1. Venture Capital and Private Equity: What Venture Capitalists look for
Rob Carroll
Session 10: 28 Oct 15 AM
Venture Capital and Private Equity: What Venture Capitalists look for
Mike Collis
13 November 2017

2. Appraisal of Potential VC Investments
VC market development
A model of the VC Investment Process
Pre-investment appraisal – why is it important?
Where do deals come from?
How does the VC decide which
ventures to invest in?
OUTSIDE-IMPACT - a framework approach to Due Diligence (DD)
VC market development
A model of the VC Investment Process
Pre-investment appraisal – why is it important?
Where do deals come from?
How does the VC decide which ventures to invest in?
VC screening - criteria for investment decisions
Due diligence
Valuation & required returns
OUTSIDE-IMPACT approach to DD

3. Determinants of VC market development
See Wright et al., (1992)
Three key requirements for VC market to develop:
Generation of Opportunities
Infrastructure to complete deals
Realisation of gains - EXIT

4. Macro determinants of VC market development
Rob Carroll
Session 10: 28 Oct 15 AM
Generation of opportunities:
attitudes towards risk and entrepreneurship
ownership structure – this can provide opportunities for deals (e.g. family succession issues, non core group activities)
state of development of the M&A market
economic climate e.g. growth, recession, interest rates, availability of capital
Generation of opportunities:
attitudes towards risk and entrepreneurship
ownership structure - as this determines opportunities for sale (e.g. family succession; diversified groups, restructuring of state sector, stock-market quoted firms)
state of development of the M&A market
economic climate e.g. recession, interest rates, fund availability

5. Macro determinants of VC market development
Infrastructure:
legal and taxation framework
sources of debt and equity finance and range of instruments
Government/EU sponsorship
intermediaries, advisors and expertise
EXIT:
e.g. Trade sale, IPO (flotation), secondary tier markets (e.g. AIM), secondary buy-out, administration (Bernard Matthews)

6. Deal Generation Find deals: Sit and Wait Proactive Referral
Attract deals by reputation - Top firms attract top deal makers - Proprietary or self originated deal flow means less competition over terms
Rely on advisors and intermediaries - Accountants - Investment banks - Boutique CF advisors - Legal advisors - Brokers
Self originate - Select target sectors - Research target companies - Partner with entrepreneurs
Find deals:
Sit and Wait
Proactive
Referral
Proprietary deals:
Very important to buy-out firms, buy-out auctions leave little chance for easy gains. For VCs entrepreneur contacts GP directly, GP knows deal intimately.

7. In the words of a VC…
Video of Paul Holland – a general partner in Foundation Capital, a VC firm that specializes in IT (

8. VC needs to communicate several issues:
Maven Capital Partners deal flow year ended August 2016
Maven saw 350 deals in and invested in 5 businesses (less than 2%)
VC needs to communicate several issues:
Expertise
Does the firm/partner have expertise in this sector
Good networks
Value added services
Recruitment, marketing, PR
Exit
Plan and timescale
Reputation
Funds raised
What do other entrepreneurs say
Successful exits

9. VC credentials in the market
Deal Generation
VC credentials in the market
Expertise
Value added services / Portfolio management
Reputation – How do they treat their management teams? Do they deliver? “Are these people good to work with”
“Do they add value”
VC needs to communicate several issues:
Expertise
Does the firm/partner have expertise in this sector
Good networks
Value added services
Recruitment, marketing, PR
Exit
Plan and timescale
Reputation
Funds raised
What do other entrepreneurs say
Successful exits

10. Screening Investments
Rob Carroll
Session 10: 28 Oct 15 AM
Initial screen = VC-specific screen
Size of investment
Investment policy of fund;
Does the sector have good growth prospects?
The competitive environment
Management skills and experience
Proposed terms of investment
How many other VC’s are looking at it? Will there be a bidding war?
Should VC spend any time on this opportunity at all?
Initial screen = VC-specific screen
Size of investment
Investment policy of fund;
technology and market sector of venture;
geographic location;
stage of financing
A sector that fits their expertise
Should VC spend any time on this opportunity at all?
Three things VCs look for?

