Entrepreneurial Finance H3

What are the 5 characteristics of Venture Capital?

1) VC acts as financial intermediary

2) VC invests in private companies

3) VC takes active roles

4) VC primary goal to maximize returns, aiming for exits through IPOs or acquistion

5) VC invests in entrepreneurial companies with growth potential

VC investments fuel internal growth to ….

Maximize exit returns

How does the fund flow in the Venture Capital cycle?

VC funds managed by general partners (VCs or GPs) → Portfolio companies → Exits (IPO or Sale or Portfolio companies) → Limited Partners (investors or LPs) → in cirkels

Venture capital against other financial providers, about their characteristics

1) Venture capitalists are not angel investors. Angle investors use their own capital and are therefore not financial intermediaries.

2) Venture capitalists are not mutual/hedge funds. VCs invest in private companies and fall under Private Equity, a category of Alternative Investments.

3) VCs differ from crowdfunding by being active investors who actively monitor and help manage the companies they invest in.

5) All VCs are Private Equity funds, but not all PE funds are VCs. Buyout PE funds, for example, typically invest in mature public companies.

Who are the most important players within VC fund structure?

VC firm (GPs), LPs, VC fund, Portfolio companies

How are the tasks and allocation divided within VC fund?

VC firm (GPs) manages the fund. LPs have ownership of the fund. The VC fund has shares in the portfoliofirms.

What are the characteristics of an average VC on Fund level?

Usually 20-30 Portfoliocompanies

What are the characteristics of an average VC on Firm level?

Can have multiple funds (Fund I, Fund II, Fund III, Fund IV)

Usually has 50 to 100+ portfoliocompanies

VC firm

Group of professionals, GPs, that manages venture capital investments. They do the investing, manage the fund and provide expertise.

VC fund

Investment vehicle created and managed by VC firm. Holds the committed capital by various investors (LPs) and is used to make direct investments into private companies. Each fund has limited timespan, usually 10 years. VC may raise multiple funds over time, each fund with its own committed capital and investment period.

VC funds are typically organized as Limited partnerships. Which 2 partners are part of those and what do they do?

1) Limited partners (LPs): investors with limited liability who supply the capital (mostly institutional investors, pension funds, university endowments, large corporations, or sometimes wealthy individuals). Investors’ capital is locked in.

2) GPs: VC firm who manages the fund and has unlimited liability

Limited partnerships are tax efficient, what are the specific benefits?

They do not pay corporate tax, partners instead pay income tax.

They can distribute securities to partners without tax effect (tax is only paid when securities are sold).

What is the agency problem between GPs and LPs?

The GP makes investment decisions on behalf of the LPs, leading to a potential misalignment of incentives. E.g., The GP may use LPs’ money to pursue her private benefit, failing to maximize returns for the LPs.

Mechanisms to Mitigate Agency Problems

Incentive compensation: The 20% carried interest aligns the GP's interest with maximizing fund profits.

Limited lifespan: The 10-year fund life prevents GPs from holding money indefinitely and encourages timely exits

LPs' Control: LPs can potentially withdraw from funding beyond the initial commitment.

Skin in the Game: GPs' personal capital contribution (about 1%) aligns their interests with the LPs' financial outcome.

Contracts and Reputation: Legal contracts and the VC firm's reputation concerns prevent self-dealing and ensure proper conduct.

General partner compensation structures: 2 sources

GPs receive their income from two sources:

Fixed management fee

-            2-3% of committed capital.

-            Base salaries of VC fund managers can be paid from management fees.

Variable compensation

-            20% of profits (‘carried interest’ or ‘carry’).

-            Biggest slice of variable pay comes from the carry.

The fixed base component is higher for younger and smaller firms, and compensation is less sensitive to performance.

-            This may reflect reputational concerns forcing new VCs to work harder.

-            Or, older VCs receiving higher compensation as a return on superior human capital.

How VCs add value?

General partners should generate ‘alphas’ to justify their compensation.

They do this by:

-            Screening investments that can benefit from their active involvement

-            Negotiating deals that adequately compensate investors for their risk

-            Making good decisions about follow-on investments

-            Monitoring portfolio companies

VCs obtain board seats in their portfolio companies

-            Boards with VC representation have a higher level of strategic involvement than boards where members do not have a large ownership stake

Supporting evidence: VCs with operating experience in the venture's industry add more value than those with less experience

Is success predictable?

X-axis: Scores that VC partners assigned to each venture of at the time of their first investment.

Y-axis: Realized returns.

It turns out success is NOT predictable. Weak-selection effect: VCs’ initial prediction on success works not so well.

Another type of VC: Corporate Venturing

Big corporations establish their own in-house venture capital divisions to invest in external start-ups.

Why corporations do it:

-            Benefit from technological knowledge/innovations of the company is successful

-            Often co-invest with regular venture capitalists (syndication) and may not need to be active investors

What is the benefit of Corporate venturing for Entrepreneur?

-            May benefit from shared corporate resources if they develop a product that complements the existing products of the corporation.

-            Corporate venturers may be willing to take on more risk.

Why security design matters: Conflicts of Interests

VC financing does not use simple debt or common equity. They are complex contracts (security design).

This complexity is essential because entrepreneurs and VCs have different objectives and risks, leading to potential conflict of interest.

Entrepreneurs care about:

-            Maintaining as much value and control of the company as possible.

-            Receiving financial returns from the venture.

