Topic 2: Venture Capital

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Topic 2: Venture Capital

  1. 1. Venture Capital Dr Jack Favilukis Room A357 j.favilukis@lse.ac.uk
  2. 2. Reading <ul><li>Much of today’s lecture is in the textbook: </li></ul><ul><ul><li>Chapter 16, “Handbook of Alternative Assets” by Mark J.P. Anson </li></ul></ul>
  3. 3. Outline <ul><li>What is VC and why is it different from other financial intermediation </li></ul><ul><li>Starting a VC fund and raising money </li></ul><ul><li>Valuing the Investment </li></ul><ul><li>Exiting the Investment </li></ul><ul><li>The client’s perspective </li></ul><ul><li>Good source on VC: “Venture Capital Cycle” by Paul Gompers and Josh Lerner </li></ul>
  4. 4. History <ul><li>In 1492 Queen Isabella of Spain agreed to finance Columbus’ exploration </li></ul><ul><ul><li>His venture was earlier rejected by competing VC’s Portugal, England, Genoa, and Venice </li></ul></ul><ul><li>She financed it by selling her jewlery </li></ul><ul><li>She received 90% of all future profits </li></ul><ul><ul><li>Her equity share was 90% </li></ul></ul><ul><li>Columbus received 10% of future profits </li></ul><ul><ul><li>He was also named CEO (Admiral of the Ocean Sea and appointed Viceroy and Governor of all the new lands) and option to buy 1/8 of any new venture in new lands </li></ul></ul><ul><ul><li>He was fired in 1500 (and arrested) </li></ul></ul>
  5. 5. Financing <ul><li>When you want to start a business or buy a house you oftentimes do not have enough money to pay the full cost </li></ul><ul><li>Option 1: You save, and save, and save and … save until you have enough money </li></ul><ul><ul><li>Many ventures will never get started </li></ul></ul><ul><ul><li>You might be 50 when you buy a house </li></ul></ul><ul><li>Option 2: You borrow money to finance the project </li></ul>
  6. 6. Financing <ul><li>Two major types of financing, debt and equity </li></ul><ul><li>Debt: You are the full owner of your house or project but you promise to pay back creditors some prespecified amount </li></ul><ul><ul><li>Monthly mortgage </li></ul></ul><ul><ul><li>Coupons on corporate debt </li></ul></ul><ul><li>Equity: Your creditor becomes your partner and owns a piece of your house or project </li></ul><ul><ul><li>Any cashflows from your project are split among all equity holders </li></ul></ul><ul><ul><li>Dividends and share repurchases </li></ul></ul><ul><ul><li>Equity holders typically have a say (vote) in how the firm is run </li></ul></ul>
  7. 7. Equity <ul><li>Public Equity: Shares of the firm are traded on a public market (NYSE, Nasdaq, LSE) </li></ul><ul><ul><li>Typically large number of dispersed shareholders </li></ul></ul><ul><ul><li>Typically liquid (easy to buy/sell) </li></ul></ul><ul><li>Private Equity: Pieces of firm (or part of firm) are owned by a small number of concentrated owners </li></ul><ul><ul><li>No liquid public market for shares, investment horizons up to 10 years </li></ul></ul><ul><ul><li>Asymmetric info problems for outsiders </li></ul></ul><ul><ul><li>Monitoring benefits for insiders </li></ul></ul>
  8. 8. Illiquidity <ul><li>Suppose there is a project which requires an initial investment of I=1 at t=1 </li></ul><ul><ul><li>You are risk neutral and appropriate interest rate is 10% </li></ul></ul><ul><li>It will pay 1.5 with certainty at t=3 </li></ul><ul><ul><li>NPV=-1+1.5/1.1 2 =.24 </li></ul></ul><ul><li>At t=1 you borrow 1 at 10% </li></ul><ul><li>At t=2 you owe 1.1, you refinance </li></ul><ul><ul><li>Borrow 1.1, use it to pay off initial debt </li></ul></ul><ul><li>At t=3 you owe loan from t=2, pay off 1.1*1.1=1.21 and are left with: </li></ul><ul><li>1.5-1.21=.29 profit  PV=.29/1.1 2 =.24=NPV </li></ul>
  9. 9. Illiquidity <ul><li>However, suppose there is a chance (33%) that no new financing is available at t=2 </li></ul><ul><ul><li>Liquidity crunch </li></ul></ul><ul><li>If a project is liquid, you sell it at t=2 for its present value 1.5/1.1=1.36 and use it to pay off creditors </li></ul><ul><li>You are left with 1.36-1.1=.26 </li></ul><ul><ul><li>Expected payout: .67*(.29/1.1 2 )+.33*(.26/1.1)=.24=NPV </li></ul></ul><ul><li>However, if project is illiquid you cannot sell it for its full value, you can only sell it for α *Value </li></ul><ul><ul><li>Perhaps you are the only one who can run it </li></ul></ul><ul><ul><li>Bank knows quality of loans it gave, but outside banks do not </li></ul></ul><ul><ul><li>Project’s value is correlated with market liquidity </li></ul></ul><ul><li>If α is low enough, you will never fund the project: </li></ul><ul><ul><li>Suppose α =.25, then in period 2 project is liquidated for .34 all of which goes to creditors </li></ul></ul><ul><ul><li>Creditors will not accept 10% interest rate, will ask for 1=(.67*(1+r)+.33*.34)/1.1  r=47% </li></ul></ul><ul><ul><li>If r=47%, at t=3 you will owe 1.47*1.1=1.62>1.5 </li></ul></ul><ul><li>Illiquidity is risky </li></ul>
  10. 10. Private Equity <ul><li>Venture Capital </li></ul><ul><ul><li>Financing of start ups </li></ul></ul><ul><ul><li>Eventual goal is IPO </li></ul></ul><ul><li>Leveraged Buyout (LBO) </li></ul><ul><ul><li>A small group (often insiders) buys out all of the public equity and takes the firm private </li></ul></ul><ul><ul><li>This is often financed by a large amount of debt </li></ul></ul><ul><ul><li>Often done to poorly run firms, firms taken public again after problems fixed </li></ul></ul><ul><li>Mezzanine Financing </li></ul><ul><ul><li>Mix of private debt and private equity </li></ul></ul><ul><li>Distressed Debt </li></ul><ul><ul><li>Private equity investment in established but troubled firms </li></ul></ul><ul><ul><li>If firm close to bankruptcy equity is cheap </li></ul></ul>
  11. 11. Young Firms <ul><li>Public Equity not a solution: </li></ul><ul><ul><li>No history so cost of learning whether firm is good/bad is high </li></ul></ul><ul><ul><li>Small, uninformed investors will not pay such a cost  Going public is infeasible </li></ul></ul><ul><li>Debt not a solution: </li></ul><ul><ul><li>Few assets and cannot provide collateral for loans </li></ul></ul><ul><ul><li>No CF for first few years so debt contract would have to be backloaded (not typically how debt works) </li></ul></ul><ul><ul><li>Info asymmetry leads to risk shifting problem </li></ul></ul>
  12. 12. Risk Shifting <ul><li>If young firm is financed with debt, its downside is limited but its upside is unlimited </li></ul><ul><li>It will want to take a lot of risk (increase option value) </li></ul><ul><li>Investors know this and ask for a higher stake in the firm to compensate for more risk, thus entrepreneurs receive less money </li></ul><ul><li>Equity does not have this problem </li></ul>
  13. 13. Risk Shifting <ul><li>You have two projects available </li></ul><ul><li>Safe/Good: Invest I=1 at t=1, receive 1.3 or 1.0 with p=.5 at t=2 </li></ul><ul><li>Risky/Bad: Invest I=1 at t=1, receive 2 or 0 with p=.5 at t=2 </li></ul><ul><li>Note Risky/Bad is riskier and has a lower expected value than Safe/Good </li></ul><ul><li>Risk neutrality and r=10% </li></ul>
  14. 14. Risk Shifting <ul><li>Suppose you have equity financing </li></ul><ul><ul><li>Promise share α to outside investors </li></ul></ul><ul><li>Safe/Good: </li></ul><ul><ul><li>1= α SG *(.5*1+.5*1.3)/1.1  α SG =.957 </li></ul></ul><ul><ul><li>Payoff: (1- α SG )*(.5*1+.5*1.3)/1.1=.045 </li></ul></ul><ul><li>Risky/Bad: </li></ul><ul><ul><li>1= α RB *(.5*2+.5*0)/1.1  α RB =1.1 </li></ul></ul><ul><ul><li>α >1 impossible, project not funded </li></ul></ul><ul><ul><li>Payoff=0 </li></ul></ul><ul><li>Tell investors Safe/Good but take Risky/Bad </li></ul><ul><ul><li>Payoff: (1- α SG )*(.5*2+.5*0)/1.1=.039<.045 </li></ul></ul><ul><li>With equity financing you choose the best project </li></ul>
  15. 15. Risk Shifting <ul><li>Suppose you have debt financing and you convince creditors you will take the Safe/Good project </li></ul><ul><ul><li>You must promise to pay face value F SG and creditors’ expected return should be 10% </li></ul></ul><ul><li>You told the truth </li></ul><ul><ul><li>1.1=.5F SG +.5*1  F SG =1.2, r SG =20% </li></ul></ul><ul><ul><li>Payoff: (.5*(1.3-F SG )+.5*0)/1.1=.045 </li></ul></ul><ul><li>You lied </li></ul><ul><ul><li>Payoff: (.5*(2-F SG )+.5*0)/1.1=.364>.045 </li></ul></ul><ul><li>When your obligation is fixed and your downside is limited you want to take on as much risk as possible </li></ul><ul><ul><li>In real world reputation may mitigate this problem </li></ul></ul>
  16. 16. Risk Shifting <ul><li>However, creditors will anticipate that firms may want to risk shift and will charge a higher interest rate </li></ul><ul><li>Creditors anticipate Risky/Bad chosen: </li></ul><ul><ul><li>1.1=.5F SG +.5*0  F SG =2.2, r SG =120% </li></ul></ul><ul><ul><li>But even in the good state, the project will not be valuable enough to pay this rate (same as saying NPV<0) </li></ul></ul><ul><ul><li>No project is funded! </li></ul></ul><ul><li>For young firms with high risk and little available info, debt and public equity face major problems </li></ul><ul><ul><li>Debt induces risk shifting </li></ul></ul><ul><ul><li>Info cost too high for small public investors </li></ul></ul><ul><ul><li>Private equity (VC) remains best option despite liquidity problems </li></ul></ul>
  17. 17. Venture Capital <ul><li>A single large shareholder has incentive to pay informational cost of learning firm quality </li></ul><ul><ul><li>VC’s often specialize in a sector (ie Biotech or Software) </li></ul></ul><ul><ul><li>Avoids free-rider problem </li></ul></ul><ul><li>VC has a vote and provides monitoring </li></ul><ul><ul><li>Avoids risk shifting problem </li></ul></ul>
