Week 3 - Venture Capital Flashcards
Characteristics of Venture Capital
- Act as financial intermediaries
- Invest in private companies - investments are illiquid
- Take active roles
- Primary goal is to maximize financial return
- Invests in entrepreneurial companies with growth potential
How are VCs organized?
They are organized as Limited Partnerships
2 categories of partner:
- Limited partners - investors with limited liability who supply capital (wealthy individuals, banks, mutual funds, etc.)
- General partner - managers the fund and has unlimited liability
Limited partnership typically has a 10 year lifespan and investors’ capital is locked in
Limited partnerships are tax efficient: do not pay corporate tax (partners pay income tax) and they can distribute securities to partners without tax effect
Carried Interest
General partners receive a management fee and a percentage of the profits over the life of the fund
Solution to Limited Partnership Agency Problem
- Limited lifespan
- LPs can withdraw from funding beyond the initial investment
- Incentive compensation: carried interest
- Skin in the game: GPs contribute capital to fund
- Contracts and reputation
Solution to Limited Partnership Agency Problem
- Limited lifespan
- LPs can withdraw from funding beyond the initial investment
- Incentive compensation: carried interest
- Skin in the game: GPs contribute capital to fund
- Contracts and reputation
Corporate Venturing
Big corporations have established their own in-house VC dividends to invest in external start-ups
They do not need to be active investors - often co-invest with regular VC (syndication)
Types of Securities Available to Investors
- Debt: Investors lend money in exchange for interest payments and principal repayment (payoff: linear then straight)
- Equity: Investors buy shares from the entrepreneur (payoff: linear)
- 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 (payoff: non-linear)
Calculating Expected Return with Debt
Debt = Principal + Principal*Interest
E(R) = ΣProbability*Debt / Principal
Note: If company does not make enough to repay debt, pay as much as possible
Calculating Expected Return with Equity
E(R) = (Expected Value of Firm*% Equity - Initial Investment) / Initial Investment
Expected Value of Firm = Probability*Value
Calculating Expected Return with Convertible Debt
Idea is to compare whether the value of debt is more or less than the value of the convertible for each scenario of valuation
We then multiply whichever is highest by their probabilities
E(R) = [Σ(Probability * Value of Convertible or Debt) - Initial Investment]/Initial Investment
Convertible Debt offers the best of both worlds! It protects the VC in the default state (debt-like) and it allows the VC to share the payoff in success (equity-like)
What securities do VCs use in practice?
They use a combination of Common Stocks and Preferred Stocks
Features of Preferred Stocks
- Liquidation Preference: preferred stocks must be paid before any common stock could be liquidated
- Redemption Rights: VCs can decide to “put” the stocks back to the entrepreneur
The redemption price of preferred stocks is agreed ex-ante, making it a debt-like security (provide downside protection)
Common stocks are equity-like (provide upside potential)
Convertible Preferred Stocks
They can be converted at the shareholders’ option into common stock at a pre-specified conversion price
Convert if total value at IPO/sale/liquidation > liquation value
Calculating Expected Return with Preferred Convertibles
Check how much equity you own (i.e. #shares)
Check for each scenario of company valuation if equity greater or less than redemption payoff
Choose what to do in each scenario
E(R) = [Σ(Probabilities*Equity or Redemption Payoff) - Initial Investment]/Initial Investment
The Jockey or the Horse?
The jockey: the team
The horse: the product/idea
Early stage VCs bet more on the jockey, late stage VCs bet more on the horse