-            Sharing some of the business risks with investors.

Whereas, Venture Capitalists care about:

-            Maximizing financial returns

-            Ensuring the firm makes sound investment/management decisions

-            Eventually achieving liquidity (selling the firm via IPO or merger)

Logic of VC contracts: Aligning incentives

The venture capital contract uses security design (e.g. Preferred Stock) to dynamically allocate control and returns based on performance.

Mechanisms to Mitigate Potential conflicts of interest:

Reward and Incentive Alignment: Imagine an investors gets a fixed payoff from her investment. Would it be enough to induce entrepreneur/VC to put their best effort to grow company? Hence, VC contracts often provide high-powered incentives for:

-            Entrepreneurs to maximize value and stay with the firm

-            VCs to actively add value through expertise and contacts.

Dynamic control:

-            Gives more control to the entrepreneur if things turn out well.

-            Gives more control to the VC if things do not turn out well.

Liquidity and Downside protection:

-            The terms provide incentives to eventually achieve a liquidity event.

-            Features like Liquidation Preference (discussed next) are used to protect the investor’s downside risk while maintaining the entrepreneur’s upside potential.

Simple securities

Debt: Investors lend money to entrepreneur in exchange for receiving interest payments and principal repayment at the end of the loan. If project succeeds: Investors receive at most: principal + interests. If project fails: Debt defaults. Debtholders then have the control right of the company – they receive whatever can be salvaged from liquidating the venture. Priority over equityholders.

Equity (common stock): Investors buy shares in the venture from the entrepreneur. If project succeeds: Equity holders receive a fraction of cash flow equal to the fraction they own. If failure: equity holders receive a similar part of the salvage value, net of what is owed to debtholders.

Do Simple securities meet the needs of VCs or entrepreneurs?

Single debt or common equity cannot fully meet the needs of entrepreneurs and VCs because they do not

-            Provide appropriate licenses

-            Allocate control dynamically

-            Offer adequate downside protection

-            Ensure liquidity for Investors

Convertible debt

Convertible debt: investors lead money to entrepreneur and, under certain conditions, can decide to convert the debt into a (pre-specified) fraction of equity.

-            If success: Investors can convert the debt into equity and obtain part of the cash flow.

-            If failure: Investors do not convert and are protected as debt-holders.

-            “Under certain conditions” = at pre-specified company milestone (like next financing round)

Convertible Preferred Stock in Venture Capital

Similar to convertible debt, convertible preferred stock is also popular. Preferred Stock in VCs have the following features:

-            Liquidation Preference: Preferred shareholders are paid before common stock in any liquidation or exit

-            Redemption Rights: Investors may have the right to “put” the stock back (force redemption or buyback), creating a quasi-debt payoff if the company underperforms

-            Option to Convert to Common Stock: capture upside potential when the firm’s value exceeds their liquidation preference

Hybrid payoff: debt-like downside protection and equity-like upside participation

Popular securities in VCs and reasons

Convertible debt:

-            Simple and fast to close (no need to value company now)

-            Defers valuation until later rounds

-            Used in early-stage financing

Convertible preferred stock:

-            Gives investors downside protection

-            Gives upside through conversion if the company exits big

-            Provides governance

-            Used in financing stayed past seed

Bonus: SAFE notes

-            The safe is a non-debt alternative to convertible debt.

-             SAFEs have recently overtaken convertible debt in early stage startup. Its even simpler (no interest, no maturity date) and created by Y combinator.

The VC investment process

Less than 1% of companies considered for investment actually get it.

Deal sourcing: Where do investment opportunities come from?

-            Professional network most likely

-            Proactively self-generated

-            Referred by other investors

-            Inbound from management

-            Referred by portfolio company

-            Quantative sourcing least likely

Investment criteria: Horse or jockey?

-            Jockey: the team (does not matter what they do)

-            Horse: the product/idea (does not matter who does it)

Early stage VCs bet more on jockey, while late VCs bet more on horse. (but team still important) (Gompers et al. 2019).

The early stage money map (before VC)

Goal: ship a product, prove traction, raise VC.

Typical path: Founder savings & grants -> FFF -> Angels -> Accelerators -> Crowdfunding -> VC.

Angel Investors/Business Angels

High-networth individuals who invest their personal wealth in high-risk, high-return ventures. Often have strong VC investment/business experience.

Checks: 25k-100k; fast decisions; local networks. Value: operator experience, “bridge” to seed VC. Costs/risks: dilution, variance in involvement quality, follow-on capacity limited.

Accelerators & Incubators (A&I’s)

Organizations that support creating and developing start-ups through a set of services and resources.

-            ‘’Schooling’’ model: cohort-based program + mentorship + network.

-            Equity-for program is common; some grant/free or hybrid models.

-            Corporate A&I’s: A&I’s set up by corporations

-            University A&I’s: A&I’s set up by universities, either public or private

-            Value: speed to market, community.

-            Costs/risks: equity cost for small capital, program bit varies and also time-intensive.

-             Best for pre-seed to see; need structure and investor access.

Crowdfunding - 4 flavors

Funding venture where many individual investors pledge small amounts of capital, usually through an internet platform.

-            Reward: pre-sell product; signal demand

-            Equity: sell small ownerships stakes via platforms

-            Debt: small loans from many lenders

-            Donation: cause-drivers, no financial return

Note: Token-based sales (ICOs) = specialized, regulatory consideration; not mainstream seed for most startups.