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© Cumming & Johan (2013) Venture Capital Investing Venture Capital and Private Equity Investing Cumming & Johan (2013, Chapter 10) 1

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© Cumming & Johan (2013) Venture Capital Investing

Venture Capital and Private Equity Investing

Cumming & Johan (2013, Chapter 10)

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© Cumming & Johan (2013) Venture Capital Investing

Figure 1.1. Venture Capital Financial Intermediation

Investors

Venture Capitalist

Entrepreneurial Firm

Returns Capital

Equity, Debt,Warrants, etc. Capital

Part II:Chapters 4-9

Part III:Chapters 10-13

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Chapter Objectives

• This chapter overviews issues considered in Chapters 10-14, and provides supplementary issues dealing with venture capital and private equity investment activities

1. Due diligence (screening potential investee firms)2. Selecting the stage of entrepreneurial firm development at which to invest (the various

stages were indicated in Chapter 1) and industry in which to invest (e.g., biotech, computers, etc.)

3. Staging (number of financing rounds)4. Valuation5. Syndication (number of investors)6. Board seats7. Contracts between the fund and its investee firms, which includes decisions over matters

that include, but are not limited to:a. Security (debt, preferred equity, common equity, etc.)b. Control rights (such as the right to replace the founding entrepreneur as the CEO, among other

rights)c. Veto rights (such as over asset sales and purchases)

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1. Due Diligence: How do VC’s choose investments?

Kaplan and Stromberg (2004 Journal of Finance)“Characteristics, Actions and Analyses: Evidence from Venture Capital”

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Data

• 67 Investments from 11 U.S. limited partnerships

• Specific details introduced here that have previously been ‘unknown’ outside the venture capital funds themselves

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Criteria for Deciding to Invest

A. Opportunity: Market Conditions, Product, Strategy and Competition

• Large market size and growth• Attractive product and/or technology• Attractive business strategy/model• High likelihood of customer adoption• Favourable competitive position

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Criteria (continued)

B. Management: Quality and Previous Experience

6. Quality of management7. Favourable performance to date

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Criteria (continued)

C. Deal Terms: Valuation, Contractual Structure, syndicate and portfolio considerations

8. Low valuation9. Contractual structure that limits risk10. Positive influence of other investors11. Good fit in VC investment portfolio

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Criteria (continued)

D. Financial and Exit Conditions12. Financial market conditions and exit

opportunities

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Large Market Size and Growth

• Examples:• Two very important and visible market opportunities, which should both be over

$1B with an few years• Large market amenable to rapid growth• Very large market in which incumbents can earn high profit margins• Virtually unlimited market potential in the long run• Large and growing market with favourable demographic and privatization trends• Company could dramatically impact the evolution of the computer industry• Dramatic shifts in business favour the company’s product

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Attractive Product and/or Technology

• Examples:• Late stages of product development (first product launch planned in 15 – 18

months)• Superior technology with large market potential• Revolutionary new technology• Has developed excellent product• Has built a robust, scalable system that can meet the current market demands• Best product on the market• Well tested technology/product• Early stage company with post-beta product with competent/experienced

technology team

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Attractive Business Strategy/Model

• Examples:• Company significant reduces costs while maintaining quality• Compelling business strategy. Presence or likelihood of validating corporate

alliances• Attractive and demonstrated profitability of business model• Excellent new concept• Dinstictive strategy• High value-added, high margin strategy for very little upfront capital• “Lean and mean” operation with few employees and good customer focus• Pure play / focused

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High Likelihood of Customer Adoption

• Examples:• Conceptual acceptance by professional community• Beta arrangements with large customers• Solid base of customers who regularly renew• Increasing popularity of approach among customers• Company has very interesting beta sites, who have been enthusiastic about

product• Major corporations are customers and are positive regarding the capabilities of

the product and the management team• Attractive customer value proposition

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Favorable Competitive Position

• Examples:• Company has intellectual property rights to all significant research findings using this

technology, not very threatening competitors• Company is targeting a significant segment that is underserved by incumbents• Early mover advantages from being pioneer of this concept and largest player• Highly fragmented industry, which makes the industry ripe for consolidation• No competitors• Early entrant• Very few effective alternatives available, and none currently targeting all three target

segments• First-mover advantage, similar to Amazon and AOL• Given the large market, there is more than enough room for several competitors• Strong proprietary and patent position• Potential for large market share with early penetration – meeting clearly unaddressed needs

