Security Design

1. Security Design Cumming & Johan (2013, Chapter 11) 1

2. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary Forms of Finance • Debt • 1st priority in bankruptcy • Stipulated interest payments • Non-payment of interest  can force bankruptcy • Preferred Equity • 2nd priority in bankruptcy • Stipulated preferred dividend payments • Non-payment of dividends  cannot force bankruptcy 2

3. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary Forms of Finance (Con’t) • Common Equity • Last priority in bankruptcy • Dividends may or may not be forthcoming • Residual claimants  upside potential  capital gains! • Warrants • Option to purchase common equity • Like an American call option to purchase the firm (but different because increases # securities when exercised) 3

4. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary Forms of Finance (Con’t) • Convertible debt • Debt + option to convert from debt to common equity • Similar to debt + warrants • Convertible preferred equity • Preferred equity + option to convert from preferred equity to common equity • Similar to preferred equity + warrants 4

5. Figure 2.1. Payoff Functions $ Payoff to Common Equity Present Value of Interest + Principal on Debt Present Value of Pre-Specified Preferred Dividends Payoff to Debt Payoff to Preferred Equity Slope is 45o for 100% of the common shares (45o * X/100 for X% of the common shares) 45o 45o 45o Value of Entrepreneurial Firm 5

6. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary The Conventional Wisdom • “Convertible preferred equity is optimal” • No threat of bankruptcy for entrepreneurial firm (contrast to debt & interest payments) • Priority for the VC in the event of bankruptcy • Upside potential for the VC • Entrepreneur would not agree unless truly committed to the venture – mitigates adverse selection problems • Provides incentives for the VC to help the firm in bad times (VC a residual claimant in bankruptcy) • Pricing of securities is robust to errors in firm valuation 6

7. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary The Conventional Wisdom (Con’t) • “Convertible preferred equity is optimal” • Mitigates ‘window-dressing’ problems in staged financing arrangements • Mitigates ‘risk-shifting’ problems • Terms of the contract can be flexible • Incentives for the entrepreneur (terms of conversion less favorable for VC the more successful the firm) • Incentives for the VC (ensure worth converting the securities) 7

8. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary Detailed Intuition on why Convertible Preferred Equity might be ‘Optimal’ • Incentives for investor to add value • Share in profit potential of company • Downside protection for investor in case of bankruptcy • Incentives for entrepreneur to work hard • Also share in profit potential • Ownership provided to investor not as great as with common equity • Terms of conversion are graduated, such that conversion for investor worse the better off the performance • E.g., value < 10,000,000  convert 2 preferred for 1 common • E.g., value > 10,000,000  convert 3 preferred for 1 common (better for entrepreneur in this second case) 8

9. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary Empirical Evidence in U.S. Research • Gompers (1998) Harvard University Working Paper • 50 venture capital investments from limited partnership funds in US • Kaplan and Stromberg (2003) Review of Economic Studies • 213 investments from 14 venture capital funds (limited partnerships) in US • No industry-wide evidence from the United States 9

10. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary Question • Does it make sense to use the same form of finance for all different possible types of entrepreneurial firms?! 10

11. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary All of these countries show VCs using a variety of forms of finance, not just convertibles • Canada • Cumming (2005 Journal of Corporate Finance; 2005 Journal of Business Venturing) • Australia • Cumming et al. (2005 Journal of Banking and Finance) • Europe • Schwienbacher (2008 Financial Markets and Portfolio Management); Cumming (2008 Review of Financial Studies); Cumming and Johan (2008 European Economic Review), Bascha and Walz (2008 Chapter in Venture Capital in Europe); Parhangkas and Smith (2000 Working Paper) • Taiwan • Songtao (2000 Asia & Pacific Finance) • Developing Countries • Lerner and Schoar (2005 Quarterly Journal of Economics); Cumming Schmidt and Walz (2013 Journal of Business Venturing) • To the best of our knowledge, every country outside the US where data have been collected up to January 2013 shows patterns that are consistent with the Canadian data, not the US data. In no country is convertible preferred equity used most frequently except in the US!!! 11

12. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary Empirical Evidence from Canada • 12,343 transactions! • 1991-2003 • Source: Macdonald & Associates, Ltd. • Observations from all types of venture capital funds (private independent LPs, corporate, government, LSVCC, US VCs financing Canadian entrepreneurs) • This is by far the largest and most comprehensive data on security design in VC and PE of any country worldwide where VC or PE data have been collected 12

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21. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary Data Summary: Major Puzzles • Mix of forms of finance observed is NOT explained by: • Type of VC fund • Type of entrepreneurial firm • Amount invested • When invested • United States versus Canadian VC funds for Canadian entrepreneurial firms 21

22. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary Explanations • Not enough U.S. data • U.S. venture capitalists are more sophisticated • Restrictive covenants on venture capital funds • Exit more difficult in Canada • U.S. Tax Laws(!) • Differences in types of firms financed – agency costs differ by transaction type 22

23. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 1. Enough U.S. Data? • Gompers (1998) 50 observations • Kaplan and Stromberg (2003) 213 observations • Unavailable data on security design from the population of US investments 23

24. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 2. Sophistication? • That forms of finance other than convertible preferred equity is used is not de facto evidence of a lack of sophistication • Some ‘sophisticated’ U.S. VCs use other forms of finance (based on casual search of U.S. VC web pages) 24

25. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Sophistication (Continued) • The PricewaterhouseCoopers MoneyTreeTM Survey (http://www.pwcmoneytree.com/) of U.S. venture capital financings indicates: “Debt is very often part of a venture capital deal” 25

26. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Sophistication (Continued) Benchmark Capital states (see www.benchmark.com): • “At Benchmark Capital, we're focused on one, and only one, mission: to help talented entrepreneurs build great technology companies. That's what drives us and everything we do - from how we organize our firm to our investment strategy Our investment strategy is simple: be the first venture investor in technology companies that seek to create new markets. We focus on early-stage investing and take a labor-intensive, service-oriented approach in markets where we have direct experience. These markets include application services, infrastructure services, Internet retail, Internet services - business, Internet services - consumer, mobile Internet, networking equipment, semiconductor, and software. Minimum investment: $500,000; Maximum investment: $5,000,000… • “Raising debt funding is a recent phenomenon for venture-backed start-ups and such funding can be a valuable source of capital. To help companies evaluate debt terms, we recently conducted an informal survey of our portfolio companies that summarizes the terms and conditions being offered to venture-backed start-ups. The spreadsheet below [see www.benchmark.com] contains a summary of our findings.” [Emphasis added.] 26

27. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Sophistication (Continued) St. Paul Venture Capital states (http://www.stpaulvc.com/): • “With annual investments placing us among the top 10 venture capital firms in the United States, we have committed more than $1.5 billion to venture capital investments since our founding in 1998… • While the dominant portion of our investing is in early-stage companies, we also invest in more established companies which are showing excellent progress and could benefit from an additional round of private financing. These are often companies with proven business models that are raising funds to finance rapid growth. Or they may be pursuing an acquisition-and-consolidation strategy in an industry burdened with inefficiencies. We also invest selectively in equity securities of middle-market management buyouts. As with our early-stage investments, we bring strategic thinking and financial engineering skills to the relationship, as well as capital. Our involvement is frequently weighted toward the front end in our later stage deals, structuring mutually beneficial multi-party financings and developing equity and debt structures to fit a company's unique circumstances.” [Emphasis added.] 27

28. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Sophistication (Continued) Northwest Venture Associates states (http://nwva.com/): • “Northwest Venture Associates ("NWVA") has $190 million under management and is the largest venture capital fund manager focused exclusively on companies headquartered in the Pacific Northwest. The funds were established to provide equity capital and financial guidance to successful, rapidly growing Northwest businesses managed by entrepreneurial, creative and ethical individuals… • The preferred size of our investment ranges from $250,000 to $7,500,000, in the form of common or convertible preferred stock. In many cases, we can arrange the balance of your capital needs with investors whose objectives are similar to yours and to ours. We have extensive contacts with other equity funds and syndicates of high net worth individuals. In addition, we can facilitate investments from strategic partners. Our ultimate objective is to earn a rate of return commensurate with the risk we are assuming. Our time frame is roughly five years from the date of our investment in a company. The mechanism for realizing our return may include an initial public offering (IPO), sale or stock repurchase.” [Emphasis added.] 28

29. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 3. Restrictive Covenants • Most U.S. venture capital limited partnerships face restrictive covenants on the types of forms of finance they may use • E.g., many are restricted against using debt (e.g., from leveraging up the fund) (see Chapter 5) • The frequency of use of this restriction changes over time, etc. • Less of an incentive to use debt when financing entrepreneurs to match the timing of cash flows into and out of a VC or PE fund when the fund itself does not use debt 29

30. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Restrictive Covenants (continued) • Canadian data: not just limited partnerships, but also government, hybrid, LSVCCs and corporate VC funds • Each faces different types of constraints 30

31. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 4. Exit More Difficult in Canada? • Securities regulation: IPOs more costly • Fewer strategic acquirers • Lots of buybacks • Possibly less of a need for equity-type securities(?) • **Later on we relate contract choice to exit outcome (Chapters 14, 20 and 21) 31

32. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 5. TAX • U.S. Tax Law biases the selected form of VC finance in the U.S. (Gilson and Schizer, 2003 Harvard Law Review) • These tax biases do not exist in Canada (Sandler, Canadian Tax Journal, 2001) 32

33. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Taxation in the US Gilson & Schizer(2003 Harvard Law Review) • US VCs + US Entrepreneurs: tax bias • Convertible Preferred Equity lowers the value of Entrepreneur’s common shares  lowers the strike price for employee stock options. • Tax is deferred until the incentive compensation is sold • “Eat em up Preferreds” [!] • Suggest (note 51) adverse tax consequences in Canada with preferred dividends, but VC backed entrepreneurial firms typically do not pay significant dividends ($ comes from capital gain upon exit) • If adverse tax consequences with preferred dividends, would never expect straight (non-convertible) preferred equity in Canada 33

34. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Taxation in CanadaSandler (2001 Can Tax Journal) • No clear perception on how Revenue Canada (IRS equivalent) would treat US Style “Eat em up preferreds” • BUT: No Canadian VC uses ConvPrefs more than 50% of the time (Cumming, 2005) • Would US VCs try “Eat em up preferreds” in Canada? • No pertinent change in tax code in years covered by the data • Significant changes in intensity of use of different forms of finance over time •  Suggestive that factors other than tax are determinative of capital structure 34

35. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 6. Types of Transactions • Different transactions are, yes, different • E.g., moral hazard costs may be more problematic among different types of firms • E.g., adverse selection problems may be different for other types of firms 35

36. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Agency Problems • The degree to which agency costs are pronounced (and therefore the choice of security) depends on: (i.e., NOT the same for every financing transaction!!!) • Entrepreneurial firm development stages • start-up, expansion, buyout, turnaround • Other non-mutually exclusive entrepreneurial firm characteristics • high-tech, # employees, etc. • Type of transaction • staging and/or syndication, capital contribution 36

37. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Principal  Agent Venture Capitalist 1 Venture Capitalist 2 Entrepreneur 37

38. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Objective • Determine which form of finance may be optimal depending on: • Characteristics of entrepreneurial firm • Characteristics of VC firm(s) • Regulatory environment 38

39. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 1. Buyout Stage Firms • The operating management of the entrepreneurial firm acquires a product line, a division, or a company • Established firms • Adverse selection costs of debt are less significant relative to earlier stage firms • Syndication unnecessary 39

40. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Buyout (Con’t) • Moral Hazard • Effort of entrepreneur is important • Effort of venture capitalist is less important • Transparent type of transaction • Staging re monitoring is unnecessary 40

41. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Buyout (Con’t) • What form(s) of finance would you expect? 41

42. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 2. Turnaround Stage • The entrepreneurial firm is earning less than its cost of capital • Established Firm • But risk of a ‘lemon’ is significant (significant adverse selection problems) 42

43. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Turnaround (Con’t) • Moral Hazard • Effort of both VC and entrepreneur significant • Trilateral Bargaining • Risk entrepreneur may give up control of the firm (after contracting with the VC) to an outside third party to lower the firm’s cost of capital 43

44. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Turnaround (Con’t) • Which form(s) of finance does this suggest? 44

45. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 3. Start-up Stage • The firm may be based on a concept without a product or any marketing, or it may have a product being developed, but not yet sold commercially • No track record • Adverse selection problems are significant 45

46. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 4. Expansion Stage • The entrepreneurial firm requires significant capital for plant expansion, marketing, and to initiate full commercial production and sales • Short track record • Adverse selection significant 46

47. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Start up and Expansion (Con’t) • Moral hazard • Effort of both entrepreneur and VC(s) significant • Staging • Need for Syndication • Prevent hold-up problems and renegotiation • Maximize growth options with a greater number of suppliers of capital 47

48. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Consider Agency Problems Among Syndicated VCs: Staged Round 1: VC1 invests in Entrepreneur Staged Round 2: VC1 and VC2 invest in Entrepreneur VC2 invests based on recommendation of VC1 VC1 may “trick” VC2 to invest How to contracts to mitigate this problem?! 48

49. Changing equity ownership percentages and the value of the entrepreneurial firm Case 1 Case 2 ENT 25% VC1 50% VC2 25% ENT 45% VC1 50% Low firm value • VC1 increases price paid by VC2, • Decrease ownership of VC2 • Increase ownership of ENT • Increase value of Firm • Increase payoff to VC1 !!! VC2 5% High firm value, high ENT share 49

50. Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems Agency Problems (Continued) • Start-up and Expansion VC Contracting objectives: • Continue financing positive expected NPV projects after each performance review • Limit mispricing of securities between lead (inside) and follow-on (outside) investors • Limit misstatement of capital requirements 50