Lecture 3: Venture Capital

Question 1

What are the five characteristics of VC?

Answer 1

1) VCs act as financial intermediaries
2) VCs invest in private companies. As a result, investments are illiquid.
3) VCs take active roles in monitoring and helping with the
management of the portfolio companies (i.e. VCs are active investors)
4) A VC’s primary goal is to maximize its financial return and therefore it aims at exiting investments through acquisitions or IPOs
5) A VC invests in entrepreneurial companies with growth potential . VC investments are aimed at fuel internal growth of companies to maximise chances and returns of exits

Question 2

How do VCs compare to other investors?

Answer 2

1) Angel investors invest their own funds and are therefore not financial intermediaries

2) Venture Capita ists are not mutual /hedge funds because VCs invest in private companies

3) A VCs are Private Equity funds, but not a PE funds are VCs.

4) VCs differ from Crowdfunding in being active investors who actively monitor and help managing the companies they invest in

Question 3

How are VCs organized?

Answer 3

VCs are organized as Limited Partnerships

Limited partnerships have two categories of partners:
1) Limited partners are investors with limited liability who supply capital
2) General partner manages the fund and has unlimited liability

The limited partnership typically has a 10 year lifespan and investors’ capital is locked in

General partners receive a management fee and a percentage of the profits over the life of the fund (carried interest)

Limited partnerships are tax efficient. They do not pay
corporate tax (partners have to pay income tax) and they can distribute securities to partners without tax effect (only pay tax when securities are sold)

Question 4

What is a problem in a Limited Partnership?

Answer 4

Agency problem: genera partner acts as an agent for the limited partners (principals) and choose the companies to invest in. Incentives of GPs and LPs could be misaligned

Solutions to the agency problem:

• Lim ted lifespan (venture capitalist cannot keep money forever)
• LPs can withdraw from funding beyond the inital investment to set up the partnership
• Incentive compensation: GPs receive 20% of the profits (carried interest)
• Skin in the game: GPs contribute capital to the fund
• Contracts and reputation considerations prohibit general partner to self-deal

Question 5

What are the available security designs to investors and how does the payoff of those develop?

Answer 5

• Debt: Debt in return for interest payments and principle repayment at the end of the loan – if investment is a bust, investors have a right to salvage what’s left
• Equity: Buy shares – grow / decline with the investment in case of success / bust
• Convertible Debt: investors lend money to the entrepreneur and under certain conditions they can decide to cancel the debt, obtaining a pre-specified fraction of equity in exchange
  - If successful: investors can convert and obtain part of the cash flow
  - default: investors do not convert and are protected as debt-holders
  - Convertible debt is the best option!

Question 6

Preferred vs Common vs convertible preferred stock; characteristics and payoff

Answer 6

• Preferred and common stocks:
  
  • Preferred stocks provide downside protection (debt-like)
  • Common stocks provide upside potential (equity-like)
• Convertible Preferred stocks
  
  • Can be converted at the shareholders’ option into common stock at a pre-specified conversion price
  • Convert if total value at IPO / sale / liquidation is greater than the liquidation value