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Quality of Management

• Examples:• Comfortable with the management team• Management team is of the highest quality in the industry• Experienced management team which is critical driver of success• VC is investing because of quality of management team, who is believed to be

good in science, and at raising and conserving money• Experienced, proven and high-profile CEO competing in a market where execution

is key• Very good CFO just hired• Known CEO for a long time• CEO / founder is one of the few managers in the industry capable of attracting

necessary employees. Has developed excellent product while consuming only modest amounts of capital.

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Quality of Management (continued)

• Examples (continued):• Experienced managers out of successful venture backed company• Strong CEO/founder with very high marks from existing investors• Current management team has extensive internet and website management

experience• Key members of management team has industry experience. Team is well-

balanced, young and aggressive• Highly sought-after entrepreneur/founder, who co-founded successful company

that subsequently went public. Strong board• Excellent CEO joining company• CEO is frugral and will not spend capital unwisely• Executive team has acquired a significant level of penetration an relationships in a

fairly short time.

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Favorable Performance to Date

• Examples:• Attractive and demonstrated profitability of business model• Rapid growth: over 40% last four years• Company has a manageable cash burn rate and is expected to be cash-flow break-even with

12 months• Company has good reputation in industry• Company has been successful to date and has made substantial improvements during last

two years• Significant sales growth momentum• Has developed product, well positioned to achieve revenue target• Company is operationally break-even• Year one sales of $3.2M, profitabe so far• Cash flow positive

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Low Valuation

• Examples:• Low valuation 5-year IRR of 46% in conservative case• Very profitable unit model (60% IRR over 10 years)• Valuation is attractive and should give high returns if successful• Exit multiples are shooting up• VC only has to invest $1m at a $2m pre-money valuation

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Contractual Structure that Limits Risk

• Examples:• The participating preferred should protect the VC in the case of mediocre performances• Unique investment structure: only have to put in money if milestones are met; combination

of cumulative non-convertible preferred stock and regular convertible preferred has benefit that VC will be paid back most of investment out of IPO proceeds

• Equipment can be funded with debt• Gives investors ability to control growth• Successfully structured investment to minimize downside, by only providing limited funds

until milestones met• VC commitment will be invested over time. If initial (Chicago) launch no successful, VC has

option to cut back• Cash-efficient early stage thanks to future company acquisitions with stock• New investor has the benefit of reduction in VC pro rata investment if more funds needed• Limited risk for VC: will only own 4.4% of company• Can take company to leading industry position with minimum amount of capital

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Positive Influence of Other Investors

• Examples:• Investing partners include investors who previously invested in some extremely

successful companies• Former CEO of US industry involved as active chairman and interim CEO, as well as

investor• Main reason that VC is investing is that it is required to get a new individual

investor which has the benefit of (1) reduction in VC pro rata investment if more funds needed, and (2) the skills of the investor and the interim “turnaround” CEO that he is getting company

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Good Fit in VC Investment Portfolio

• Examples:• Adds additional breadth to VC portfolio with this market segment• VC is strong in this geographic region• Participation in the rapidly growing market• Good strategic fit with VC• VC has board seat on company in complementary business, with which VC could

facilitate marketing partnership• Represents new market segment for the funds, which should stimulate some

additional opportunities (assuming a positive outcome)• Potential for )Non-California) VC to lead a Silicon Valley deal

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Financial Market Conditions and Exit Opportunities

• Examples:• If successful, possibility for early exit or acquisition• Expect to have access to both debt and equity in public markets in attractive

terms• Quick flip potential for the investment• Many strategic buyers available• Recent public market enthusiasm for e-commerce companies might enable public

equity financing to mitigate future financing risks• Given the size of the market opportunity and company’s strategy, capital markets

will be receptive given that company achieves business plan. Also, a consolidation trend should emerge in industry as more companies enter market

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NDAs?

• Non-disclosure agreements

• Rarely considered by VCs

• Why?!