11. Pre-investment Appraisal
Why is appraisal important?
Entrepreneurs’ perspective
Important for entrepreneur to understand what VC wants
VC perspective
Major adverse selection problems
due to information asymmetry.
Evaluating the business
Evaluating manager/entrepreneur
Helps assess / reduce risks (e.g. competition; managerial risks)
Structuring deal, set expectations & subsequent stages in investment
Adverse selection refers to cases where asymmetric information leads to goods and services being bought and sold that are not of the quality expected. The selection by either the seller or the buyer is adverse. PE firm may chose wrong company to invest in.
What VC wants in terms of share of equity, recruitment, sitting on board, monitoring arrangements and exit

12. What should a VC look for?
Theory
IO strategy & PE perspectives, see Shepherd, 1999.
Probability of venture success related to:
Management
Higher general human capital
Higher industry specific human capital
Market
Stable key success factors
Timing (later rather than early-stage entrant )
Competition
Barriers to entry
Less competitive rivalry
IO = industrial organization perspective, deals with competitive positioning of the firm
PE = population ecology perspective, deals with liability of newness
Market
Stable key success factors: e.g. shifting consumer tastes, a particular technology which may be superseded
Timing: pioneers have higher returns but greater risk of failure. Companies entering a market later in the life-cycle have a better chance of success.
Competition
Lead time: period of monopoly
Competitive rivalry: level of competition
Management
Human capital:
Industry specific human capital:

13. The Maven “One Pager” screening process
Background
Activities
Management
Market and competition
Strategy and exit (“the angle”)
Attractions
Reservations
Financials (historic and forecast)
The Deal (Investment structure, valuation, prospective returns)
IO = industrial organization perspective, deals with competitive positioning of the firm
PE = population ecology perspective, deals with liability of newness
Market
Stable key success factors: e.g. shifting consumer tastes, a particular technology which may be superseded
Timing: pioneers have higher returns but greater risk of failure. Companies entering a market later in the life-cycle have a better chance of success.
Competition
Lead time: period of monopoly
Competitive rivalry: level of competition
Management
Human capital:
Industry specific human capital:

14. The Maven appraisal process
The “One Pager”
Credit Committee initial appraisal
Authorisation of commitment to due diligence and abort costs
Due diligence process
Initial Briefing Note (“IBN”) for Committee approval
Finalisation of due diligence
Final Investment Paper for approval
Deal completion
IO = industrial organization perspective, deals with competitive positioning of the firm
PE = population ecology perspective, deals with liability of newness
Market
Stable key success factors: e.g. shifting consumer tastes, a particular technology which may be superseded
Timing: pioneers have higher returns but greater risk of failure. Companies entering a market later in the life-cycle have a better chance of success.
Competition
Lead time: period of monopoly
Competitive rivalry: level of competition
Management
Human capital:
Industry specific human capital:

15. Evaluation: Due Diligence and Valuation
Often overlap with screening
Involves verifying business plan + valuation
Important because per investment valuation determines proportion of shares or equity the VC acquires.
Elements of Evaluation:
Information – due diligence [what are we really buying?]
Assessment of risk and required rate of return
Entry or pre investment valuation

16. Due Diligence
Detailed scrutiny of the business to assess the deliverability and credibility of the business plan
Consideration of hard and soft factors
Hard [objective factors]
Management qualifications;
number and type of customers;
Historic financial performance
production facilities
Soft [subjective factors]
Personal connection with management;
Market traction of new products or will the concept float commercially?
Evaluation of underlying assumptions
Feeds into valuation and deal structuring and drives the 100 day plan

17. Assessment of the Competitive Environment
The Porters Five Forces Model:
Barriers to ENTRY (patients, cost of set up, regulatory barriers)
Substitutability
Power of suppliers
Power of customers
Barriers to EXIT
IO = industrial organization perspective, deals with competitive positioning of the firm
PE = population ecology perspective, deals with liability of newness
Market
Stable key success factors: e.g. shifting consumer tastes, a particular technology which may be superseded
Timing: pioneers have higher returns but greater risk of failure. Companies entering a market later in the life-cycle have a better chance of success.
Competition
Lead time: period of monopoly
Competitive rivalry: level of competition
Management
Human capital:
Industry specific human capital:

18. Due Diligence Activities

19. Risk and Return Assessing risk influences expected rate of return
Portfolio approach to risk management - Do lots of deals and accept there will be winners and losers? - Or be more clinical, fewer solid deals and be more risk averse
How to mitigate risk
Due diligence informs risk areas
Debt and equity investment structures
Ratchets that give more value to the VC in the bottom slice
Convertibles
Preferred stock
Legal safeguards/investor protection
Convert preference shares to ordinary shares. In the event of the company failing, the proceeds from the sale of the assets are used to repay the preference shareholders before the ordinary shareholders.

20. Investor protection tools (1)
Articles of Association: - Rights to appoint a Chairman of the board - Special voting rights (Swamping) - Restrictions on share transfers - Drag and tag along rights - Frequency of board meetings - Good leaver/bad leaver provisions - Preferred shareholder rights
Investment Agreement - Restrictions on salary increases - Capital expenditure limits - Prohibition on raising debt - Default triggers - Rights to information - Management and corporate covenants - Warrantees and indemnities (guarantees)
Convert preference shares to ordinary shares. In the event of the company failing, the proceeds from the sale of the assets are used to repay the preference shareholders before the ordinary shareholders.