  18. 18. Venture Capital <ul><li>VC’s finance high-risk, illiquid, unproven firms by purchasing senior equity stakes </li></ul><ul><li>For their services (monitoring) they often get high rates of return </li></ul><ul><li>Many of today’s biggest firms were once funded by VC’s (Cisco, Microsoft, Genentech) </li></ul>
  19. 19. Counterpoint <ul><li>The term VC (Venture Capitalist) is an oxymoron. It should be UB (Unadventurous Broker) especially in hard times. VCs today prefer to invest in products which are being developed by sedate, well entrenched companies. If that’s your company, VCs are a good source to approach for additional equity funding… have developed personality traits more akin to professional wrestlers than professional investors. </li></ul><ul><ul><li>“ Funding High Tech Ventures” Manweller (1997) </li></ul></ul>
  20. 20. Counterpoint <ul><li>VCs … take a company public while the ink is still drying on its incorporation papers. VCs would rather have you risk your money than risk their own. Besides, going public lets them profit now, rather than waiting. </li></ul><ul><ul><li>Washington Post (1997) </li></ul></ul>
  21. 21. Determinants of VC Activity <ul><li>Supply of Funds (to VC) </li></ul><ul><ul><li>Interest Rates </li></ul></ul><ul><ul><li>Cap Gains Taxes </li></ul></ul><ul><ul><li>General market performance </li></ul></ul><ul><ul><li>Outside opportunities </li></ul></ul><ul><li>Demand of Funds (from VC) </li></ul><ul><ul><li>R&D activity </li></ul></ul><ul><ul><li>GDP growth </li></ul></ul><ul><ul><li>Active stock market </li></ul></ul><ul><li>VC activity is positively related to R&D activity and job growth (cross-sectionally by state) </li></ul>
  22. 22. History of Venture Capital <ul><li>American Research and Development </li></ul><ul><li>Publically traded </li></ul><ul><ul><li>Shares of ARD traded publically </li></ul></ul><ul><ul><li>Firms owned by ARD are not traded publically </li></ul></ul><ul><li>Closed End Fund </li></ul><ul><ul><li>No new shares are created (closed to new capital injections) </li></ul></ul><ul><ul><li>Existing shares are not redeemable until fund liquidation </li></ul></ul><ul><li>Formed in 1946 by MIT and Harvard Professors to invest in broadcasting, aerospace, pharmaceuticals </li></ul><ul><ul><li>Most were WWII military innovations </li></ul></ul><ul><li>Small number of similar VC’s established over next 12 years </li></ul>
  23. 23. SIBC <ul><li>Small Business Investment Companies </li></ul><ul><li>SIBC program created by US congress in 1958 to help entrepreneurs </li></ul><ul><li>Must have at least $5M in private capital, >30% from sources unaffiliated with management </li></ul><ul><li>Must have “qualified management” </li></ul><ul><li>May receive leverage up to 300% of private capital </li></ul><ul><ul><li>Ex: $5M in private capital + $10M in loans from Gov’t  $15M to invest </li></ul></ul><ul><ul><li>Interest rate subsidized by Gov’t </li></ul></ul><ul><li>Must provide loans and/or equity to qualified (value creating) small businesses </li></ul>
  24. 24. SIBC <ul><li>Firms funded by SIBC’s grow faster than otherwise similar firms over the next decade </li></ul><ul><li>They are more likely to attract VC financing </li></ul><ul><li>However superior performance confined to regions with high VC activity </li></ul><ul><li>Furthermore, size of SIBC subsidy was not a determinant in performance </li></ul><ul><li>This suggests SIBC’s play an important monitoring/certification function </li></ul>
  25. 25. History of Venture Capital <ul><li>1979: change in rules allowed pension funds to have VC’s and other high risk investments (hedge funds) in their portfolio </li></ul><ul><ul><li>“ Gatekeeper” consultant who helps PF find appropriate VC investment </li></ul></ul><ul><li>VC financing $1.5B (1980)  $5B (1987) </li></ul><ul><ul><li>Industry term: “committed capital” </li></ul></ul><ul><li>Down to $2.5B in 1991 (recession) </li></ul><ul><li>$100B in 2000 (1990’s expansion, Al Gore invents internet, eToys.com) </li></ul><ul><li>$20B in 2000’s (Tech Bubble Crash) </li></ul><ul><li>Even at peak, VC investment was 1% of US GDP and 5% of total US investment </li></ul>
  26. 26. Venture Capital Investing <ul><li>Figure 16.1 in textbook </li></ul>
  27. 27. Limited Liability <ul><li>Typical of U.S. corporations (LLC) </li></ul><ul><li>Investors cannot be asked to contribute more than what they have already put in </li></ul><ul><ul><li>I buy $1M worth of OnlineCasino.com </li></ul></ul><ul><ul><li>I now own 20% of its shares ($5M Mkt Cap) </li></ul></ul><ul><ul><li>Joe College gambles away his tuition and whines to Congress </li></ul></ul><ul><ul><li>Court awards $100M in punitive damages to Joe </li></ul></ul><ul><ul><li>I lose my $1M but cannot be asked to contribute more </li></ul></ul>
  28. 28. Limited Partnership <ul><li>Most private equity firms today are limited partnerships (80%) </li></ul><ul><li>Draper, Gaither, and Anderson was the first VC LP (1958) </li></ul><ul><li>GP’s have joint liability for the partnership </li></ul><ul><ul><li>Debts, lawsuits, etc. </li></ul></ul><ul><ul><li>More risk for GP but signals GP is serious and committed </li></ul></ul><ul><ul><li>No corporate tax on partnerships </li></ul></ul><ul><li>LP’s have limited liability </li></ul><ul><ul><li>Cannot lose more than initial investment </li></ul></ul><ul><ul><li>Are promised some rate of return </li></ul></ul><ul><ul><li>Commit initial investment but are not asked to contribute until called (when VC finds investment) </li></ul></ul><ul><li>This makes it easier for VC to raise money </li></ul>
  29. 29. Corporate Venture Capital Fund <ul><li>Many large firms created their own VC funds </li></ul><ul><ul><li>Often (but not always) to nurture and bring to market internally developed ideas </li></ul></ul><ul><ul><li>Parent company’s capital only </li></ul></ul><ul><li>Intel started Intel Capital which focuses on the Internet Economy </li></ul><ul><ul><li>1991-2005: $4B invested in 1000 companies </li></ul></ul><ul><ul><li>160 acquired, 150 IPO’d </li></ul></ul><ul><li>Microsoft, Xerox, Hewlett-Packard, Amaco, Oracle are some of the other big names </li></ul><ul><li>Universities (MIT, Stanford) have done this too </li></ul>
  30. 30. Xerox and XTV <ul><li>Xerox committed $30M to subsidiary XTV which would invest in promising technologies developed by Xerox </li></ul><ul><ul><li>Desired rates of return above VC rates and above Xerox’s IRR </li></ul></ul><ul><li>XTV had relative autonomy within Xerox and compensation similar to VC </li></ul><ul><li>Investment projects were separate entities, had own board </li></ul><ul><li>In long run Xerox planned to hold 20-50% stake </li></ul>
  31. 31. Corporate Venture Capital Fund <ul><li>Possible conflicts of interest between parent and subsidiary </li></ul><ul><li>10 year horizon (and illiquidity) may be too long for short term profits required by public shareholders </li></ul><ul><li>Increased risk of loss (doubling down) </li></ul><ul><ul><li>VC already operates in parent’s main line of business </li></ul></ul><ul><ul><li>Dell lost $200M in 2001 on Dell Ventures in addition to $1B on its general investment portfolio </li></ul></ul>
  32. 32. Raising Funds <ul><li>VC is typically the GP and outside investors are LPs </li></ul><ul><li>GP has full authority to manage the fund subject to covenants </li></ul><ul><ul><li>Covenants are restrictions put on the manager in charter </li></ul></ul><ul><ul><li>These restrict the GP from expropriating from the LPs </li></ul></ul><ul><li>If these covenants did not exist then LPs would be less likely to invest with GP </li></ul><ul><ul><li>Thus GP is actually better off from installing the covenants even though they are restricting him ex-post </li></ul></ul>
  33. 33. Covenants on Overall Fund Management <ul><li>Limit on amount invested in any one firm </li></ul><ul><ul><li>Prevents GP from throwing good money after bad </li></ul></ul><ul><ul><li>GP typically paid after LP so has incentive to risk shift </li></ul></ul><ul><li>Limits use of debt </li></ul><ul><ul><li>Debt allows higher leverage so higher volatility so again risk shifting </li></ul></ul><ul><li>Directs reinvestment of profits </li></ul><ul><ul><li>Board or LPs must approve profits being reinvested rather than distributed </li></ul></ul>
  34. 34. Covenants on GPs Activity <ul><li>Limit on investing personal funds in firm </li></ul><ul><ul><li>Otherwise might devote too much time in that firm or refuse to pull the plug </li></ul></ul><ul><ul><li>Typically GP can invest in underlying portfolio only in same proportion as full fund </li></ul></ul><ul><li>Limit on selling personal interests </li></ul><ul><ul><li>Otherwise GPs incentives to work hard reduced </li></ul></ul><ul><li>Limit on future fundraising and outside interests </li></ul><ul><ul><li>Keep GPs focus solely on running fund </li></ul></ul>
  35. 35. Covenants on Types of Investments <ul><li>Aimed to keep GP focused on investing in areas he knows and has promised to invest in </li></ul><ul><li>Typically restrictions on investing in LBOs, other VCs, FX, certain industries, etc. </li></ul>
  36. 36. Determinants of Covenants <ul><li>Gompers and Lerner regressed the number of covenants on various characteristics and found that: </li></ul><ul><ul><li>Managers with high pay performance sensitivity face fewer covenants (PPS is a substitute) </li></ul></ul><ul><ul><li>When VC activity is high there are fewer covenants (GP has more bargaining power) </li></ul></ul>
