Chapter 14


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Chapter 14

  1. 1. Chapter 14: 1. What are venture capital firms? And what characteristics do they seek in their investments? Answer: A venture capital firm is a specific type of financial intermediary that has a unique organizational structure and a specific market niche. Venture capital firms tend to seek out young companies with the potential for rapid and substantial growth and companies that require a substantial amount of capital investment to finance growth. Venture capital fills the gap between early-stage private investment by the entrepreneur, their friends and business angels, and the established-company market for public capital or private corporate acquisition. Venture capital firms provide both financing and managerial help. 2. Institutional investors, such as endowments, pensions, and insurance companies provide a significant fraction of investment capital to venture capital funds. What factors contribute to their choice to make such investments? Answer: Venture investing is a long-term proposition that exposes the investor to illiquidity. Until the investment is harvested, by IPO or other means, there is no convenient means to achieve liquidity. Because institutional investors have long-term investment horizons and large portfolios of more liquid assets, the lack of liquidity is not as significant a problem as for other types of investors. Also, institutions fit the profile of investors who can be trusted to contribute capital on schedule and who are not very sensitive to the timing of distributions. As a result, compared to other investors, institutions view venture capital investing as more attractive relative to alternatives. 3. “Managing a fund with multiple closings gives rise to opportunism.” True, false, or uncertain? Explain. Answer: Multiple closings may enable investors to get into the fund at different times, existing investors would not want new investors to buy into existing successes at low prices, and prospective investors would not want to buy into existing failures at high prices. 4. Why does the prospect of multiple closings increase the importance of an accurate valuation of the fund’s existing portfolio? Answer: The concern is with opportunism, where an earlier-stage investor may try to take advantage of later-stage investors, and vice versa. Hence, to abate these problems, ownership claims need to be based on accurate valuations. Alternatively, the fund manager can try to address potential opportunism by segregating existing and new investment by forming separate venture funds for each.
  2. 2. 5. Provide examples of how venture capitalists can add value to new ventures. Do you think they add enough value to justify their compensation? Explain. Answer: Venture capitalists are able to add value to cover their compensation by competing to find the best ventures and those that can benefit from their involvement, and by negotiating deals that adequately compensate investors, while preserving the incentive of the entrepreneur. They also try to time fund creation to correspond to periods of the greatest opportunity. Later, they try to add value by making good decisions about follow-on investments, by monitoring the portfolio companies as an aid to making informed decisions about the investment, and by assisting the venture’s managers in a variety of ways. Ultimately, they try to find harvesting opportunities that create the most value for investors. 6. “The compensation structure of the general partner in a venture capital fund can affect the kinds of ventures the general partner may seek, as well as the deal structure.” Explain. Answer: General partner compensation usually includes a management fee and 20 to 30 percent of the capital appreciation of the portfolio. The financial claim of the general partner has characteristics of a call option: a limited downside and a significant upside. A venture with a reasonably high expected return, but limited upside potential, is unlikely to be a prospect for venture capital, even if downside risk is small. Other things being equal, such a venture does not offer potential for the general partner to benefit significantly by sharing in the capital appreciation. The attractiveness of the investment to the general partner also depends on the terms of the financial contract. A high-risk venture that is structured to create financial claims that offers safe but modest returns to investors is unlikely to attract venture capital funds. On the other hand, a low-risk venture can receive venture capital funding if the structure of the financial claims offers substantial upside potential by shifting project risk to the investor. 7. How might the interests of the general partner in a venture capital fund diverge from those of the limited partner? Answer: The general partner receives the carried interest from the fund and generally receives only management fees if the fund does not do well. A manager who is concerned about the fee may make investments partly to increase management fees, even if the potential of an investment is not great. Because the carried interest is like a call option (with only upside risk) the fund manager may want to structure investments so that the upside potential is very great, even if doing so reduces the expected return from the investment. In addition, managers may be able to select investments that go into the fund versus those in which the manager invests personally, so there is a potential for self-dealing. There