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Diversification?

• Venture capital funds typically have around 10 investees in their portfolio.

• Why not more investments (diversify risk)?

• This issue is studied further in Chapter 18

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2. Stage of Development

Cumming, Fleming and Schwienbacher (2005 Financial Management) “Liquidity Risk and Venture Capital Finance”

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Exit Conditions in Stock Markets Affect VC/PE Markets

• Relationship between IPOs and Early Stage Investments

• Inverse relation… early stage investments take a while to bring to fruition (Chapter 19)

• Can delay exit requirements by investing early stage, hence early stage activity is counter cyclical relative to IPO market conditions

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1.5

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Relative Importance of New Early-Stage IPO Volume

Figure 10.1: Importance of New Early-Stage Investments and IPO Volume in the United States from 1985 to 2004. The bold line (with left-hand Y-axis) gives the ratio of new early-stage investments over all new expansion-stage and later-stage investments in each year. The IPO volume (right-hand Y-axis) is shown by the dashed line and represents the number of initial public offerings (IPOs) as reported by Ritter and Welch (2002). It refers to IPOs on the NASDAQ, NYSE and AMEX. Source: Cumming et al. (2005b).

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3. Venture Capital Staging

Gompers (1995 Journal of Finance)"Optimal Investment, Monitoring, and the Staging of Venture Capital"

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Tradeoff

• Agency Costs versus Monitoring Costs

• This tradeoff enables us to make predictions regarding the duration and size of venture capital investments

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Typical Monitoring

• Gorman and Sahlman (1989) Monitoring is costly and can’t be done continuously Between financing rounds, on average inside VCs visit the

entrepreneurial firm once per month and spend 4-5 hours at the firm per visit

On average outside VCs visit the firm once a quarter for an average of 2-3 hours

Checks between financing are designed to limit opportunistic behaviour by entrepreneurs between performance evaluations for new capital commitments

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Value of Staging

• Gather information about the firmReduce informational asymmetry between

entrepreneur and venture capitalist

• Monitor the progress of the firm

• Maintain the option to abandon financing

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Monitoring Costs

• Opportunity costs of generating reports for the VC and entrepreneur

• Opportunity costs of visiting an entrepreneurial firm

• Contracting costs (legal, negotiating, and other incidental costs) associated with each new financing round

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Factors that affect agency costs

1. Asset intangibility and R&D2. Growth options

Increase in market to book ratios increasing role of investment opportunities in firm value

3. Asset specificity4. Firm development stage

• No agency costs irrelevance of financing structure (similar to MM proposition)

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Asset Intangibility

• Agency costs of debt E.g., Risk-shifting, under-investment, asset stripping

• Value of leverage Increases with liquidation values and asset tangibility

• Asset characteristics that increase the agency costs of debt reduce the value of leverage and make monitoring more valuable Should also shorten funding duration in staged venture capital

investments

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Growth Options

• Growth options more scope for the entrepreneur to act in his or her own interest against the interest of the VC(s)

• Market to book ratios are indicative of growth options

• Shorter investment durations when higher market to book options

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Asset Specificity

• Assets with high industry-specific and firm-specific value have smaller liquidation values

• Greater asset specificity reduced liquidation values shorter investment duration more monitoring

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Firm Development Stage

• Which firms (start-up, expansion, turnaround, buyout) should be staged and which should have shorter investment durations?

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Investment and Liquidity

• When more capital is available for investment, will VCs invest more or less per round and more or less frequently in the firms they finance?

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Importance of Exit

• Do firms that are exited by means of an IPO receive more or fewer rounds of financing and more or less total financing than their counterparts that are exited by an acquisition, secondary sale, buyback or writeoff?

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Examples of Staging

• Federal Express $12,250,000 September 1973 $204.17 / share $6,400,000 March 1974 $7.34 per share $3,800,000 September 1974 $0.63 per share Firm went public in 1978 at $6 per share

• Apple Computer $518,000 January 1978 $0.09 / share $704,000 September 1978 $0.28 / share $2,331,000 December 1980 $0.97 / share

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What If No Staging?