  37. 37. Sources of Funding <ul><li>1985-1990: Pension funds accounted for 70% of VC funding, Gov’t 11% </li></ul><ul><li>2005: Pension funds are 50% of funds, private sources make up the rest </li></ul><ul><ul><li>Endowments (ie Universities) </li></ul></ul><ul><ul><li>Wealthy individuals </li></ul></ul><ul><ul><li>Hedge Funds, Funds of Funds, etc </li></ul></ul>
  38. 38. Sources of VC funds <ul><li>Figure 16.4 in textbook </li></ul>
  39. 39. Compensation <ul><li>Two types of fees, management and percent of profits </li></ul><ul><li>Management </li></ul><ul><ul><li>Fixed fee, irrespective of how well VC performs </li></ul></ul><ul><ul><li>1%-3.5% of committed capital (not invested capital!) </li></ul></ul><ul><li>Percent of Profit </li></ul><ul><ul><li>20% for most funds, 35% for best funds </li></ul></ul><ul><ul><li>If VC’s investments go bust, GP loses nothing (except reputation) </li></ul></ul><ul><ul><li>Strong incentive to risk shift (increase volatility) </li></ul></ul>
  40. 40. Compensation <ul><li>Clawback provision: LPs can claim back previously paid incentive fees if at end of fund LPs did not earn some prespecified amount of money </li></ul><ul><li>Escrow agreement: portion of VC’s incentive fees held in separate account until fund is liquidated </li></ul><ul><li>Timing of Distribution: Profit sharing fees cannot be distributed until after all committed capital is paid back to LPs. </li></ul><ul><ul><li>Year 3: fund receives first profits and pays them to LPs </li></ul></ul><ul><ul><li>Year 5: LPs initial investment fully paid </li></ul></ul><ul><ul><li>Year 6: All future profits paid out, 80% to LPs and 20% to GP </li></ul></ul><ul><li>Note that hedge funds do not have such profit sharing covenants </li></ul>
  41. 41. Risk Shifting <ul><li>You are a fund manager and have raised $100M </li></ul><ul><ul><li>Your pay package is standard: $200K/year salary, 1.5% of managed funds, 20% of all profits </li></ul></ul><ul><li>You have two available projects </li></ul><ul><ul><li>A: I=100M, pays 200M or 150M with p=50% </li></ul></ul><ul><ul><li>B: I=100M, pays 1B with p=40%, 0 otherwise </li></ul></ul><ul><ul><li>For simplicity, these payoffs are net of your salary and fees </li></ul></ul><ul><ul><li>Note B has higher expected payoff (400M to 175M) but also higher risk </li></ul></ul><ul><li>Your utility function is p*(W L ) .5 +(1-p)*(W H ) .5 </li></ul><ul><ul><li>Utility over final period wealth only </li></ul></ul><ul><ul><li>LP’s have the same utility </li></ul></ul><ul><li>For simplicity assume no information available on project success until fund closes in year 7 </li></ul>
  42. 42. Risk Shifting <ul><li>Your salary and fees are: .2*7+.015*100=2.9 </li></ul><ul><li>If you choose A: </li></ul><ul><ul><li>With 50% prob: 2.9+.2*200=42.9 </li></ul></ul><ul><ul><li>With 50% prob: 2.9+.2*150=32.9 </li></ul></ul><ul><ul><li>With 50% prob LP’s receive: .8*200=160 </li></ul></ul><ul><ul><li>With 50% prob LP’s receive: .8*150=120 </li></ul></ul><ul><li>If you choose B: </li></ul><ul><ul><li>With 40% prob: 2.9+.2*1000=202.9 </li></ul></ul><ul><ul><li>With 60% prob: 2.9+.2*0=2.9 </li></ul></ul><ul><ul><li>With 40% prob LP’s receive: .8*1000=800 </li></ul></ul><ul><ul><li>With 60% prob LP’s receive: .8*0=0 </li></ul></ul><ul><li>Your utility: </li></ul><ul><ul><li>A: .5*42.9 5 +.5*32.9 5 =6.14 </li></ul></ul><ul><ul><li>B: .4*202.9 5 +.6*2.9 5 =6.72 > 6.14 </li></ul></ul><ul><li>LP’s utility: </li></ul><ul><ul><li>A: .5*160 5 +.5*120 5 =11.80 </li></ul></ul><ul><ul><li>B: .4*800 5 +.5*0 5 =11.31 < 11.80 </li></ul></ul><ul><li>You choose to take on much more risk than LP’s prefer </li></ul>
  43. 43. Compensation <ul><li>The Learning (Effort) Model </li></ul><ul><ul><li>VC raises two funds, one after another </li></ul></ul><ul><ul><li>Investors cannot observe VC’s effort but can observe outcome (which depends on effort and luck) </li></ul></ul><ul><li>Pay Performance Sensitivity higher in VC’s 2 nd fund </li></ul><ul><ul><li>VC must work very hard in 1 st fund to develop reputation  no need for high PPS </li></ul></ul><ul><li>Level of PPS (across funds) unrelated to performance </li></ul><ul><ul><li>Young funds have low PPS but high effort while older funds need higher PPS to produce high effort </li></ul></ul><ul><ul><li>Must control for age of fund to see relationship between PPS and performance </li></ul></ul>
  44. 44. Compensation <ul><li>The Signaling Model (no effort for simplicity) </li></ul><ul><ul><li>VC has private info about personal ability before entering contract with outside investors </li></ul></ul><ul><ul><li>Good VC wishes to signal ability to outside investors </li></ul></ul><ul><ul><li>Pay takes form of Q t =A+B*X t where X t is performance of underlying projects </li></ul></ul><ul><li>Good VCs agree to higher PPS in first fund (high B) </li></ul><ul><ul><li>This means they get paid a lot when investments do well, very little when investments do poorly </li></ul></ul><ul><ul><li>Good VC willing to do this because he knows X t likely to be high, in return outsiders give him high A </li></ul></ul><ul><ul><li>Bad VC unwilling to do this because he knows X t likely to be low, outsiders give him a low A </li></ul></ul><ul><li>In second fund PPS will be low since types already revealed </li></ul><ul><li>Real world likely to have both effort and asymmetric info effects, which is stronger? </li></ul>
  45. 45. Compensation <ul><li>Table from Gompers and Lerner </li></ul>
  46. 46. Compensation <ul><li>Note that older funds tend to have higher PPS and lower fixed pay </li></ul><ul><ul><li>Learning (Reputation and Effort) effect dominates </li></ul></ul><ul><li>Gompers and Lerner find no relationship between PPS and ex-post success </li></ul><ul><ul><li>Consistent with learning but not signaling model </li></ul></ul><ul><ul><li>Not in above table </li></ul></ul><ul><li>On average PPS has been falling </li></ul><ul><ul><li>Perhaps supply of funds to VC’s has grown, given VC’s more bargaining power over compensation? </li></ul></ul><ul><li>High technology and early stage funds have higher base compensation </li></ul><ul><ul><li>Compensation for higher risk? </li></ul></ul><ul><li>Older, larger (reputable) funds receive larger capital commitments than similar younger funds </li></ul><ul><ul><li>Sirri and Tufano (1998) </li></ul></ul>
  47. 47. Compensation <ul><li>Preferred shares </li></ul><ul><ul><li>Typically senior to common shares in liquidation of assets </li></ul></ul><ul><ul><li>Often have some guaranteed dividend </li></ul></ul><ul><ul><li>May have stronger or weaker voting rights </li></ul></ul><ul><li>Convertible preferred shares </li></ul><ul><ul><li>Preferred shares that can be converted into prespecified number of common shares </li></ul></ul><ul><ul><li>Can be done any time but cannot be undone </li></ul></ul><ul><li>Convertible debentures </li></ul><ul><ul><li>Bond (>10 years maturity) that can be converted into shares in some prespecified amount </li></ul></ul>
  48. 48. Agency Costs <ul><li>With risk shifting we saw that when compensation involves too much equity, GP has incentives to take on too much risk </li></ul><ul><li>However, when there is not enough incentive based compensation (equity, options), other problems arise: </li></ul><ul><ul><li>Managers receive perks from firm (private jet, 5 assistants, bodyguards) even if it is very costly to the firm and unnecessary </li></ul></ul><ul><ul><li>Empire building: managers like to feel very important, may acquire lots of projects so that they are in charge of large empire, even when projects are unprofitable </li></ul></ul><ul><ul><li>This would not occur if compensation was highly dependent on bottom line since corporate jet or unprofitable project doesn’t just cost LP but also GP </li></ul></ul><ul><li>In general, it is a very fine line between the dangers of too much incentive based compensation (risk shifting) and too little (lack of effort, perks, empire building) </li></ul>
  49. 49. J-Curve <ul><li>Figure 16.7 </li></ul>
  50. 50. VC Lifecycle <ul><li>Stage 1: Fund Raising </li></ul><ul><ul><li>Capital committed, not collected </li></ul></ul><ul><li>Stage 2: Looking for Investments </li></ul><ul><ul><li>Fund is closed to new capital </li></ul></ul><ul><ul><li>Losses, not profits (costs of operation, fees) </li></ul></ul><ul><li>Stage 3: Investment of Capital </li></ul><ul><ul><li>How much to each start-up? </li></ul></ul><ul><ul><li>What type of financing (convertible preferred shares, convertible debentures, etc)? </li></ul></ul><ul><li>Stage 4: Monitoring and Managing Portfolio </li></ul><ul><ul><li>VC works with investments </li></ul></ul><ul><ul><li>Improves management team, consults, positions firm for resale </li></ul></ul><ul><ul><li>Positive cash flows begin </li></ul></ul><ul><li>Stage 5: Liquidation </li></ul><ul><ul><li>Assets sold off to private or public (IPO) buyers, or liquidated (Chapter 7 bankruptcy) </li></ul></ul>
  51. 51. Stages of Investment <ul><li>Angel Investor </li></ul><ul><li>Seed Capital </li></ul><ul><li>Early Stage Venture Capital </li></ul><ul><li>Late Stage Venture Capital </li></ul><ul><li>Mezzanine Stage </li></ul><ul><li>If at some stage product proves to be not viable, no more financing at later stages, what can be sold off is sold off and VC cuts losses </li></ul><ul><li>Valuation is analogous to real options framework </li></ul>
