Private Equity/Venture Capital Lecture Notes PDF

AGENDA 1. Introduction to private equity/venture capital 2. Investment process 3. Financial aspects of venture capital investments 4. Legal aspects of private equity investments 5. Valuation of private equity investments 6. Transaction structuring. Fund remuneration. 7. Operations of private equity...

AGENDA 1. Introduction to private equity/venture capital 2. Investment process 3. Financial aspects of venture capital investments 4. Legal aspects of private equity investments 5. Valuation of private equity investments 6. Transaction structuring. Fund remuneration. 7. Operations of private equity fund in portfolio companies 8. Exits of funds 9. Business Angels as an informal type of venture capital 10.Venture capital and private equity funds and their portfolio companies 11. Case studies  Literature 1. P.Gompers, J.Lerner, The venture capital cycle, The MIT Press, Boston 2006; 2. S.Bloomfield, Venture capital funding: a practical guide to raising finance, Kogan Page, London 2008; 3. D.Podedworna-Tarnowska, Private equity/venture capital, SGH, Warsaw 2015; 4. M.Panfil, Private equity funds, Difin, Warsaw 2005; 5. D.Klonowski, Private equity in Poland:winning leadership in emerging markets, Palgrave Macmillan, New York 2011; 6. A. Metrick, A.Yasuda, Venture capital and the finance of innowvation, John Wiley&Sons 2007; 7. S.Povaly, Private equity exits:divestment process management for laveraged buyouts, Springer 2007. Introduction to private equity/venture capital  Introduction to private equity/venture capital Two terms are used interchangeably: „Venture capital” and „private equity”. It is important to distinguish between these two industry terms. According to the European Venture Capital Association (EVCA), the venture capital (VC) is a professional equity co-invested with the entrepreneur to fund an early-stage (seed and start-up) or expansion venture. In such high risk investment, investors expect higher than average returns. VC focuses on investments in new companies with high growth potential and accompanying hiht risk. Private equity is an investment in non-public companies, usually specified as being made up of venture capital funds and buyout funds.  Introduction to private equity/venture capital The National Venture Capital Association (NVCA) - U.S. venture capital community – uses following definition in its reports: Private Equity = Venture Capital + Buyout/-Mezzanine VC is regarded as a subset of private equity, referring more to the investments made during the launch stages of a business. Private equity provides the equity capital to enterprises that are not quoted on stock market. It can be used for following reasons: 1) to develop new products and technologies 2) to expand working capital, to make acqusitions 3) To strengthen a company’s balance sheet 4) To resolve ownership and management issues  Introduction to private equity/venture capital Mezzanine – a venture that has increasing sales volume and is breaking even or is profitable, but additional funds are needed for further expansion, marketing or working capital; Bridge – a venture that requires short-term capiatl to reach a clearly defined and stable position; Acquisition/merger – a venture that is in need of capital to finance and aquisition or merger; Turnaround – a venture that is in need of capital to effect a change from unprofitability to profitability.  Introduction to private equity/venture capital Origin of venture capital. VC has existied since the time of the ancient civilizations, as private individuals have always had a tendency to invest in high-risk project. Even financing the voyage of Christopher Columbus by Spanish Kings could be treaded as an example of the venture capital investment. After 7 years of lobbying he convinced the Ferdinand II of Aragon and Queen Isabella I of Castile to sponsor his trip towards the West; Investing into the development of several new industries in the US by groups of the American and European private wealthy individuals during the nineteenth and the early twentieth century (creating IBM in 1924 among other) is a kind of the venture capital issue; In the institutional sense the VC industry is stemmed from the management of the wealth of high net worth families in the US during the early decades of the last century. These includes Rockefeller (Douglas Aircraft and eastern Airlines), Phipps (Ingersoll Rand and International Papers) and Whitney (Vanderbilt) families.  Introduction to private equity/venture capital Venture capital in its formalized meaning is relatively new. Only in the US growing from zero in the 1970s. At the end of 2016, global assets under management by private equity firms/venture capital totaled about $5 trillion. The amount of new financing raised by these investor groups may be leveraged by as much as $4 dollars for every $1 dollar of equity capital. Development of the private equity industry Infancy Rise of venture Rise of buy-out Concentration Revival and (pre-1980) capital (early funds (late 1980s and globalization (late 190s) early 1990s) specialization 1990s-today) (mid-1990)  Introduction to private equity/venture capital Characteristic of major issuers in the private equity market Size Financial Reason for Major sources Extent of attributes seeking of private access to private equity equity other financial market Early-stage new ventures Revenue between High growth To start operations Angels Early-Stage For more mature 0 and $15 mio potential venture firms with partnerships collateral. Limited access to bank loans Later-stage new ventures Revenues between Hight growth To expand plant Later-stage Access to bank $15 mio and $50 potential and operations; to ventures loans to finance mio cash out early- partnerships working capital stage investors  Introduction to private equity/venture capital Size Financial Reason for Major sources Extent of attributes seeking of private access to private equity equity other financial market Middle-market private firms Established, with Growth prospects To finance a Later-stage Access to bank stable cash flows vary widely required change in venture loans, For more between $25 mio ownership or partnerships Now mature, larger and $500 mio capiatl structure; venture firms, access to to expand by partnerships private placement acquiring or market purchasing new plant Public and private firms in financial distress Any size May be over- To effect a Turnaround Very limited levarraged or have turnaround partnerships access operating problems  Introduction to private equity/venture capital Size Financial Reason for Major sources Extent of attributes seeking of private access to private equity equity other financial market Public buyouts Any size Underperforming; To finance a LBO and Access to all public high levels of free change in mezzanine debt and private cash flow management or partnerships markets management incentives Other public firms Any size Depend on To ensure Non-venture Access to all public reasons for confidentality; to partnerships and private seeking private issue a small markets equity offering for convenience because industry is temporarily out of favor with public equity markets  Introduction to private equity/venture capital Five largest Companies by Market CAP as of August 1, 2016 VC/PE- Market Cap ($B) Employees backed Apple Yes $ 571.40 116,000 Alphabet Yes $ 549.50 69,952 Microsoft Yes $ 440.90 114,000 Amazon Yes $ 364.00 230,800 Facebook Yes $ 356.00 12,691 Source: NVCA Yearbook 2017  Introduction to private equity/venture capital The amount of the PE/VC investment per citizen in 2016 Wykres 2. Wielkość inwestycji Private Equity na mieszkańca. Źródło: Raport KPMG „Rynek private equity w Polsce 2016”. Amounts in $  Introduction to private equity/venture capital The value of investment and exits of PE/VC in Poland Values in millions EUR  Introduction to private equity/venture capital Influence of Venture Capital (VC) on Innovation (researches): ✓ Research done by National Science Foundation (1982-1984) presented, that in many cases innovation was supported by know- how comming from Venture capital; ✓ Research done by Coppers&Lybrant Capital in 1989-1993, based on 500 companies financed by VC proved 4 x quicker increase expenses on R&D than corporates present on Fortune 500, 17 x higher increase of sales and 4 x better qualified employees; ✓ Based on researches done by EVCA (2000-2006), financing of R&D by Venture Capital was 6 x bigger then 500 the biggest corporates in UE.  Introduction to private equity/venture capital The role of private equity/venture capital funds in deal financing ✓ PE/VC funds take money from large institutions such as pension funds, borrow additional cash, and buy private and public companies. PE funds invest for the long term and often take an active role in managing the firms they acquire. They also take money from institutional investors and make numerous small investments in start-ups. ✓ In deal financing, these investor groups play the role of financial intermediaries and „lenders of last resort” for firms having limited access to capital. ✓ They also provide financial engineering and operating expertise and monitor management activities such that private equity- owned firms often show superior operational performance and are less likely to go bankrupt than comparably leveraged firms. Investment process  Investments process The process of structuring the investment process is very long and complex. Even though the details may vary from one venture capital fund to another and can also differ depending on the deal, the investment structures used by the venture capital community tend to fit common patterns and are designed to achieve a few basic objectives. A successful venture capital deal is a multistage process: ✓ It is up to the VC to educate the young entrepreneurs who often confuse venture capital with other types of financing. ✓ Entrepreneurs are often not prepared to receive venture capital. They may not have any formal documentation describing their business, and may not have prepared the business plans or the financial forecasts. ✓ The process of structuring and negotiating the venture capital deals is inherently difficult – the fact that is especially true for the first-time venture capital recipients.  