TH10/11/2012 ExternalFinancingPart1Prof.

KimLecture13 FIRST LECTURE AFTER MIDTERM EXAM (LECTURE 13) READ CH 12 Business Financing Stages Angel Financing Pros and Cons Venture Capital Financing Pros and Cons Venture Capital Financing Process Private Equity Articles

 Less likely with limited record, unproven entrepreneur, uncertain horizon Less likely while working on product development and not generating revenue Less likely without asset base of sufficient value or liquidity to secure or collateralize debt More likely to engage in moral hazard at expense of creditor

Debt Financing

Business Initial External Financing Stages

Financing Stages by Purpose A)Early Stage (typically angels)=for seed capital for concept, then start up funding B)Development (typically venture capitalists)=for initial growth, expansion with sales growth, bridge financing before public offering (can be DPO or IPO)

Angel Financing Pros and Cons

100,000-250,000 angels invest $10billion-$20billion in 30,000 to 50,000 firms, ranging from $25K-$500K per firm Business angels=generally high net worth, informationally sophisticated individual investors, including other entrepreneurs or retirees, often as one of 200 organized angel investor groups (generally not larger than 80 members) or even angel funds with professional mgmt Where to find it=Angelist.com, www.kauffman.org How to obtain it=basis contacts and referrals, elevator pitch to angels followed by Q&A session, champion takes lead in due diligence BUT cannot make decisions on behalf of other angels due to SEC provision on formality of investment practices Pros: early-stage (seed and start-up), informal, simple, speedy, long-term investment horizon (often five to 10 years) Cons: generally very localized, smaller-scale funding, equity requirement in exchange for capital and expertise, requires valuation, milestones

Venture Capital Financing Pros and Cons

Around 1000 venture capital firms invest $10billion-$20 billion in several thousand entrepreneurial ventures, ranging from $2million$10million per investment Venture capitalist=firm investing typically on behalf of venture fund organized as partnerships with typically large diversified investors as limited partners (insurance companies, pension funds, university endowments, foundations, corporations, funds of funds) Where to find it=National Venture Capital Association, other national and regional associations, professional referrals How to obtain it=approach venture capital firm with business plan for initial screening, then deal evaluation for 1st round (Series A round early sales and manufacturing), 2nd round (working capital for early stage entrepreneur selling product but unprofitable, 3rd round (mezzanine financing for newly profitable entrepreneurs expansion), 4th round (bridge financing for going public) stages of financing Pros: larger scale funding, offers valuation, consulting Cons: later-stage, more mature, more complex contracts, significant due

Venture Capital Financing I FOCI

Timing=Venture must be mature enough for venture capitalist to add value (monitor, sit on boards, provide incremental financing at stages based on milestones) Industry=Venture must be in industry for venture capital to add value (majority in high-tech fields, but occasionally in lowtech fields such as retail, consumer products, and healthcare services) Geography=Venture must be in region where agglomeration economies possible, still focused on specific regions such as Boston and Silicon Valley, Research Triangle Area Fund objectives=Venture must have high growth potential and can be harvested within three-to-seven year window, since fund has finite life and investors seeks equity-like returns

Venture Capital Financing II OVERVIEW

Venture capital firm (venture capitalist) establishes new venture capital funds every two to five years Fund is established as partnership with portfolio of investments in number of entrepreneurial ventures, with life of generally 10 years Venture capitalist as general partner contributes capital, expertise in identifying deal flow (entrepreneurial investment opportunities), raises capital, deploys capital, monitor and advise, finally harvest Fund investors (typically large diversified investors)as limited partners contribute capital and retain limited liability and passive investor status and thus not involved in day-to-day operations, but monitor funds progress Financial commitments from fund investors drawn down over time with financing in stages; monitoring and assisting to increase probability of success of ventures in the portfolio; harvesting begins within seven years; usually invest in overlapping funds at same time in case one funds runs out of capital before end of its life

Venture Capital Financing III PROCESS

Venture capital fund managers face less uncertainty about unexpected inflows and outflows of capital, allows to operate with low cash flow, allows to take advantage of immediate investment opportunities, less concern about valuation on continuing basis Venture capitalist markets fund attracts investors who make commitment to fund but dont provide capital initially WHILE venture capitalist goes through deal flow AND negotiates deals with entrepreneurial venturesmakes capital calls to investors to draw down capital from them over time to make promising investments for fund while conducting due diligence (up to 100 days) for final approval penalties to investors for not participating in a capital call, not delivering capital within the time frame (often 30 days)YEAR 0 closing identifies investment cohort AND when actual investments can be made with minimum total sufficient commitments of capital with initial capital callsubsequent capital calls and investments made 2-3 yearscontinued value creation by venture capitalist 4-5 yearsharvest investment (IPO, acquisition, LBO, liquidation) AND distribution to investors(cash,public shares,etc.)2-3 years=7-10 years

Venture Capital Fund Contribution and Distribution

Compensation to venture capitalist contributes 1% of capital: 2/20=2-3% of the committed capital as annual management fee for administrative and operational expenses in managing the fund, 20-30% share of funds capital appreciation, socalled carried interest Return to fund investor contributes 99% of capital: 70-80% nontradable share of funds capital appreciation within five years

Private Equity
Why hasnt the private equity industry been that regulated? Nearly thousand firms (ignoring venture capital firms), more than $1 trillion in assets under management. The Carlyle Group, Kohlberg Kravis Roberts KKR(Bear Stearns), The Blackstone Group(Lehman Brothers), Bain Capital, Warburg Pincus, Barclays Ventures, Berkshire Partners, Morgan Stanley Capital Partners, Goldman Sachs Capital Partners, UBS Capital. Lobbying efforts. Sophisticated informed investors. Dodd Frank Act (most firms must register with the SEC by end of March). SEC using proprietary risk analytics across investment advisor space. SEC concern about overvaluation of portfolio (possible Ponzi scheme implications), esp. subjective nonuniform valuation of private companies without ascertainable market prices, fee structures. BUT interim valuations less important to their investors. Attention from Romneys association with Bain Capital, executive compensation, large buyout boom.

What arguments would you make in support of and against private equity firms? Traditional 2% management fee/20% of profits compensation mechanism. BUT earn profits only when sell a holding rather than gains at end of each year. BUT majority of revenue from the fixed fees regardless of performance. And higher debtloads contributed to higher returns.Create more leverage than necessary.Executive earnings from capital gains (referred to as carried interest) rather than income, so pay capital gain tax rate rather than personal income tax rate. BUT since investments not traded on stock exchanges, can focus on longterm rather than monthly or quarterly public market pressures. Also tax code favors deduction of interest payments on debt, so biases towards more leverage. Make markets.Make generally mid-sized firms (NOT startups) more competitive. BUT management by private equity of such firms dubious. Allow for more risky innovation. Loss of jobs and reduced cash position with dividend payouts. Force necessary costcutting and restructuring.Create better investment return opportunities. BUT illiquid, leveraged, long-duration investment with high fees. Move away from financial engineering, control, and leverage to alternative asset manager growth equity deals, particularly sparked by emerging countries, including China.