  3. 3. are other ways that the interests can be in conflict. Generally, the investment agreements include efforts to control the conflicts. 8. Contractually, how might the interests of the general partner be more closely aligned with those of the limited partners? Answer: Interests are aligned when both types of partners (general and limited) participate in the venture success but are protected against losses if the venture performs poorly. Convertible stock, for example, offers some downside protection, and still preserves the potential for significant gain. Other structures, involving staging of investment or put options for the investor, can have similar effects. 9. Identify economics reasons for why convertible equity is commonly used in venture capital financing. Answer: There is a burgeoning literature regarding the use of convertible securities in new venture contracting. Among the (non-mutually-exclusive) reasons offered for convertible securities are: tax considerations, testing the beliefs of the entrepreneur, and improving the alignment of incentives between managers and investors. 10. What are some of the measures that the venture investors use to address the general partner incentive to take excessive risk? Answer: The investor may have agreement that limit the amount of fund investment in a single venture and restrict the ability of the general partner to add leverage by borrowing. 11. What are some of the measures that the venture capital investors use to address the concern that the general partner may favor an existing fund over a new fund that the general partner is forming? Answer: A fund contracts may give limited partners the right to review the general partner’s investment decisions. Sometimes limited partners serve on the fund’s investment committee. The agreement may prevent the general partner from investing in a new fund in the portfolio companies of the existing fund. Or the agreement may require that, if the general partner wants to make follow-on investments in portfolio companies of its other funds, it may do so only as a co-investor, along with another first-time investor in the venture. 12. Why do you think venture capital funds are organized as limited partnerships instead of closed-end mutual funds? Answer:
  4. 4. The limited partnership structure enables the fund to raise capital from all investors at the same time (or at a few discrete closings), and enables the general partner to match the timing of capital raising and investing in ventures. The requirement that the fund be liquidated after several years subjects the general partner to the discipline of the market, because, unless the fund is successful, the general partner will have trouble raising capital for the next fund. In addition, limited partnerships can offer tax advantages that closed- end funds cannot. The fact that closed-end funds are open to small investors is a drawback for limited partnerships, but does not appear to be critically important to fund managers. 13. Describe the contractual structure of a typical venture capital fund. Answer: Funds are organized as limited partnerships, where the general partner is responsible for management. Limited partners provide most of the financial capital (usually around 99 percent). The general partner provides the other one percent. In exchange, the limited partners generally receive their return of principal first. After that, they normally receive 80 percent of capital appreciation. The general partner receives and annual management fee of around 2.5 to 3 percent of capital under management, and receives 20 percent of the capital appreciation as a carried interest. 14. How does using capital calls enable a venture capital fund to earn a higher rate of return for the limited partners? Answer: By only calling on limited partners to provide capital when the fund manager is ready to invest in opportunities, the fund’s rate of return is measured from the point of the capital call to the point when the capital is returned to investors. Thus, the fund return is not depressed by holding capital in abeyance in a low-return, liquid form, while waiting for investment opportunities to be identified. Additionally, the manager does not feel pressure to invest capital in sub-optimal opportunities. 15. Why is it valuable for the passive investors in a venture capital fund to have established reputations? Answer: Venture capital funds operate best when they match the timing of capital calls with investment opportunities. However, the fund must be able to rely on the limited partners to deliver the capital when they are called upon to do so. Failure to provide capital when requested to do so can harm other limited partners. Litigation to force an investor to honor a capital commitment is unrealistic for a variety for reasons. Thus, reputations are important to the venture capitalist.
  5. 5. 16. What are the advantages of a venture capital fund having a finite life? Answer: The finite life enables the fund to allocate proceeds with less concern about favoring some investors over others, subjects the fund manager to greater market discipline, enables the market to downsize more efficiently, when investment opportunities decline, and in some cases enables the fund manager to negotiate harvests of investments more efficiently. There are also some disadvantages, such as the possibility that the fund will need to harvest some of its investments too soon.