Investments process All funds have the same basic investment pattern, but the process details may slightly differ depending on the particular structure of the fund. In the essence it follows below listed components: ✓ Approach by the company; ✓ Initial appraisal by the fund managers; ✓ Meetings with management; ✓ Detailed examination of the visit; ✓ Offer letters, accountants’ investigation; ✓ Submission of the proposal to the approval; ✓ Legal stages; ✓ Closing.  Investments process Characteristic of the rounds of financing Stage Acitivities Selecting investments Vobtaining access to high-quality deals and evaluating potential investments The aquisition of a large amount of information and the sorting and evaluation of the information Structuring investments Preparation and settlement all investments agreements, which affect both managerial returns at portfolio companies and the partnership’s ability to influence a company’s operations Monitoring investments Active participation in the management of portfolio comanies Exercise control and provide the portfolio companies with financial, operating, and marketing expertise through membership on boards of directors of general partners and less firmal channels Exiting investments Preparing exiting strategy by taking portfolio companies public or selling them privately  Investments process The essence of the investment process from the investee side Steps Acitivity 1 Determination by the potential investee that cash is required for expansion, development, buying out existing shareholders or whatever 2 Preparation of a business plan and funding proposal 3 Initial aproach to an investor 4 Investors’ preliminary (likely desk-based) consideration followed by investigation (meetings and visits) 5 Preliminary (indicative) offer letter – now known almost universally as the „term sheet”; discussion of terms internally by the applicant 6 Acceptance of the indicative offer 7 Due diligence 8 Study of result of due diligence and indicative offer confirmed or modified 9 Investment committee proposal (VC), and indicative terms approved, modified or rejected 10 Issue of full offer (subject to legal stages) by VC 11 Formal acceptance of terms (subject to legal stages) by investee  Investments process Steps Acitivity 12 Legal stages: Meetings between the VC and the VC’s lawyer to draft the legal agreement Meetings between the company and its lawyers to consider its reply A series of meetings between both parties to hammer out the differences between what has been offered and what will be accepted and agreed 13 Completion meeting – held at the offices of the VC’s lawyers 14 New investor joins the company (and probably the board) 15 Everyone lives happily ever after  Investments process Selection of investment: While selecting the companies in order to make a decision as to which of them to invest money in, the investors can also use a different approach. Usually, when creating the business model of their investment activity venture capital usually focus on: ✓ A particular industry, field or technology, ✓ Certain stages of financing (early- and later-stage, venture capital and the entire range of non-venture private equity), ✓ Size of investment (min – max) ✓ Location of the investment. The key to success for entrepreneurs who wish to be successful in dealing with VC’s is spending the time and effort to understand the objectives of their potential investors and to expect proposed investment structures that accommodate thos objectives.  Investments process Examples of pre-investment considerations are the following: ✓ Business plan – the management must develop a coherent, dairly complete and redable business plan with a clear statement of business strategy and a relatively complete picture of the resources required (people, plant, money etc); ✓ Intelectual property rights – the company’s value is considerably enhanced if its patents and other intelectual property form a barrier-to-entry against its competitors; ✓ Prior history of the company – the legal entity to be used as the vehicle for the investment and the cunduct of the business should have no unusual prior history; ✓ Regulatory matters – all regulatory filings required by the company should be up-to-date and well documented; ✓ Tax matters – the impact of all tax issues on the probable invetsment structure should be analyzed and understood;  Investments process ✓ Cross border considerations – as markets and competition for most products are increasingly global, VC’s generally expect every company’s business plan to evaluate and discuss how the company will deal with international opportunities and threats. It also means taking into consideration the the VCs which invest in the company include one or two VCs from another country. The company usually send the summery of the business plan with a cover letter. It is worth noting that the chances of surviing in the initial process of selection made by VCs are very slight. Only well- prepared companies which meet the criteria listed by VC funds will have chance to meet with the investors. Also the impression created by the entrpreneurs at that time has a crucial impact on the final decision of the investors.  Investments process Private investors look for the investments that have above average advantage and include a unique technology, make a leap in innnovation and can act as a barrier to competition. The criteria taken into account by investors are as follows: ✓ Properietary advantage or unique technology; ✓ Exciting and fun; ✓ New features recognized competitors do not have resulting in significant barriers to competition; ✓ Cost advantage; ✓ Something investors can understand; ✓ The possibility of new markets; ✓ Potential for fast growth and share of the market; ✓ Potential for return; ✓ History of profitablity (if applcable) or a borrowed track record;  Investments process ✓ Not just an invention but plan for profit; ✓ A management team with the following attributes: decency, competence track record, personal financial commitment of their own net worth, desire to succeed; ✓ Affordable loss in their price range; ✓ Geographical accepted distance; ✓ Incremental funding based on performance; ✓ „must have” a clear strategy.  Investments process Executive summery of the business plan submitted to investors Executive summery of the business plan submitted to investors The company’s business Defina business purpose and strategic mission Provide summary of the company’s history and current status State overall corporate strategy and objectives The product or service Describe important features and benefits – relative to market and to the competition Describe existing products and status of new products Discuss procing and margins for both products and your competitor’s products Explain propertary position Articulate any relevant regulatory or environmental issues The market Market analysis, strategy (the way of reaching the market) Competitive advantage (what makes you different) Competition Discuss the issues or circumstances that drive or create the market  Investments process Executive summery of the business plan submitted to investors The management team Give brief backgrounds of the key indivuduals – specifically why they add value to the company, their past success and achievements etc. History of working together as a team, role and responsibilities Board composition The financial summary and deal Provide revenues, income and expenses projectes over 3 to 5 years Key financial assumptions Define funding requirements to achieve break-even and profitability Anticipated valuation and deal structure overview Use of proceeds Exit strategy QUESTIONS? Legal aspects of private equity investments  Legal aspects of private equity investments Most common forms of incorporation available to the ventures: ✓ Ordinary corporation [PL – SA]. A corporation is an artificial legal entity created to facilitate the incorporation of persons into a single, business-oriented economic body. It is seperate from its shareholders, who becouse of it are protected, since the liability of each member is limited to the amount invested in purchasing the company’s shares. ✓ Limited partnerships [PL - spółka komandytowa]. The partnership is a legaly entity characterized by the fact that its memebers are personally liable t third party and to the liability imposed on the partnership itself, the Limited Partenrship means, that the liability of each partners is limited to the amount of money he invested. This kind of entity includes at least one general partner who is responsible for all its liabilities and at least one limited partner who is liable only for the invested capital. In practice the liability of general partner is limited, since he is incorporated as limited company.  Legal aspects of private equity investments Most common forms of incorporation available to the ventures: ✓ LLCs (Limited Liability Company - USA) – [Sp. z o.o. - PL]. It is a partnership for the tax purpose. Tha company’s profits or losses are atributed directly to its shareholders and the company itself is not levied with the tax. The limited liability of the members is retained until they participate in the management of a Limited Liability Company.  