all risk money)’ e.g. Mgt invest £50k for 25% equity, Cap = £200k But PE invests £600k for 75% (say £150k for equity + £450k prefs) Cap = £800k Envy Ratio is 200: 800 i.e 1 : 4

Instruments Used Ratchets Redeemable Ordinary Shares/Buyback Convertible preference shares Convertible loan Options

Instruments Used Debt terms - market conditions/risk profile Repayment over 6-8 years 2% over base rate Secured creditor Mezzanine terms Bridge between debt & equity Year 8-9 bullet repayment 3 to 4% over base rate + warrant (to encourage repayment) Returns c. 15-20% Used to enhance equity returns where cashflow is good

Deal Structuring Newco Target

Deal Structuring Management Equity VC Equity Newco VC Prefs VC Mezz Debt Target

Deal Structuring – Share Buyin New Mgt Equity Target VC Equity Debt VC Prefs Need Revenue Reserves to do this

A structuring model The Inputs The Outputs We are trying to achieve a satisfactory return (IRR) :- By varying: The Inputs The Outputs

IRR Inputs – The Variables Price Working capital/ overdraft facility Fees Debt (£ + Int rate + repayment + warrant Vendor loan note/rollover (£ + Int rate + repayment) Mezzanine loan - VC (£ + Int rate + repayment Equity - mgt (£ + %) Equity - VC (£ + % + dividends) EBIT Depreciation/capex/other cash items Working capital movements Tax rate Trading Projections Exit year & multiple

IRR Inputs Exit assumptions - Timing & P/E applied Classic IRR measurement 3 & 5 yrs. Actual timing specific to deal / market/shareholders Usually multiple in = multiple out (unless business bought “cheaply”) Target returns: 25-35%

Target Outputs Yearly cash headroom IRR - VC & Mgt and Mezz A financial structure that works!

In Summary……. Need to: Balance risk / reward expectations Juggle repayment profiles / levels of gearing Use debt instruments Stepped interest profiles Equity ratchets To get the required IRR

QUESTIONS?

Business Angels

Business Angels 90% of them are men. 75% are over 50 years old. 84% have start up experience. 79% have started one or more businesses themselves. 55% are syndicate founders of at least one SME. 75% had made their wealth from existing businesses. Only 29% of angel investments make money (?) .

Business Angels – changing market Average age reducing Investment of City bonuses More female angels emerging Tax incentives increasingly attractive Rise of angel networks Crowdfunding

Business angels Reasons for investing Financial return Tax incentives - EIS Job Fun Social Other Amounts invested Average angel investment is about £75,000 – but there are a lot more looking to invest £10,000 than there are £100,000 Virgin angels Are they serious?

Angels’ investment criteria Good balance of risks and rewards Impressions of management including the business plan Understand the business/sector Size of investment Projected margins and return on investment Sales potential Niche markets Synergies with own skills Asset backing Location Exit strategy

Angel investment Criteria But : Less worried about terms Less sensitive to pre money valuation Prefer straight forward deals driven by tax incentives

Do I want an angel? Advantages Disadvantages Fewer prejudices May invest in earlier stage businesses Quicker decisions Flexible May be cheaper Longer term view Hands on experience and advice Disadvantages Second round funding and less chance of syndication Meddlesome Less investment experience than VC firms Less prestigious than VC Buying a job? Midas complex

How do I find an angel? Friends and family Local referrers Networks European Business Angels Network (Eban.org) BBAA.co.uk Specialist networks Internet search Crowdfunding platform

Questions ?

Start Ups and Early Growth Capital Melanie Perkins 17 March 2015

What we will cover: How these types of deal differ Types of funding available Stages of development of a new business Sources of funds Academic spin outs

Start Ups How are these types of deal different?

Start Ups No track record Often technology based Unproven markets Boot strapped Will require further funding later But higher returns?

Buy-outs vs Start Ups Buy Outs Start Ups High growth Low growth Cash positive Low risk Low return High growth Cash negative High risk High return

Important we have: Good management Investor who can provide more than just funding Partners Protected IP Alignment of interests Credibility

How these deals are assessed: Detailed due diligence People Market Technology Competition Need to add value as well as money Specialist sector knowledge

Types of Funding Where can companies get the money? Family/Angels Grants/Government/Universities Internal Positive Cashflow Debt Equity

Types of Money:Public Sources Grants Government Seedcorn Funds NESTA Business Angel co investment fund Universities

Types of Money: Debt Early stage companies generally have difficulty borrowing money. Few assets/collateral No history of earnings No record of credit Guarantor required Example: Exacttarget – our web based email marketing company. We were growing quickly and we needed to lease new servers to support our clients. We guaranteed the loans. This is not an easy thing to do.