  52. 52. Angel Investor <ul><li>An investor who provides financing to entrepreneur at a very early stage </li></ul><ul><ul><li>Your mom </li></ul></ul><ul><ul><li>Wealthy individuals who like start-ups </li></ul></ul><ul><li>Agreement may be formal or informal but typically angel investor is promised some equity </li></ul><ul><li>Amount typically small ($50K-$500K) </li></ul><ul><li>This allows entrepreneur to begin development </li></ul><ul><li>Mike Markkula lent $250K to Steve Jobs and Steve Wozniak in 1977 </li></ul><ul><ul><li>$170K loan + $80K for 1/3 of Apple’s Equity </li></ul></ul><ul><ul><li>This allowed them to build first few prototypes </li></ul></ul>
  53. 53. Marc Cuban Stimulus Plan <ul><li>http://blogmaverick.com/2009/02/09/the-mark-cuban-stimulus-plan-open-source-funding/ </li></ul><ul><li>It can be an existing business or a start up. </li></ul><ul><li>It can not be a business that generates any revenue from advertising. Why? Because I want this to be a business where you sell something and get paid for it. Thats the only way to get and stay profitable in such a short period of time. </li></ul><ul><li>It MUST BE CASH FLOW BREAK EVEN within 60 days  </li></ul><ul><li>It must be profitable within 90 days. </li></ul><ul><li>Funding will be on a monthly basis. If you dont make your numbers, the funding stops </li></ul><ul><li>You must demonstrate as part of your plan that you sell your product or service for more than what it costs you to produce, fully encumbered </li></ul><ul><li>Everyone must work. The organization is completely flat. There are no employees reporting to managers. There is the founder/owners and everyone else </li></ul><ul><li>You must post your business plan here, or you can post it on slideshare.com, scribd.com or google docs, all completely public for anyone to see and/or download </li></ul><ul><li>I make no promises that if your business is profitable, that I will invest more money. Once you get the initial funding you are on your own </li></ul><ul><li>I will make no promises that I will be available to offer help. If I want to, I will. If not, I wont </li></ul><ul><li>If you do get money, it goes into a bank that I specify, and I have the ability to watch the funds flow and the opportunity to require that I cosign any outflows </li></ul><ul><li>In your business plan, make sure to specify how much equity I will receive or how I will get a return on my money </li></ul>
  54. 54. Use of Venture Capital <ul><li>Figure 16.5 in textbook </li></ul>
  55. 55. Specialization <ul><li>By Industry: </li></ul><ul><ul><li>Biotech, Healthcare, Telecom, Software, Financial, Renewable Energy, etc </li></ul></ul><ul><li>By Region: </li></ul><ul><ul><li>Certain regions have amassed concentrations of new technology (Silicon Valley – Software, Southern California – Biotech) and VC’s find it convenient to concentrate on a particular region </li></ul></ul><ul><ul><li>Easier to monitor capital but may lack diversification </li></ul></ul><ul><li>Turnarounds: </li></ul><ul><ul><li>Buy near failed start-ups from other VC’s </li></ul></ul><ul><ul><li>High risk since firm is likely to be bad </li></ul></ul><ul><ul><li>However firm bought at a deep discount </li></ul></ul>
  56. 56. Seed Capital <ul><li>This is the first stage where VC’s invest capital with a start-up </li></ul><ul><li>Business Plan is created, parts of management team assembled </li></ul><ul><li>$1M-$5M provided to complete development, begin marketing </li></ul><ul><li>Prototype maybe complete and testing with customers may have began </li></ul><ul><ul><li>“ Beta Testing” product sent to potential customers for free, they provide input </li></ul></ul><ul><li>Little or no revenue, start-up still a long shot at this point </li></ul><ul><li>Technology Venture Investors, Advanced Technology Ventures, Onsent </li></ul>
  57. 57. The Business Plan <ul><li>Start up submits a plan to VC based on which VC decides whether to fund start up </li></ul><ul><li>States business strategy, niche firm will fill, resources needed </li></ul><ul><li>Provides qualifications of management team </li></ul><ul><li>Assumptions about revenue growth, cash-burn rate, additional financing rounds, timing/value of future IPO </li></ul>
  58. 58. The Business Plan
  59. 59. The Business Plan
  60. 60. Executive Summary <ul><li>The Market </li></ul><ul><li>The Product/Service </li></ul><ul><li>Intellectual Property Rights </li></ul><ul><li>The Management Team </li></ul><ul><li>Operations and Prior Operating History </li></ul><ul><li>Financial Projections </li></ul><ul><li>Amount of Financing </li></ul><ul><li>Exit Opportunities </li></ul>
  61. 61. The Market <ul><li>Is there an existing market? If so opportunity exists but is there too much competition? If not is there demand for product? </li></ul><ul><li>How is product better than competitors? Compare products, including price, quality, warranty, ease of use, distribution, audience </li></ul><ul><li>Pricing: If product is new can start out with high price. Will competition erode future prices? What are expected margins </li></ul><ul><li>Distribution: Wholesalers, retailers, internet, direct sales? Size/cost of sales team? Help desk? Discount to wholesalers? </li></ul><ul><li>Marketing: Trade shows, Internet, Mass media, tie-ins to other products. Audience? Cost of advertising </li></ul>
  62. 62. Executive Summary <ul><li>Product/Service: </li></ul><ul><ul><li>What makes this unique or better than competitors? </li></ul></ul><ul><ul><li>New, lower price, higher quality? </li></ul></ul><ul><ul><li>Address long term future, 2 nd generation </li></ul></ul><ul><li>Intellectual Property Rights: </li></ul><ul><ul><li>Does the startup own full rights to its technology? </li></ul></ul><ul><ul><li>If firm merely owns license it is not as good as license can expire </li></ul></ul><ul><ul><li>Other erosions of intellectual rights: expirty of patents, software piracy, etc </li></ul></ul><ul><ul><li>Non-disclosure and non-competition agreements for employees </li></ul></ul>
  63. 63. Executive Summary <ul><li>Management Team </li></ul><ul><ul><li>All skills covered? marketing, technology, finance, operations </li></ul></ul><ul><ul><li>Academic backgrounds, professional work, references, arrests, facebook </li></ul></ul><ul><ul><li>Good plan with bad team  VC can add value </li></ul></ul><ul><li>Prior History </li></ul><ul><ul><li>Already existing operations </li></ul></ul><ul><ul><li>Barriers of entry </li></ul></ul><ul><ul><li>Legal standing, charter, by-laws </li></ul></ul><ul><ul><li>Existing Investors: Employees, family, angel investors. Each equity stake must be clearly defined </li></ul></ul>
  64. 64. Executive Summary <ul><li>Financial Projections </li></ul><ul><ul><li>All existing income and balance sheet statements and cash flow projections </li></ul></ul><ul><ul><li>Sales forecasts, cost of goods sold, marketing and other costs, margins </li></ul></ul><ul><ul><li>Cash flow statement: how fast is firm using up cash (burn rate) </li></ul></ul><ul><ul><li>When will breakeven point occur? </li></ul></ul><ul><ul><li>Several possible future scenarios </li></ul></ul><ul><li>Amount of Financing </li></ul><ul><ul><li>How much money is needed? </li></ul></ul><ul><ul><li>Financing requested must equal future financial needs (burn rate) + some slack </li></ul></ul>
  65. 65. Accounting <ul><li>Depreciation is not real! </li></ul><ul><ul><li>Don’t confuse it with the way depreciation is used in economics, which is real </li></ul></ul><ul><li>It is a concept made up for accounting purposes and cannot affect total cash flow </li></ul><ul><li>However it can affect your cash flow because it is tax deductable </li></ul><ul><li>EBIT=Revenue-Cost-Depreciation </li></ul><ul><li>CF = EBIT*(1-T)+Dep </li></ul><ul><li>= (Rev-Cost)*(1-T)-Dep*(1-T)+Dep </li></ul><ul><li>= (Rev-Cost)*(1-T)+T*Dep </li></ul><ul><ul><li>There are other things (such as Capital Expenditure) that go into the CF calculation but we are ignoring them for simplicity </li></ul></ul>
  66. 66. Income and Cash Flow Statements
  67. 67. Balance Sheet
  68. 68. Early Stage VC <ul><li>$2M and more </li></ul><ul><li>Start up already has viable product </li></ul><ul><li>Some price may already be charged for product </li></ul><ul><li>Revenue Generated but start-up still not profitable </li></ul><ul><li>This financing is used to build commercial scale manufacturing services and grow market share </li></ul>
  69. 69. Present Value <ul><li>The value of any project (or firm) is the present value of all future cashflows coming from that project </li></ul><ul><li>The present value of future cash flows must be discounted at an appropriate discount rate </li></ul><ul><ul><li>If you can put money in a savings account at 2%, then $1.02 next year is worth $1 today </li></ul></ul><ul><ul><li>Similarly 1.02 2 =$1.04 in 2 years, or 1.02 3 =$1.061 in 3 years, or $1.02 T in T years are all worth $1 today </li></ul></ul><ul><li>A project that costs $1 to implement today and will pay $.5 next year and $.6 the following year is worth </li></ul><ul><li>-1+.5/R+.6/R 2 =.0669 if R=1.02 (2% discount rate) </li></ul>
  70. 70. Present Value <ul><li>A project that pays D every year starting next year is worth: </li></ul><ul><ul><li>D/(R-1)=D/r </li></ul></ul><ul><li>A project that pays D next year, D(1+g) the following year, D(1+g) 2 the year after, and so on is worth: </li></ul><ul><ul><li>D/(r-g) </li></ul></ul><ul><ul><li>This is the Gordon Growth Model </li></ul></ul>
  71. 71. Valuation <ul><li>Step 1: Estimate the VC’s exit date </li></ul><ul><li>Step 2: Forecast cash flows to equity until the exit date </li></ul><ul><li>Step 3: Estimate the exit price, use it as terminal value (TV). </li></ul><ul><li>Step 4: Choose a discount rate </li></ul><ul><li>VC discount rates are typically very high </li></ul><ul><li>Step 5: Discount CF and TV using this discount rate </li></ul><ul><li>Step 6: Determine the VC’s stake in the company </li></ul>