Legal aspects of private equity investments Investment agreement: It is a complex legal document, which regulates many issues concerning the investment itself, the future relationship between the company and the investor and often also with other entities such as employees, directors and previous investors. A typical structure of the Investment Agreeement includes the following components: ✓ The material terms of the transaction containing a description of the buyers, the purchased asset (securities), and the consideration (the price per share); ✓ The company’s representations and warranties, designed to provide detailed information about the business and condition of the company; ✓ The investor’s represenations and warranties – the standard representation and warranties with respect to the investor’s authority to invest and request represenations regarding the investor’s experience in venture capital investments and having  Legal aspects of private equity investments a status of „accredited investor”, as well as additional representations supporting the classification of the transaction as a private sale which does not require the filing of a registration statement; ✓ The company’s covenants, which is a promise to perform or refrain from perfoming (negative covenants such as an undertaking to refrain from certain acts without the investor’s approval) certain acts in the future; ✓ Conditions precedent to closing, usually obtaining approvals and adopting resolutions, changing the interal rules of a company, having employees and entrepreneurs sign employment agreements and other undertakings; ✓ Verification that all of the conditions precedent to closing have been met and that all of the documents which need to be delivered at the closing have been prepared; ✓ Idemnification of the investors for any damage they may suffer due to breach of the represenation or a covenant by the company in the form of cash or shares.  Legal aspects of private equity investments Content of investment agreement Securities Purchase Agreement The financial commitment of the investors to purchase the newly issued securities of the company in a given period; The representations and warranties of the company as to the material facts relating to its organization and business, requiring relatively a complete disclosure of any material arrangements; The representations and warranties of investors as purchasers of the company’s securities; Affirmative and negative covenants of the company (the breach of which may give rise to contractual claims for damages, or which may result in other consequences), including limitations on debt, mergers and aquisitions, changing the business focus, transactions with affiliates and changes in compensation for the key managers, as well as provision for certain information right; Conditions to the obligations of the VC investors to fund the investment; Special provisions (covering any special arrangements between the parties); Miscellaneous provisions (often called „legal boilerplate”).  Legal aspects of private equity investments Content of investment agreement Investment security agreement For equity securities: ✓ Voting rights ✓ Dividents ✓ Liquidation preferences ✓ Conversion or exchange rights ✓ Redemption or „put” rights ✓ Special provisions relating to the Board of Directors ✓ For debt instruments ✓ Provisions for the payment of interest and principal ✓ Default provisions ✓ Provision for collateral or guarantees ✓ Conversion or exchange rights Special affirmative or negative covenants „anti-dilution” protection, usually giving the investors the right to obtain more common stock, without additional aggregate consideration, in the event the company subsequently issues new common stock at a price below the effective „as converted” common stock price paid by the investors.  Legal aspects of private equity investments Content of investment agreement Registration Rights agreement The rights of the investors to SEC registration of their equity securities Related agreements governing the procedures and understandings of the parties as to the implementation of such rights Stockholders Agreement Provisions that are important to each investment transaction or company, but will typically include restrictions on transfer Rights of first refusal on proposed transfers Voting agreements with respect to the Board of Directors or other matters Provision for the purchase of the stock held by the entrepreneur or other key management personnel in the event of death or terminantion of employment So called „co-sale” rights: ✓ The rights of the investors and/or others to participate in certain sales of stock by the entrepreneur or other key management stockholders ✓ The right of the investors to require the management to participate in a sale of stock by the investors.  Legal aspects of private equity investments Content of investment agreement Inventions and Confidentiality Agreement rights of the company to any intellectual property developed by the key employees The obligation of the key employees to maintain confidentality as to the company’s properetary information and trade secrets Appendices attached to investment agreement Disclosure schedules, which constitute part of the representatives and warranties and provide information about the company Additional exhibits, such as the organizational documents, employment agreements, the projected budget, the company’s legal counsel’s opinion on legal matters. Exit Rights Agreement (Investor Rights Agreement) Affirmative and negative covenants applicable to future operations Board seat rights Information delivery requirements and the like The registration rights of the investors Any redemption or „put” rights as to common stock or warrants Any „co-sale” rights, all of which provide opportunities for the investors to obtain liquidity for, or „exit”, the investment.  Legal aspects of private equity investments Content of investment agreement Employee Agreement Duties and responsibilities Compensation (including participation in bonus or other profit sharing or incentive compensation plans or stock option arrangements) The rights of the company to terminate the emplyment arrangements, including severance benefits that may be available Some or all of the common stock or option held by the key management team, or issued to them pursuant to equity incentive plans, be subject to „vesting” of the rights to the stock or options over a period of three to five years, with restrictions on transfer and „call” or buy- back rights in favor of the company at death or other termination of emplyment at a proce depending on the circumstances of such termination Non-compete agreements in the event of termination of emplyment, the duration of which may be related to the availability of severance benefits.  Legal aspects of private equity investments Due diligence and Term sheet ✓ Types of due diligence Due diligence, in its basic meaning, is an investigation or audit of a potential investment. It serves to confirm all material facts with regards to a potential sale. It means, that it is a way of preventing unnecessary harm to other party involved in a transaction. Type Aim of the study/examination Business Perspectiveness of the business and sector Attractiveness of the marketplace in long term horizon Competitveness of the sector Financial The credibility of financial results presented in business plan to investor The reality of achieded margins Tax Identification of any tax risk connected with the structuring the transaction, which could cause any liability in the future  Legal aspects of private equity investments Type Aim of the study/examination Legal Identyfication of any legal risk Preparation of legal aspects of transaction Environmental Identyfication of any infringement of rights in environmental protection issues confirmation of the quality of the environment Technological Examining assets and technology and their potential for the growth of productivity Insurance Examining the terms of conditions of insurance of assets Identyfication of any areas that need to be insurance  Legal aspects of private equity investments Due Diligence generally includes the following main components: ✓ A business investigation: the technology, the market, the intellectual property, the business forecasts and their assumptions, the revenue structure, the expense structure, the budget, the management suitability; ✓ A legal examination: the organizational documents of the company, ownership structure, the resolution taken by the Board of Directors, material agreements, the assets and the liabilities, ownership of intellectual property (like patents, right to name), agreements with the employees, agreements with parties, proceedeings opposite various aouthorities, legal exposure; ✓ An auditor examination: financial statements, taxation and any liability.  Legal aspects of private equity investments Term sheet – is the document prepared and collected by the VC. It includes the basic terms of the investment structure. This is non- binding agreement setting forth the basic terms and conditions, including the fundamental terms of the investment structure as well as the financial terms under which the investment is proposed to be made. The term sheet is: ✓ often negotiated in details ✓ always template to develop more detailed legal documents ✓ sometimes a stand-alone document and is part of so called „Letter of Intend”. The delivery of a sign term sheet to the company is a substantial milestone on the path leading to the investment. Many investors have standard patterns for the term sheet they use. The term sheet may be one or two pages long and contain only the most basic terms, or it may also be long, consisting of around or more than 20 pages document, not clearly distinguishable from a final investment agreement.  Legal aspects of private equity investments The Term sheet: ✓ is no legally binding for the parties, since the provisions included serve only as a basic for the future investment agreement ✓ Includes one binding clause, which is one of the most important – it states, that the company undertakes not to seek out other investors for a pre-determined period of time (usually 30-60 days), during which the investor conducts the due diligence process and negotiations are cunducted for the investment contract ✓ is also used in the final offer letter. ✓ contains: ❑ The amount of the investment ❑ The purpose of the investment ❑ The components of the investment ❑ The amounts to be invested collectively and separately by the existing managers of the business ❑ Costs to be born by the investee, etc. QUESTIONS? Financial aspects of venture capital investments  Financial aspects of venture capital investments Rounds od financing/aquisition of funds 1. A new found is established when the venture capital firm obtains necessary commitments from its investors. 