Types of Money: Equity Selling a piece of the company. Doesn’t “cost” anything upfront Partner relationship High cost if successful Must convince others of value Build support network “Force” your commitment

Alternative sources of funding R&D Partner Distributors Partnering e.g. merge with better capitalised company

Stages of Development Of a New Business

Stages of Development of a New Business Seed Start Up Early Growth Expansion Maturity

Stages of Development (But first…) Idea Development of idea Proof of concept Prototype Market testing/Proof of market Launch

Types of company Lifestyle High Growth Depends on objectives of shareholders

Stages of Development High Growth Lifestyle Money Time You have a new business Business plan is solid Patents, if any, may be in process Product demo or prototype has traction – interested clients/investors Maybe some initial sales Key management, in place or on sidelines Lifestyle Time Seed Startup Early Growth Expansion Maturity

Stages of Development High Growth Lifestyle Money Time Success in marketplace Hiring sales and marketing Hiring operations Office space/warehouse/manufacturing Equipment purchases Money High Growth Lifestyle Time Seed Startup Early Growth Expansion Maturity

Stages of Development High Growth Lifestyle Money Time Growing quickly More hiring Transition from initial admin/operations to full scale Move offices to accommodate hires New production facilities/hardware Invest in marketing Invest in product development Competition takes notice Fire-fighting, keeping the wheels on Money High Growth Lifestyle Time Seed Startup Early Growth Expansion Maturity

Risk Assessment Risk Risk* Time 80% of startups fail Less than 5% become high growth Risk Time Seed Startup Early Growth Expansion Maturity * Level of investment risk assumed by investor

Sources of Funds Risk Time Seed Startup Early Growth Expansion Founders Friends and Family Angels Venture Capitalists Acquisitions & Equity Markets Banks Time Seed Startup Early Growth Expansion Maturity

Sources of Funds Risk Time Seed Startup Early Growth Expansion Founders: Highest risk Typically invest up to £100K Use their own savings Ask friends to join them Offer a piece of company as incentive – outlined in Operating Agreement Work without salary (may defer on books) Provide space (garage/basement) Ask for favors (legal advice, accounting) Should all be highly active Founders Time Examples Digital River was started with $40K ExactTarget: - was started in a 3 season porch - 4 founders worked for free for the first year gave a piece of the co. (then worth nothing) to a software developer to build a demo Got Ice Miller, large Indianapolis law firm to provide free services Seed Startup Early Growth Expansion Maturity

Sources of Funds Risk Time Seed Startup Early Growth Expansion Friends and Family High risk Fund most new businesses Typically invest up to £200k Can be quick money Personal relationship risk Part of networking for your business Formal Private Placement Memo Have consistent agreements drawn and approved by a lawyer Keep records Generally passive investors Valuation Founders Friends and Family Time Seed Startup Early Growth Expansion Maturity

Sources of Funds Risk Time Seed Startup Early Growth Expansion Angels Moderate to high risk Typically invest £50K to £1M Perform due diligence Groups may work as a syndicate Can help with next round of funding 1/3 of deals at the seed stage May take seat on board Founders Friends and Family Angels Time Seed Startup Early Growth Expansion Maturity

Sources of Funds Risk Time Seed Startup Early Growth Expansion VCs Moderate risk Typically invest £1M to £5M Perform due diligence Can help with next round of funding 6% of deals at the seed or startup stage Generally lead a round Will take seat on board Founders Friends and Family Angels Venture Capitalists Time Seed Startup Early Growth Expansion Maturity

Sources of Funds Risk Time Seed Startup Early Growth Expansion Banks More likely to loan when cash flow is good and assets on the books Borrow on receivables and other assets Acquisitions/Equity: IPOs are rare Acquisitions are much more common Founders Friends and Family Angels Venture Capitalists Acquisitions & Equity Markets Banks Time Seed Startup Early Growth Expansion Maturity

Funding Stages Multiple steps in raising funds – rounds Funds advanced against achievement of milestones Larger sums raised at each step New investors at Series A Growing valuation Owners get diluted

Common Issues Worry about dilution Raising too little Insufficient cash for marketing Unrealistic milestones and technical slippages Too slow to execute or adapt Over optimistic sales forecasts Naïve exit expectations

Academic Spin-out Companies International increase in commercialisation of university inventions and knowledge A source of income for universities Does a spin-out have to create wealth? How can universities organise for spin out wealth creation?

