Venture Capital and Private Equity Contracting: An International Perspective

Douglas J. Cumming and Sofia A. Johan Elsevier Science Academic Press (2009)

Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Materials
Textbook:
Cumming, D.J., and S.A. Johan, 2009. Venture Capital and Private Equity Contracting: An International Perspective, Elsevier Science Academic Press.

Web:
http://venturecapitalprivateequitycontracting.com/

Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Chapter 1 Objectives

Introduction
Venture Capital and Private Equity Definitions

Issues addressed in course and textbook

Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Sources of funds What do VC/PE Managers Do? Possible Misconceptions?

Sources of Funds for Entrepreneurial Firms

There are various sources of funds

Characteristics of other sources are very briefly provided on the next slide
Our focus in this course is on Venture Capital (VC) and Private Equity (PE)

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Venture Capital and Private Equity Contracting

Table 1.1. Greatly Oversimplified Typical Characteristics of Funds Providers Investment Motivation Reinvestment Focus of Attention Execution Cash Typically Available Unlimited Source of Funds Earnings Biggest Advantages Non-Dilutive Security Required None Subject to Market Conditions? Some

Source

Biggest Drawbacks

Internal Operations

Slow

Founders
Friends and Family Private Angel Investors

Ambition
Relationships The Entrepreneur

Varies
Support Varies

$100,000
$250,000 $500,000 to $1.5M

Savings
Savings Previous Successes

Personal Risk
Relationships Varying Commitment

Non-Dilutive
Easy Sell Brings Credibility

None
None None

Little
Some Considerable

Venture Capital Funds

Business Plan, Team, Market, Trajectory

Mezzanine, Buyout, Turnaround

Contracts, Liquidity Event, Valuation

Contracts, Liquidity Event, Valuation Two Repayment Sources

$1M to $20M

Limited Partners, Institutions

Limited Partners, Institutions

Time Consuming, Expensive

Brings Help, Credibility

Contractual Terms and Conditions

Contractual Terms and Conditions A/R, Inventory, IP

Greatly

Private Equity Funds

$20M to $500M

Time Consuming, Expensive

Brings Help, Credibility

Greatly

Commercial Banks (& Venture Banks)

Risk versus Return

80% of A/R, 50% of inv.

Deposits

Regulatory Agencies

Advice, Clean, Straight-forward, Businesslike

Little

Bridge Funds

Risk versus Return

Low Risk

$500K to $5M

Limited Partners, Institutions Company Treasury Company Treasury Company Treasury Company Treasury

Warrants

Speed (5 days to get a loan) Cheaper than Equity Cheaper than Equity Cheaper than Equity 2-Way Economics, Low Pricing Pressure Inexpensive, No Recourse Advice, Public Exposure

All Assets Including IP

Greatly

Leasing Companies

Risk versus Return

Liquidation Values Collections

80% of value

Costly

Varies

Little

Factors (buy your A/R)

Risk versus Return

80% of A/R 80% of A/R, 60% of inv.

~5% over Prime

Varies Personal Guarantee

Little

Asset Lenders

Risk versus Return

Balance Sheet

Expensive

Little

Partner Companies

What You Can Do For Them

Synergies

Varies

May Preclude Other Opportunities Paperwork, Oversight Costs, Underpricing, Public Disclosure

Little

Some

Government Agencies

Mandates

Regulations, Warrants

Varies

Taxes

Little or None

Little

Investment Bankers at IPO

Fees

Stock Market

Unlimited

Public

Escrow, Lock-in

Extreme

Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Figure 1.1. Venture Capital Financial Intermediation

Investors
Returns Capital

Venture Capitalist
Equity, Debt, Warrants, etc. Capital

Entrepreneurial Firm
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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Sources of funds What do VC/PE Managers Do? Possible Misconceptions?

What Do Venture Capitalists (VCs) Do?

Due Diligence
Screening 1 to 2 deals out of >1000

Value-added
Monitoring, Networks, Expertise Legal, Financial, Accounting, Suppliers, Buyers, Boards of Directors, Human Resources, Strategic, Marketing, other
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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Sources of funds What do VC/PE Managers Do? Possible Misconceptions?