2. There are several stages in the development of the company and then in the venture capital investments: ✓ Pre-seed financing – when the feasibility study of the idea has not been proven yet, the company does not existi yet; ✓ Seed financing – when the feasibility of the idea or plans on developing a product is proven, the company exists but still is in infant phase, research and development is indicated as a separate one when there is a financing of the productdevelopment for early-stage or more developed companies; ✓ Start-up financing-provided capiatl required for the product development and initial marketing activities;  Financial aspects of venture capital investments ✓ First-stage financing-the company has a thorough familiarity of the market and the competition on, an understanding and conception of the product, a visible management team; ✓ Second – and third-stage of financing – the company has a marketing system, solid management and existing or pending sales; it is providing the working capital funding and required financing for young firms during the first growth period and then the expansion of growth; ✓ Pre-IPO financing – relevant to companies 12-18 before an IPO as they need the bridge financing to demonstrate increasing sales and well-functioning marketing system, it is last financing reound, often called bridge financing.  Financial aspects of venture capital investments Differences between the stages of financing Pre-seed financing The progress achieved in proving the feasibility of the idea Seed financing The progress of the company in terms of business development and leading team achieved in proving the feasibility of the First-stage financing idea  Financial aspects of venture capital investments Characteristic of the rounds of financing Pre-seed Seed First stage Second Pre-IPO and third stage The condition of the company Inmature idea Vasic team of Understanding Solid marketing Increasing sales Incomplete managers or of the market system Well-functioning management entrepreneurs and a product Solid marketing team Basic business under management system The idea is still plan development Existing Absence of not orpending sales consistent technologically growth in sales feasible and commercially viable  Financial aspects of venture capital investments Pre-seed Seed First stage Second Pre-IPO and third stage sources Individuals close Private Venture capital Funds Passive to the investors funds Institutional investors who entrepreneur (business investors expect to sell (family&friends) angels) Corporate their stakes Private investors Incubators or investors after the IPO (not organized) specialized VC funds who funds invested in previous stages Underwriters seeking priority or exclusivity in the role potential underwriters for the company’s upcoming IPO  Financial aspects of venture capital investments Pre-seed Seed First stage Second Pre-IPO and third stage process Short and Short as Due diligence Long and Design to simplified as investors are process lasting complicated provide bridge investors are not involved in 3-6 months Requires financing until organized in providing Long and deep managerial the IPO is institutions and general advice investigations attention completed. usually know the performed by Usually 1 year entrpreneur VC in terms after first-stage personally of:existence of financing and the market for reducing the product and involvment of its possible the investor in development daily performed by management of the company, the company ability to create a team, meet operaing targets  Financial aspects of venture capital investments Pre-seed Seed First stage Second Pre-IPO and third stage use Support the Recruiting To complete the Working capiatl To finance development of management development to enhance the increasing the idea at least team and and marketing investments’ to the next stage employees commercializatio system To reduce the Completing n of the product To buy fixed company’s the business To expand the assets to dependency on plan managerial support the the condition of Developing team growth the stock the product To develop the To expand the exchange marketing team sales To allow to wait To support the for the optimal team timing for IPO. To reach the stage of sales  Financial aspects of venture capital investments Financial instruments in VC investments (* European Commission 2015. Guidance for Member States on Financial Instruments – Glossary): FIs can support projects by providing four main financial products: LOANS GUARANTEE “Agreement which obliges the lender “Written commitment to assume to make available to the borrower an responsibility for all or part of agreed sum of money for an agreed a third party’s debt or obligation or period of time and under which the for the successful performance by borrower is obliged to repay that that third party of its obligations if amount within the agreed time*”. an event occurs which triggers such Under a FI, a loan can help where guarantee, such as a loan default*”. banks are unwilling to lend on terms Guarantees normally cover financial acceptable to the borrower. They operations such as loans. can offer lower interest rates, longer repayment periods or have lower collateral requirements.  Financial aspects of venture capital investments Financial instruments in VC investments: FIs can support projects by providing four main financial products: EQUITY QUASI-EQUITY “Provision of capital to a firm, “A type of financing that ranks invested directly or indirectly in between equity and debt, having return for total or partial ownership a higher risk than senior debt and of that firm and where the equity a lower risk than common equity. investor may assume some Quasi-equity investments can management control of the firm be structured as debt, typically and may share the firm’s profits*”. unsecured and subordinated and in The financial return depends on some cases convertible into equity, the growth and profitability of or as preferred equity*”. the business. It is earned through The risk-return profile typically dividends and on the sale of the falls between debt and equity in shares to another investor (‘exit’), a company’s capital structure. or through an initial public offering (IPO). QUESTIONS? Valuation of private equity investments  Valuation of private equity investments In estimating the value of the investment there should be used an appropriate methodology, including facts, circumstances and its materiality in the context of the portfolio. The enterprise value is the kind of price expressed in money or an equivalent. The following 4 categories can be adopted as the standard of value: ✓ Fair market value – the price is established with the assumption of a hypothetical seller and a hypothetical buyer interesed in the transaction and is accepted by both of them; ✓ Fair value – the price is established with the assumption od a specific seller and a specific buyer not necessarily interesed in the transaction to take place; ✓ Intrinsic value - the price is not established for the needs of any transaction and is based on all information concerning the subject of valuation and external factors influencing the present and future economic growth; ✓ Investment value – the prise is established for a specific investor, so the individual expectations and requirements should be taken into account.  Valuation of private equity investments The valuation of each company should be preceded by financial analysis and strategic analysis; The financial analysis is based on the available historical data disclosed in financial statements – it allows to assess the efficiency of its operation and estimate its condition in future periods; The strategic analysis identifies the strenghts and weakness of the entity as well as threats and opportunities existing in its environment. The most widely used methodologies in valuation of the company are: ✓ Price of recent investments – valuation based on the price of the recent investemnt is an indication of the fair value which may be provided by the cost of the investment, if the investment being valued was made recently ✓ Net assets – this type involves deriving the value of the business from the value of its assets since the value derives itself from the assets of the underlying business rather than from its earnings;  Valuation of private equity investments ✓ Discounted cash flows or earnings of underlying business – involve deriving the value of a business by calculating the present value of expected cash flows or earnings from the underlying business – not from the investment itself; ✓ Discounted cash flows from the investment – involve deriving the value of a business by calculating the present value of expected cash flows or earnigs from the investment itself; ✓ Multiple – involves the application of an earnings multiple to the earnings of the business being valued in order to derive a value for the business; ✓ Industry valuation benchmark – uses specific industry valuation benchmarks, for example „price per bed” for hotels or „price per subscriber” for cable television companies only in limited situation rather as a kind of sense-check of value estimated using different types of methods.  