Levels of Support Low Small department and team Funded with public money Networking with university departments Limited IPR

Levels Of Support Supportive A financially independent, commercial organisation Spin out service employs specialists in IP,legal etc Public/private equity funds to finance development Networking with local industry, specialised advisers and VC community University owns IPR Business plan required Incubation space and specialised support are offered, at market prices Equity in spin out company is taken

Levels of Support Incubator Highly capitalised and leading edge companies An independent R&D organisation Internal research space and infrastructure provided (for free?) Spin out service employs specialist advisers Revenues generated by contract research and licenses Spin out service manages IPR service internally

What can go wrong! Insufficient cash resources Sales and profits take longer to come through IP cannot be protected Technology overtaken Concept not proved Approvals (e.g. FDA) refused Entrepreneurs not managers

Things Not To Do Wait until the last minute to raise money Get more money than you need Hire names rather than competencies Spend money extravagantly Be secretive about your problems and worries

Things To Do Have contingency plans Fail quickly, fail small, try again Focus on revenues, margins – this will make raising money easier and valuations better Minimise your burn rate Don’t be a big business too soon Focus on the size of the cake and not the size of your piece Build a strong relationship with your investors Get excited, be confident and think big but recognise your own limitations

Questions

Portfolio Management Melanie Perkins 17 March 2015

Objective: Maximise Institutional Return Income Capital Gain

Key Areas: Your rights under the Investment Agreement Relationship with management Board representation Relationship with other investors Financial Information Company strategy Shareholder objectives

Institutional Rights: Shareholder Protections Right to appoint NXC/NXD Drag along/Tag along Right to Financial & other Information Restriction on borrowings Restriction on emoluments

Drag & Tag Assuming a 100% acquisition: PE 95% Mgt/Other 5% - PE can DRAG management PE 15% Mgt/Other 85% - PE can TAG along

Management Incentives: Salary and emoluments (employment contract) Sweet equity Ratchets + ve & - ve Options Exit bonus

Portfolio Management Board Meeting Strategy Meeting Ad hoc meeting/Liaison Meeting AGM

Liaison Meeting Agenda Update of progress v budget v 3 year plan – milestones? Cash position Market / competition People issues – succession planning? Shareholder relationships Any other issues

Buy-outs vs. Technology Investments Low growth Cash Generative Low risk Low return Exit strategy High growth Cash negative High risk High return Exit?

If all is going well: Focus on shareholder strategy Maximise profit Prepare for exit

Methods of Valuation Cost Earnings Net asset value Market value Full provision (BVCA Guidelines)

Potential Pitfalls Failure to achieve plan Inability to service & repay debt People issues Political issues Shareholder issues ‘Act of God’

Failure to achieve plan What levers do you have to effect change ?

Cash Issues Relationship with debt providers Friend or foe ?

What interests the bank? Security Cover available Income Cover available Overall level of gearing Overall yield Will/How can we get our money back?

Options: Change/strengthen management Need to keep all interests aligned Provide further funding/raise new capital Restructure balance sheet BOGOF Increase or decrease risk ?

Beware: Solvency issues Directors’ responsibilities Directors’ contracts Bank’s agenda Is the business worth rescuing ?

Rescue Funding: Equity with preferred rights Convertible loan Reward for risk

Waterfall Sale for £1,000,000 Less: Secured Debt (300,000) Less :Mezz. Debt (200,000) Available for shareholders: £500,000 Less: Preference Shares (400,000) Less Pref. Ordinary Shares (200,000) Surplus for Ordinary Shareholders Nil

Exit Trade sale Flotation Management buyout Company buyback

Need to align: Shareholder objectives Management objectives

Trade Sale Market price Company has greater resources going forward Management may not be required “Friendly’’ buyer Consideration cash / paper / deferred / earn out

Flotation Access to capital In the public eye Management stay on Harder to exit Costly Dependent on stock market conditions

Management Buyout Continuity of business and management; Need to raise capital (again); No warranties or indemnities; 100% ownership Opportunity to bring in new management shareholders NEA

Company Buyback Need sufficient revenue reserves Need to raise capital (again) Other shareholders increase pro rata NEA

Potential Issues Need to keep interests aligned Management contracts Incentives to management – keep them on side Warranties & indemnities Tax Issues Is it market price ? Keep business performing !

Any questions ?

Case Study “Softin”

Softin - Issues Should they consider going through an IPO? What do you think of Smittenwith’s proposals? What do you consider are the main issues? What advice would you give Paul?

Softin – To date Start up which has been successful Good profits and strong cash flow No institutional involvement Board structure right What about the future? What do the shareholders want?

Softin Outcome

Portfolio Management Questions?

Portfolio Management Thank You !