• Entrepreneurs may pursue personally beneficial strategies at expense of VCExamples:

Risk-shiftingFame as opposed to fortune

• Entrepreneur may invest in negative expected NPV venture

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Gompers Data

• 794 firms that received VC financing between 1961 and 1992 in the US

• Received 2143 rounds of venture capital financing (15% of all VC over the period)

• Industry focus (min 70% of annual investments) on high-tech firms (communication, computers, electronics, biotechnology, medical/health)

• VCs specialize in investments in which asymmetric information and agency costs are most pronounced

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Info on Exits in the Sample

• 22.5% IPO• 23.8% merger / acquisition• 15.6% writeoff• 38.1% remain private

• Useful contrasts relative to Chapters 20 and 21

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The Duration & Size of Financing Rounds (1/2)

• Duration of financing rounds declines for late stage companies

• The average amount of financing per round generally rises for late stage companies

• Asymmetric information and agency costs decline as investment stage is later

• Rate of cash utilization increases as investment stage is later (rate of working capital utilization and investment increases with investment stage)

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Independent Variables (2/2)

• Dummy variable for stage of financing• Firm age at time of financing (+)• (Tangible assets) / (Total assets) (+)• Size of financing round (insignificant)• Market-to-book ratio (-)• R&D / Sales (also: R&D / Assets) (-)• Amount of $ in VC industry (-)

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Regression Analysis Total Financing & # Financing Rounds

• Independent variables:Exit types (IPO +)(Tangible assets) / (total assets) (insignificant)Market to book ratio (+)R&D / Sales (insignificant)R&D / Assets (insignificant)

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Supplementary Issues in Staging

• What else may explain the results?– Monitoring costs are not measured

• Also, relevant to consider cyclicality of new investments versus follow-on staged investments (next slide)

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0.1

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Proportion of New Investments IPO Volume

Figure 10.2: Importance of New Investments Compared to Follow-On Investments. The bold line (left-hand Y-axis) gives the proportion of new investments from all investments (new and follow-on) in each year. The dashed line (right-hand Y-axis) gives again the number of IPOs in each given year (IPO volume), as in Figure 2. Source: Cumming et al. (2005b Financial Management).

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4. Valuation in VC relative to Public Markets

Gompers & Lerner (2000, Journal of Financial Economics) "Money Chasing Deals?: The Impact of Fund Inflows on the Valuation of Private Equity Investments

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Valuation Issues

• How does fund inflows into the VC market affect the pricing of deals?

• Is the relation driven by demand pressures or is it related to an improvement in deal prospects?

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Data

• 4000 venture investments between 1987 and 1995

• Data from VentureOne (a US consulting firm)

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Findings (1/2)

1. Strong positive relation between venture capital valuations and capital inflows

• A doubling of the fund inflows into venture capital funds causes an increase in valuations by 7-21%

• A doubling of public market values causes an increase in value of private equity by 15-35%

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Findings (2/2)

2. The results are consistent with the demand pressure interpretation – high values are higher because of money flowing into the VC market and not due to an improvement in investment opportunities

• Success rates (IPO or acquisition) did not differ from early 1990s (bad market) and late 1980s (hot market)

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Figure 10.3. Relation between Pre-Money Valuation and Annual Fund Inflows into Venture Capital. Source: Gompers and Lerner (2000)

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Annual Inflow into Venture Funds (1987=1) Average Pre-Money Valuation

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Additional Issues

• Additional valuation issues were considered in Chapter 4

• Valuation considered further in Chapter 22

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5. Syndication

Lerner (1994 Financial Management) “The Syndication of Venture Capital Investments”

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Syndication = More than 1 investor per investee

Venture Capitalist 1 Venture Capitalist 2

Entrepreneur

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Reasons for Syndication

1. Sah and Stiglitz (1986)• VCs make better decisions about whether

to invest• Prediction: syndicated investments perform

better

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Reasons (Con’t)

2. Lakonishok, Shleifer, Thaler, and Vishny (1991)

• VCs collude and overstate the value of the entrepreneurial investment upon exit

• Prediction: VCs offer best deals to those that can reciprocate (well-established VC firms)

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Reasons (Con’t)

3. Admati and Pfleiderer (1994)• Inside versus outside VCs• Inside VCs have an informational advantage over

outside VCs• Inside VCs will overstate performance at each staged

financing round• Solution (a testable prediction): inside VC has a fixed

share of equity• As such, necessarily must have outside VCs

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Question

• Can you think of a possible problem with Admati and Pfleiderer’s theory?