  72. 72. Valuation
  73. 73. Valuation <ul><li>Cyberdyne Systems projects its Skynet will have $30M operating income in 2015 and will grow at 2% per year </li></ul><ul><li>This requires an initial investment of $120M in 2010 </li></ul><ul><li>The appropriate discount rate is 15% per year </li></ul><ul><li>For simplicity there are no taxes or additional expenses after 2014 so Net Income is fully paid out as a dividend </li></ul><ul><li>The present value as of 2014 is: </li></ul><ul><ul><li>TV=30/(.15-.02)=$230.77M </li></ul></ul>
  74. 74. Valuation <ul><li>Suppose there is an IPO in 2014 where 100% of the firm is sold off for $230.77 </li></ul><ul><ul><li>Assumption about type of final payout does not matter, only value does </li></ul></ul><ul><li>The present value as of 2010 is: </li></ul><ul><ul><li>PV(TV)=230.77/1.15 4 =$131.94 </li></ul></ul><ul><li>The Net Present Value is: </li></ul><ul><ul><li>-120+131.94=$11.94M </li></ul></ul>
  75. 75. Valuation <ul><li>Post-Money Value: Firm value after the VC has injected funds </li></ul><ul><ul><li>Post-money value = Pre-money value + VC Investment </li></ul></ul><ul><ul><li>This is what an investor would pay for the firm once it is up and running </li></ul></ul><ul><li>Post-funding, VC’s stake is worth a fraction α of the post-money value. For an equity stake the VC should be willing to pay: </li></ul><ul><ul><li>(VC Investment) = α *(Post-Money Value) </li></ul></ul><ul><li>This implies that the VC’s stake is: </li></ul><ul><ul><li>α =(VC Investment)/(Post-Money Value) </li></ul></ul>
  76. 76. Valuation <ul><li>Cyberdyne Systems approaches John Connor Capital with a request for funding </li></ul><ul><li>John Connor knows that after the initial investment is made, Cyberdyne will be worth $131.94, thus to he asks for a share α =120/131.94=90.95% stake in the firm </li></ul><ul><ul><li>This share makes it worth his while to invest </li></ul></ul><ul><ul><li>In a competitive market he cannot ask for more since other VC’s would agree to 90.95% </li></ul></ul><ul><li>Cyberdyne’s initial investors will keep 9.05% which is valued at .0905*131.94=$11.94M </li></ul><ul><ul><li>Note this is equal to NPV </li></ul></ul><ul><ul><li>If NPV<0 then α >100% and this project is unfundable </li></ul></ul><ul><li>Cyberdyne creates 10000 Class A shares, gives 9095 to John Connor, and keeps 905 for the founders </li></ul>
  77. 77. Valuation <ul><li>An alternative to NPV method is the multiples method </li></ul><ul><li>Union Aerospace Corporation has operating income of $200M and a market cap of $1.6B </li></ul><ul><ul><li>UAC has a similar business model to Cyberdyne </li></ul></ul><ul><ul><li>UAC is 100% equity (otherwise we must take account of the tax advantages of debt) </li></ul></ul><ul><li>UAC’s Value to EBIT is: 1600/200=8 </li></ul><ul><li>Since Cyberdyne is similar, we can assume it will also trade at same multiple once it goes public </li></ul><ul><li>Cyberdyne’s EBIT in 2014 is 30 so its value in 2014 (TV) should be 30*8=$240M </li></ul><ul><ul><li>Could use this instead of $230.77 in earlier slide </li></ul></ul><ul><li>Multiple method works well because it incorporates market beliefs instead of relying on CF and discount rate forecasts. However: </li></ul><ul><ul><li>What if market is wrong? </li></ul></ul><ul><ul><li>What if Cyberdyne is not similar to UAC? </li></ul></ul>
  78. 78. Late Stage VC <ul><li>$5M-$15M </li></ul><ul><li>By now start-up may have experienced first profitable quarter, product is likely to be commercially viable </li></ul><ul><li>However firm still vulnerable, needs additional cash infusions for stable profitability and to reach potential </li></ul><ul><li>Attract new talent, expand manufacturing, improve distribution channels, etc </li></ul><ul><li>Often firm has large A/R but needs cash immediately to grow </li></ul>
  79. 79. Late Stage VC <ul><li>Note that the amount of financing is getting bigger at each stage </li></ul><ul><li>However, only the best firms have made it to this stage </li></ul><ul><ul><li>Bad ideas dropped out early </li></ul></ul><ul><li>Once the idea has proven to be good, it makes sense to increase its scale </li></ul><ul><ul><li>This costs more money </li></ul></ul><ul><ul><li>Real options: Option to expand </li></ul></ul>
  80. 80. Late Stage VC <ul><li>The angel investor who contributed $100K may at this point have the same number of shares as a VC who contributed $15M </li></ul><ul><ul><li>Early investor took a chance, got in on the ground floor </li></ul></ul><ul><li>Consider a situation where an initial $100K allowed the inventor to create a project with NPV=$15M </li></ul><ul><ul><li>Angel and inventor own 50% each </li></ul></ul><ul><ul><li>NPV=PV(Rev)-Cost(Factory)=$30M-$15M </li></ul></ul><ul><li>Inventor and Angel still only have an idea </li></ul><ul><ul><li>A very valuable idea </li></ul></ul><ul><li>VC contributes $15M for factory </li></ul><ul><ul><li>Post-Money Value: $30M  VC share 50% </li></ul></ul><ul><li>Angel investor contributed $.1M and owns 25% </li></ul><ul><li>Late stage investments are relatively less risky, but earn lower expected returns </li></ul>
  81. 81. <ul><li>Oct 2007: Microsoft paid $240M for 1.6% stake of Facebook </li></ul><ul><li>This implies Microsoft thinks Facebook is worth 240/.016=$15B </li></ul><ul><ul><li>Note this is a private valuation, it could be Facebook’s future cashflows are not worth $15B, but Microsoft+Facebook creates synergies </li></ul></ul><ul><li>Marc Zuckerberg’s 20% stake estimated at .2*$15B=$3B </li></ul><ul><ul><li>Note illiquidity of his investment, it is highly unlikely he can sell his shares for $3B at this time </li></ul></ul><ul><li>Accel Partners invested $12.7M for 11% in May 2005, stake now worth $1.65B </li></ul><ul><li>Facebook promises to use money for doubling workforce and expanding internationally </li></ul>
  82. 82. Mezzanine Stage <ul><li>$5M-$15 </li></ul><ul><li>Final stage before IPO or strategic sale </li></ul><ul><li>Start-up is now fairly grown, with solid management team, proven product but further growth aspirations </li></ul><ul><li>Financing needed to keep firm from running out of cash before IPO </li></ul><ul><li>Often in form of convertible debt </li></ul><ul><li>Regular bank debt often added at this stage </li></ul><ul><li>Note: during tech bubble, many firms far from ready (who later proved to be disasters) were quickly brought through all stages </li></ul>
  83. 83. Financing <ul><li>Average early stage investment $1.3M-$2M smaller than comparable late stage investment </li></ul><ul><ul><li>Greater investment needed to expand firm </li></ul></ul><ul><ul><li>Expenditure justified by higher probability of success </li></ul></ul><ul><li>Firms that end up going public receive $3M-$5M more than firms that stay private, also receive more financing rounds </li></ul><ul><ul><li>VC’s gather info about potential profitability </li></ul></ul><ul><ul><li>Project funded only if potential to go public </li></ul></ul><ul><ul><li>Otherwise VC searches for corporate buyer or liquidates firm </li></ul></ul>
  84. 84. Financing <ul><li>Firms in industries with more tangible assets receive less VC financing </li></ul><ul><ul><li>Less informational asymmetry </li></ul></ul><ul><ul><li>Easier to get alternate financing (ie bank debt) </li></ul></ul><ul><li>Firms in industries with high M/B ratios, R&D intensive industries receive more VC financing </li></ul><ul><li>Most important determinant of total VC financing is number of financing rounds </li></ul><ul><ul><li>Correlation, not necessarily causation </li></ul></ul>
  85. 85. Quick Question <ul><li>A biotech start-up is developing a new drug which will be finished in 4 years </li></ul><ul><ul><li>With 50% probability a competitor will develop the drug first rendering the start-up worthless </li></ul></ul><ul><ul><li>With 50% probability no competitor succeeds and the drug is sold to Merck for $100M </li></ul></ul><ul><li>The appropriate discount rate is 25% </li></ul><ul><li>Start up asks you to invest $25M, what share of equity do you ask for? What if its only $15M? </li></ul>
  86. 86. Quick Question <ul><li>The expected present value is V=.5*100/1.25 4 = 20.48M </li></ul><ul><li>Let α be the share of equity you receive </li></ul><ul><li>Even if you were offered α =100% you would only receive 20.48M which is smaller than $25M so for no amount of equity would you invest $25M </li></ul><ul><li>15 = V α = 20.48 α  α = 15/20.48 = 73.2% </li></ul>
  87. 87. Valuation
  88. 88. Valuation <ul><li>Positive revenues start in 2013 but they are small early on </li></ul><ul><li>Expenses incurred from inception (2010) long before any revenues </li></ul><ul><li>Firm has $50M in cash from a bank loan but $5M in annual interest payments </li></ul><ul><ul><li>For simplicity we assume cash earns no interest, otherwise additional Interest Income row </li></ul></ul><ul><li>Capital Expenditure is lumpy and is typically bigger later in life cycle </li></ul><ul><li>Firm undergoes two rounds of VC financing to avoid having too negative a cash balance </li></ul><ul><ul><li>In theory no VC financing needed, firm just has negative cash balance, then repays it all once cash flows are realized or IPO </li></ul></ul><ul><ul><li>In real world most people are borrowing constrained and cannot build up very negative cash positions </li></ul></ul>
