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Venture Capital and Private Equity Contracting: An International Perspective

Venture Capital and Private Equity Contracting: An International Perspective. Douglas Cumming B.Com .( Hons ), M.A., J.D., Ph.D., CFA York University Schulich School of Business Sofia Johan LL.B., LL.M., Ph.D. York University Schulich School of Business

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Venture Capital and Private Equity Contracting: An International Perspective

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  1. Venture Capital and Private Equity Contracting:An International Perspective Douglas Cumming B.Com.(Hons), M.A., J.D., Ph.D., CFA York University Schulich School of Business Sofia Johan LL.B., LL.M., Ph.D. York University Schulich School of Business Tilburg Law and Economics Centre (TILEC) 1

  2. Materials • Textbook: • Cumming, D.J., and S.A. Johan, 2013. Venture Capital and Private Equity Contracting: An International Perspective, 2nd Edition, Elsevier Science Academic Press. • Web: • http://booksite.elsevier.com/9780124095373/ 2

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  4. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Chapter 1 Objectives • Introduction • Venture Capital and Private Equity Definitions • Issues addressed in course and textbook 4

  5. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Sources of funds What do VC/PE Managers Do? Possible Misconceptions? Sources of Funds for Entrepreneurial Firms • There are various sources of funds • Characteristics of other sources are very briefly provided on the next slide • Our focus in this course is on Venture Capital (VC) and Private Equity (PE) 5

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  7. Figure 1.1. Venture Capital Financial Intermediation Investors Returns Capital Venture Capitalist Equity, Debt, Warrants, etc. Capital Entrepreneurial Firm 7

  8. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Sources of funds What do VC/PE Managers Do? Possible Misconceptions? What Do Venture Capitalists (VCs) Do? • Due Diligence • Screening • 1 to 2 deals out of >1000 • Value-added • Monitoring, Networks, Expertise • Legal, Financial, Accounting, Suppliers, Buyers, Boards of Directors, Human Resources, Strategic, Marketing, other 8

  9. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Sources of funds What do VC/PE Managers Do? Possible Misconceptions? Possible Misconceptions (?!) • “Vulture” capital: significant ownership and control rights • Insufficient funds • Sell bad investee firms public in initial public offerings (IPOs) 9

  10. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data Venture Capital and Private Equity Some Definitions 10

  11. Figure 1.2 VCs, Acquisitions/Mergers Strategic Alliances, etc. SEO Angels, FFF P R O F I T S Later Stage Early Stage Seed Capital (Could include VC) Public Market IPO Mezzanine 3rd 2nd Break Even 1st Valley of Death TIME 11

  12. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data “Venture Capital” vs “Private Equity” (1/3) • Seed • Financing provided to research, assess and develop an initial concept before a business has reached the start-up phase. • Start-up • Financing provided to companies firms for product development and initial marketing. Companies Firms may be in the process of being set up or may have been in business for a short time, but have not sold their product commercially. • Other Early Stage • Financing to companies firms that have completed the product development stage and require further funds to initiate commercial manufacturing and sales. They will not yet be generating a profit. • Expansion • Financing provided for the growth and expansion of a company firm which is breaking even or trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital. 12

  13. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data “Venture Capital” vs “Private Equity” (2/3) • Bridge Financing • Financing made available to a company firm in the period of transition from being privately owned to being publicly quoted. • Secondary Purchase / Replacement Capital • Purchase of existing shares in a company firm from another private equity investment organization or from another shareholder or shareholders. • Rescue / Turnaround • Financing made available to an existing business firm which has experienced trading difficulties (firm is not earning its cost of capital (WACC)), with a view to re-establishing prosperity. • Refinancing Bank Debt • To reduce a company’s firm’s level of gearing. • Management Buyout • Financing provided to enable current operating management and investors to acquire an existing product line or business. • Management Buyin • Financing provided to enable a manager or group of managers from outside the company firm to buy-in to the company firm with the support of private equity investors. 13

