What is Venture Capital?

Venture Capital

Topics Covered



Definition of Venture Capital



Activities of Venture Capitalists



Organization Structure of Venture Capital



History of Venture Capital



Patterns of Venture Capital Investment



Cost of Capital for Venture Capital

What is Venture Capital?

Since success of a new firm is highly

dependent on the effort of the managers,

restrictions are placed on management by

the venture capital company and funds are

usually dispersed in stages, after a certain

level of success is achieved.

Venture Capital (VC)

Money invested to finance a new firm

(Please see, Heukamp, Liechtenstein and Wakeling (2007) p.68)

What is Venture Capital?

A VC has five main characteristics:

 A VC is a financial intermediary, meaning that it takes the investors’ capital and invests it directly in portfolio companies.

 A VC invests only in private companies. This means that once the investments are made, the companies cannot be immediately traded on a public exchange.

 A VC takes an active role in monitoring and helping the companies in its portfolio.

 A VC’s primary goal is to maximize its financial return by exiting investments through a sale or an initial public offering (IPO).

 A VC invests to fund the internal growth of companies.

(1) What is a VC?

A VC is a financial intermediary, i.e., that they take the investors’ capital and invest it directly in portfolio companies.

Entrepreneurs VC Investors

The Flow-of-Fund in the Venture

Capital Cycle

VC Funds Managed by

General Partners (“VCs” or

“GPs”)

Portfolio Companies

Limited Partners (Investors or

“LPs”)

“Exits”: Sale of Portfolio companies

to public markets (IPOs) or to

other companies

Typically, a VC fund is organized as a limited partnership, with the venture capitalist acting as the general partner (GP) of the fund, and the investors acting as the limited partners (LP).

Private Equity Partnership

Investment Phase Payout Phase General Partner put

up 1% of capital General Partner get carried interest in 20%

of profits Limited

partners put in 99% of

capital

Limited partners get

investment back, then

80% of profits

Investment in diversified

portfolio of companies

Sale or IPO of companies Partnership Partnership

Company 1 Company 2

Company N Mgmt fees

(2) What is a VC?

A VC will only invest in private companies. This means that once the investments are made, the

companies cannot be immediately traded on a public exchange.

- no simple mark to market - no liquidity

- VCs tend to focus on high-technology industries

- most VC firms specialize their funds by stage, industry, and/or geography

VC is a Segment of Private Equity

Hedge Funds

 Hedge Funds are flexible investing vehicles that share many characteristics of private equity funds, including the limited partnership structure and the forms of GP compensation.

The main differences:

 Hedge funds tend to invest in public securities.

 Private equity funds are long-term investors and hedge funds are short-term traders.

 Hedge funds investments are more liquid than those for private equity investors, so that hedge funds can offer their investors faster access to their money.

(3) What is a VC?

A VC takes an active role in monitoring and

helping the companies in his portfolio.

(4) What is a VC?

A VC’s primary goal is to maximize his financial return by exiting investments through a sale or an initial public offering (IPO).

$0

$5

$10

$15

$20

$25

$30

$35

2002 2003 2004 2005 2006 2007 2008 2009

M&A exits ($B) IPO exits ($B)

(5) What is a VC?

VCs invest to fund the internal growth of companies.

The investment proceeds are used to build new businesses, not to acquire existing businesses.

Stages of Growth



Early-Stage



Seed/Startup



Early Stage



Expansion Stage



Later Stage

(Please see, Black and Gilson (1998) p.250)

What do Venture Capitalists do?

VC activities can be broken into three

main groups:



Investing



Monitoring



Exiting

Investing

Investing begins with VCs prospecting for new opportunities and does not end until a contract has been signed. For every investment made, a VC may screen hundreds of possibilities:

 A few dozen will be worthy of detailed attention.

 Fewer still will merit a preliminary offer (preliminary offers are made with a term sheet, which outlines the proposed valuation, type of security, and proposed control rights for the investors).

 If this term sheet is accepted by the company, then the VC performs extensive due diligence by analyzing every aspect of the company.

 If the VC is satisfied by this due diligence, then all parties negotiate the final set of terms to be included in the formal set of contracts to be signed in the final closing.

Monitoring

Once an investment is made, the VC begins

working with the company:



Through board meetings



Recruiting



Regular advice

Together, these activities comprise the

monitoring group

Exiting

VCs plan their exit strategies carefully,

usually in consultation with investment

bankers:



Historically, the IPO has been the source of

the most lucrative exits.



The main alternative to the IPO is a sale to a

strategic buyer, usually a large corporation.

The Key Players in the VC Industry

 VC firms (small organizations, averaging about ten professionals, who serve as the GP for VC funds)

 general partner (GP)

 VC fund (a limited partnership with a finite lifetime, usually ten years plus optional extensions of a few years)

 limited partner (LP)

 committed capital (total amount of capital promised by the LPs over the lifetime of the fund)

 early-stage, mid-stage, late-stage fund, multi- stage fund

 the fund has been closed (once the GP has raised the full amount of committed capital and is ready to start investing)

 vintage year

 capital call = drawdown = takedown (periodic capital provisions)

Who are the LPs?