  89. 89. Valuation <ul><li>Lets calculate NPV first </li></ul><ul><li>PV of future cash flows: </li></ul><ul><li>PV of future capital expenditures: </li></ul><ul><li>NPV: 50-20.12+33.17=63.05 </li></ul><ul><li>Note that if there was no debt, there would be no cash (1 st term smaller), but there would be more cash flows (3 rd term bigger) </li></ul><ul><ul><li>Total value remains same if bond’s interest is equal to firm’s discount rate </li></ul></ul><ul><ul><li>Total value not the same here because two rates of return not the same </li></ul></ul>
  90. 90. Valuation <ul><li>Work backwards to calculate stakes given to each VC </li></ul><ul><li>After VC 2 makes investment (in 2012) he has α 2 shares of firm </li></ul><ul><ul><li>Firm has 20 in cash, but loss of 25 next year, profit of 5 the following year, these will offset </li></ul></ul><ul><ul><li>Only CF VC 2 will see is dividends of 25 (growing at 2%) starting in 2015: </li></ul></ul><ul><li>He asks for α 2 =50/145.41  α 2 =34.4% </li></ul><ul><li>Note that cash earns no interest and we are assuming negative cash position in 2013 carries no cost </li></ul>
  91. 91. Valuation <ul><li>The firm’s owners before the 2 nd round of financing are the original entrepreneurs and VC 1 </li></ul><ul><ul><li>They own 65.6% of 145.41, or 95.41 </li></ul></ul><ul><li>After VC 1 makes investment (in 2010) he has α 1 shares of firm </li></ul><ul><ul><li>Firm has cash, future obligations, future financing expectations which all offset </li></ul></ul><ul><ul><li>Only CF VC 2 will see is dividends of 25 (growing at 2%) starting in 2015 </li></ul></ul><ul><ul><li>However α 2 will be promised to 2 nd round investor so VC 1 will receive α 1 (1- α 2 )*109.95. This must equal to his initial investment of 20  α 1 =27.7% </li></ul></ul><ul><li>Initial investors keep (1- α 1 )(1- α 2 )*109.95=52.14 </li></ul><ul><ul><li>Note this is smaller than NPV because we are assuming cash is not reinvested </li></ul></ul>
  92. 92. Quick Question <ul><li>Suppose the VC was able to convince the firm owners that the firm is (i) more, (ii) less valuable than they think. Which would the VC do and why? </li></ul><ul><li>Suppose the owners were able to convince the VC that the firm is (i) more, (ii) less valuable than the VC think. Which would the owners do and why? </li></ul>
  93. 93. Real Options <ul><li>Option to contract </li></ul><ul><ul><li>The full investment does not have to be made at time zero </li></ul></ul><ul><ul><li>Small initial investment can be made, if it turns out project is not good, no further investments made </li></ul></ul><ul><li>Option to expand </li></ul><ul><ul><li>After first investment is made, it turns out product is better than all competitors </li></ul></ul><ul><ul><li>Large secondary investment is made to expand product reach </li></ul></ul><ul><li>Option to wait </li></ul><ul><ul><li>We can wait and learn about project before committing any money </li></ul></ul><ul><li>All of these are why multi-stage financing makes sense </li></ul><ul><ul><li>This also explains why firms in later stages are worth more, and why investments are bigger </li></ul></ul>
  94. 94. Monitoring <ul><li>VC doesn’t just provide funding, but also monitoring </li></ul><ul><ul><li>Risk shifting example showed disadvantage of debt funding </li></ul></ul><ul><ul><li>Agency example showed disadvantage of weak equity </li></ul></ul><ul><ul><li>VC’s combination of equity financing + monitoring is crucial for young firms </li></ul></ul><ul><li>VC is often on board of directors </li></ul><ul><li>Provide advice, set goals </li></ul><ul><li>Fire/hire managers </li></ul><ul><li>Have access to consultants, accountants, bankers, lawyers, potential customers </li></ul>
  95. 95. Xerox and XTV <ul><li>Xerox spent 10yrs developing an object-oriented document management system but had not shipped anything </li></ul><ul><ul><li>Storage of content without formal structure (images, audio, video) </li></ul></ul><ul><li>XTV realized that Xerox understood nature of technical problems but designed technologically inappropriate solution </li></ul><ul><ul><li>Xerox proposed building systems for mainframes </li></ul></ul><ul><ul><li>In early 1990’s PC’s became powerful enough to replace mainframes in most organizations </li></ul></ul><ul><li>XTV converted accumulated knowledge to marketable product (Documentum) </li></ul><ul><li>Documentum IPO: $351M (valued at $1.7B in 2003) </li></ul><ul><li>XTV replaced by XNE in 1996. XNE was more similar to a traditional corporate subdivision </li></ul>
  96. 96. Syndication <ul><li>Multiple VC’s invest in the same project </li></ul><ul><ul><li>Sometimes in multiple stages </li></ul></ul><ul><li>This helps VC diversify </li></ul><ul><ul><li>$100M fund can only invest in 10 $10M firms  10 is small enough for idiosyncratic risk to really matter </li></ul></ul><ul><ul><li>$100M fund can invest in 20 $10M firms if it settles for ½ of each firm </li></ul></ul><ul><li>Added benefit of getting 2 nd opinion on start-up’s viability </li></ul>
  97. 97. Exit Plan <ul><li>After several years VC (and other shareholders) want to cash out </li></ul><ul><li>Firm may be sold to existing company, or to public (IPO) </li></ul><ul><li>Existing firm may want to acquire start up’s technology, or market share, or brand name </li></ul><ul><li>IPO (Initial public offering): Shares are sold to public </li></ul><ul><ul><li>Investment bank acts as intermediary </li></ul></ul><ul><ul><li>IPO underpricing </li></ul></ul>
  98. 98. Microsoft’s Acquisition Strategy <ul><li>From blog of Spark Capital VC Bijan Sabet </li></ul><ul><li>15-20 acquisitions per year </li></ul><ul><ul><li>$2B per year on acquisitions (compared to $10B on R&D) </li></ul></ul><ul><li>Internal teams alert corporate development to a need start up could fill </li></ul><ul><li>Acquisitions are in areas MSFT is in but not winning </li></ul><ul><ul><li>No client software acquisitions but many in search, advertising </li></ul></ul><ul><ul><li>No ‘open source’ firms </li></ul></ul><ul><li>Current revenue irrelevant </li></ul><ul><li>Would have acquired ~20 in 2008 after crash but private valuations have not come down enough </li></ul><ul><ul><li>VC response: good firms know their true value and refuse to sell for less </li></ul></ul>
  99. 99. IPOs <ul><li>IPO (Initial Public Offering): Privately owned firm goes to public market to raise funds by selling equity </li></ul><ul><li>Benefit: More liquidity allows firm to get better terms </li></ul><ul><li>Benefit: Ability to cash out and diversify for initial owners </li></ul><ul><li>Cost: Legal requirements for regular information (accountants, lawyers, etc) </li></ul><ul><li>Cost: Direct (legal, underwriting fees) </li></ul><ul><li>Cost: Indirect: Underpricing </li></ul>
  100. 100. Firm Commitment <ul><li>Underwriter agrees to bear risk by purchasing all shares minus underwriting discount </li></ul><ul><li>Preliminary prospectus issued with tentative price </li></ul><ul><li>Marketing campaign, SEC approval, final price </li></ul><ul><ul><li>Information is acquired during pre-sell period </li></ul></ul><ul><li>Bank must sell all shares at price no higher than offering price </li></ul><ul><li>Used mainly by larger IPOs (>$10M) </li></ul><ul><li>60% of IPOs in USA </li></ul>
  101. 101. Best Effort <ul><li>Firm and underwriter agree on offer price and min/max number of shares </li></ul><ul><ul><li>Underwriter bears no risk </li></ul></ul><ul><li>If minimum not sold after 90 days, offer withdrawn, money refunded </li></ul><ul><li>Allows for greater range of shares to be sold </li></ul>
  102. 102. International <ul><li>Japan: similar to US  offer price is set, underwriters have considerable latitude in allocation of shares </li></ul><ul><li>UK: Firms use either offer for sale of placing </li></ul><ul><ul><li>Offer for sale: price set 10 days before date of offering, banker bears all risk, similar to firm commitment </li></ul></ul><ul><ul><li>Placing: Similar to best effort </li></ul></ul><ul><li>France and Netherlands: </li></ul><ul><ul><li>System is much more like an auction than US or UK </li></ul></ul><ul><ul><li>Less IPO underpricing than most countries </li></ul></ul>
  103. 103. IPO’s <ul><li>New Issue Underpricing: Large positive returns in first few days </li></ul><ul><ul><li>Firm receives far less than market seems to be willing to pay, why not raise price? </li></ul></ul><ul><li>Long Term Underperformance: Long term negative returns </li></ul><ul><ul><li>Why market willing to pay such high price? </li></ul></ul><ul><li>Hot Issue Market: Cyclicality in number of IPOs </li></ul>
  104. 104. Underpricing: Empirical Evidence <ul><li>High mean, median close to zero. After first 2 months, cannot reject market efficiency </li></ul><ul><ul><li>Ibbotson (1975) </li></ul></ul><ul><li>Exists in every nation with stock market, although amount varies </li></ul><ul><ul><li>Australia 11.9%, Brazil 78.5%, Finland 9.6%, France 4.2%, Germany 11.1%, India 35.3%, Japan 32.5%, Korea 78.1%, UK 12%, USA 15.3% </li></ul></ul><ul><ul><li>Studies usually test first few days or weeks </li></ul></ul><ul><li>Smaller offerings underpriced by more than larger ones </li></ul><ul><li>3,025 U.S. IPOs left > $27B on the table 1990-1998 </li></ul><ul><ul><li>Loughran and Ritter (2002) </li></ul></ul>
  105. 105. Underpricing: Winner’s Curse <ul><li>Some firms “good” and some “bad” </li></ul><ul><ul><li>Firms cannot reveal this credibly so price is same for all firms </li></ul></ul><ul><li>Informed investors can tell “good” firms from “bad” but uninformed cannot </li></ul><ul><li>Informed investors only buy “good” firms </li></ul><ul><li>All buyers of “bad” firms are uninformed, buyers of “good” firms are mixed (rationing) </li></ul>
