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  • Venture Capital Financing

    Thomas Chemmanur

  • *VENTURE CAPITAL FINANCING MANY FIRMS GO THROUGH A LIFE-CYCLE:1. START OUT AS SMALL PRIVATE FIRMS2. EXPAND THROUGH VARIOUS STAGES OF V.C/PRIVATE EQUITY FINANCING (ALSO: BANK-DEBT).3. GO PUBLIC (HAVE AN INITIAL PUBLIC OFFERING-IPO). 4. FURTHER EXPAND THROUGH ADDITIONAL ROUNDS OF PUBLIC EQUITY/DEBT FINANCING. FOCUS ON STAGE (2), VENTURE CAPITAL FINANCING HERE.

  • *SOURCES OF V.C FINANCING 1. PRIVATE PARTNERSHIPS AND CORPORATIONS SET UP TO PROVIDE FUNDS.ORGANIZER BEHIND THE PARTNERSHIP MAY OBTAIN FUNDING FROM INSTITUTIONS (INSURANCE COMPANIES AND PENSION FUNDS) OR INDIVIDUALS.PRATTS GUIDE TO VENTURE CAPITAL LISTS 2000 SUCH FIRMS.AVERAGE AMOUNT INVESTED BY THESE PER FIRM: $1 TO 2 MILLIONE.g: ARTUR ROCK & COMPANY OF SAN FRANCISCO PROVIDED VENTURE FUNDS TO APPLE COMPUTERSONLY 2% OF REQUESTS RECEIVE FINANCING.

  • *SOURCES OF V.C FINANCING2. VENTURE CAPITAL SUBSIDIARIES OF LARGE INDUSTRIAL OR FINANCIAL CORPORATIONS.E.g: CITICORP VENTURE CAPITAL, CHEMICAL VENTURE CAPITAL CORP. ONLY SMALL PORTION OF V. C. MARKET.3. HIGH NET-WORTH INDIVIDUALS AND FAMILIES (ANGELS), WITH EXPERIENCE AND KNOWLEDGE IN THAT INDUSTRY. (TYPICAL ANGEL NET WORTH OVER $1 MILLION).ANGELS TEND TO INVEST ONLY SMALLER AMOUNTS ON AVERAGE ($250,000) THAN V.C. FIRMS.HOWEVER, THE AGGREGATE INVESTMENTS FROM THIS SOURCE IS MUCH LARGER (AT LEAST TWICE AS MUCH) AS FROM VENTURE CAPITAL FIRMS.

  • *WHAT DO VENTURE CAPITALISTS DO? 1. PROVIDE FINANCING2. MONITOR THE ENTREPRENEUR: MANY VENTURE CAPITALISTS SPEND SEVERAL HOURS A WEEK WITH THE FIRM THEY HAVE INVESTED IN.3. PROVIDE EXPERTISE TO FIRM MANAGEMENT (AND CONTACTS, OBTAINED FROM BEING INVOLVED IN SIMILAR FIRMS BEFORE).4. HELP THEM WITH ADDITIONAL FINANCING FROM OTHER SOURCES, INCLUDING INITIAL PUBLIC OFFERINGS (IPOs).

  • *WHAT DO VENTURE CAPITALISTS DO? IPOS WITH VENTURE BACKED FINANCING:EVIDENCE INDICATES THAT VENTURE-BACKED DEALS TEND TO BE LESS UNDERPRICED THAN NON-VENTURE BACKED DEALS.ALSO, VENTURE CAPITALISTS (MANY) SEEM TO HAVE EXCELLENT TIMING ABILITY (i.e., THE TIMING OF THE GOING-PUBLIC DECISION).EXAMPLE: KAPOR STARTED LOTUS IN 1981 WITH FINANCING FROM SEVIN-ROSEN

  • *LOTUS EXAMPLE WHAT EACH PARTY BROUGHT TO THE DEAL: KAPOR (ENTREPRENEUR)(I) RECOGNIZED A MARKET NEED(II) TECHNICAL ABILITIES AND TEAM(III) HAD A REASONABLE BUSINESS PLANSEVIN-ROSEN (V.C)(I) CAPITAL(II) EXPERIENCE(III) INDUSTRY CREDIBILITYSOMETIMES, THE V.CS CONTACTS CAN BE SO CRUCIAL THAT FROM WHOM CAPITAL IS RAISED CAN BE MORE IMPORTANT THAN TERMS ON WHICH RAISED.

