Private Equity and IRR Insights

Agenda

• Introduction to private equity/venture capital
• Investment process
• Financial aspects of venture capital investments
• Legal aspects of private equity investments
• Valuation of private equity investments
• Transaction structuring. Fund remuneration.
• Operations of private equity fund in portfolio companies
• Exits of funds
• Business Angels as an informal type of venture capital
• Venture capital and private equity funds and their portfolio companies
• Case studies

Literature

• P.Gompers, J.Lerner, The venture capital cycle, The MIT Press, Boston 2006
• S. Bloomfield, Venture capital funding: a practical guide to raising finance, Kogan Page, London 2008
• D. Podedworna-Tarnowska, Private equity/venture capital, SGH, Warsaw 2015
• M.Panfil, Private equity funds, Difin, Warsaw 2005
• D.Klonowski, Private equity in Poland: winning leadership in emerging markets, Palgrave Macmillan, New York 2011
• A. Metrick, A. Yasuda, Venture capital and the finance of innowvation, John Wiley&Sons 2007
• S.Povaly, Private equity exits: divestment process management for leveraged buyouts, Springer 2007

Introduction to private equity/venture capital

• Two terms are used interchangeably: "Venture capital" and "private equity"
• According to EVCA, venture capital (VC) is a professional equity co-invested with the entrepreneur to fund early-stage (seed and start-up) or expansion ventures. Investors expect higher than average returns for high-risk investments.
• VC focuses on investments in new companies with high growth potential and accompanying risk.
• Private equity is an investment in non-public companies, often composed of venture capital funds and buyout funds.

Introduction to private equity/venture capital (cont.)

• NVCA uses "Private Equity = Venture Capital + Buyout/-Mezzanine"
• VC refers more specifically to investments during the launch stages of a business.
• Private equity can be used to develop new products/technologies, expand working capital, make acquisitions, strengthen a company's balance sheet, or resolve ownership/management issues.
• Different venture capital investment types are: Mezzanine, Bridge, Acquisition/Merger, and Turnaround

Introduction to private equity/venture capital (cont.)

• Origin of venture capital existed since ancient times, with individuals investing in high-risk projects. Examples include the financing of Christopher Columbus' voyage.
• The institutional VC industry arose from managing wealth of high-net-worth families in the early 20th century (e.g. Rockefeller, Phipps, Vanderbilt).
• Venture capital in the formalized sense is relatively new, emerging in the US in the 1970s and growing to over $5 trillion in global assets under management by 2016.

Investment Process

• The investment process is complex and varies between venture capital funds and deals.
• VC's role is to educate entrepreneurs, as they are often unfamiliar with the process and don't necessarily have comprehensive business plans or financial forecasts.
• The process is multi-stage and involves detailed components: an initial appraisal by fund managers, meetings, detailed examination of the proposal, legal stages, and final closing.

Investment Process (cont.)

• Investment selection criteria include industry, stage of financing, size of investment, and location.
• Pre-investment considerations involve the business plan (coherent, complete, detailed description of resources), intellectual property (patents as barriers), history of the company, regulatory matters, and tax implications.
• Cross-border considerations are important as markets and competition are increasingly global.

Investment Process (cont.)

• Criteria for investment attractiveness include proprietary advantages, unique technology, exciting concepts, or cost advantages, as these are barriers to competition.
• Key factors for a successful investment include a competent management team with proven track records and financial commitment, a well-defined business plan, and an understanding of market acceptance
• Investors examine company summaries of the business plans and the management team's background.

Legal Aspects of Private Equity Investments

• Common forms of company incorporation include Ordinary Corporations (PL-SA) and Limited Partnerships (PL - spółka komandytowa).
• LLCs are another common structure, treated as partnerships for tax purposes, with limited liability for members.
• Investment agreements are complex documents governing many issues concerning the investment, company-investor relations, and other parties (e.g. employees or prior investors).

Legal Aspects of Private Equity Investments (cont.)

• Investment agreement components include material terms of the transaction, company representations/warranties, investor representations/warranties (investor experience concerning venture capital), and conditions precedent to closing
• Conditions precedent to closing involve approvals, resolutions, agreements, and verification of conditions.
• Indemnification for the investor includes compensation for damages due to company breaches.

Legal Aspects of Private Equity Investments (cont.)

• Securities Purchase Agreements, such as the financial commitment to purchase newly issued company securities; representations/warranties of the company ("material facts"), investor representations/warranties; covenants (restrictions on actions); and special provisions / "legal boilerplate."
• Registration Rights agreements include the investor's rights in securities registration and associated procedures.
• Investor agreements involve important provisions, like transfer restrictions, board of directors voting, and co-sale rights.
• Inventions and Confidentiality Agreement, Disclosure Schedules, and Additional Exhibits are used to support the information about the company.

Legal Aspects of Private Equity Investments (cont.)

