Introduction to private equity & venture capitalist fund

Introduction to private equity & venture capitalist fund

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  2 What isVenture Capitalist/Private Equity?  Venture capital is a subset of private equity and refers to equity investments made for the launch, early development, or expansion of a business  Among different countries, there are variations in what is meant by venture capital and private equity  In Europe, these terms are generally used interchangeably and venture capital thus includes management buy-outs and buy-ins (MBO/MBIs).  This is in contrast to the US, where MBO/MBIs are not classified as venture capital.
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  Why companies needfinancing? For start-ups or growing companies, as well as those facing a major change, financing is one of the key business issues. New capital is needed e.g. for  Financing of product development  Financing of market penetration  Financing of investments  Working capital financing to secure operative continuity  Maintaining liquidity to be able to cover daily payments
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  Company Life Cycleand Investment Requirements Incubator Family Capital/ Bootstrap R&D Venture Capital Start-up Funds Business Angels Expansion Capital MBO/LBO/Expansion Start-Up Take-off Development Maturity & Sale Company Life Cycle 4 Growth/financing requirements
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  5 Type ofInvestors Business Angels Definition: An angel investor (also known as business angel or informal investor) is an affluent individual who provides capital for a business start-up. The capital they provide can be a one-time injection of seed money or ongoing support to carry the company through difficult times. Motivations: Dramatic return on investment via exit or liquidity event, • Initial Public Offering (IPO) of company • Subsequent financing rounds, Interest in technology and industry Financial Instrument: Convertible debt & ownership equity. Risk : Investments are characterized by high level of risk and a potentially large return on investment Venture Capitalists Definition: An investor/financial institutions which either provides capital to start up ventures or supports small companies that wish to expand but do not have access to public funding. Financial Instrument: equity or quasi –equity instruments, and some times debt Risk: It typically entails high risk for the investor, but it has the potential for above-average returns.
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  Types of VentureCapitals Investment is made by venture capital firms to finance the founding or early growth of new companies that do not yet have access to the public securities market or to institutional lenders such as banks or insurance companies Type of Companies where investment is made Type of Financing May include equity or quasi –equity instruments, and some times debt—normal or conditional in exchange for ownership for a predetermined time period. In particular, the purchase of convertible securities (preferred shares or convertible debt) by the venture capitalist is the predominant form of investments in many countries. 6
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  Venture Capitalist Overview Venture Capital is the term applied to investments in new and untried enterprises that are lacking a stable record growth. Investment is made by venture capital firms to finance the founding or early growth of new companies that do not yet have access to the public securities market or to institutional lenders such as banks or insurance companies Venture Capitalist Type of Companies where investment is made Type of Financing May include equity or quasi –equity instruments, and some times debt—normal or conditional in exchange for ownership for a predetermined time period. In particular, the purchase of convertible securities (preferred shares or convertible debt) by the venture capitalist is the predominant form of investments in many countries. Exits Once any venture reaches the stage of profitability the venture capitalist divests it investment through available exit routes (buy back, stake sale or an initial public stock offering) and redeploys the resources in new ventures. 7
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  Role of aVenture Capitalist The Venture capitalists plays the role of a resource manager for business development. Venture capital business demands skills, attitudes and systems very different from those of traditional financial intermediaries such as banks Role  Funds: Venture capital funds the fill the gap between an entrepreneur's personal resources and funds that may eventually be raised from traditional credit institutions or public stock offerings.  Stake: Entrepreneurs give up a percentage of the ownership of their new company, often not more than 50% , in exchange for acquiring capital. As a result, entrepreneurs avoid interest payments and can more quickly achieve profitability,  Co-Promoter: Venture capitalist joins entrepreneur as a co-promoter in projects and share the risks and rewards of the enterprise with the objective of long-term capital appreciation.  