  • *POTENTIAL ISSUES WITH V.C. FINANCING 1. POTENTIAL FOR EXCESSIVE DILUTION OF EQUITY (OBVIOUS).2. POTENTIAL INTERFERENCE IN THE DAY-TO-DAY RUNNING OF THE FIRM.3. MAY FORCE PRE-MATURE ABANDONMENT OF PROJECT(S) IF V.C IS SOLE SUPPLIER.4. FIRM MAY HAVE TO TRY TO GO PUBLIC TOO EARLY.

  • *EXIT STRATEGIES ADOPTED BY V. C.S1. GOING PUBLIC TYPICALLY THE MOST DESIRABLE ROUTE - SO THE ONE THE V.C. AIMS AT; MOST COMMON2. SALE TO ANOTHER COMPANY3. SALE OF OWNERSHIP STAKE TO ANOTHER INVESTOR: - OFTEN TO A WORKING PARTNER.4. SALE BACK TO ENTREPRENEUR.- RARE, BUT USED IF ENTREPRENEUR CAN BORROW FROM BANK OR HAS CASH.5. REORGANIZING THE COMPANY (CHAPTER 11)6. LIQUIDATION OF ASSETS.

  • *FINANCIAL CONTRACTING WITH V. C.SA V.C DEAL IS ANY AGREEMENT BETWEEN PARTIES FOR THE ALLOCATION OF ECONOMIC VALUE.A DEAL ALLOCATES CASH FLOWS BY AMOUNT AND TIMING, AS WELL AS RISK.THE STRUCTURE OF A V.C. DEAL CAN RESULT IN THE SUCCESS OR FAILURE OF THE FIRM/PROJECT.

  • *FINANCIAL CONTRACTING WITH V. C.SA VENTURE-CAPITAL CONTRACT OR DEAL SHOULD: (I) ALLOCATE CASH FLOWS APPROPRIATELY.(II) ALLOCATE THE RISKS INVOLVED IN THE FIRM(III) GIVE RISE TO THE RIGHT INCENTIVE EFFECTS BETWEEN THE ENTREPRENEUR AND VENTURE CAPITALIST. (i.e., IT SHOULD MOTIVATE THE ENTREPRENEUR TO PUT FORTH OPTIMAL EFFORT AND PUT-FORTH REALISTIC CASH FLOW PROJECTIONS)

  • *DESIGNING DEALSDESIGNING DEALS INVOLVES CHALLENGES AND OPPORTUNITIES:(1) UNCERTAINTY ABOUT CASH FLOWS(2) DISCOUNT RATES DIFFICULT TO DETERMINE.(3) PARTIES MAY DISAGREE ABOUT EXPECTED CASH FLOWS, THEIR RISKS AND THE APPROPRIATE RATES.(4) PARTIES AFFECTED DIFFERENTLY BY TRANSACTION (TAX EFFECTS, FOR EXAMPLE).(5) ASYMMETRIC INFORMATION(6) CONFLICTS OF INTERESTS(7) INCENTIVE EFFECTS OF DEAL ITSELF.

  • *ADDRESSING DIFFICULTIESDIFFICULTIES ARE DEALT WITH BY:(A) STAGE FINANCING FINANCING THE PROJECT (INVESTING IN THE FIRM) IN STAGES. (B) USE OF APPROPRIATE FINANCIAL CONTRACTS:(I) DEBT WITH WARRANTS(II) CONVERTIBLE DEBT(III) PREFERRED EQUITY, ESPECIALLY CONVERTIBLE PREFERRED EQUITY.