  14. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data “Venture Capital” vs “Private Equity” (3/3) • Venture Purchase of Quoted Shares • Purchase of quoted shares with the purpose of delisting the firm. • Other Purchase of Quoted Shares • Purchase of shares on a public stock market. • In practice, sometimes broader categories of definitions are used. For example, • Start-up: sometimes used in practice to refers to Start-up, and Other Early Stage • Expansion: sometimes used in practice to refers to Expansion, Bridge Financing, Rescue/Turnaround • Replacement Capital: sometimes used in practice to refers to Secondary Purchase/Replacement Capital, Refinancing Bank Debt • Buyouts: sometimes used in practice to refers to Management Buyout, Management Buyin, Venture Purchase of Quoted Shares. 14

  15. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data Size of VC and PE Markets? • VC is a small but important sector of the economy • Connected to: • IPO markets (stock markets) • Legality: shareholder protection, bankruptcy law, tax • Government programs • Armour and Cumming (2006 Oxford Economic Papers) 15

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  17. Figure 1.5. Comparison of VC Amounts by total PE versus GDP and Population This figure shows the differences across countries in terms of amounts of early stage VC / total PE, early stage VC / GDP and early stage VC / population. Amounts are scaled as indicated to enable direct comparisons and show how country rankings for VC amounts change depending on the benchmark used to compare countries. Data are averaged by country for the period 1989-2011. 17

  18. Figure 1.6. Comparison of the Number of VC Investments by total PE versus GDP and Population in Europe This figure shows the differences across countries in terms of numbers of early stage VC investment / total PE, early stage VC / GDP and early stage VC / population. Amounts are scaled as indicated to enable direct comparisons and show how country rankings for VC amounts change depending on the benchmark used to compare countries. Data are averaged by country for the period 1989-2011. 18

  19. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data VC Data • U.S.: http://www.ventureeconomics.com, http://www.vfinance.com, http://www.v1.com • The PricewaterhouseCoopers MoneyTreeTM Survey:http://www.pwcmoneytree.com/ • Canada: http://www.cvca.ca, http://www.canadavc.com • Europe: http://www.evca.com • Australia: http://www.abs.gov.au/Ausstats/abs@.nsf/0/bffef2819df68ca2ca256b6b007ab94e?OpenDocument • Private data sources • Data and empirical methods summarized in Cumming and Johan (2013, Chapter 3) 19

  20. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data VC Industry in US • Over 1000 funds • Geographic concentration • Specialized focus • Over $US 100 billion capital under management • Predominantly Private Limited Partnership VC Funds 20

  21. Figure 1.7.a Capital Overhang for Venture Capital Funds Raised by US Investors Source: Pitchbook 21

  22. Figure 1.7.b. Capital Overhang for Private Equity Funds Raised by US Investors Source: Pitchbook 22

  23. Figure 1.8.a. Average Venture Capital Return Multiples by Vintage Year Source: Pitchbook 23

  24. Figure 1.8.b. Average Private Equity Return Multiples by Vintage Year Source: Pitchbook 24

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  26. Figure 1.9. Venture Capital Horizon IRR by Fund Size Source: Pitchbook 26

  27. Figure 1.10. IRR Quartiles by Fund Size for Mature Venture Capital Funds Source: Pitchbook 27

  28. Figure 1.11. Median 1-Year Rolling Horizon IRR by Fund Type Source: Pitchbook 28

  29. Figure 1.12. Horizon IRR – Private Equity, Venture Capital and Public Index Source: Pitchbook 29

  30. Figure 4.13. US Buyout Returns by Vintage Year Median, Upper and Lower Quartiles as of December 2006 Source: Kaplan (2007), Venture Economics 70.00% 60.00% 50.00% 40.00% Lower 1/4 30.00% Median Upper 1/4 20.00% 10.00% 0.00% 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 -10.00% 30

