What is venture capital? Why is it needed?

Venture capital is an alternative asset that provides financing to new, young and
growing businesses. These start ups find it difficult to raise traditional financing
through mainstream markets so they need to raise through a different channel
VCs provide capital and guidance in return for equity. Because of the high risk of new
ventures they require a significant proporian of equity.

How do the appropriate sources of equity financing change as a start-up

develops and matures?

In the initial stages entrepenuers will usually raise money on their own using their
own savings, credit cards, loans, second mortgages etc. This is known as boot
strapping. This allows the EN to keep all ownership at the initial stage and leave the
control in their own hands. It eliminates moral hazard and information asymmetry as
the entrepenur owns 100% of the business

The second stage could be through angel investors and seed capitalists. These are
professional investors using their own funds. Ususlly high net worth indivisudials, IB,
Lawyers etc. they aim to get high returns by joining early and prepare the business for
VC fundraising. Angels get involved in the firm rather than purely investing using
their network of human and financial resources and intelectualt capital.

In the expansion stage venture capital fundraising takes place. They raise capital and
maintain relationships with investors. They monitor the investment and finally exit
the investment and aim to make substantial returns

How does VC fundraising work?

VCs raise funds from limited partners and then invest those funds in different
businesses. They then return the capital invested and returns to their limited partners
while taking a management fee and fee on the profits of the investment.

VCs are strict in choosing a business due to the high risk. The relationship/investment
usually lasts 10 years before the VC will exit the investment either through the sale of
the firm, IPO or liquidation.

Moral hazard, information assymetry

Who are the major players in the fundraising process?

General partners VCs – day to day management of the fund, usually invest a small
amount of their own capital

Limited partners – a wide range of individual and institutional investers, wealthy

families, pension funds, endowments etc. these invest in the VC fund and aim to get a
return. The top GPs are generally very picky and popular making it difficult to invest.
Established relationships are key
Investment advisors – advise LPs which GP to get involded with. They also set up
funds of funds to invest in many VCs and private equity partnerships. Major IBs
undertake this role. Charge a fee

Why is reputation so important in VC fundraising?

In past history top funds have usually remained top funds and bottom funds struggle
to gain the returns of their more successful competitors. This means the LPs will base
their investment mainly on the reputation of the fund and their previous performance.
This makes it even more challenging for first time funds as they have an unproven
team. They would recruit a lead advisor and establish aliances with existing
institutions.

Need to overcome substantial agency costs and information asymetary. VC investors

are hypersensitive to performance

VC with larger stakes in funds that have recently gone public raise funds with greater
probalitliy and rais larger funds

What is the legal structure under which VCs raise their funds?

Limited liability – LPs cannot be involved in the day to day running of the business

GPs are responsible for the running of the business and have unlimited liability

What have been the problems with this structure in Australia?

Too restrictive – can only invest in Australian companies, cannot invest in companies
more than 250m – difulut for buyout firms, cannot invest in financial, property,
construction

Slow results in Australia, foreign firms are reluctant to invest

What determines the supply and demand of the Venture Capital?

Supply: availability of funds for VC/PE, need for diversification, potential high
returns, capital gains tax lower than income tax, prudent man rule, strong performance
of public market encourage exit routes for start ups

Demand: economic growth, capital gain tax, R&D tax incentives, markets – banks
current policies

How do venture capitalists get compensated? What are some of the complexities
in workingout a VCs carried interest?

Management fee – fee charge to LPs between 1.5-2.5% of committed capital for the
running of the fund
Carried interest – GPs take a share in the profits of a private equity fund. Sometimes
funds must be returned to LPs first and then GPs will receive a percentage of the net
profits

Limited partnership agreement will specify the time and form of distribution to the
LPs and can be very complex

Fixed Componant – fixed dollar amount

Variable component – varies with performance – promotes alignment of interests –

induces effort, exposes risk

Pay performance sensitivity – measure of how pay varies with performance

What is the role of coventants in VCLPs? What factors deternine the number of
covenants in an LPA?

Covenants aim to prevent opportunistic behaviour – MH and AC, IA. Once LPs
commit funds GPs may behave in a way that benefits them but is against the interest
of the LPs – 3 Types:

Management of the fund – restrictions in size of investment in one fund –

diversification. Use of debt – GP position is a call option – take risks. Restrictions on
co investment, reinvestment of capital gains

Activities of the general partners – co investment – cannot invest their own funds. –
use LPs funds to discover winner and then invest themselves. Restriction on sale of
partnership interests, fundraising, addition of more GPs

Types of investment – cant invest in other VC funds – double fees. Investment in

public securities – high fees unneciasry, could invest in mutual fund. Invenstments in
LBOs, foreign securities, other asset classes

It is impossible to write contract for every eventuality – inevitably incomplete.

Negotiation, renegociation and enforcement is costly – include provision if
benefit>cost

Number of covenants depandant on size of fund – larer=more

Reputation – high reputation = fewer covenants – oppurtunitic behavuious can

damage reputation

Compensation – VCs that are residual claimants have less of a need for restrictive
covenants

Types of investment – tech funds eg – high information assymetary and agency costs
– need for more covenants
Sophistication of investors – high sophistication=low need for covenants – choose
more wisely

How does corporate venture capital differ from independent venture capital?

Corporate VC returns dividends to shareholders

Issues arise because of a lack of well defined missions – do not want to invent a
product that makes core product obsolete

Insuffisient commitment to corporate VC initiative

Inadequate compensation structures

It is important that the VC firm has the same vison as the parent company to better
select new firms. They make investments at a premium. Unsuccessful without similar
focus to parent.

Corporate VCs are oftern inexperienced, enjoy more indiect benefits associated with
involvemtne relative to independent VCs

What are the key problems in financing starting firms?