  106. 106. Underpricing: Winner’s Curse <ul><li>If price is fair (averaged over all firms), informed investors have positive returns, uninformed have negative </li></ul><ul><li>Since uninformed buyers know this, they demand all firms to be underpriced to compensate them </li></ul><ul><li>Underpricing causes uninformed to have zero returns, informed to have positive returns, total returns positive on average </li></ul><ul><ul><li>Rock (1986) </li></ul></ul>
  107. 107. Underpricing: Winner’s Curse <ul><li>“ good” firms have NPV 20 (q=50% of firms), “bad” 10 </li></ul><ul><ul><li>Market cannot tell firms apart so all sell for price X </li></ul></ul><ul><li>All IPOs happen through an auction, investors submit bids and are randomly chosen </li></ul><ul><li>Informed investors (p=50% of all) know “good” from “bad” </li></ul><ul><ul><li>Informed investors never bid to buy “bad” firms (unless X<10) </li></ul></ul><ul><ul><li>Uninformed can’t tell, bid for “good” with q=50% </li></ul></ul><ul><ul><li>Since there will be both informed and uninformed bidding for “good” firms, if you are uninformed and bidding randomly your chances of winning “bad” are higher than your chances of winning “good” </li></ul></ul>
  108. 108. Underpricing: Winner’s Curse <ul><li>Suppose there are two informed and two uninformed investors </li></ul><ul><li>There are 6 possible scenarios: 2x3 </li></ul><ul><ul><li>2 (which uninformed picks good stock) </li></ul></ul><ul><ul><li>3 (which of 3 good bidders wins) </li></ul></ul><ul><li>Probability that uninformed won good, given he won is 25% </li></ul><ul><li>Probability that uninformed won bad, given he won is 75% </li></ul>Good/Loss Good/Win Bad/Win Good/Loss Good/Win Good/Loss Bad/Win Good/Loss Good/Loss Good/Loss Bad/Win Good/Win Good/Loss Good/Win Good/Loss Bad/Win Good/Win Good/Loss Good/Loss Bad/Win Good/Loss Good/Loss Good/Win Bad/Win Informed 2 Informed 1 Uninformed 2 Uninformed 1
  109. 109. Underpricing: Winner’s Curse <ul><li>Return to informed investor who wins bid is: 20/X </li></ul><ul><li>Return for uninformed investor who wins bid is: </li></ul><ul><li>If X=15 (“fair” price) R inf =33%, R uninf =-17% </li></ul><ul><li>Uninformed participates only if X=12.5 </li></ul><ul><li>If X=12.5, R uninf =60%, R uninf =0%, Avg 30% underpricing </li></ul><ul><li>“ good” firm loses 7.5, “bad” firm gains 2.5, Avg 2.5 loss </li></ul>
  110. 110. Hot Issue Markets <ul><li>Lots of IPOs in early 70s, few in mid 70s, lots in mid 80s, few in early 90s, lots in late 90s </li></ul><ul><li>Possibly there are more projects/ideas available at certain times (expansions) so more firms do IPOs </li></ul><ul><li>Possibly certain times are more risky so firms choose not to do IPO </li></ul><ul><li>Possibly not fundamentals at all but sentiment/bubbles  Firm can choose when to go public (asymmetric info) so firms go public when market sentiment is high and they can receive higher price </li></ul><ul><ul><li>Consistent with Baker and Wurlger’s story of market timing determining capital structure </li></ul></ul><ul><ul><li>IPOs are hard to short so rational investors may not be able to undo this </li></ul></ul>
  111. 111. Hot Issue Markets <ul><li>There is cyclicality in raising of funds </li></ul><ul><ul><li>Jensen (1991) </li></ul></ul><ul><li>Institutional investors are prone to over or underinvest in speculative markets like VC </li></ul><ul><ul><li>Sahlman and Stevenson (1986) </li></ul></ul><ul><li>Underpricing is biggest when recently: stock market did well, many IPO’s, underpricing was big (Korea) </li></ul><ul><ul><li>Hughes and Lee (2006) </li></ul></ul><ul><li>Long term underperformance is worst after “hot” markets, related to sentiment or market timing (UK) </li></ul><ul><ul><li>Coakley, Hadass, Wood (2005) </li></ul></ul>
  112. 112. Hot Issue Markets <ul><li>There is a relationship between valuations of new investments and commitments to VC and </li></ul><ul><ul><li>Regress valuations on characteristics (age, stage of development, industry), and inflows </li></ul></ul><ul><ul><li>Doubling of inflows leads to 14% rise in valuations </li></ul></ul><ul><ul><li>Doubling of stock market leads to 25% rise in valuations </li></ul></ul><ul><ul><li>Impact greatest in states with most VC activity </li></ul></ul><ul><li>Is this price pressure (sentiment, hot/cold market) or caused by investment quality? </li></ul><ul><li>Success rate of VC backed firms (completion of IPO or acquisition at attractive price) did not differ significantly between early 1990’s (low inflows) and late 1980’s (high inflows) </li></ul><ul><ul><li>Suggestive of sentiment or hot/cold markets </li></ul></ul>
  113. 113. The Long Run: Empirical Evidence <ul><li>Most studies agree that IPOs underperform in the long run (6-36 months) </li></ul><ul><li>Below is cumulative return over next 3 years relative to similar firms. </li></ul><ul><li>The numbers are relative to early market price, not offer price </li></ul><ul><li>Long run underperformance is less severe if we used offer price (offer price<market price due to underpricing) </li></ul><ul><li>Australia -46.5% </li></ul><ul><li>Brazil -47% </li></ul><ul><li>Chile -23.7% </li></ul><ul><li>Finland -21.1% </li></ul><ul><li>Germany -12.8% </li></ul><ul><li>Sweden 1.2% </li></ul><ul><li>UK -8.1% </li></ul><ul><li>USA -17% </li></ul>
  114. 114. The Long Run: Empirical Evidence <ul><li>Declines in operating performance over 3 years after IPO relative to matched sample </li></ul><ul><ul><li>Jain and Kini (1994) </li></ul></ul>
  115. 115. The Long Run: Empirical Evidence <ul><li>Related to the winner’s curse </li></ul><ul><li>When high divergence of opinion, buyers are the most optimistic </li></ul><ul><ul><li>High initial valuation </li></ul></ul><ul><ul><li>Not necessarily correct </li></ul></ul><ul><li>As more info arrives, difference between pessimists and optimists narrows </li></ul><ul><ul><li>On average this will be at midpoint of their views </li></ul></ul><ul><li>This leads to initially high returns, followed by low declines </li></ul><ul><ul><li>Miller (1977) </li></ul></ul>
  116. 116. The Long Run: Empirical Evidence <ul><li>This hypothesis suggests that long run performance is worst when divergence of opinion is high </li></ul><ul><li>3 opening day proxies for divergence of opinion: percentage opening spread, time of first trade, flipping ratio </li></ul><ul><li>After controlling for issue quality, wide opening spread, late opening trade, high flipping ratio associated with poor long run returns </li></ul><ul><ul><li>Houge, Lougran, Suchanek, Yan (2001) </li></ul></ul>
  117. 117. Survivorship Bias <ul><li>VC invests $1M each in 10 different ventures </li></ul><ul><li>One IPO’s and VC receives $5M, another sold to competitor and VC receives $5M </li></ul><ul><li>All others fail and VC takes a loss </li></ul><ul><li>True return: VC invests $10M and receives $10M, R=-1+10/10=0% </li></ul><ul><li>Suppose we don’t observed the failed ventures and only see the two successes </li></ul><ul><ul><li>Return on each success: -1+5/1=400% </li></ul></ul><ul><ul><li>Perceived return to VC is the average of the two successes, or 400% </li></ul></ul><ul><li>Survivorship bias is present in most financial data, but it is especially severe in high risk, low disclosure, and right-skewed data such as private equity and hedge funds </li></ul>
  118. 118. VC returns <ul><li>The average return of firms that go public or are sold is 698% </li></ul><ul><li>Correcting for survivorship bias this is 59% </li></ul><ul><ul><li>CAPM alpha goes from 462% to 32% </li></ul></ul><ul><ul><li>Geometric mean from 108% to 15% </li></ul></ul><ul><ul><li>These numbers are still very large </li></ul></ul><ul><ul><li>Correction done by using ML to estimate probability distribution over success/failure using IPO/acquisitions only </li></ul></ul><ul><li>Volatility remains very high too, 89% </li></ul><ul><ul><li>Cochrane (2004) </li></ul></ul>
  119. 119. VC returns <ul><li>Above numbers consistent with a highly skewed distribution of few successes and many failures </li></ul><ul><ul><li>9 firms with -56% and 1 firm with 7000% return </li></ul></ul><ul><li>Why are returns so large? Perhaps because investments are illiquid, undiversified? </li></ul><ul><li>On the other hand VC is a competitive business with relatively free entry </li></ul><ul><li>Diversification should be possible since final investors (ie pension funds) are large </li></ul>
  120. 120. VC returns <ul><li>Investments in later rounds are less risky </li></ul><ul><ul><li>Means, alphas, betas all decline from 1 st to 4 th round </li></ul></ul><ul><ul><li>Idiosyncratic variance stays same </li></ul></ul><ul><li>However similar traded stocks behave same way as ventures </li></ul><ul><ul><li>Sample of very small Nasdaq stocks had similarly large arithmetic returns (>100%), large standard deviations, and large alphas </li></ul></ul><ul><li>Thus high returns may not be a VC puzzle but a small, highly skewed securities puzzle in general </li></ul>
  121. 121. VC returns <ul><li>Average arithmetic returns 55% </li></ul><ul><ul><li>Peng (2001) </li></ul></ul><ul><li>Average arithmetic returns 30.5% and beta=1.4 </li></ul><ul><ul><li>Gompers and Lerner </li></ul></ul><ul><li>Betas between 1 and 3.8 </li></ul><ul><ul><li>Reyes (1990) </li></ul></ul>