Historically, just under half of all committed

capital comes from pension funds.



The next two largest groups are financial

institutions and endowments/foundations,

each with about 1/6 of the total.



Individuals/families and corporations make up

the remainder, and are more fickle than the

other types.

direct corporate VC investment (business angels) in portfolio companies (please see, Morrissette (2007) p.54).

Committed Capital by LP Type

Investment vs. Fundraising

11

19

28

31

35

25

15

20 22 23

27

31 28

18

0 5 10 15 20 25 30 35 40

2003 2004 2005 2006 2007 2008 2009

Raised ($B) Invested ($B)

Example: Sierra Ventures

Fund Name Vintage Year Committed Capital

(previous funds information omitted)

Sierra Ventures V 1995 $100M Sierra Ventures VI 1997 $175M Sierra Ventures VII 1999 $250M Sierra Ventures VIII 2000 $500M Sierra Ventures IX 2006 $400M

Compensation structure

 Management fees (most commonly 2% of the

committed capital every year, this fee remain constant or in most cases the fee drops somewhat after the 5 year

investment period is over)

 Carried interest (often referred to simply as the

carry). The carried interest definition: % of the realized fund profit that gets paid to GPs. Realized fund profit = cumulative distributions – committed capital or investment capital.

 Level: 20 to 25-30

 Basis: committed capital or investment capital

Fees: definitions

 Annual management Fees

 Level: 2%

 Basis: committed capital or net invested capital

 lifetime fees = The total amount of fees paid over the lifetime of a fund

 investment capital = committed capital - lifetime fees

 invested capital = cost basis for the investment capital of the fund that has already been deployed at a given point

 Net invested capital = invested capital - cost basis of all exited and written-off investments

VC COMPENSATION (IN$ THOUSANDS)

Top-Tier Venture Capitalists

The History of Venture Capital

The modern organizational form of VC dates back only to 1946.

 American Research and Development Corporation (ADR), began operations in 1946 as the first true VC firm (by George Doriot, as open-end funds). Unlike modern funds, it was organized as a corporation and was publicly traded.

 The U.S. government began its own VC efforts as part of the Small Business Act of 1958, which was legislation that created the Small Business

Administration and allowed the creation of Small Business Investment Companies (SBICs).

The History of Venture Capital

 An important milestone for the VC industry came in the

1960s with the development of the limited partnerships for VC investments. Limited partnerships are by far the

most common form of organization in the VC industry.

 Total VC fund-raising in the U.S. was still less than $1B a year throughout the 1970s. The next big change for VC came in 1979, when the relaxation of investment rules for U.S. pension funds led to historically large inflows from these investors to the asset class.

 Investing activity rose sharply to $3B in 1983 and

remained remarkably stable through the 1980s. From

$2.2B in 1991, it rose gradually to $4.1 B in 1994 (preboom period).

U.S. VC Investment ($ billions)

Boom era Post-boom

era

7.9 11.0 14.7 20.9

53.4

104.0

40.3

21.9 19.7 22.4 23.1 26.7 30.8 28.3

17.7 0.0

20.0 40.0 60.0 80.0 100.0 120.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Investment by Stage

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Later Expansion Early

Startup-Seed

Investment by Industry

Pre-boom = 1980-1994, Boom = 1995-2000, Post-boom = 2001-2009 Percent of VC dollars invested

0% 5% 10% 15% 20% 25% 30%

Communications Software Semiconductors/Electronics Hardware Biotechnology Medical Devices and Equipment Industrial/Energy Media/Retail Business/Financial Services

Post-boom Boom Pre-boom

U.S. VC Investment by Region (2008)

100% = $28 billion

Silicon Valley, 38.8%

New England, 11.6%

LA/Orange County, 7.0%

NY Metro, 6.6%

Midwest, 4.8%

Texas, 4.5%

Southeast, 4.4%

San Diego, 4.3%

Northwest, 4.1%

DC/Metroplex, 3.5%

Colorado, 2.9%

Philadelphia, 2.7%

Other, 4.8%

The Global Distribution of High-Tech Private-Equity Investment, 2007, Top-20 Countries, in $Billions

Source: PWC Global Private Equity Report 2008.

Fund-Level Returns: Data

 Venture Economics

 Collects data from GPs, publishes vintage-year specific quartile performance data while keeping anonymity of individual funds

 Freedom-of-Information-Act (FOIA) requests

 Forces public pensions to disclose performance of their fund holdings

 Private Equity Performance Monitor

 Collects, packages and sells fund-specific performance data for a fee.

 Assigns quartile rankings to funds

Industry Returns



Industry returns are constructed as time-

weighted returns

 Nice for comparison with market indices

 Nice for making risk adjustments



3 sources:

 Sand Hill Econometrics (SHE): portfolio comp level

 Cambridge Associates (CA): fund level

 Venture Economics (VE)

A Gross-Return Index

Kleiner Perkins Returns

Cost of Capital for VC

 Historically, annualized VC return index raw return is superior to those of public stock market indices.

 Individual investment outcomes vary greatly.