Fee: The common form of compensation is an annual management fee based on capital committed and a portion of carried interest.  Skills Set: Venture capital is not solely an injection of funds into a new firm, it is also an input of the skills needed to set the firm up, design its marketing strategy, organize and manage its  Specialized venture capitalists can better understand the industry in which the firm operates and its technology, through this they can better control the business risk associated with early stage investing by remaining in close contact with the venture. Further, such specialization aids in the monitoring process.  Investment Range: Venture capital invest between 5 lakhs ( for example - Seed funds) to 50 crore (or larger). This is due to the fact that the characteristics of the venture vary by stage of development and thus the degree of involvement also differs. 8
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  Role of aVenture Capitalist  Governance : Venture capitalists take an active role in the governance of their portfolio companies by contributing their business experience and industry knowledge gained from helping other young companies  Specific Industry Expertise: Venture Capitalists are typically well connected in the specific industry, they help to recruit key personnel, they negotiate with suppliers and customers, they advise the entrepreneur on strategic decisions, play a major role in structuring mergers, acquisitions and initial public offerings and sometimes are even engaged in the day to day operations of the firm.  Board Members : Also serves on the Board of the company. 9
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  Stages of Financing Seed Financing Early Stage Financing Usually involves a small amount of capital provided to an investor or entrepreneur to prove a concept Startup Financing Provides funds to companies for use in product development and initial marketing. Other Early stage Financing Provides funds to companies that have exhausted their initial capital and need funds to initiate commercial manufacturing and sales Mezzanine/ Expansion Financing Later Stage Financing Includes working capital for the initial expansion of a company or for manor growth expansion and financing for a company expecting to go public within six months to a year. Management /Leverage Buyout Financing Includes funds to acquire a product line or business from either a public or private company, utilizing a significant amount of debt and little or no equity Acquisition Financing Provides financing to obtain control , possession or ownership of a private portfolio company. 10
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  Venture Capitalist Activities Investing – Prospecting for New Opportunities Stage 1 --- Screening - For every investment made, a VC may screen hundreds of possibilities. Out of these hundreds, perhaps a few dozen will be worthy of detailed attention, and fewer still will merit a preliminary offer. Stage 2 --- Preliminary offers are made with a term sheet, which outlines the proposed valuation, type of security, and proposed control rights for the investors. Stage 3 --- Due Diligence - If this term sheet is accepted by the company, then the VC performs extensive due diligence by analysing every aspect of the company. Stage 4 --- Final Closing - If the VC is satisfied, then all parties negotiate the final set of terms to be included in the formal set of contracts to be signed in the final closing. Investment Stages Selected Proposal at Each Stage Screening 100 -1,000 Preliminary Due Diligence 10 Term Sheet 3 Final Due Diligence 2 Closing 1 Key Questions Does this venture have a large and addressable market? (Market test) Does the current management have the capabilities to make this business work? (Management test) 11
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  Venture Capitalist Activities Monitoring Once an investment is made, the VC begins working with the company through board meetings, recruiting, and regular advice. Exiting VCs are financial intermediaries with a contractual obligation to return capital to their investors. However, the exit process itself requires knowledge and skills that are somewhat distinct from the earlier investment and monitoring activities. VCs plan their exit strategies carefully, usually in consultation with investment bankers. 12