  122. 122. VC returns <ul><li>However, note that all above returns are for individual ventures </li></ul><ul><li>While they all attempt to control for survivorship bias, it is questionable whether they succeed </li></ul><ul><li>A better way might be to look at average return for a VC fund, rather than a VC investment </li></ul><ul><ul><li>Money earned by fund relative to money raised by fund </li></ul></ul><ul><ul><li>Still not survivorship bias free as funds may have died without reaching database </li></ul></ul>
  123. 123. VC returns <ul><li>IRR of 13.5% (1974-1989) </li></ul><ul><ul><li>Bygrave and Timmons (1992) </li></ul></ul><ul><li>IRR 19.8% after controlling for beta </li></ul><ul><ul><li>Ljungqvist and Richardson (2003) </li></ul></ul><ul><li>Private Equity portfolio has mean and standard deviation similar to value weighted market index </li></ul><ul><li>25.2% 5yr and 18.7%10yr return for all VC funds in 1999 database. This is below stock returns over same period </li></ul><ul><ul><li>Venture Economics (2000) </li></ul></ul><ul><li>VC investments returned -1.6% (Nov 2007-Sept 2008) </li></ul><ul><ul><li>IPO drought (poor market conditions) results in poor returns on investment </li></ul></ul>
  124. 124. Discount Rates <ul><li>The discount rate should reflect the risk of a project </li></ul><ul><ul><li>For example with CAPM the only risk that matters is covariance with market </li></ul></ul><ul><ul><li>Idiosyncratic risk does not matter because it can be hedged away </li></ul></ul><ul><li>Typically, VC discount rates range from 25% to 80%: </li></ul><ul><ul><li>lower for investments in later stage or more mature businesses </li></ul></ul><ul><ul><li>higher for seed investments </li></ul></ul><ul><li>These discount rates are typically higher, and oftentimes much higher, than those calculated using a CAPM-based type model </li></ul>
  125. 125. Discount Rates <ul><li>Why are discount rates so high? </li></ul><ul><li>Such high discount rates cannot be explained as being a reward for systematic risk </li></ul><ul><li>In most practical cases, CAPM would give discount rates well below 25%, let alone 80% </li></ul><ul><li>Three (limited) “rationales” </li></ul><ul><ul><li>Compensate VC for illiquidity of investment </li></ul></ul><ul><ul><li>Compensate VC for adding value </li></ul></ul><ul><ul><li>Correct optimistic forecasts </li></ul></ul>
  126. 126. Rationale 1: Investment Illiquidity <ul><li>The VC cannot sell an investment in a private company as easily as it could sell public company stock </li></ul><ul><li>All else equal, this lack of marketability makes private equity investments less valuable than easily-traded public investments </li></ul><ul><li>The question is, how much less valuable? </li></ul><ul><li>Practitioners in private equity investments often use liquidity discounts of 20%-35%, i.e., they estimate the value of a private equity stake to be 20% to 30% less than an equivalent stake in a publicly traded company </li></ul>
  127. 127. Caveats <ul><li>Practitioners use these rates not only to value private equity transactions, but also to calculate estate taxes. Higher rate  Lower valuation  Lower taxes  Take these with grain of salt </li></ul><ul><li>VC make most of money at/after IPO when the firm is fully liquid </li></ul><ul><li>Typical VC fund investors are large institutions (pension funds, financial firms, insurance companies, university endowments) </li></ul><ul><li>Illiquidity is probably not a big concern these investors as private equity investments is a small portion of their portfolios they have plenty of other liquid investments </li></ul>
  128. 128. Rationale 2: VC Adds Value <ul><li>VCs are active investors and bring more to the deal than just money: </li></ul><ul><ul><li>spend a large amount of time </li></ul></ul><ul><ul><li>reputational capital </li></ul></ul><ul><ul><li>access to skilled managers </li></ul></ul><ul><ul><li>industry contacts, network </li></ul></ul><ul><ul><li>and other resources </li></ul></ul><ul><li>A large discount rate is a crude way to compensate the VC for this investment of time and resources </li></ul>
  129. 129. Caveats <ul><li>How do we know how to adjust the discount rate? </li></ul><ul><li>The higher discount rate implicitly charges for the VC services as long as the VC expects to be invested in the company </li></ul><ul><li>In reality, a successful VC may add more value earlier on and relatively little later </li></ul><ul><li>It would be more accurate to compensate the VC explicitly for the value that they are expected to add </li></ul>
  130. 130. Rationale 3: Optimistic Forecasts <ul><li>Forecasts tend not to be expected cash flows (i.e., an average over many scenarios) </li></ul><ul><li>Rather they typically assume that the firm hits its targets </li></ul><ul><li>A higher discount rate is a crude way to correct forecasts: </li></ul><ul><ul><li>that the VC judges optimistic; </li></ul></ul><ul><ul><li>that are objectively optimistic (best case scenario) </li></ul></ul>
  131. 131. Caveats <ul><li>Better to try and make the adjustment explicit -- i.e., apply probabilities to the forecast cash flows to come up with true expected cash flow forecasts. </li></ul><ul><li>May yield very different and more precise forecasts. </li></ul>
  132. 132. Alternative to High Discount Rates <ul><li>It’s better to model the sources of uncertainty and to put probabilities on the various events. </li></ul><ul><ul><li>Some major uncertainties will get resolved soon </li></ul></ul><ul><ul><li>Others will take more time </li></ul></ul><ul><ul><li>Some scenarios will require you to take different actions </li></ul></ul><ul><li>Other advantage: Allows you to identify and value (roughly) the options embedded in many start-ups, particularly: options to abandon, to expand, to switch strategies </li></ul><ul><li>Black-Scholes is usually an over-kill here. Simple decision trees are more appropriate. (Simulations can be very useful) </li></ul>
  133. 133. Example <ul><li>Put up $10M now </li></ul><ul><li>In 2 years: </li></ul><ul><ul><li>Good news (proba.1/3): Invest $60M  Get out $300M </li></ul></ul><ul><ul><li>OK news (proba.1/3): Invest $60M  Get out $150M </li></ul></ul><ul><ul><li>Bad news (proba.1/3): Invest $60M  Get out $30M </li></ul></ul><ul><li>If do not invest $60M, the firm is worth nothing </li></ul><ul><li>One approach would be to discount the cashflow from the best case scenario (300 - 60) using a high discount rate to correct for prob. of less favorable outcomes. But which one? And why? </li></ul><ul><li>Alternatively, analyze each scenario and realize that you won’t invest if bad news arrives, so expected payoff in year 2 is really: </li></ul><ul><li>1/3 * (300-60) + 1/3 * (150-60) + 1/3 * 0 </li></ul>
  134. 134. CacheFlow Case Study <ul><li>Founded in 1996 by Michael Malcolm, a former University of Waterloo computer science professor </li></ul><ul><li>Idea was to speed up internet by storing (and quickly updating) data from popular websites at multiple locations </li></ul><ul><ul><li>Akamai Technologies (founded 1998, $3.5B Mkt Cap in 2009) does this </li></ul></ul><ul><li>March 1996: Raises $1M from 12 angel investors </li></ul>
  135. 135. CacheFlow Case Study <ul><li>Oct 1996: Sells 3.2M shares of series A convertible preferred stock for $2.8M </li></ul><ul><ul><li>Benchmark Capital receives 25% stake </li></ul></ul><ul><ul><li>CacheFlow valued at 2.8/.25=$11.2M </li></ul></ul><ul><li>Dec 1997: Sells $6M of Series B convertible preferred stock </li></ul><ul><ul><li>U.S. Ventures receives 17% stake </li></ul></ul><ul><ul><li>CacheFlow valued at 6/.17=$35.3M </li></ul></ul><ul><li>March 1999: Sells $8.7M of Series C convertible preferred stock </li></ul><ul><ul><li>Technology Crossover Ventures receives 7% stake </li></ul></ul><ul><ul><li>CacheFlow valued at 8.7/.07=$124.3M </li></ul></ul><ul><li>Nov 1999: Sells $3.1M of Series D preferred stock </li></ul><ul><ul><li>All bought by Marc Andreessen, founder of Netscape </li></ul></ul><ul><ul><li>He also joined board and gave CacheFlow extra credibility just before IPO </li></ul></ul>
  136. 136. CacheFlow Case Study <ul><li>Jan 1999: CacheFlow records first revenue </li></ul><ul><ul><li>Products sold to ISP’s and eventually major firms seeking to speed up websites </li></ul></ul><ul><li>Nov 1999: CacheFlow has accumulated losses of $26.2M </li></ul><ul><ul><li>Cash raised: 1+2.8+6+8.7+3.1=21.6 </li></ul></ul><ul><ul><li>In most recent quarter losses of $6M on sales of $3.6M </li></ul></ul><ul><li>Nov 18, 1999: IPO at $24/share </li></ul><ul><ul><li>Shares close at $127/share </li></ul></ul><ul><ul><li>Closing price implies $3B value </li></ul></ul><ul><li>Closing price implies gains of 14000%, 5400%, 2600%, 1150% for Series A, B, C, D shares respectively </li></ul>
  137. 137. CacheFlow Case Study <ul><li>Stock priced reached $165/share by end of Nov </li></ul><ul><li>Over next year revenue growth was below expectations </li></ul><ul><ul><li>2001Q3 revenue $21M (half of expectations) </li></ul></ul><ul><li>Dec 2001: Stock price <$1/share, CacheFlow announces restructuring to reduce costs </li></ul>
  138. 138. CacheFlow Case Study <ul><li>CacheFlow reinvents itself </li></ul><ul><li>CacheFlow focuses on security applications which turned out more valuable than caching services to its clients </li></ul><ul><li>Aug 2002: changes name to Blue Coat Systems, Inc (NASDAQ: BCSI) </li></ul><ul><li>Sept 2002: 1/5 reverse split </li></ul><ul><ul><li>Firms with stock prices below $1 not taken seriously </li></ul></ul><ul><li>2005: $96.2M revenue, $5.4M income, $47.2M cash, $35.2M NWC </li></ul>

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