Valuation of private equity investments Price of recent investments This methodology is appropriate but only for the limited period after the date of the relevant transactions. If the price of recent investment is no longer relevant, industry specific benchmarks can be used. Although a set of agreed milestones for valuation varies across different types of investment, companies and industries, investment in an early or development stage commonly include: ✓ Financial measures such as revenue growth, profitability expectations, cash burn rate, covenant compliance; ✓ Technical measures such as phases of development, testing cycles, patent approvals; ✓ Marketing and sale measures such as customer surveys, testing phases, market introduction, market share; ✓ The key market drivers of the investee company and overall economic environment. Valuation of private equity investments Discounted Cash Flows A correctly executed enterprise valuation process with the use of the DCF method should be carried out in five main stages: ✓ Stage I – Financial and strategic analysis; ✓ Stage II – Free cash flow forecast; ✓ Stage III – Discount rate forecast; ✓ Stage IV – Discounting of future cash flows and terminal value; ✓ Stage V – Interpretation of valuation results. The following sets out the calculations for a firm’s free cash flow: Earnigs before interest and tax (EBIT) – National taxes on EBIT (i.e. company’s highest marginal tax rate times EBIT)=NOPAT (Net Operating Profit After Tax) + Non-cash expenses, particularly depreciation and amortization – Capital expenditures Increase (decrease) in non-cash working capital = Free cash flow  Valuation of private equity investments Free Cash Flow can be regarded from two points of view: 1) Free Cash Flow to Firm (FCFF): It is the cash flow available to all the firm’s suppliers of capital once the firm pays all operating expenses (including taxes) and expenditures needed to sustain the firm’s productive capacity. The expenditures include what is needed to purchase fixed assets and working capital, such as inventory. The firm’s suppliers of capital include common stockholders, bondholders, and preferred stockholders (if the firm has preferred stock outstanding). 2) Free Cash Flow to Equity (FCFE): It is the cash flow available to the firm’s common stockholders once operating expenses (including taxes), expenditures needed to sustain the firm’s productive capacity, and payments to (and receipts from) debtholders are accounted for.  Valuation of private equity investments FCFF vs. FCFE approaches to equity valuation Equity Value FCFE Discounted FCFF Discounted at Required at WACC – Debt Equity Return Value Valuation of private equity investments Calculation of the equity value and enterprise value according to DCF models FCFE Equity Value  FCFEt Equity value =  t =1 (1 + r ) t FCFF Firm Value Designations: FCFE – free cash flows to equity FCFF – free cash flow to firm t - years of forecast r – cost of equity WACC – weighted average cost of capital (before taxation)  Valuation of private equity investments Example: FCFF model Current FCFF $6,000,000 Target debt to capital 0.25 Market value to debt $30,000,000 Shares outstanding 2,900,000 Required return on equity 12% Cost of debt 7% Long-term growth in FCFF 5% Tax rate 30% Valuation of private equity investments  MV(Debt)   WACC =    rd  (1 − Tax rate)   MV(Equity) + MV(Debt)    MV(Equity)   +   r  MV(Equity) + MV(Debt)   WACC =  0.25  7%  (1 − 0.30)  +  0.75  12%  = 10.23% Valuation of private equity investments FCFF1 Firm value = WACC −g $6,000,000 (1.05) Firm value = = $120.5 million 0.1023 −0.05 Equity value = $120.5 million – $30 million = $90.5 million Equity value per share = $90.5 million/2.9 million = $31.21  Valuation of private equity investments Multiplies / Relative valuation This is value of assets based on how similar assets are priced in the market. It is appropriate for an investment in an established business with an identifiable stream of continuing earnings that are considered to be maintainable. There are 3 steps in this methodology: 1) Finding comparable assets that are priced by the market 2) Scaling the market prices to a common variable to generate standardized process that are comparable 3) Adjusting for differences across assets when comparing their standardized values. Resulting both from the debt and the equity, there are 3 types of mutiples: 1) Based on the market value (public and private transactions): ❑ P/E – price per earnigs ratio; ❑ P/EBIT – price per earnings before interest and tax; ❑ P/BV – price per book value;  Valuation of private equity investments 2) Based on the value of the entire enterprise: ❑ EV/EBIT – enterprise value per earnings before interest and tax; ❑ EV/EBITDA – enterprise value per earnings before interest, tax, depreciation and amortization; ❑ EV/S – enterprise value per revenues; 3) Based on the sector-specific values: ❑ EV/unique user; ❑ EV/number of subscribers. While selecting companies to use in peer group analysis, bankers look for similar: ✓ Size and future growth prospects; ✓ Risiness of the business; ✓ Scope of product offering; ✓ Geographic reach; ✓ Customer base; ✓ Current and future profitability.  Valuation of private equity investments The procedure of estimation of fair value using different methods (The choice of valuation method) Net assets DCF Multiple Deriving an enterprise Deriving the enterprise Applying a multiple that is value for the company value using reasonable appropriate and using appropriate measure assumptions and reasonable to maintainable to value its assets and estimations of expected earnings of the company liabilities future cash flows (or (given the risk profile and expected future earnings) earnings growth prospects and the terminal value and of the company under discounting to the present valuation) by applying the Adjusting the enterprise appriopriate risk-adjusted value for surplus assets or rate that quantifies the excess liabilities and other risk inherent in the contingencies and relevant company factors Deducting any financial instruments ranking ahead of the highest ranking instrument of the fund in a liquidation scenario (e.g. the amount that would be paid) and taking into account the effect of any instrument that may dilute the funds investment to derive the attribute enterprise value Apporting the attributable enterprise value appropriately between the relevant financial instruments Transaction structuring. Fund remuneration. Transaction structuring. Fund remuneration. The transaction structures most commonly used on the venture capital market is the private placement. The investment process is a kind of a purchase of equity by investors or purchase of shares of the company or rights to acquire the equity by investor. The most common securities on the venture capital market are: ✓ Equity securities (i.e., common stock or prefered stock in the case of corporate issuers) – is prefered or a common stock. ✓ Debt instruments (i.e., promissory notes or debentures, which may be convertible into the equity security) – it is convertible subordinated debt, which is much more common to the institutional transactions. ✓ Subscription warrants – rights to acquire an equity security (i.e., stock purchase warrants) – it comes as a long-term debt with warrants and this applies only to later-stage ventures. All listed structures relate to the equity. Most early-stage deals tend to be the equity or the equity related private placement structures. Transaction structuring. Fund remuneration. Advantages and disadvantages of equity related structures. Advantages Disadvantages Capital Dilutes ownership Permanent capital that increases More expensice than debt when company’s net worth, borrowing successful capacity and overall financial strenght No means of reversing the Enhance credibility transactions No scheduled repayment Give up control/flexibility No personal liability Difficulty in finanding investors Help Accountability The difference between the convertible preferred stock and the common stock is that holders of a preferred stock are paid before holders of a common stock in the event of liquidation. The issuance of a preferred stock reduces the partnerhip’s investment risk and provides strong performance incentives to the company’s management, because the management typically holds the common stock, or warrants to purchase the common stock. Transaction structuring. Fund remuneration. Basic comparison of private placement and public offers Characteristic Private placement Public offer Disclosure requirements Easier to handle More difficult to handle Costs lower Higher Time frame More rapid time Longer period Size of transaction smaller Bigger Supporting elements Capital, knowledge, Mainly capital experience, contacts Target More narrow Wider Legal aspects Less formal More formal Transaction structuring. Fund remuneration. Venture capital limited the partnership agreements clearly defining the compensation to be paid to venture capitalists (general partners). Fund remunaration typically include: ✓ So-called management fees (calculated as a percentage of the fund’s capital or assets), and ✓ Carried interests (calculated as a percantage of the profits to be paid as investment returns are realized). In setting annual management fees, partners must agree on both the fee percentage and the base on which the fee is assessed; Funds usually charge the annual management fees of 1.5%-3% of their size. Fees could be specified as a percentage of the committed capital, the value of fund’s assets or combination, or sometimes the modification of these two measures; The definition of the size of the fund varies from one agreement to another; Transaction structuring. Fund remuneration. The base of calculating the management fee could refer to: ✓ Capital commitments; ✓ Actually invested capital; ✓ The value of the managed portfolio, which is changing. The calculation of the fee is usually based on the capital under management, which means, that exits made by the fund which are allocated to the limited partners, reduce the basic for the calculation of the management fee; Initial definition of the management fee is valid usually 3-5 years and is set at a fixed percentage of committed capital until the end of the period during which the fund is supposed to invest the money; The venture capital fund managers are also paid by sharing in the profits that the fund make, which are called incentive payments; Approximately 80% of funds give their managers a share of 20- 21% of the return after the return of the capital invested and min return arrangements, as determined in the fund’s partnership agreements. Transaction