Most entrepreneurs are capital constrained so they seek external funding for their projects.
Entrepreneurial firms with limited collateral (i.e., tangible assets), negative earnings, and large degree of uncertainty about their future cannot borrow from banks.
An alternative to banks is wealthy individuals (e.g., businesspeople, doctors, lawyers) referred to as angel investors. However, these investors are widely dispersed and amount they contribute is small.
Lack of outside funding hampers growth of new businesses in many countries around the world. Venture capital is a means to overcome capital constraints.
is a financial intermediary , collecting money from investors and invests the money into companies on behalf of the investors
invests only in private companies. ( Question : What is a private firm?)
actively monitors and helps the management of the portfolio firms ( Question : How do VCs help their portfolio firms?)
mainly focuses on maximizing financial return by exiting through a sale or an initial public offering (IPO). ( Question : So, what are the necessary conditions for the development of the VC sector in a country?)
invests to fund internal growth of companies, rather than helping firms grow through acquisitions.
Microsoft, Google, Intel, Apple, FedEx, Sun Microsystems, Compaq Computer etc.
Some of these investments resulted in incredibly high returns for VC funds:
“ During 1978 and 1979, for example, slightly more than S3.5 million in venture capital was invested in Apple Computer. When Apple went public in December 1980, the approximate value of the venture capitalists’ investment was $271 million , and the total market capitalization of Apple’s equity exceeded $1.4 billion.”
There are also big disappointments though. What the VC funds are doing is to try to find the next Microsoft, Google, Apple, which might help offset the losses associated with 100 other investments.
Both VCs and hedge funds are organized as limited partnerships .
Fund manager (GP: general partner) compensation structure at both types of firms are very similar. (we will talk more about this later)
VCs invest in private but hedge funds typically invest in public firms .
Hedge funds often invest in financial assets of a company for quick financial returns, while VCs often help structure or restructure the firm. In other words, hedge funds are short-term traders and private equity firms are long-term investors .
The investments of hedge funds are more liquid than the investments of private equity firms.
VCs are organized as limited partnerships. Tax advantages:
Not subject to double taxation like corporations; income is taxed at the LP level.
Gain or loss on the assets of the fund are not recognized as taxable income until the assets are sold.
Conditions to be considered a limited partnership for tax purposes:
(1) Pre-specified date of termination for the fund
(2) The transfer of limited partnership units is restricted
(3) Withdrawal from the partnership before the termination date is prohibited.
(4) Limited partners cannot participate in the active management of a fund if their liability is to be limited to the amount of their commitment. (Note, however, that LPs typical vote on key issues such as amendment of the partnership agreement, extension of the fund’s life, removal of a GP etc.)
While LPs have limited liability, GPs have unlimited liability (they can lose more than they invest): Not critical because VCs don’t use debt.
1% of the capital commitment comes from the GPs. Why?
Limited partnership status prevents LPs from being involved in the management of the fund, so GPs may take advantage of LPs.
Mechanisms to overcome potential agency problems:
Limited fund life
Reputation: if the GP steals from me today, I will not invest in his next fund
Compensation systems is designed to align the incentives of the GPs and LPs: GPs receive 20% of the fund’s profits
Mandatory distributions (when assets are sold proceeds should be distributed to the LPs, they cannot be reinvested), so no free cash flow problem
GPs commit 1% of the capital (could be sizable depending on the GP’s wealth)
Covenants (see next slide)
Restrictive Covenants in VC Agreements Description % of contacts Covenants relating to the management of the fund: Restrictions on size of investment in any one firm 77.8% Restrictions on use of debt by partnership 95.6% Restrictions on coinvestment by organization's earlier or later funds 62.2% Restrictions on reinvestment of partnerships capital gains 35.6% Covenants relating to the activities of the GPs: Restrictions on coinvestment by general partners 77.8% Restrictions on sale of partnership interests by general partners 51.1% Restrictions on fund-raising by general partners 84.4% Restrictions on addition of general partners 26.7% Covenants relating to the types of investments: Restrictions on investments in other venture funds 62.2% Restrictions on investment in public securities 66.7% Restrictions on investments in leveraged buyouts 60.0% Restrictions on investments in foreign securities 44.4% Restrictions on investments in other asset classes 31.1%
Rather than giving the entrepreneur all the money up front, VCs provide funding at discrete stages over time. At the end of each stage, prospects of the firm are reevaluated. If the VC discovers some negative information he has the option to abandon the project.
Staged capital infusion keeps the entrepreneur on a “short leash” and reduces his incentives to use the firm’s capital for his personal benefit and at the expense of the VCs.
As the potential conflict of interest between the entrepreneur and the VC increases, the duration of funding decreases and the frequency of reevaluations increases.