21. Investor protection tools (2)
Contracts of employment - Notice periods - Confidential information - Restrictive covenants
Insurance policies - Directors and officers liability - Crime policies - Keyman insurance policies
Management contribution - Good to the managers putting their “money where their mouth is” - Sufficient to be painful and show commitment
Convert preference shares to ordinary shares. In the event of the company failing, the proceeds from the sale of the assets are used to repay the preference shareholders before the ordinary shareholders.

22. Types of Risk for VCs: Agency vs. Market Risk
Uncertainty associated with market/environmental factors
Indicators:
technical obsolescence
competition
New entrants
many substitutes
weak demand
Agency Risk:
Uncertainty that entrepreneur or VC will pursue own interests rather than comply with contract
Indicators:
potential dishonest entrepreneurs
entrepreneur knowing more than VC (asymmetric information)
Geographic distance reduces monitoring
contractual ambiguities
Personal performance issues
Sector
Experience
Contracts

23. Importance of Valuation
Venture Capitalist
How much of the equity will I get
Entrepreneur
How much do I have to give away
Difficulties/ Mismatch
Often VC’s valuation will not match with entrepreneur’s
Early stage ventures have no history
Later stage investments maybe going through substantial change
Valuation is more of an art than science
Cornell's eClips - Anita Stephens Discusses Valuation

24. Valuation Valuation methods:
P/E ratios multiples based on actual earnings, transaction prices for similar acquisitions in sector
Expected future cash flows
(DCF; Dividend yield)
Asset valuation
Multiples of sales
Gut feel, judgement

25. Valuation methodology – multiple of earnings
Price/ Actual Earnings ratio (P/E) quoted in the FT that can be used to benchmark valuations within sectors
Earnings before interest, tax, depreciation and amortisation = EBITDA the most common metric used in private equity
Enterprise Value/EBITDA company ratios
S&P 500, FTSE 100/250/all share
Comparable stocks Apple, Microsoft, Facebook
Not always easy to find a directly comparable quoted company, distortions arise from comparing large quoted businesses to SME’s
Competitive tension for the deal may drive multiples higher

26. Enterprise value multiple example
Def: The value of a business based on no debt or cash equivalents
Quoted company Scamsoft PLC listed on the LSE
Market capitalisation (shares in issue x market price) £100m
Corporate bonds/debt in issue £30m
Bank debt £10m
Free cash £5m
Enterprise value = £100m + £30m + 10m - £5m = £125m
EBITDA in last published accounts = £12.5m
EV/EBITDA multiple = 10x (£125m/£12.5m) Advantage:
- Objective ratio based on actual earnings and quoted market prices
- Avoids comparable distortions such as financing structure, cash reserves, different tax rates, depreciation and amortisation policies etc.

27. The “Marketability discount”
Discounts are commonly applied to quoted company EV/EBITDA multiples to take into account:
The target company will probably be much smaller
Earnings from the SME target maybe less stable
Liquidity restrictions, private company shares will not be freely traded on a recognisable exchange
Marketability discounts are applied when using quoted ratios to value a smaller private company
Typically discount as much as 40%.

28. Enterprise value multiple discounts
Example:
Littlesoft Limited
Operates in the same markets at Scamsoft PLC
Scamsoft quoted EV multiple = 10
Last reported Littlesoft EBITDA = £1m
Estimated Enterprise Valuation = £1m x 10 x (1-40%) = £6m
Disadvantages:
There maybe no directly comparable quoted companies
Can not be used when the target is early stage and has no earnings
May not be appropriate to value high growth companies

29. Alternative valuation methods - NPV
Net present value of future cash flows or forecast profits:
Useful for companies that have intellectual property rights and rights to future revenue streams.
Can be used to value early stage companies
Uncertainty regarding accuracy of forecasts
Complexity/subjectivity of what discount rates to use to factor in risk
Disadvantage: dependent upon subjective forecasts and challengeable assumptions

30. Alternative valuation methods – Net asset valuations
Ignores cash flows
Used to value asset rich earnings poor
May have freehold property assets or
Other marketable assets
Preferred valuation method used by “asset strippers” and “pension dumpers”
Not appropriate early stage businesses because the tend to have no tangible marketable assets.

31. Alternative valuation methods – Multiples of sales
Commonly used to value loss making early stage businesses
Attempts to place some value on the basis that the business has sales traction in its market
Only appropriate to value high growth businesses in expanding markets
Typical ratios x turnover dependant on the risk and prospective return
Disadvantages:
Valuation decoupled from underlying current or forecast net earnings
Cynic might observe it’s the valuation method of last resort if all other methods fail
Only justifiable if the prospective returns compensate for the high risk

32. Alternative valuation methods – Judgement or “art”
Exercise judgement taking into account the following factors:
The prospective return on the investment if forecasts are achieved
The risks surrounding the achievability of the forecasts identified in due diligence
Competitive tension from other investors looking at the deal
The maximum equity the management team is prepared to surrender and the amount of capital required
Similar deals done in the same sector
Disadvantages:
Subjective and high risk
Pre money valuations inevitably become a function of the fund raising requirement
Casino capitalism?