 Venture = investments with high variance in outcomes

 30-40% go bankrupt

 20-25% return 5 times or higher

 What should investors expect to earn from investing in VC?

 Not the entrepreneurs!

 Not the venture capitalists!

Model

 Our starting point is the Capital-Asset-Pricing Model (CAPM). It states

r_i = R_i = R_f + β(R_m – R_f) , where

r_i is the cost of capital for asset i, R_i is the expected return for asset i, R_f represents the risk-free rate,

R_m is the return on the whole market portfolio, β, or “beta”, is the level of risk for asset i^.

The difference (R_m – R_f) is called the market premium.

Risk

We make a key distinction between two kinds of

risks that are potentially present in any investments.

1. Beta risk = market risk = non-diversifiable risk = systematic risk = “covariance”

2. Idiosyncratic risk = diversifiable risk = firm-specific risk = residual risk = “variance”

• Why should we care which kinds of risks it is?

• Should investors demand higher returns for holding all risks?

Estimating VC Cost of Capital

To estimate VC cost of capital according to CAPM model, we use historical aggregate VC industry return data and estimate the following equation:

R_{vc, t} - R_f,t = + β(R_m,t – R_f,t) + e_vc,t,

where β, R_vc,t, R_m,t, and R_f,t are as defined before, except that previously the return variables represented expected returns,

while here they represent realized (= historical) returns for period t. The new elements in this equation are α, or “alpha”, the

regression constant, and e_vc,t, the regression error term.

Alpha represents the unexpected portion of the return, and positive alpha is interpreted as skills of portfolio managers.

CAPM Estimation Results

 Two data sources

 Beta is smaller than 1 here, but CAPM is not perfect, and we will make further adjustments.

Adjustment (1):

The Fama-French (1993) Model

 The Fama-French (3-factor) Model has become part of a

standard tool kit for cost of capital estimation (much like CAPM) in the last 25 years.

 It is based on empirical observations that certain styles of

investments, such as “small stocks” or “value stocks” do not fit CAPM model well.

 Now the equation is

R_{vc, t} - R_ft = α + β * (R_mt – R_ft) + β^size * SIZE_t + β^value * VALUE_t + e_{vc, t}

where α, β, R_mt, R_ft, e_{vc, t} are defined as in the CAPM, SIZE_t and VALUE_t are the returns to portfolios of stocks that capture

correlations with these styles, and β^size and β^value are the regression coefficients on these returns.

Adjustment (2):

The Pastor-Stambaugh (2003) Model (PSM)

 Another relevant issue for VC is that investors may require premium for illiquid investments.

 The PSM model incorporates this illiquidity risk as the additional factor to the Fama-French 3-factor model.

 The equation is

R_{vc, t} - R_ft = α + β * (R_mt – R_ft) + β^size * SIZE_t + β^value * VALUE_t + β^liq * LIQ_t + e_{vc, t}

where LIQ is the new liquidity factor, β^liq is its regression coefficient, and all other variables are as defined before.

 More sensitive the return on an asset is to the change in this liquidity factor, the higher premium the investors demand when liquidity factor return is high in the economy.

Final Estimation Results

 Market beta is now close to 2.

 Alpha is no longer significantly different from 0.

 Using both sets of estimates and taking the mid-point, r_VC = 15%

 0.04 (r_f) + 1.63 * 0.07 (Market) – 0.090 * 0.025 (size) – 0.68 * 0.035 (value) + 0.26 * 0.05 (liquidity) = 14.1% (SHE estimates)

 0.04 (r_f) + 2.04 * 0.07 (Market) +1.04* 0.025 (size) – 1.46 * 0.035 (value) + 0.15 * 0.05 (liquidity) = 16.6% (CA estimates)

 We use 15% as the cost of capital for VC in this course.

***, **, and * Indicates statistical significance at the 1, 5, and 10% level, respectively.

Types of Factor Models



Single Factor Models

 Capital Asset Pricing Model (CAPM) and Market Model



Multi-factor Models

 Macroeconomic Factor Models – prespecify

macroeconomic indicators such as interest rates,

inflation, exchange rates (e.g. Arbitrage Pricing Theory)

 Statistical Factor Models – extract from historical time- series and cross-section of stock returns (e.g. Principal Components or Factor Analysis)

 Fundamental Factor Models – use firm-level attributes and market data, like P/B, P/E, industry, momentum,

trading activity, etc. (e.g. Fama-French, Carhart, BARRA)

Fama-French (1993) Three-Factor

Model

E(R

) – r

=

[E(R

) – r

] +

E[SMB]

+

E[HML]



SMB is return spread between small-cap and

large-cap



HML is return spread between high ΒΕ/MVE

and low BE/MVE

Carhart (1997) Four-Factor Model

E(R

) – r

=

[E(R

) – r

] +

E[SMB]

+

E[HML] +

E[UMD]

UMD (momentum factor) is return spread

between high prior returns portfolio and low

prior returns portfolio

Web Resources

www.nvca.org www.evca.com www.avcj.com

www.pwcmoneytree.com

www.vnpartners.com/primer.htm