What is Venture Capital?

Venture Capital

Topics Covered Definition of Venture Capital Activities of Venture Capitalists Organization Structure of Venture Capital History of Venture Capital Patterns of Venture Capital Investment Cost of Capital for Venture Capital

What is Venture Capital? Venture Capital (VC) Money invested to finance a new firm (Please see, Heukamp, Liechtenstein and Wakeling (2007) p.68) Since success of a new firm is highly dependent on the effort of the managers, restrictions are placed on management by the venture capital company and funds are usually dispersed in stages, after a certain level of success is achieved.

What is Venture Capital? A VC has five main characteristics: A VC is a financial intermediary, meaning that it takes the investors capital and invests it directly in portfolio companies. A VC invests only in private companies. This means that once the investments are made, the companies cannot be immediately traded on a public exchange. A VC takes an active role in monitoring and helping the companies in its portfolio. A VC s primary goal is to maximize its financial return by exiting investments through a sale or an initial public offering (IPO). A VC invests to fund the internal growth of companies.

(1) What is a VC? A VC is a financial intermediary, i.e., that they take the investors capital and invest it directly in portfolio companies. Entrepreneurs VC Investors

The Flow-of-Fund in the Venture Capital Cycle Typically, a VC fund is organized as a limited partnership, with the venture capitalist acting as the general partner (GP) of the fund, and the investors acting as the limited partners (LP). VC Funds Managed by General Partners ( VCs or GPs ) Portfolio Companies Limited Partners (Investors or LPs ) Exits : Sale of Portfolio companies to public markets (IPOs) or to other companies

Private Equity Partnership Investment Phase Payout Phase Limited partners put in 99% of capital General Partner put up 1% of capital Investment in diversified portfolio of companies Partnership Mgmt fees Company 1 Company 2 Company N General Partner get carried interest in 20% of profits Partnership Sale or IPO of companies Limited partners get investment back, then 80% of profits

(2) What is a VC? A VC will only invest in private companies. This means that once the investments are made, the companies cannot be immediately traded on a public exchange. - no simple mark to market - no liquidity - VCs tend to focus on high-technology industries - most VC firms specialize their funds by stage, industry, and/or geography

VC is a Segment of Private Equity

Hedge Funds Hedge Funds are flexible investing vehicles that share many characteristics of private equity funds, including the limited partnership structure and the forms of GP compensation. The main differences: Hedge funds tend to invest in public securities. Private equity funds are long-term investors and hedge funds are short-term traders. Hedge funds investments are more liquid than those for private equity investors, so that hedge funds can offer their investors faster access to their money.

(3) What is a VC? A VC takes an active role in monitoring and helping the companies in his portfolio.

(4) What is a VC? A VC s primary goal is to maximize his financial return by exiting investments through a sale or an initial public offering (IPO). $35 $30 $25 $20 $15 M&A exits ($B) IPO exits ($B) $10 $5 $0 2002 2003 2004 2005 2006 2007 2008 2009

(5) What is a VC? VCs invest to fund the internal growth of companies. The investment proceeds are used to build new businesses, not to acquire existing businesses.

Stages of Growth Early-Stage Seed/Startup Early Stage Expansion Stage Later Stage (Please see, Black and Gilson (1998) p.250)

What do Venture Capitalists do? VC activities can be broken into three main groups: Investing Monitoring Exiting

Investing Investing begins with VCs prospecting for new opportunities and does not end until a contract has been signed. For every investment made, a VC may screen hundreds of possibilities: A few dozen will be worthy of detailed attention. Fewer still will merit a preliminary offer (preliminary offers are made with a term sheet, which outlines the proposed valuation, type of security, and proposed control rights for the investors). If this term sheet is accepted by the company, then the VC performs extensive due diligence by analyzing every aspect of the company. If the VC is satisfied by this due diligence, 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.

Monitoring Once an investment is made, the VC begins working with the company: Through board meetings Recruiting Regular advice Together, these activities comprise the monitoring group (Please see, Kaplan and Stromberg (2004) p.2194).

Exiting VCs plan their exit strategies carefully, usually in consultation with investment bankers: Historically, the IPO has been the source of the most lucrative exits. The main alternative to the IPO is a sale to a strategic buyer, usually a large corporation.

The Key Players in the VC Industry VC firms (small organizations, averaging about ten professionals, who serve as the GP for VC funds) general partner (GP) VC fund (a limited partnership with a finite lifetime, usually ten years plus optional extensions of a few years) limited partner (LP) committed capital (total amount of capital promised by the LPs over the lifetime of the fund) early-stage, mid-stage, late-stage fund, multistage fund the fund has been closed (once the GP has raised the full amount of committed capital and is ready to start investing) vintage year capital call = drawdown = takedown (periodic capital provisions)

Who are the LPs? Historically, just under half of all committed capital comes from pension funds. The next two largest groups are financial institutions and endowments/foundations, each with about 1/6 of the total. Individuals/families and corporations make up the remainder, and are more fickle than the other types. These types of indirect corporate investment (individuals/families) as an LP should not be confused with direct corporate VC investment (business angels) in portfolio companies (please see, Morrissette (2007) p.54).