  31. Figure 1.14. US versus Non-US Venture Capital Investment by Fund Vintage Year Source: Thompson SDC. 31

  32. Figure 1.15. US versus Non-US Venture Capital IPO Exits by Fund Vintage Year Source: Thompson SDC 32

  33. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data VC Industry in Canada • The estimated size of Canada’s VC/PE) market: $76 billion at the end of 2013 • Buyout:$53.2 bil.; Mezzanine: $7.6 bil.; VC: $14.9 bil. • Private indp. Funds: 59% of total funds; $44.6 billion, Institutional captive funds accounted for $20 billion Corporate captives $2.3 billion. Retail funds were $7.6 billion and Government owned and -directed $1.8 billion. 33

  34. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data Venture Capital in Australia 34

  35. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data Venture Capital in Europe • Fundraising by European private equity houses reached €16bn in 2013, 80% below the €81bn raised in 2008 35

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  37. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Main Issues addressed in this Course [Not a comprehensive list] 37

  38. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? I. Why Do VCs Exist? • Why not simply borrow from banks? • What does this imply about any theory / evidence in venture capital? • Review agency theory in detail because it is paramount to all issues addressed in this course • Cumming and Johan (2013 Chapter 2) 38

  39. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (1/6) • What do institutional investors care about? • Return expectations, Reporting, Liquidity • How does this affect fundraising? • How does this affect specialized fund mandates, such as socially responsible funds? • Cumming and Johan (2013, Chapter 4) 39

  40. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (2/6) • What terms with institutional investors? • Limited partnership agreements • Restrictive covenants • Limited liability • What clauses to use and when to use them • Cumming and Johan (2013, Chapter 5) 40

  41. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (3/6) • How to structure compensation? • Fixed fees • Carried interest • Cash versus share distributions • Clawbacks • Cumming and Johan (2013, Chapter 6) 41

  42. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (4/6) • Style Drift • Why and when should institutional investors care? • Why and when does it matter to fund managers? • Cumming and Johan (2013, Chapter 7) 42

  43. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (5/6) • Listed private equity (LPE) • What are the differences between LPE and limited partnerships? • Who invests in LPE, and when and why? • Cumming and Johan (2013, Chapter 8) 43

  44. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (6/6) • What role for government? • Existence of capital gaps? • Economic sources of capital gaps • Legal sources of capital gaps • Direct government investment programs • Legislation • Evidence from US, UK, Continental Europe, Israel, Australia, Canada • Cumming and Johan (2013, Chapter 9) 44

  45. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? III. Financial Contracting with Entrepreneurs (1/4) • Investment process • Due diligence • Stage of development and industry • Location • Staging • Fund flows and valuations • Syndication • Portfolio size / manager • Board seats • Contracts • Innovative activity • Investment duration • Cumming and Johan (2013, Chapter 10) 45

  46. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? III. Financial Contracting with Entrepreneurs (2/4) • What structure of investment? • Security design • Warrants • Common equity • Preferred equity • Convertible preferred equity • Convertible debt • Debt • Other veto and control rights • Cumming and Johan (2013, Chapter 11) 46

  47. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? III. Financial Contracting with Entrepreneurs (3/4) • Specific veto, control and cash flow rights • Definitions and terms • Role of preplanned exits • Cumming and Johan (2013 Chapter 12) 47

  48. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? III. Financial Contracting with Entrepreneurs (4/4) • International differences in contracts, due diligence, board seats, syndication, co-investment • Role of legal systems • Cumming and Johan (2013, Chapter 13) 48

  49. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? IV. Investor Value-Added (1/4) • VC and PE Value-Added • Jobs • Total Factor Productivity • Patents • Locusts? • Cumming and Johan (2013 Chapter 14) 49

  50. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? IV. Investor Value-Added (2/4) • Do contracts ensure effort? • Advice • Monitoring • Conflicts • When more pronounced • Role for contracts in facilitating effort and mitigating problems • Cumming and Johan (2013 Chapter 15) 50

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