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Rationales (Con’t)

4. Wilson (1968)• Diversification through risk sharing• (Don’t want to underperform your peers

and risk not attracting new capital for investment)

• Not a testable proposition with Gompers & Lerner’s data

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Rationales (Con’t)

5. Hold-up

• Testable?• With the Gompers and Lerner data, not

empirically distinguishable from the 1st rationale

• Will be able to test when return to forms of finance

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Lerner’s Empirical Evidence

• 271 biotechnology firms; 651 investment rounds 78-89• Support for the three rationales for syndication• Mean # of VC investors (Table 9.1 p.191)

Round 1: 2.2 Round 2: 3.3 Round 3: 4.2

• Mean # of new VC investors in each round Round 1: 2.2 Round 2: 1.5 Round 3: 1.3

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Evidence (Con’t)

• Experienced VCs don’t invest with inexperienced VCs in the first round

• Experienced VCs don’t invest with inexperienced VCs in later rounds where the inexperienced VC initiated the 1st round financing

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Evidence (Con’t)

• Equity holdings are relatively constant across investment rounds

• Later-round syndications of investments in promising firms (collusion; overstate value of portfolio of investments)

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Question

• Relate the issue of “moral hazard” among syndicated VCs to Admati and Pfleiderer’s theory of syndication

• Can you see a problem with Admati and Pfleiderer’s theory?

• This question is considered in detail in the Appendix to Chapter 11

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2

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Syndicate Size IPO Volume

Figure 10.4: Syndicate Size for New (First-Round) Investments and IPO Volume in the United States from 1985 to 2004. The bold line (left-hand Y-axis) gives the average number of syndicate partners involved in new investments in each year. The dashed line (right-hand Y-axis) gives again the number of IPOs in each given year (IPO volume). Source: Cumming et al. (2005b).

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6. Board Seats

Lerner (1995 Journal of Finance) Venture Capitalists and the Oversight of Private Firms”

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Monitoring and Assistance

• VCs are active investors

• Being active involves costs

• Implications:Successful investmentsRegional development

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Lerner’s Data

• 271 biotechnology firms 1978 – 1989 US

• Table 8.2 p.175• VC board membership generally increases

with each financing round • (but so does membership from other

outsiders and other insiders)

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Board Membership

• Composition of the board determined by need for oversight

• When may the firm’s managers deviate from value maximizing decisions?

• Increased presence of VCs when likelihood for deviations is greatest

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Board Membership & CEO Turnover

• Why care about CEO turnover?

Uncertainty about new CEO

Problems in a firm that fired the old CEO

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Evidence

• Increase in VC board membership around time of CEO turnover

• No significant change in number of other outsiders on board around CEO turnover

• Nonparametric evidence Table 8.3• Parametric evidence Table 8.4

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Board Membership & Geographic Proximity

• >50% have a VC director within 60 miles of headquarters

• >25% have a VC director with 7 miles• Prob (VC director within 5 miles) = 22%

• Control factors: Stake held by VC in firm Size of VC fund Age of venture organization

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Questions

• What does this imply about venture capital fundraising?

• What does this imply about regional development?

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7. Contract Terms

• Contracts between the fund and its investee firms, which includes decisions over matters that include, but are not limited to:– Security (debt, preferred equity, common equity, etc.)

• Focus of Chapters 11-13– Control rights (such as the right to replace the founding

entrepreneur as the CEO, among other rights)– Veto rights (such as over asset sales and purchases)

• Focus of Chapter 14• Samples: Term Sheet, Shareholder Agreement and Subscription

Agreement are available athttp://venturecapitalprivateequitycontracting.com/

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8. Summary

• Many interrelated issues in venture capital investment decisions

• Easier to understand in context of agency theory (Chapter 2)

• Focus in Chapters 11-13 on financial contracting

• Thereafter Chapters 14-18 consider impact of investing on effort

• Lastly Chapters 19-22 consider exits and returns

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