Possible Misconceptions (?!)

Vulture capital: significant ownership and control rights Insufficient funds

Sell bad investee firms public in initial public offerings (IPOs)
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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Definitions Size Countries/ Data

Venture Capital and Private Equity

Some Definitions

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Figure 1.2

VCs, Acquisitions/Mergers Strategic Alliances, etc.

SEO

P R O F I T S

Angels, FFF Seed Capital Early Stage Later Stage Public Market

(Could include VC)

IPO Mezzanine 3rd Break Even 1st Valley of Death 2nd

TIME
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Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Definitions Size Countries/ Data

Venture Capital vs Private Equity (1/3)

Seed
Financing provided to research, assess and develop an initial concept before a business has reached the start-up phase.

Start-up
Financing provided to companies firms for product development and initial marketing. Companies Firms may be in the process of being set up or may have been in business for a short time, but have not sold their product commercially.

Other Early Stage

Financing to companies firms that have completed the product development stage and require further funds to initiate commercial manufacturing and sales. They will not yet be generating a profit.

Expansion
Financing provided for the growth and expansion of a company firm which is breaking even or trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital.

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Definitions Size Countries/ Data

Venture Capital vs Private Equity (2/3)

Bridge Financing
Financing made available to a company firm in the period of transition from being privately owned to being publicly quoted. Purchase of existing shares in a company firm from another private equity investment organization or from another shareholder or shareholders. Financing made available to an existing business firm which has experienced trading difficulties (firm is not earning its cost of capital (WACC)), with a view to re-establishing prosperity. To reduce a companys firms level of gearing. Financing provided to enable current operating management and investors to acquire an existing product line or business. Financing provided to enable a manager or group of managers from outside the company firm to buyin to the company firm with the support of private equity investors.

Secondary Purchase / Replacement Capital Rescue / Turnaround Refinancing Bank Debt Management Buyout Management Buyin

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Definitions Size Countries/ Data

Venture Capital vs Private Equity (3/3)

Venture Purchase of Quoted Shares

Purchase of quoted shares with the purpose of delisting the firm.

Other Purchase of Quoted Shares

Purchase of shares on a public stock market.

In practice, sometimes broader categories of definitions are used. For example,

Start-up: sometimes used in practice to refers to Start-up, and Other Early Stage Expansion: sometimes used in practice to refers to Expansion, Bridge Financing, Rescue/Turnaround Replacement Capital: sometimes used in practice to refers to Secondary Purchase/Replacement Capital, Refinancing Bank Debt Buyouts: sometimes used in practice to refers to Management Buyout, Management Buyin, Venture Purchase of Quoted Shares.

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Definitions Size Countries/ Data

Size of VC and PE Markets?

VC is a small but important sector of the economy
Connected to:
IPO markets (stock markets) Legality: shareholder protection, bankruptcy law, tax Government programs Armour and Cumming (2006 Oxford Economic Papers)

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0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0
Iceland United States Canada The Netherlands United Kingdom Sweden Belgium Norway Finland European Union Ireland Germany France Spain Switzerland Portugal Italy Denmark Greece Austria Poland Czech Republic Hungary Slovak Republic Korea (1995-2000) Australia (1995-2000) New Zealand (1995-2000) Japan (1995-2000)

Cumming & Johan (2009)

Tota l Buyo ut an d Oth Expa ers nsion Early Stag e

Figure 1.3. Venture capital investment by stages as a percentage of GDP, 1998-2001 Source: OECD

Venture Capital and Private Equity Contracting

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Figure 1.4. Size of Venture Capital and Private Equity Markets Across Countries Source: Armour and Cumming (2006)

0.8 0.7 0.6 0.5 Amounts Averaged 1990 - 2003 0.4 Relative to GDP Expressed in % 0.3 0.2 Fundraising 0.1 0
Austria Belgium Denmark Finland France Germany Ireland Italy