structuring. Fund remuneration. Perspectives of the private equity performance valuation: ✓ Gross performance on the basis of realized investments – the performance assessment captures only investments that were either fully divested or written-off the books; this is the perspective of the private equity fund managers; ✓ Gross performance on the basis of all investments – all portfolio investments are recorded on the basis of the net asset value; this is a perspective of the private equity fund manager; ✓ Performance net of fees – returns are calculated on ther basis of underlying actual cas flows to limited partners after deducting the management fees and the performance fees meaning that the returns are the net to investor this is the perspective of the external investor. The standard metric to measure the private equity returns in terms od an individual investment, the fund and the industry performance is the internal rate of return (IRR). This denotes the discount rate that brings the present value of all cash flows equal to zero. Transaction structuring. Fund remuneration. For realized cash flows the formula of IRR looks like: T – lifetime of the fund, CFt - the cash flow over period „t”. The IRR calculation can be extended for the net asset value of investment that are not realized yet. Transaction structuring. Fund remuneration. The arithmetic average is the simplest from of aggregating the IRR data, but it does not consider, that the investment differs in size of the capital commitment. This difference is taken into account by the other metric – the capital weighted IRR. Cash Flows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 IRR Investment A -50 0 0 100 26% Investment B -50 0 0 50 50 22,1% Investment C -25 -25 0 100 31,5% Investment D -100 200 100,0% Arithmetic Average 44,9% Capital Weighted Average 55,9% Transaction structuring. Fund remuneration. Both earlier mentioned metrics do not take into consideration that there are different capiatl commitment periods. This means that short-term investment are over-emphasized and longer-term investments are under-emphasized. See below pooled IRR. Cash Flows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 IRR Investment A -50 0 0 100 26% Investment B -50 0 0 50 50 22,1% Investment C -25 -25 0 100 31,5% Investment D -100 200 100,0% Pooled IRR (gross) -50 -75 -25 0 350 50 34,1% Management fee (2%) -5 -5 -5 -5 -5 -5 Carried interest (20%) 0 0 0 -10 -30 -10 Pooled IRR (net of fees) -55 -80 -30 -15 315 35 23,5% Transaction structuring. Fund remuneration. The lower returns can be explained that the investments conducted early receive a greater weight than the later ones. Using the next metric – composite IRR (time zero IRR) – we should assume that investments are performed in year 0. Cash Flows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 IRR Investment A -50 0 0 100 26% Investment B -50 0 0 50 50 22,1% Investment C -25 -25 0 100 31,5% Investment D -100 200 100,0% Composite IRR -225 175 0 250 50 41,3% The IRR is extremely useful in gauging the progress and relative performance of one or a series of private equity investments. It can be used for calculating a company, a fund, a group of funds that originated in the same year, or on the whole portfolio of funds. QUESTIONS? Operations of private equity fund in portfolio companies  Operations of private equity fund in portfolio companies The VC fund is not only a source of financing for a startup, but is also a financial partner with connections in the capital market and experience in building up companies. Companies can rely on the fund’s know-how, experience and connections. The private equity investors are able to keep a close watch on what is happening to its investment through the appointment of investor or observes to attend the board meetings; Usually the fund managers are forme entrpreneurs or people who previosly managed companies; Accroding to the NVCA, the venture capitalists are professional investors who specialize in funding and building young, innovative enterprises; There are differences between managerial and entrpreneurial mindset (see below table) Operations of private equity fund in portfolio companies Characteristic Managerial Mindset Entrepreneurial Mindset Decision-making assumptions The past is the best predicator of A new idea or an insght from a the future. Most business decisions unique experience is likely to can be quantified provide the best estimate of emerging trends Values The best decisions are those based New inside and real-world on quantitative analyses. Rigorous experience are more highly valued analyses are highly valued for than results based on historical making critical decisions data Beliefs Law of large numbers: chaos and Law of small numbers: a single uncertainty can be resolved by incident consists of several isolated systematically analyzing the right incidents quickly becoming pivotal data for making decisions regarding future trends. Decisions need to be made quickly. Approach to problems Problems represent an unfortunate Problems represent an opportunity turn of events that threatens to detect emerging changes and financial projections. Problems possibly new business must be resolved with substantial opportunities analyses  Operations of private equity fund in portfolio companies VC fnds assist companies while seeking for an additional capital in the later stages (they are well-connected in the financial community); VC assist the portfolio company’s internal crisis, supporting them with additional financial backing, even if the process takes longer than expected; VC help portfolio companies with the M&As, and prepare companies for the public market entry. The managers of VC funds are usually well-connected in the business industry, either directly or through their acquintances with their own investors. These connections on the market can significantly facilitate a company’s securing of both strategic alliances and business deals; VC support portfolio companies in recruitment of senior emplyees as well as assist in the recruitment of top management. VC have connections with the managers who manage different companies and help to bring them to the company;  Operations of private equity fund in portfolio companies VCs assist in constructing a balanced and contributing board of directors, which is involved in strategic and material decisions and complements the company’s management team with its experience; VC negotiations have a number of unique characteristics: ✓ They are comprehensive, covering many functional areas of the business and the personal behaviors of all the shareholders; ✓ they are future-oriented focusing on a plan that can achieve the firm’s future market success, better its competitive position, increase its profitability and market share, and, above all, grow its value; ✓ They are emotional. From the entrepreneur’s point of view, this includes „selling out” a part of their own business to a new partner. From the venture capitalists’ perspective it invovles personal engagement to be successful and increase personal credibility.  Operations of private equity fund in portfolio companies The VCs play an active role in the development of the portfolio companies through the supervisory board representation, without becoming involved in their day-to-day operations; Creating net value as a phase in the cycle of PE process consists of numerous activities of PE fund: ✓ Attractive acquisitions with the prospects for eventual exit options; ✓ Capital structuring of investee companies (debt-equity); ✓ Fiscal optimization; ✓ Financial reporting and discipline; ✓ Strategic leadership and managerial – technical support; ✓ Nurturing internally or by add-on; ✓ Overshight of portfolio companies; ✓ Risk management of the portfolio; ✓ Efficient, transparent, and speedy communication between the PE firm and the investee companies;  Operations of private equity fund in portfolio companies PE managers create value in the portfolio companies through following activities both managing and governing: ✓ Giving advisory for the executive management, participation at regular board of directors meeting; ✓ Engaging in many management processes, including recruiting, compensation of key managers; ✓ Participation in the key strategic and operational decisions (restructuring, expansions, new business or product launching); ✓ Sustaining management information and reporting system in order to auditing the boards; ✓ Replacing or adding to the existing management teams new emplyees or affiliated managers; ✓ Monitoring the financial performance and the key performance indicators; ✓ Reveiwing business strategies; ✓ Monitoring major trends and reacting;  Operations of private equity fund in portfolio companies The PE investors are very active, directly deciding about the directions a business is taking, overcoming appeared disadvantages; Improving the financial performance of acquired companies is a key objective of executives fro PE; The strategies used by executives from PE including: ✓ formulating strategic plans to monitor progress and performance; ✓ Retooling of manufacturing or other operations for greater efficiency; ✓ Reducing the workforce to cut costs; ✓ Acquiring other business that complement the acquired company’s operations; ✓ Reducing the cost of goods and supplies by consolidating purchasing; ✓ Selling nonperforming lines of business; ✓ Developing new sources of revenue and improving marketing and sales for good, but under-supported, products. QUESTIONS? Venture capital and private equity worldwide and in Poland Venture capital and private equity wordwide and in Poland VENTURE CAPITAL AND PRIVATE EQUITY ASSOCIATIONS Many organizations and associations operate all over the world to represent venture capital and provate equity and help their memebrs to develop themselves; They provide networking opportunities and wide range of information services for the memebers; They act as lobbying and compaigning organizations and work to promote these asset classes throughout the world; They represent the public policy