  • *VENTURE CAPITAL VALUATIONPRE-MONEY VALUATION PRODUCT OF PRICE PAID BY V.C PER SHARE AND THE NUMBER OF SHARES OUTSTANDING PRIOR TO V.CS INVESTMENT.POST-MONEY VALUATION: PRODUCT OF PRICE PAID PER SHARE BY V.C AND THE TOTAL NUMBER OF SHARES (INCLUDING NEW SHARES ISSUED TO V.C) OUTSTANDING AFTER V.CS INVESTMENT.

  • *EXAMPLE OF A V.C VALUATION POST-MONEY VALUATION EXAMPLE:ASSUME:INVESTMENT FROM V.C = $300,000 EQUITY PARTICIPATION OF V.C = 15%IMPLIED EQUITY OF FIRM = 300,000/0.15 = 2 MILLION POST-MONEY BALANCE SHEET

    ASSETS LIABILITIESCASH $300,000EQUITY $2,000,000 OTHER 100,000 INTANGIBLES 1,600,000 $2,000,000 $2,000,000

  • *EXAMPLE OF A V.C VALUATIONVC EXPECTED RETURN: RISKLESS RATE (LTG)6.0%MARKET PREMIUM5.0%11%SMALL CAPITAL PREMIUM2%13%LIQUIDITY PREMIUM + VALUE ADDED PREMIUM+ CASH FLOWADJUSTMENT =30% V.C EXPECTED RETURN 40 TO 50%

  • *EXAMPLE OF A V.C VALUATIONASSUME THAT THE V.C EXPECTS A RETURN OF 50%. THEN, IN FIVE YEARS: VALUE OF V.CS INVESTMENT= $300,000 * (1.50)5 = $2.3 MILLION(1+r)5 EQUITY VALUE OF ENTIRE FIRM = 2.3/0.15 = $15.3 MILLION.

  • *EXAMPLE OF A V.C VALUATIONIS THIS REALISTIC? ASSUME (BUSINESS PLAN PROJECTS): (FOR YEAR FIVE) SALES $37.4 MILLIONEBIT (10% OF SALES) = 3.7 MILLIONPROFITS (NO DEBT ASSUMED) = 1.8 (AFTER Tc = 0.5)HENCE, REQUIRED PRICE/EBIT MULTIPLE = 15.3/3.7 = 4.2AND PRICE/EARNINGS MULTIPLE = 15.3/1.8 = 8.5BOTH OF WHICH ARE REASONABLE.

  • *FLOW OF MONEY & VALUATIONSFLOW OF MONEY INTO V.C FUNDS SEEMS TO FOLLOW A BOOM-BUST PATTERN; ALSO PRE-MONEY VALUATIONS SEEM TO FOLLOW SUCH VARIATIONS IN INFLOWS

  • *STAGES OF PRIVATE FINANCING A. FIRST ROUND: START-UP; R&D, TESTS, MARKET RESEARCH.B. SECOND ROUND: PROTOTYPES. FURTHER TESTING; EARLY EXPANSION.C. THIRD ROUND: FULL SCALE MANUFACTURING & MARKETING D. FOURTH ROUND: CONVENTIONAL FINANCING (PRIVATE PLACEMENT, MEZZANING FINANCING, AND IPO).(V.Cs TYPICALLY INVOLVED IN 2nd AND 3rd ROUNDS).ANOTHER CLASSIFICATION OF INVESTMENT STAGES BENEFIT OF STAGE FINANCING: INCREASED NPV

  • *STAGED FINANCING: OPTION TO ABANDON ONE ADVANTAGE OF STAGED FINANCING IS THAT THE V.C HAS THE OPTION NOT TO PROVIDE FUNDING AS MORE INFORMATION BECOMES AVAILABLE. CASE-I (SINGLE-ROUND FINANCING) PV = 500 (NEWS = GOOD)INVEST 0.5UPFRONT -200 0.5PV = 10 (NEWS = BAD)E[NPV] = -200 + 0.5(500) + 0.5(10) = $55

  • *STAGED FINANCING: OPTION TO ABANDONCASE-II: STAGED FINANCINGINVEST $100, PV = 500 GOOD NEWSINVEST 0.5DONT INVEST, PV = 0UPFRONT$100 0.5INVEST $100, PV = 10 BAD NEWSDONT INVEST, PV = 0

    E[NPV] = -100 + 0.5[500 - 100] + 0.5(0) = $100 NPV HAS GONE UP IN STAGED FINANCING!