All Dispositions Total Private Equity Expansion Stage

Netherlands Portugal Spain

Early Stage
Sweden UK US Canada

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Table 1.2. Size of Venture Capital and Private Equity Markets Across Countries
This table presents the size of the early stage, expansion stage, total private equity (including early, expansion, late, buyout and turnaround stages), fundraising and dispositions (exits) expressed as a fraction of GDP. Values are averaged for the 1990-2003 period. Source: Armour and Cumming (2006). Country Austria Belgium Canada Denmark Finland France Germany Ireland Early Stage 6.06E-03 2.85E-02 8.68E-02 1.94E-02 3.54E-02 1.92E-02 1.92E-02 2.37E-02 Expansion Stage 1.38E-02 5.33E-02 9.34E-02 2.79E-02 4.40E-02 5.15E-02 3.89E-02 5.78E-02 Total Private Equity 2.44E-02 1.03E-01 2.01E-01 6.43E-02 1.23E-01 1.61E-01 8.65E-02 1.05E-01 Fundraising 3.72E-02 1.18E-01 2.13E-01 9.99E-02 1.84E-01 1.91E-01 8.60E-02 1.54E-01 All Dispositions 9.41E-03 4.61E-02 4.38E-02 1.16E-02 4.26E-02 8.74E-02 3.52E-02 6.01E-02

Italy
Netherlands Portugal Spain Sweden UK US

1.16E-02
3.17E-02 1.32E-02 9.82E-03 3.52E-02 2.96E-02 7.75E-02

4.10E-02
9.93E-02 4.75E-02 5.18E-02 6.98E-02 1.31E-01 1.57E-01

1.19E-01
2.22E-01 8.16E-02 8.42E-02 2.96E-01 5.45E-01 2.96E-01

1.12E-01
2.26E-01 7.87E-02 9.01E-02 4.12E-01 7.70E-01 3.29E-01

1.98E-02
1.03E-01 4.27E-02 2.99E-02 6.13E-02 2.50E-01 1.72E-01 18

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Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Definitions Size Countries/ Data

VC Data

U.S.: http://www.ventureeconomics.com, http://www.vfinance.com, http://www.v1.com

The PricewaterhouseCoopers MoneyTreeTM Survey: http://www.pwcmoneytree.com/ Canada: http://www.cvca.ca, http://www.canadavc.com Europe: http://www.evca.com Australia: http://www.abs.gov.au/Ausstats/abs@.nsf/0/bffef2819df68ca2ca256b6b007ab94 e?OpenDocument Private data sources Data and empirical methods summarized in Cumming and Johan (2009, Chapter 3)

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Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Definitions Size Countries/ Data

VC Industry in US

Over 1000 funds Geographic concentration Specialized focus Over $US 100 billion capital under management Predominantly Private Limited Partnership VC Funds
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Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Definitions Size Countries/ Data

VC Industry in Canada

A little more than 100 funds Geographic dispersion, Less-specialized focus $Can 20 billion capital under management Mix of Private Funds and Government Sponsored Funds

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Definitions Size Countries/ Data

Venture Capital in Australia

$US 3 billion committed capital in 2003 174 funds http://www.abs.gov.au/Ausstats/abs@.nsf/ 0/bffef2819df68ca2ca256b6b007ab94e?Op enDocument

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Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Definitions Size Countries/ Data

Venture Capital in Hong Kong

$US 26 billion committed capital in 2003 177 funds

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Definitions Size Countries/ Data

Venture Capital in Europe

Approx 700 funds in 2004

A little more than $US 50 billion capital under management

Significant regional differences

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Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Main Issues addressed in this Course

[Not a comprehensive list]

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

I. Why Do VCs Exist?

Why not simply borrow from banks?
What does this imply about any theory / evidence in venture capital?
Review agency theory in detail because it is paramount to all issues addressed in this course Cumming and Johan (2009 Chapter 2)

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

II. What Matters in Running a Fund? (1/6)

What do institutional investors care about?

Return expectations Reporting Liquidity Cumming and Johan (2009, Chapter 4)

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Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

II. What Matters in Running a Fund? (2/6)

What terms with institutional investors?