interests of the venture capital community, strive to maintain high professional standards; Provide reliable industry data, sponsors professional development, and facilitate interaction among their members; These organizations are functioning across the globe, but they are banding members together on continents (ie.NVCA, Invest Europe) or, if their scale of activity is smaller, in the particular country (ie. BVCA, PSIK). Venture capital and private equity wordwide and in Poland Invest Europe (previously, The European Private Equity and Venture Capital Association - EVCA) represents, promotes and protect the interests of the European private equity and venture capital industry. With over 1,200 memebers in Europe, the IE’s activities cover the whole range of private equity, from seed and start-up to the development capital, buyouts and buy-ins, and the flotation of the private equity-backed companies; The IEs role includes: ✓ Representing the interests of the industry to regulators and standard setters; ✓ Developing professional development and forums; ✓ Facilitating interaction between its members and the key industry participants including institutional investors, entrepreneurs, policy makers and academics; Venture capital and private equity wordwide and in Poland IE activities: Area Activity Representing the European On behalf of its memebrs, IE undertakes public policy activities and maintains a dialogue private equity and venture with policy institutions and regulatory bodies at European, international and national capital industry towards a levels, often in cordination with national trade associations, variety of stakeholders It promotes and onreases the understanding of the key roles that private equity and venture capital and entrpreneurship play in creating and protecting jobs and enriching the European economy Raising professionals standards IE is at the forefront of developing guidelines for professional standards and best practice, contributing to harmonization across the industry; IE has produced a range of widely-used guidelines for the professional conduct of private equity equity and venture capital fund managers, both in respect of the management of their activities and in their relationships with investors and portolio companies Networking opportunities IE provides opportunities for members from across Europe to meet together, exchange information and ideas, and discuss the latest industry trends and issues, Throughout the year IE holds regular networking events with leading practitioners and industry participants from all over Euroipe, including the Investors’ Forum, the CFO-COO Summit, the Venture Capital Forum and Buyout Forum as well as workshop on ICT, life science, buyouts and corporate venturing topics. Venture capital and private equity wordwide and in Poland IE activities: Area Activity Enhancing professional The Insitute;s comprehensive range of PE management training courses is designed to development enhance the professional skills and expertise of a PE practitioner at all stages of his or her career; The group-based courses provide an opportunity to network mwith peers from across Europe and to profit from the experience of instructors drawn from leading senior industry professional and academics. Conducting and publicizing IE conducts and commissions a wide variety of private equity and venture capital industry research research, Through its partnership with PEREP_Analytics AND Thomson Reuters, it collects and publishes quarterly and annual statisctics, based on rigorous and transparent methodologies, covering industry activity and performance; IE members have the IE Library and Research Helpdesk at their disposal, with access to industry data and information at no extra cost. Venture capital and private equity wordwide and in Poland The National Venture Capital Association (NVCA) is the venture community’s trade association that represent the USA venture capital industry. The NVCA’s mission is to foster a greater understanding of the importance of venture capital to the US economy, and support entrpreneurial activity and innovation. NVCA serves as the definitive resource for the venture capital data and unites its members through a full range of professional services; NVCA activity is basicly similar to IE It is comprised of more that 440 members firms. The membership includes a wide variety of benefits and services like: ✓ Professional development; ✓ Insurance program; ✓ Networking; ✓ Research&publications; ✓ Public relations; ✓ Technologu services. Venture capital and private equity wordwide and in Poland The Polish Private Equity Association (PPEA) gathers the private equity/venture capital investors active in Poland. An associate membership is also available for other persons, companies and institutions interested in the development of the private equity/venture capital industry in Poland. The mission of the PPEA is to promote and develop the private equity and venture capital industry in Poland, and to represent the interests of the polish private equity and venture capital community in Poland and abroad. The objectives of the PPEA include: ✓ Increasing awareness and understanding of the Polish private equity/venture capital industry, in particular among potential investees; ✓ Making PE/VC investing more widely known and better understood; Venture capital and private equity wordwide and in Poland ✓ Presenting the industry as a viable, accessible and critical part of the capital market and a key factor for development and growth of individual companies and the Polish economy in general; ✓ Keeping the members informed about the significant initiatives and proposed changes to the legal, tax and regulatory envoronment. If necessary, developing and articulating common positions on relevant issues; ✓ Facilitating contacts between the members: sharing experience, discussions and networking; ✓ Assisting in education and training for the PE/VC professionals; ✓ Collecting and presenting information and statistics about the industry in Poland. Venture capital and private equity wordwide and in Poland Other Vanture capital associations. There are many others venture capital associations all over the world. The information about some of them are gathered in below table. Venture capital associations AFIC Assciation Francaise des Invesstiseurs an Capital AIFI Italian Private Equity and Venture Capital Association AMEXCAP Mexican Private Equity Association AMIC Moroccan Private Equity and Venture Capital Association APCRI Portuguese Private Equity and Venture Capital Association APEA Arab Private Equity Association ASCRI Spanish Private Equity and Venture Capital Association ATIC Tunisian Venture Capital Asociation AVCAL Australian Private Equity and Venture Capital Association Other…… ……. Exits of funds  Exits of funds The key VC’s goals is to grow the company to a point where it can be sold at a price that far exceeds the amount of the capital invested (it is so-called „exit” or divestment process); Researches show, that approximately 1/3 of the portfolio companies fail. This means that out of a portfolio of 10 investments, the average venture results are: ✓ One or two will collapse through bad management or bad luck; ✓ Three or four will underperform badly so that they just hang on by the tips of their fingers; ✓ A couple will perform już above expactations; ✓ One or perhaps two will be real stars; ✓ So those companies which are successful, must do it in a pretty big way. When VC investors are active, velueadded investors that bring not only the capital to the table, but knowledge, skill, and the network of legal, accounting, investment banking, marketing, and other contacts that are useful to an enterprise;  Exits of funds The framework for th exits can differ among the funds but typically it consist of ten steps: Step Characteristic 1 Identification of exit opportunity 2 Evaluation of portfolio firm and exit routes 3 Designing exit process and mandating advisers 4 Assigning roles and responsibilities, negotiating incentives 5 Preparation before launch of exit process 6 Launch exit process 7 Conduct exit process, negotiations with bidders 8 Evaluation of exit options and offers 9 Transaction closing 10 Ex-post review  Exits of funds Types of exits/divestments: ✓ Going public/IPO (or flotation); ✓ Being acquired by a larger corporation (buy-out); ✓ A sale to a third-party investor. Apart from these 3 basis ways out of an investment for VCs (and management too), the term commercial collapse is being taken into account as one of the kind of exits, although it is not a way for beneficial realization of the investment; The most common type of exit in the USA is doing M&A deals  Exits of funds The Exit Funnel Outcomes of the 11,686 Companies First Funded 1991 to 2000 in the US 500 450 436 429 400 382 348 350 300 273 250 200 150 100 86 75 52 50 6 12 0 2007 2008 2009 2010 2011 M&A Deals IPOs Source: NVCA Yearbook  Exits of funds The Exit Funnel Outcomes of the 11,686 Companies First Funded 1991 to 2000 in the US 14% IPO 35% M&A 33% known failed 18% still private or uknown or have quietly failed Source: NVCA Yearbook Exits of funds 140 U.S. VC-backed IPOs by YEAR 122 120 100 87 89 79 77 80 59 60 60 Nb of deals closed 46 capital Invested ($B) 43 42 39 40 20 21.46 10 10 9.12 10.57 6.25 7.61 5.94 8.07 2.89 3.45 3.69 2.93 0 0.63 1.26 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016  Exits of funds An exits/divestments may be full or partial: ✓ A full exit for an IPO involves the sale of all of venture capitalists’ holdings within one year of the IPO. A partial exit involves the sale of only a part of the venture capitalist holdings within that period; ✓ A full acquisition exit involves the sale of the entire firm for cash. In a partial acquisition exit, the venture capitalist receives (often illiquid) shares in the acquirer firm instead of cash; ✓ In the case of the secondary sale or the buyback exit (in which the entrpreneur buys out the venture capitalist), a partial exit entails the sale of only a part of the venture capitalists holdings; ✓ A partial write-off involves a write down of the investment on its books. In circumstance of high information asymmetries, the exit type preferences from the value maximization stanpoint would be ranked as follows: buybacks, trade sales, secondary buyouts an finally IPOs.  