Market condisions – systematic risk – size of potential market, direction of economy,

future competiton, future replacement technologies

Firm specific risk – wide array of potential outcomes for a company or project, even
with a good team, product, market the probability of success can still be low

Risk vs information

Agency problems - Agency problems – marking down value of firm may leave
entrepenuer with little ownership and little incentive. Entrepenuer reaction to risk can
deviate from VC desired level of risk – too much personal wealth could make EN risk
averse – choose low NPV projects. Over optomisstic EN or too little ownership –
exposes VC to risk – ownership is a call option – need for appropriate structuring

Assymetric information – EN has better information about true extent of risk –

adverse selection. Only one party knows true state and hides if from the others – high
information assymety driven by high levels of intangible assets – more tangible assets
makes obtaining financing easier.
Consider the following investment tools/strategies. How do they help the VC
overcome the risks and problems in financing startups?

• - Screening and Due Diligence

screening – top down – analysing industries/markets and identifying opputunities and

approaching firms – late stage investors, buyout funds
bottom up – inviting proposals and screening – narrowing doen tarket firms and
building portfolios – early stage funds with deep technology focus – screening
process leads to high rejection of funding

Due diligence – need to start verifying what you believe to be true – ensuring
information disclosed by entrepreneur is correct, identifying all relvant risks and
reducing information assymetries before making invesntment.
starts from screening process – both qualitative and quantitave information – feel of
business as well as financial and legal details
verifying information with experts, check regulatory backgounds, questions toward
entrepenuers – attitude toward risk
verifying information with previous round investors – dilution=conflicts, price paid,
need to repurchase earlier rounds

• - Conservative Valuation

divestication = only a few companies need to deliver returns to make up for losses

VC price investee company cheaply – overall returns will compensate for the high
level of risk – sensitivity analysis – valuation of investee should be BELLOW the
average case scenario.

• - Staging and Syndication

Staging – financing in discreat stages over time – shorter duration = more frequent
monitoring. Aims to mitigate moral hazard/information assymitary – keep EN on
track
gathers information, monitors progress and maintains option to abandon financing
key variables are the duration and size of stages – tied to specific milesstones
agency costs vs monitoring costs tradeoff – monitoring is very costly
new investors ownership is based on post money valuation – staging means that
entrepenuer keeps more ownership

Syndication – more than 1 investor in a firm

risk sharing, sharing of monitoring tasks, expertise, less Info Asym, control of board
if many firms agree that invesmetn is worth while, chances of success increase

What are the major ways that VCs can add value to an entrepreneurial firm?

HR – attract large pool of talent – large network – very good at attracting human
capital – VC backing accelerated hiring of senior execs
Matchmaking – network, contacts and reputation gives access to new: VCs,
Customers, suppliers, alliances, aquasiton targets, aquirers, Invesmtent banks

What type of financing instruments do VCs use? How do their pay-offs change
under various exit scenarios?

Common Stock

Preferred stock – Face value – preference over common

Redeemable preferred – either redeem for FV or convert

Convertible Prefered – can be converted to common whenever – issues with dilution –

can be mitiaged though anti dilution provisions – full ratchet or weighted average –
bad for EN – most common form of financing

Participating converatble preferred – Converable preferred except owner receives FV

PLUS value of equity participation – late stage investors pay large amounts for this

How do anti-dilution provisions work? How does full-ratchet anti-dilution differ

from weighted average anti-dilution?

What is a term sheet? How do the following provisions in a term sheet operate.

• - Vesting of founder stock

Owners stock does not become his until he has been at the company for a certain
length of time – typically 1/16th per quarter. Sometimes accelerating occurs

• - Restrictive Covenants on a firm’s activities

restrictions on what a firm cannot do without approval of incoming investor – sale pf

certain assets, sale of common stock, transations that significalty change the financial
ratios, mergers, sale or transfer of control, issuance of securities

• - Mandatory Redemption Rights

VCs can force the firm to pay back face value of investment at any time – 2 reasons –
VC partnerships have limited life – mechanism to force liquidation. Prevent lifestyle
companies from operating by demanding redemption or forcing liquidation.

• - Supermajority Provisions

company agrees not to do something unless a super majority of shareholders agree,

e.g need 70% approval – this number is higher than the normal 50% needed

• - Pay-to-Play provisions
investors aim to ensure that other investors continue to support the company when it
is not perfomring well but there is still a chance of a payout. In pay to play investors
have to invest a certain amount in later financing or they could lose their some rights.
Could be forced to convert into common stock, could stirp them of anti dilution
provisions, or could take away vaious control rights. This is good for EN as it means
they will continue to be supported

• - Board Representation rights

board is split amoung founders and company execs, investors and sometimes
independent members – small board is efficient. Effective for VCs to appoint an
expert as their member – large boards in start ups are useless.

Boards can fire CEOs or force a company to take drastic actions that the founder may
not apporove of – VCs and companies are not perfectly aligned.

Some companies grant founders super voting shares with allow them to control
almost everythint but it is rare for investors to agree to this in large or public
companies

• - Drag Along Rights

allow majority shareholders to grag along smaller shareholdrs to a sale of the

company – removes possibility of smaller shareholders halting sale to demand higher
payment. Can be good or bad depending on where the interests of small and large
shareholdrs are aligned.

Dictates whose approval invokes the drag along – majority of preferred or also
common holders, who gets dragged – only common or also preferred – raises legal
expenses

• - Co-Sale and Right of first Refusal

whatever percentage a founded or other key holder sells of his stake, the
investor gets to do the same to the same buyer. Gets invoked when founder or
key holder wants to sell stock to a third party. Company has right to buy the
stock on the same terms as the third party – enables company to control
stockholder base. Companies usually assign this right to investors either before
the company has a chance to excersixe or after they pass up on the opportunity.