Committed Capital by LP Type

Investment vs. Fundraising 40 35 30 25 20 15 10 11 20 28 22 23 19 31 27 35 31 28 25 18 15 Raised ($B) Invested ($B) 5 0 2003 2004 2005 2006 2007 2008 2009

Example: Sierra Ventures Fund Name Vintage Year Committed Capital (previous funds information omitted) Sierra Ventures V 1995 $100M Sierra Ventures VI 1997 $175M Sierra Ventures VII 1999 $250M Sierra Ventures VIII 2000 $500M Sierra Ventures IX 2006 $400M

Compensation structure Management fees (most commonly 2% of the committed capital every year, this fee remain constant or in most cases the fee drops somewhat after the 5 year investment period is over) Carried interest (often referred to simply as the carry). The carried interest definition: % of the realized fund profit that gets paid to GPs. Realized fund profit = cumulative distributions committed capital or investment capital. Level: 20 to 25-30 Basis: committed capital or investment capital

Fees: definitions Annual management Fees Level: 2% Basis: committed capital or net invested capital lifetime fees = The total amount of fees paid over the lifetime of a fund investment capital = committed capital - lifetime fees invested capital = cost basis for the investment capital of the fund that has already been deployed at a given point Net invested capital = invested capital - cost basis of all exited and written-off investments

VC COMPENSATION (IN$ THOUSANDS)

Top-Tier Venture Capitalists

The History of Venture Capital The modern organizational form of VC dates back only to 1946. American Research and Development Corporation (ADR), began operations in 1946 as the first true VC firm (by George Doriot, as open-end funds). Unlike modern funds, it was organized as a corporation and was publicly traded. The U.S. government began its own VC efforts as part of the Small Business Act of 1958, which was legislation that created the Small Business Administration and allowed the creation of Small Business Investment Companies (SBICs).

The History of Venture Capital An important milestone for the VC industry came in the 1960s with the development of the limited partnerships for VC investments. Limited partnerships are by far the most common form of organization in the VC industry. Total VC fund-raising in the U.S. was still less than $1B a year throughout the 1970s. The next big change for VC came in 1979, when the relaxation of investment rules for U.S. pension funds led to historically large inflows from these investors to the asset class. Investing activity rose sharply to $3B in 1983 and remained remarkably stable through the 1980s. From $2.2B in 1991, it rose gradually to $4.1 B in 1994 (preboom period).

U.S. VC Investments ($ billions)

Investment by Stage 100% 90% 80% 70% 60% 50% 40% 30% Later Expansion Early Startup-Seed 20% 10% 0% 198019821984198619881990199219941996199820002002200420062008

Investment by Industry Percent of VC dollars invested Business/Financial Services Media/Retail Industrial/Energy Medical Devices and Equipment Biotechnology Hardware Semiconductors/Electronics Post-boom Boom Pre-boom Software Communications 0% 5% 10% 15% 20% 25% 30% Pre-boom = 1980-1994, Boom = 1995-2000, Post-boom = 2001-2009

U.S. VC Investment by Region (2008) 100% = $28 billion Philadelphia, 2.7% Colorado, 2.9% DC/Metroplex, 3.5% Other, 4.8% Northwest, 4.1% San Diego, 4.3% Silicon Valley, 38.8% Southeast, 4.4% Texas, 4.5% Midwest, 4.8% NY Metro, 6.6% New England, LA/Orange County, 11.6% 7.0%

The Global Distribution of High-Tech Private-Equity Investment, 2007, Top-20 Countries, in $Billions Source: PWC Global Private Equity Report 2008.

Fund-Level Returns: Data Venture Economics Collects data from GPs, publishes vintage-year specific quartile performance data while keeping anonymity of individual funds Freedom-of-Information-Act (FOIA) requests Forces public pensions to disclose performance of their fund holdings Private Equity Performance Monitor Collects, packages and sells fund-specific performance data for a fee. Assigns quartile rankings to funds

Industry Returns Industry returns are constructed as timeweighted returns Nice for comparison with market indices Nice for making risk adjustments 3 sources: Sand Hill Econometrics (SHE): portfolio comp level Cambridge Associates (CA): fund level Venture Economics (VE)

A Gross-Return Index

Kleiner Perkins Returns

Cost of Capital for VC Historically, annualized VC return index raw return is superior to those of public stock market indices. Individual investment outcomes vary greatly. Venture = investments with high variance in outcomes 30-40% go bankrupt 20-25% return 5 times or higher What should investors expect to earn from investing in VC? Not the entrepreneurs! Not the venture capitalists!