  • *VALUATION & V.C. OWNERSHIP STAKE EXAMPLE: PRE-AND POST-MONEY VALUATION AND V.C OWNERSHIP STAKE $5 MILLION INVESTMENT REQUIRED IN BIO-TECH VENTUREPROJECTED NET-INCOME IN YEAR 7 = 20 MILLION.AVERAGE P/E OF PROFITABLE BIO-TECH FIRMS (COMPARABLES) = 15CURRENT NO. OF SHARES OUTSTANDING = 500,000ASSUME EXPECTED RETURN 50%CASE-I: NO FURTHER FINANCING NEEDED UNTILL FIRM GOES PUBLIC (IN YEAR 7) NO NEW SHARES ISSUED BEFORE V.C EXITS

  • *VALUATION & V.C. OWNERSHIP STAKECASE-IDISCOUNTED TERMINAL VALUE= TERM. VAL./(1 + r)7 = 20 * 15/1.57 = $17.5 MREQUIRED EQUITY OWNERSHIP= INVESTMENT/DISCOUNTED TERMINAL VALUE = 5/17.5 = 0.285 OR 28.5% TOTAL SHARES AFTER VALUATION= 500,000/(1 - 0.285) = 700,000NO. OF NEW SHARES ISSUED TO V.C = 200,000PRICE PER NEW SHARE = $5 M /200,000 = $25 /SHAREIMPLIED PRE-MONEY VALUATION = (25)500,000 = $12.5 MIMPLIED POST-MONEY VALUATION = (25)700,000 = $17.5 M

  • *VALUATION & V.C. OWNERSHIP STAKECASE-II: TWO ROUNDS OF FINANCING BEFORE V.C EXITS; THREE MORE SENIOR EXECUTIVES NEED TO BE HIRED (10% OF EQUITY GIVEN AS STOCK OPTIONS TO THEM); ALSO, 30% OF EQUITY SOLD IN A SUBSEQUENT FINANCING ROUND. CASE-II: CALCULATIONS NEED TO BE AMENDED AS FOLLOWSRETENTION RATIO:AFTER FIRST ROUND 1/1.1 = 90.9%AFTER SECOND ROUND = (1/1.1)/1.3 = 70% OF EQUITY REQUIRED CURRENT OWNERSHIP = REQUIRED FINAL OWNERSHIP/RETENTION RATIO = 0.285/0.7 = 40.7%.

  • *VALUATION & V.C. OWNERSHIP STAKENO. OF NEW SHARES = 500,000/(1 - 0.407) - 500,000 = 343,373 SHARESPRICE PER NEW SHARE = $5 MILLION/343,373= $14.56/SHAREIMPLIED PRE-MONEY VALUATION= 14.56 * 500,000 = 7.28 MILLIONIMPLIED POST-MONEY VALUATION= $7.28 + $5 = 12.28 MILLIONCURRENT VALUATION HAS FALLEN (WHY?)

  • *RISK ALLOCATION - DEBT WITH WARRANTSEXAMPLE OF RISK-ALLOCATION, USING DEBT WITH WARRANTS.ASSUME INVESTMENT BY V.C = $10000.5MEDIOCRE (I)0.5 VERY SUCCESSFUL (II) YEAR0123CASH FLOW -1000CASE-I2503001000CASE-II3507005000EXPECTED -10003005003000SAMPLE CALCULATION OF CASH FLOW IN YEAR 0:= 0.5(250) + 0.5(350) = 300

  • *RISK ALLOCATION - DEBT WITH WARRANTSASSUME EXPECTED RETURN OF V.C IS 40%IN ORDER TO INVEST, THE V.C IS GOING TO DEMAND AN EQUITY PARTICIPATION WHICH WILL GIVE HIM A PV OF $1000 (AMOUNT INVESTED) AT AN EXPECTED RETURN OF 40%. PV OF PROJECT EXPECTED CASH FLOW (AT 40% RETURN) = $1562.6 (CHECK!)EQUITY PARTICIPATION IF V.C TAKES STR

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