Equity Types of Private Equity

Question 1

1. List major contrasts between venture capital and buyouts.

Answer 1

• Whereas VC funds target nascent, start-up companies, buyouts target more established and mature companies.
• VC is necessary to get a prototype product or service out the door. In a buyout, the capital is necessary not for product development but to take the company private so that it can concentrate on maximizing operating efficiencies. Venture capital relies on new technology or innovation; buyouts look to see where they can add operating efficiencies or expand product distribution
• A VC firm typically acquires a substantial but minority position in the company. Control is not absolute. Conversely, in a buyout, all of the equity is typically acquired, and control is absolute.
• Venture capital and buyout firms target different internal rates of return. While both are quite high, not surprisingly, VC targets are higher. The reason is simple: There is more risk funding a nascent company with brand-new technology than an established company with regular and predictable cash flows.

Question 2

2. In what way does a venture capital investment resemble a call option?

Answer 2

• Investing in a start-up company is similar to the purchase of a call option. The price of the option is the capital that the venture capitalist invests in the start-up company. If the company fails, the venture capitalist forfeits the option premium, the capital invested. However, if the start-up company is successful, the venture capitalist shares in all of the upside, much like a call option.

Question 3

3. What are the two key objectives to the business plan of an entrepreneur seeking capital?

Answer 3

• To provide the information necessary to attract financing from a venture capitalist, and
• To serve as an internal game plan for the development of the start-up company.

Question 4

4. What is a venture capital fund?

Answer 4

• A venture capital fund is a private equity fund that pools the capital of large sophisticated investors to fund new and start-up companies.

Question 5

5. What is the name of the options that a venture capital fund manager often has to demand that the investors contribute additional capital?

Answer 5

• Capital calls

Question 6

6. What differentiates the seed capital financing stage from first stage of venture capital financing?

Answer 6

• The seed capital stage is the first stage where VC firms invest their capital into a venture and is typically prior to having established the viability of the product. This phase of financing usually raises $1 million to $5 million. First- or early-stage venture capital denotes the funding after seed capital but before commercial viability has been established. Early-stage VC financing is usually $2 million or more.

Question 7

7. What are the three main risks that contribute to the required risk premia for venture capital?

Answer 7

• The business risk of a start-up company
• Substantial liquidity risk.
• Idiosyncratic risk due to the lack of diversification associated with a VC portfolio.

Question 8

8. What is the primary difference between a management buy-in LBO and a management buyout LBO?

Answer 8

• A management buyout is led by the target firm’s current management, whereas a management buy-in is led by an outside management team. Thus the buy-out retains all or most top management while the buy-in replaced all or most top management.

Question 9

9. What are the two primary conflicts of interest that emanate from the potentially lucrative compensation schemes offered to exiting management teams in a management buy-in?

Answer 9

• Incumbent management has a strong incentive to resist any buyout attempt that displaces them as managers if the buyout does not provide them with generous compensation even if the buyout benefits shareholders.
• Incumbent management has a strong incentive to encourage buyouts that offer them generous compensation even if the buyout benefits shareholders.

Question 10

10. List the five general categories of LBOs designed to create value.

Answer 10

• Efficiency buyouts
• Entrepreneurship stimulators
• The overstuffed corporation
• Buy-and build strategies T
• Turnaround strategies