Model Our starting point is the Capital-Asset-Pricing Model (CAPM). It states where r i = R i = R f + β(r m R f ), r i is the cost of capital for asset i, R i is the expected return for asset i, R f represents the risk-free rate, R m is the return on the whole market portfolio, β, or beta, is the level of risk for asset i. The difference (R m R f ) is called the market premium.

Risk We make a key distinction between two kinds of risks that are potentially present in any investments. 1. Beta risk = market risk = non-diversifiable risk = systematic risk = covariance 2. Idiosyncratic risk = diversifiable risk = firm-specific risk = residual risk = variance Why should we care which kinds of risks it is? Should investors demand higher returns for holding all risks?

Estimating VC Cost of Capital To estimate VC cost of capital according to CAPM model, we use historical aggregate VC industry return data and estimate the following equation: R vc, t - R f,t = + β(r m,t R f,t ) + e vc,t, where β, R vc,t, R m,t, and R f,t are as defined before, except that previously the return variables represented expected returns, while here they represent realized (= historical) returns for period t. The new elements in this equation are α, or alpha, the regression constant, and e vc,t, the regression error term. Alpha represents the unexpected portion of the return, and positive alpha is interpreted as skills of portfolio managers.

CAPM Estimation Results Two data sources Beta is smaller than 1 here, but CAPM is not perfect, and we will make further adjustments.

Adjustment (1): The Fama-French (1993) Model The Fama-French (3-factor) Model has become part of a standard tool kit for cost of capital estimation (much like CAPM) in the last 25 years. It is based on empirical observations that certain styles of investments, such as small stocks or value stocks do not fit CAPM model well. Now the equation is R vc, t - R ft = α + β * (R mt R ft ) + β size * SIZE t + β value * VALUE t + e vc, t where α, β, R mt, R ft, e vc, t are defined as in the CAPM, SIZE t and VALUE t are the returns to portfolios of stocks that capture correlations with these styles, and β size and β value are the regression coefficients on these returns.

Adjustment (2): The Pastor-Stambaugh (2003) Model (PSM) Another relevant issue for VC is that investors may require premium for illiquid investments. The PSM model incorporates this illiquidity risk as the additional factor to the Fama-French 3-factor model. The equation is R vc, t - R ft = α + β * (R mt R ft ) + β size * SIZE t + β value * VALUE t + β liq * LIQ t + e vc, t where LIQ is the new liquidity factor, β liq is its regression coefficient, and all other variables are as defined before. More sensitive the return on an asset is to the change in this liquidity factor, the higher premium the investors demand when liquidity factor return is high in the economy.

Final Estimation Results ***, **, and * Indicates statistical significance at the 1, 5, and 10% level, respectively. Market beta is now close to 2. Alpha is no longer significantly different from 0. Using both sets of estimates and taking the mid-point, r VC = 15% 0.04 (r f ) + 1.63 * 0.07 (Market) 0.090 * 0.025 (size) 0.68 * 0.035 (value) + 0.26 * 0.05 (liquidity) = 14.1% (SHE estimates) 0.04 (r f ) + 2.04 * 0.07 (Market) +1.04* 0.025 (size) 1.46 * 0.035 (value) + 0.15 * 0.05 (liquidity) = 16.6% (CA estimates) We use 15% as the cost of capital for VC in this course.

Types of Factor Models Single Factor Models Capital Asset Pricing Model (CAPM) and Market Model Multi-factor Models Macroeconomic Factor Models prespecify macroeconomic indicators such as interest rates, inflation, exchange rates (e.g. Arbitrage Pricing Theory) Statistical Factor Models extract from historical timeseries and cross-section of stock returns (e.g. Principal Components or Factor Analysis) Fundamental Factor Models use firm-level attributes and market data, like P/B, P/E, industry, momentum, trading activity, etc. (e.g. Fama-French, Carhart, BARRA)

Fama-French (1993) Three-Factor Model E(R i ) r f = i,m [E(R m ) r f ] + i,smb E[SMB] + i,hml E[HML] SMB is return spread between small-cap and large-cap HML is return spread between high ΒΕ/MVE and low BE/MVE

Carhart (1997) Four-Factor Model E(R i ) r f = i,m [E(R m ) r f ] + i,smb E[SMB] + i,hml E[HML] + i,umd E[UMD] UMD (momentum factor) is return spread between high prior returns portfolio and low prior returns portfolio

Web Resources www.nvca.org www.evca.com www.avcj.com www.pwcmoneytree.com www.vnpartners.com/primer.htm