Limited partnership agreements Restrictive covenants Limited liability What clauses to use and when to use them Cumming and Johan (2009, Chapter 5)

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Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

II. What Matters in Running a Fund? (3/6)

How to structure compensation?

Fixed fees Carried interest Cash versus share distributions Clawbacks Cumming and Johan (2009, Chapter 6)

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

II. What Matters in Running a Fund? (4/6)

How to fundraise?
Economic drivers of institutional investment in private equity Legal drivers of institutional investment in private equity Cumming and Johan (2009, Chapter 7)

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Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

II. What Matters in Running a Fund? (5/6)

What role for specialized fund mandates?

Style drift Socially responsible funds Cumming and Johan (2009, Chapter 8)

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

II. What Matters in Running a Fund? (6/6)

What role for government?
Existence of capital gaps? Economic sources of capital gaps Legal sources of capital gaps Direct government investment programs Legislation Evidence from US, UK, Continental Europe, Israel, Australia, Canada Cumming and Johan (2009, Chapter 9)

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

III. Financial Contracting with Entrepreneurs (1/5)

Investment process
Due diligence Stage of development and industry Location Staging Fund flows and valuations Syndication Portfolio size / manager Board seats Contracts Innovative activity Investment duration Cumming and Johan (2009, Chapter 10)

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Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

III. Financial Contracting with Entrepreneurs (2/5)

What structure of investment?
Security design Warrants Common equity Preferred equity Convertible preferred equity Convertible debt Debt Other veto and control rights Cumming and Johan (2009, Chapter 11)

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

III. Financial Contracting with Entrepreneurs (3/5)

Due diligence
Adverse selection When more pronounced Strategies to mitigate adverse selection Cumming and Johan (2009, Chapter 12)

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Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

III. Financial Contracting with Entrepreneurs (4/5)

Corporate Venture Capitalists

Why different than limited partnerships? Are there differences in financial contracts with entrepreneurs? Cumming and Johan (2009, Chapter 13)

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Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

III. Financial Contracting with Entrepreneurs (5/5)

Preplanned Exits Allocation of specific veto, control and cash flow rights Cumming and Johan (2009 Chapter 14)

Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

IV. Investor Value-Added (1/4)

VC and PE Value-Added
Jobs Total Factor Productivity Patents Locusts? Cumming and Johan (2009 Chapter 15)

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

IV. Investor Value-Added (2/4)

Do contracts ensure effort?

Advice Monitoring Conflicts When more pronounced Role for contracts in facilitating effort and mitigating problems Cumming and Johan (2009 Chapter 16)
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Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

IV. Investor Value-Added (3/4)

Where to invest?
Interprovincial versus Intraprovincial Implications of proximity and local bias Cumming and Johan (2009 Chapter 17)

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

IV. Investor Value-Added (4/4)

How many investments?

Trade-off:
Diversification Diffusion in effort

Cumming and Johan (2009 Chapter 18)

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Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

V. How to Successfully Divest? (1/4)

Overview of divestment process
Investment duration Exit vehicle IPO Acquisition Secondary sale Buyback Write-off Full versus partial exits Cumming and Johan (2009 Chapter 19)

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Cumming & Johan (2009)

Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

V. How to Successfully Divest? (3/4)

Issues with IPOs

IPO short-term underpricing IPO long-term overpricing Impact of venture capital backing Impact of quality of exchange Cumming and Johan (2009 Chapter 19)

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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

V. How to Successfully Divest? (2/4)

Which exit vehicle?

Market conditions Legal conditions Fund characteristics Investee firm characteristics Allocation of control rights Cumming and Johan (2009 Chapters 20 & 21)
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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest?

V. How to Successfully Divest? (4/4)

Returns, Valuation and Disclosure

Mechanics of valuation What enhances returns? How to make adjustments with valuations based on return expectations? How to disclose valuations of unexited investments to institutional investors? Cumming and Johan (2009 Chapter 22)
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Venture Capital and Private Equity Contracting

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary

Summary

VC/PE unique form of financing Idiosyncratic risk matters Contracts matter

Fund structures: relations with limited partners Public policy and design of statutes Relations between investors and entrepreneurs Exits, Returns, Valuations, Disclosure

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