Exits of funds An IPO (Initial Public Offering) is a process of selling shares to members of the public for the first time; Typically, the VC will retain its shares at the date of the public offering, then sellling shares into the market in the months or year following the IPO; Two types of shares can be sold at the IPO: 1) The primary equity (new shares sold to the investors); 2) Secondary equity (the shares owned by the original investors). The IPO process consists of the following stages: ✓ Forming the IPO team, ✓ Preparing the company, ✓ Assembling the company, ✓ Signing a letter of intent with the underwriters, ✓ Beginning the organizational meeting, ✓ Holding the organizational meeting,  Exits of funds ✓ Preparing an amended registration statement, ✓ Distributing the preliminary prospectus, ✓ Marketing (the „road show”), ✓ Holding the due dilligence meeting, ✓ Pricing, signing the underwriting agreement and having the registration statement declared effective, ✓ Selling the shares to the public and closing, ✓ Trading, stabilization and exercise of the underwrites’ option („green shoe” option); Before going IPO, a lot of considerations should be taken into account: 1) The business needs to identify the date when it wishes to float and then work backwards several months to identify the time when the whole process should start, which means that a great deal of planning is required;  Exits of funds 2) The effort that is required for the preparation will take much of the attention of directors in the the months prior to the event; 3) Putting the company’s shares on a public market now involves continuing regulatory burdens that are costly and heavy; 4) The sanctions that the market regulators may impose on the management and the venture shareholders of a business that is considering listing may involve the shares being „locked up” to prevent the market being swamped, so they will still be the subject to detailed regulation; 5) The venture investors may be reluctant to give some of the warranties that are required to enable the listing to proceed smoothly;  Exits of funds Sale to the third party – can be executed as an acquisition or through secondary sale. In a typical acquisition, the buyer is a strategic acquirer – a larger entity in the same or similar business as the acquired firm that wishes to combine the firm’s product or technology with its own (either vertically or horizontally). The strategic acquisitions often involve the merger of two corporations with some prior contractual relationship; The secondary sale means, that VC will sell its shares to a third party, typically to a strategic acquirer and, in some cases, to another VC. In this type of exit only the shares of the VC are sold to the third party, while the entrpreneur and other investors retain their investments. This is the difference which distinguishes the acquisition and secondary sales;  Exits of funds The transaction may be structured as: ✓ A sale of all the shares in return for cash, shares of the acquirer, or other assets; ✓ A sale of the firm’s assets; ✓ A merger between the investee firm and purchasing firm; There are 4 types of acquisition exits classified by the identity of the acquirer: 1) acquisitions by public companies with deep public markets; 2) acquisitions by public companies that are thinly traded; 3) acquisitions by private companies; 4) acquisitions by the investee firm of another firm; Exits of funds In the buyback exit, the VC will sell its shares to the entrpreneur and/or the company. It is becoming increasingly apparent that buyouts provide a way to take an advanatage of critical windows of opportunity. The buyouts are an organizational mechanism that can enable the managers, and sometimes the employees as well, to develop and more fully exploit the firm resources; There are many types of buyouts: ✓ Management buyout (MBO) – the acquisition of a company (target) by its incumbent senior management team, even in privately held firms, who up until the time of the buyout may have held aither a limited equity stake, or no shareholding at all; ✓ Management buyin (MBI) – the management team that will invest alongside the private equity funds, and run the target business, has not previously been involved in the management of the target. Outsiders create a new management team by arranging capital, privatization programs etc.; Exits of funds ✓ Buying management buyout (BIMBO) – a combination of the existing management team and managers from outside the company; ✓ Leveraged buyout (LBO) – buyout where significant debt is utilized by the private equity firm in order to fund the acquisition of target. The expression originates in America, although it has been used more extensively in the UK market in recent times; ✓ Institutional buyout (IBO) – a transaction where the private equity investors are leading the acquisition process and will hold a substantial majority interest in the buyer vehicle (with the management team holding a relatively small, minority interest); There are main type of buyouts as follows: ✓ Whole-company buyout; ✓ Divisional buyout; ✓ Private firm buyout.  Exits of funds The trade sale of the portfolio company to a third party such as an industry peer or competitor; This is frequently referred to as the „merger or acquisition” exit or the „M&A” exit but it is a broader term since it captures secondary buyouts as well; Trade sales fall into three different categories: ✓ Initiated by the investor; ✓ Initiated by the management; ✓ Agreed upon by both parties that a trade sale would be beneficial; Basically, the process of selling a business to the trade buyer or the venture investor is similar. Both the legal documents and the requirements for information and warranties will also be closely related.  Exits of funds Write-off (collapse). VC makes a decision to spend no further time or effort bringing the investment to fruition, and essentially walks away from it. The investors are usually anxious to avoid failures in their portfolios for a number of reasons: ✓ It damages the portfolio rate of return; ✓ It damages their reputations; ✓ It takes time away from doing profitable deals; ✓ It costs money individually through the carried interest provisions of the fund; ✓ It makes future fund-raising very difficult, even if the overall rate of return is still good; ✓ Turning businesses around from the brink brings its own from of kudos – both within venture capital circles among investors. Business Angels as an informal type of venture capital  Business Angels as an informal type of venture capital Business angel or investors are a kind of private informal venture capitalists. They could be defined as: ✓ Wealthy individuals and families willing to invest in high-risk deals offered by people they admire and with whom they seek to be assiciated; ✓ Financially sophisticated private investors willing to provide seed and start-up capital for higher-risk ventures; ✓ Previously successful entrpreneurship, who want to invest their money and at the same time to share they knowledge, wisdom and experience. The concept of angel investors dates back to the Golden Age of Greece, its modern meaning dates to the well-heeled backer of Brodway shows who made risky imvestments to produce them. The angels invested in these shows in order both to have good relationships with eminent theater personalities they admire and to earn a return on investment;  Business Angels as an informal type of venture capital International Capital Resources of San Francisco (ICR) reviewed more than 480 entrepreneurs seeking capital. The majority of them identified private equity investors as one alternative financing recources – a practicable and preferred option; According to the survey 61% of entrepreneurs who came to its firm in their search for capital were relaying on the direct participatory investment turning toward informal, high-risk venture investors as their means of raising capital; Only 2% of the interviewed companies showed an interest in approaching professional venture capital firms to fund their venture (see below chart); Angel investor are different from their venture capital counterparts. They have more time to spend with beneficiaries and give them more detailed help in developing business and sustaining a stable growth;  Business Angels as an informal type of venture capital Primary Targeted Funding Sources 3% 2% 7% 9% 18% 61% private placement with informal venture investors self, family,friends, and business contacts profits and working capital banks, commercial finance companies joint venture and alliances other (venture capital firms, corporate investors, IPOs) Source: G.Benjamin, M.S.,J.Margulis, Angel Capital. How to Raise Early-Stage Private Equity Financing, Hohn Wiley&Sons  Business Angels as an informal type of venture capital As the finance-backed entrpreneurs are inexprerienced and very often immature the business angels give not only the capital, but also support them with wisdom, knoledge, experience and expertise; The venture capitalist are more conservative, collect more money from more diversified sources (different kind of investors), they put capital in bulk to work in the later-stage deals in majority and their main goals is to exit with as high return as possible; Business Angels prize their privacy and hence it is difficult to indicate them personally; Business Angels do not want to reveal their investment interests and wealth; The venture capital firms have become more like money management firms. They tend to gather larger and larger pools of money.  Business Angels as an informal type of venture capital Business Angels versus Venture Capitalists Characteristic Business Angel Venture Capitalist Main concern Concern with firm success Concern with exit strategy