• Employee agreements include duties, compensation plans, termination rights, and non-compete agreements.
• Due diligence is a crucial investigation into a potential investment, comprising business, financial, tax, legal, environmental, technological, and insurance assessments
• Term sheets act as non-binding agreements outlining investment terms

Financial Aspects of Venture Capital Investments

• Funding rounds (pre-seed, seed, first-stage, second and third stage, pre-IPO) are typical progression for venture capital investments
• Each stage has specific criteria relating to the company's maturity and characteristics, along with varying investor participation and goals
• Financial instruments in VC investments include loans, guarantees, equity, and quasi-equity investments.
• Valuation procedures for equity investments involve various methods.

Valuation of Private Equity Investments

• Valuation is often preceded by financial and strategic analysis of the company
• Common methods include price of recent investments, discounted cash flows, and multiples

Valuation of Private Equity Investments (cont.)

• Net assets valuation involves valuing the company's assets, while discounted cash flows involves calculating the present value of future cash flows
• Multiple valuation involves scaling market prices to a common variable and adjusting for differences across comparable assets.
• Common multiples include EV/EBIT, EV/EBITDA, EV/S, and sector-specific valuations.

Transaction Structuring. Fund Remuneration.

• Transaction structures primarily use private placement.
• Common securities are equity (e.g., common stock, preferred stock) and debt (e.g. promissory notes).
• Equity structures have advantages, like enhancing credibility and no scheduled repayment. But they also have disadvantages like diluting ownership.

Transaction Structuring. Fund Remuneration. (cont.)

• Advantages of Equity include permanent capital increasing net worth and capacity, enhances credibility, and no scheduled repayment or personal liability, while disadvantages include diluting ownership, increasing expense compared to debt.
• Fees for VC remuneration are often expressed as a percentage of capital or assets managed, or a share of profits, and typically include management fees and carried interests.
• IRR and capital-weighted IRR metrics are used in exit valuations

Exits of Funds

• VC goals often aim for a company exit price well above initial investment
• Successful exits often involve company acquisition by larger firms, initial public offerings (IPOs), or sales to third parties.
• Exits methods include buybacks, M&A deals, liquidation, and trade sales

Exits of funds (cont.)

• The exit process typically includes identifying an opportunity, evaluating the portfolio firm, designing the process, assigning responsibilities, preparing for launch, launching the process, conducting the process, evaluating the options, closing the transaction, and ex-post review.
• There are several types of company exits, including IPOs, acquisitions by larger firms, and sales to third parties.
• A write-off may occur if a VC decides for some reason not to continue with the investment

Business Angels as an Informal Type of Venture Capital

• Business Angels (BAs) are wealthy individuals/families who invest in high-risk ventures
• They offer financial support, expertise, and networks to entrepreneurs, particularly in the seed or early stages
• BAs are often motivated by the relationships they form with the founders they support, and a potentially higher than average return on investment.

Business Angels as an Informal Type of Venture Capital (cont'd)

• BA activity is more prevalent in early stages of company development and are less concerned with a structured exit strategy as compared to venture capital firms, but more on the direct involvement with the entrepreneurs
• International surveys indicate that individuals/families investing in ventures represent an important financing source
• BAs invest comparatively smaller amounts, focusing on early-stage ventures.

Business Angels as an Informal Type of Venture Capital (cont.)

• BA's main concern is success of firm, rather than a return at an exit, often having a longer time horizon and less extensive due-diligence process than venture capital
• BAs often offer non-financial support such as industry knowledge, mentorships, business networks
• There are important differences between BAs and Venture Capitalist, which could include concern with exit strategy, investor type (entrepreneur vs. strategic), and engagement (part-time vs. full-time).

Operations of Private Equity Fund in Portfolio Companies

• VC funds are more than just financial backers; they are actively involved in the management and operations of their portfolio companies
• VC fund managers often have prior entrepreneurial experience allowing for strong industry connections and understanding
• Management of portfolio companies requires a combination of managerial and entrepreneurial approaches.

Operations of Private Equity Fund in Portfolio Companies (cont.)

• VCs assist companies in constructing balanced boards, engaging in management processes and overseeing operational changes.
• Value creation for portfolio companies occurs through advisory activities on managing and governing, such as board participation, strategic decisions, and assisting with business strategies.
• Other activities include financial restructuring, talent recruitment, fiscal management, and communicating efficiently.

Operations of Private Equity Fund in Portfolio Companies (cont.)

• The active involvement of PE investors extends to activities like formulating strategies, optimizing operations, retooling, reducing workforce, acquiring related businesses, and improving marketing/sales.

Venture Capital and Private Equity Worldwide and in Poland

• Several worldwide and regional VC/private equity associations exist.
• Associations such as Invest Europe (formerly EVCA) and NVCA work to represent the interests of their industry members to regulators, developing forums, facilitating member interactions, facilitating the networking opportunity, and conducting research
• Poland has a national association (PPEA) which performs similar roles