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  Flow of fundsin the venture capital cycle Portfolio companies Exits: IPO or sale of portfolio companies VC funds managed by general Partners (VCs or GPs) Limited partners (investors or LPs)  VC firms are small organizations, averaging about 10 professionals, who serve as the general partner (GP) for VC funds.  A VC fund is a limited partnership with a finite lifetime (usually 10 years plus optional extensions of a few years).  The limited partners (LPs) of VC funds are mostly institutional investors, such as pension funds, university endowments, and large corporations.  When a fund is first raised, the LPs promise to provide a certain amount of capital, which will be provided either on a set schedule or at the discretion of the GP. These periodic capital provisions are known as capital calls, drawdowns, or takedowns.  The total amount of capital promised by the LPs over the lifetime of the fund is called the committed capital of the fund.  Once the GP has raised the full amount of committed capital and is ready to start investing, we say that the fund has been closed.  The typical fund will invest in portfolio companies and draw down capital over its first five years.  A successful VC firm will raise a new fund every few years so that there is always at least one fund in the investment period at all times. 13
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  VC Partnership Agreement  The VC firm serves as the GP of the partnership and is compensated by management fees .  This compensation structure creates some differences between the incentives of the GP and the LPs, and many partnership agreements include several restrictive covenants to mitigate these differences.  The expenses of VC investing start immediately: salaries must be paid, the lights must stay on, and due diligence must be performed.  The typical arrangement is for limited partners to start paying a set percentage of committed capital every year, most commonly 2.0 percent. Sometimes this fee remains constant or the full 10-year life of the fund, but in most cases the fee drops somewhat after the five-year investment period is over Management Fee Carried Interest  The other form of VC compensation is the carried interest, often referred to simply as the carry. Carried interest enables GPs to participate in the profits of the fund, and historically it has provided the largest portion of GP compensation. Restrictive Covenants  LPs tie up capital with no promise of a return and little control over the investment activities of the GP. They divide covenants into three broad categories: (1) restrictions on management of the fund, (2) restrictions on the activities of the GP, and (3) restrictions on the types of investment. 14
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  Valuations Methods Relative Valuations  DCF Analysis  Net Assest  Option Pricing  Real Options  Valuation of Preferred Stock  R&D Valuation  Game Theory  Monte Carlo Simulation  Later Stage Investment  Biomial Trees - The Black-scholes Equation Startups are valued differently before they receive funding and after the money comes in. The premoney valuation is a monetary estimate of various factors ranging from the strength of the founding team, competitive landscape, intellectual property and the size of the market. Once an investment is made, the final value of a startup is derived by adding the amount invested to the pre-money valuation. Experts said the percentage of stake that a founder cedes must be based on the post money valuation. 15
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  VC Trends inIndia 2010 2011 2012 Invested capital (US$b) 0.9 1.7 1.4 Invested rounds* 109 175 205 Median round size (US$m) 7.25 5.45 3.61 Number of VC-backed IPOs 6 2 2 IPO capital raised (US$b) Median time to IPO (years) 0.5 0.05 0.02 Median time to IPO (years) 4.3 N/S N/S Number of VC-backed M&As 17 5 15 Median M&A Valuation (US$m) 63.0 N/S 18.4 Median time to M&A (years) 3.5 4.0 3.8 Investment rounds increase in India  India bucked the declining global trend in VC investment activity in 2012. The number of investment rounds increased by 17% to 205, the third successive year of increasing activity  Levels of reported VC investment also probably understate the true level of activity because of unreported deals not captured in the data 16
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  Economic Development issupporting growth  The growing wealth of the Indian economy and the accompanying increase in consumerization is underpinning the growth of the VC industry.  The two predominant themes from a demand perspective are:  Competition addressing changing consumer behavior patterns – the largest proportion of the total pool of VC backed companies is in consumer services (170 companies out of a pool of 528)  The introduction of new technology, particularly internet based applications such as cloud and mobile.  From a supply perspective, rising economic prosperity has increased the pool of entrepreneurs willing to take a risk on VC investment. Some of the high-net-worth individuals have already made money as successful entrepreneurs prior to becoming VC or angel Investors.  The entrepreneurial ecosystem is becoming more developed as the availability of higher education has spread to third and fourth tier cities, with a corresponding increase in the number of engineering and medical schools. 17