33. Closing: Deal Approval and Structuring
Deal struck
only if VC and entrepreneur can agree
Establish price
determines equity relinquished by entrepreneur after extensive negotiation
Establish investor protection rights
Articles of Association, Investment Agreements
Composition of board of directors,
Reporting, voting rights, step in rights, exit
A covenant is a type of contract in which the covenantor makes a promise to a covenantee to do or not do some action

34. Array of Appraisal Methodologies
Can vary with stage - early/late (Elango et al., 1995)
Early Stage VC’s
disruptive propositions
fastTrack growth
stellar returns
Portfolio approach to winners and losers
Later Stage VC’s
interested in market acceptance
spend more time on appraisal
minimise risk, every deal must work

35. Conclusion – what all VC’s look for
Strong commercial product/proposition
Proprietary introductions with limited competition
Ambitious managers with common values and objectives
Positive market prospects for sustainable growth
Identifiable and manageable risks
Sensible financial structure and leverage
Downside protections
Attractive entry price/equity share
Exit strategy and potential for good returns

36. Key points to take away Sourcing of opportunities;
Screening, evaluation and due diligence helps reduce asymmetry between VC and entrepreneur
Different approaches to assessing a deal/DD depending on the nature and risk profile of the proposal
Pre-investment assessment for earlier stage deals will be less objective, more subjective and exposed to unknown variables
susceptible to human error or bias
can lack objectivity
Good due diligence will form a solid platform to engage following investment and help form a good 100 day plan

37. Valhalla Case Study OUTSIDE IMPACTS Template
Rob Carroll
Session 10: 28 Oct 15 AM
Valhalla Case Study OUTSIDE IMPACTS Template

38. Why This Case?
Illustrates detailed application of the OUTSIDE-IMPACTS approach to due diligence (DD)
Places DD in contexts of the investment process and competition for deals

39. OUTSIDE-IMPACTS (Kaplan): Due diligence approach
(O) Opportunity: Is this a positive present value opportunity? (Does it have IMPACTS?)
(I)What is the idea/industry?
(M) is the target market large enough to support substantial growth/valuation?
(P) Why does the opportunity generate a positive PV? What is unique?

40. OUTSIDE-IMPACTS (Kaplan): Due diligence approach
(A) Acceptance: Will customers accept/buy the product?
(C) Why won’t the value be competed away?
(T) Why is this a good time to enter?
(S) Speed? How quickly can this be implemented

41. OUTSIDE-IMPACTS (U) Uncertainties: (S) Strategy
What are the major uncertainties?
Which uncertainties can be managed so that outcome more likely to be favourable?
How do the answers affect the opportunity?
(T) Team / Management
Can management team implement opportunity?
Is the team complete?
(S) Strategy
Is the strategy viable, consistent with opportunity, uncertainty, team and exit?

42. OUTSIDE-IMPACTS (I) Investment Requirements Cash flow requirements
(D) Deal
Does deal structure
Provide appropriate incentives?
Provide/ensure appropriate governance?
Help manage the uncertainties?
(E) Exit – Why would the business be attractive to a buyer?
- Who would buy it?

43. OUTSIDE-IMPACTS – Group assignments
Group 1 – Use the framework to analyse:
(I) The Idea
(M) The Market
The Positive PV (value or return)
Group 2- Use the framework to analyse
Acceptance, will it sell?
Competed, the competitive enviromnent
Timing, Is it too early? Too late?
(S) Speed

44. OUTSIDE-IMPACTS – Group assignments
Group 3 – Use the framework to analyse:
(U) Uncertainties
(T) Team, management
Strategy
Group 4 – Use the framework to analyse
Investment, how will the funds be used?
Deal: terms of investment, valuation, agreed?
Exit, who will buy it? Why?

45. Case study - Valhalla Due Diligence Process
Benefits of Valhalla Process in any?
Impact on decision ?
Impact on the future?
Soft skills
Assessment
Time/ Costs
Disadvantages of Valhalla Process in any?
Is it a USP ?
Impact on Entrepreneur?
Time/Costs?
Impact on decisions

46. and good luck……! Rob Carroll Session 10: 28 Oct 15 AM Thank you
Over to Kevin
Questions after that
and good luck……!

47. Key reading Shepherd (1999) Tyebjee & Bruno (1984)
DeClercq et al., (2006), pp

48. Valuation Cornell's eClips - Eric Young Discusses Use Of
Comparables In Valuation Process
Cornell's eClips - Ofer Ronen States Valuation Of
Start-ups Is An Art And Not A Science