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  VC Trends Late–Stage Investment Dominates  The Indian VC industry is heavily weighted towards later-stage investment . The proportion of deals in the revenue generating stages was 87% in 2012 up from 83% in 2011 and 81% in 2010.  The reason for the predominance of later-stage investment is that compared with silicon valley.  Indian companies are focused less on innovation and more on application development and efficient delivery models, which take less time to develop into the revenue generating phase. More Deals but smaller in sizes  Median round size decreased from US$5.5m in 2011 to US$ 3.6 m in 2012.  The decrease in part reflects the influence of the growing network of angel investors on the VC market, with a preference for lower investment sizes. M&A is more likely than IPO at exit  Strategic buyers are a more likely exit route for Indian VC backed companies than IPOS. The very low level of IPO exists (two in both 2011 and 2012) reflects the absence of a junior stock market such as London, AIM  Exits are a combination of fresh investment by new VC funds and strategic M&A, with a bias towards the latter because strategic deals tend to command higher valuations. 18
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  Key Aspects ofTerm Sheet 1.Liquidation Preference This is the amount of money that holders of preference shares or the investors get when a company is sold partly or fully. For instance an investor puts in Rs 11 crore into a startup and asks for a two-fold liquidation preference. Subsequently if the company is sold for Rs 25 crore, the investor would get Rs 22 crore as his returns. This would leave the entrepreneur with just Rs 3 crore despite holding a majority share in his company. 2.ESOP Pool Investors typically bet on the jockey or the entrepreneur rather than the horse, which is the company. To ensure that the jockey has a support team backing him, investors push for stock option pools to be set aside. But this allocation is normally made from out of the share held by the founder. However this ESOP pool may never be fully utilised, leaving a hole in the stake of a founder. Experts are of the view that it is best for startups to have a hiring plan for a period of about 18 months with a smaller ESOP plan. 19
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  Key Aspects ofTerm Sheet 3.. Founders' Shareholding A term sheet provides the investor with a tool to ensure founders do not leave prematurely. This is done by ensuring that only a portion of the shares owned by the founders can be diluted immediately, the balance is normally locked up. Experts said this clause in a term sheet must be scrutinised by an entrepreneur to ensure that he gets at least half his shares immediately with the balance being vested within four years. 4.Shareholder Agreement A contract made between shareholders of a company regarding their stake in the company and the rights they hold on the board of the firm. It also contains clauses which protect interests of investors in case of a stake sale or a dispute. 5.Founders‘ Employment Agreement Investors are wary of letting the founders go for fear they will start up once more or join a rival. This document defines the mandatory length or term of a founder's employment, compensation, shareholding, ownership of intellectual property held by a founder as well as non-compete provisions in case of an exit. 20
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  Key Aspects ofTerm Sheet 6.. Double Dip An investor who asks for a two-fold return on investment while stating his liquidation preference can also slip in a clause on double dip. For instance, if a company is sold for Rs 25 crore and the investor gets Rs 22 crore, in a double-dip clause the founder may have to part with even a share of the Rs 3 crore that he is left with. 7.DRAG -ALONG CLAUSE In case an investor wants to sell his stake in a company he can force a founder and other investors to follow suit. 8.EARN-OUT MODEL An investor's stake in a startup automatically increases in case it fails to reach specific milestones. 21
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  Key Aspects ofTerm Sheet 9.TRANCHING Money is released in tranches based on targets making equity a form of structured financing. 10.PAY TO PLAY In this clause an existing investor must invest in follow-on rounds to retain his rights. 11.RIGHT OF FIRST REFUSAL The right to invest in subsequent rounds of funding rests with the first investor. 12.ANTI-DILUTION PROTECTION This allows an entrepreneur to maintain his stake even after subsequent rounds of funding 22
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  Definitions: Types ofInvestments A management buyout (MBO) involves the purchase of an independent business or subsidiary from the owners in which the incumbent management purchase a share of the equity (anything from as little as 2 percent or 3 per cent to 100 per cent to the size of the deal) and contribute to management the business post-acquisition. Venture capitalist and other investors would purchase the rest of the equity. In large deals, it is also likely that the funding is highly leveraged Management Buy Out ( MBO) Leveraged Buyout - LBO The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the bonds usually are not investment grade and are referred to as junk bonds. 23
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  Thank You 24