1/24/17
Entrepreneurial Finance Part - 2
Copyright 2009-17 Professor Gerome A. Hays
We ready to begin?
Copyright 2009-17 Professor Gerome A. Hays
Venture Capital Cash Flow Seed Capital / Startup Capital
Survival / Growth Capital
Seasoned Capital IPO
Early Stage
Later Stage
Secondary Offerings
Mezzanine
C B Valley of Death
A
Time Break even
Copyright 2009-17 Professor Gerome A. Hays
1
1/24/17
Venture Capital Defined A firm that pools capital to provide early-stage equity or equity-linked financing to high-potential entrepreneurial opportunities – that can be harvested for substantial profits.
Copyright 2009-17 Professor Gerome A. Hays
Industry Preferences 1960-80s 1970s 1980s 1980s 1990s 2000s 2005 2010
– Computers / Hardware – current / Life Sciences, Biotech – current / Software – current / Telecom, Mobile – current / Internet, E-Commerce – current / Storage, Cloud, SAAS – current / Social Media, Chat - current / upending old industries
(Software continues to eat the world)
Copyright 2009-17 Professor Gerome A. Hays
Benefactors of Venture Capital Entrepreneurs | Wealth effect, credibility Investors
| Access to deal flow
Employees
| Jobs, wealth
Government
| New tax base
Consumers
| New products, break-thru’s > Steep incentives > Freemium > Free Copyright 2009-17 Professor Gerome A. Hays
2
1/24/17
Venture Capital Historical Development
Copyright 2009-17 Professor Gerome A. Hays
1920s – 1930s Pre-World War II Era: No Venture Capital funds. Most venture investing came from wealthy individuals and families. Very difficult to get projects funded.
Copyright 2009-17 Professor Gerome A. Hays
History of Venture Capital 1940s-50s 1946 :George Doriot Father of Venture Capital. Formed American Research & Development Corporation: First Venture Fund in US.
Copyright 2009-17 Professor Gerome A. Hays
3
1/24/17
ARD Investment Activity
$3.5 million was raised ($2 million from institutional investors). Equivalent to ~ $35MM in today’s dollars. The company funded 18 companies over a 20-year lifecycle.
Copyright 2009-17 Professor Gerome A. Hays
ARD’s Home Run In 1957, ARD invested $70,000 in Digital Equipment Corporation (DEC). When DEC exited, ARD earn a 700x return on its investment.
Copyright 2009-17 Professor Gerome A. Hays
History of Venture Capital 1950s–60s Small Business Administration created SBICs in 1957: Small Business Investment Corporations borrowed $$ from Treasury to invest in start-ups.
Copyright 2009-17 Professor Gerome A. Hays
4
1/24/17
History of Venture Capital 1960s–70s SBICs come under scrutiny for mismanagement. Didn’t invest in start-ups, but established companies. Vietnam war and recession freeze capital for startups Total of $10MM raised to invest in start-ups in 1975
Innovation in US was at a standstill
Copyright 2009-17 Professor Gerome A. Hays
History of Venture Capital 1970s–80s ERISA changes “Prudent Man” standard to allow pension funds to invest with VCs. Tax Revenue act of 1978 lowered cap gains tax Apple & Genentech go public Confluence of above events triggered a cycle of heavy VC activity throughout the 80s Copyright 2009-17 Professor Gerome A. Hays
History of Venture Capital 90s-2000s Netscape IPO in 1995 kicked off consumer internet era. Tons of capital raised to invest in internet companies/technologies: Yahoo, eBay, Amazon. Business to Consumer (B2C), Business to Business (B2B) Market crash in April 2000 freezes Venture Investments
Copyright 2009-17 Professor Gerome A. Hays
5
1/24/17
History of Venture Capital: Today A 2nd Boon period for Venture Capital: Google, YouTube, Facebook, Twitter, Instagram, Tesla, etc. Hot areas: Life Sciences / Green Technologies / Social & Mobile media / Just about everything else is on the table.
Copyright 2009-17 Professor Gerome A. Hays
History of Venture Capital: Today
$59.1 Billion
Total Venture Capital Invested in 2015, a post-2000 Record.
$28.8 Billion
New money raised in 2015 for investing.
$165.5 Billion Total Venture Capital under Mgmt. Copyright 2009-17 Professor Gerome A. Hays
History of Venture Capital: Today Seed and early stage companies attracted 51% of all Venture Capital in 2015; 77 Venture-backed IPOs in 2015 (led by Biotechs) There is a backlog of Unicorns (Billion+ valuation) waiting for an exit. Should go long or exit early? Snap vs. Instagram?
Copyright 2009-17 Professor Gerome A. Hays
6
1/24/17
Why History Matters? Knowing the history informs both entrepreneurs and VCs alike in what is around the corner Cycles matter, and getting in on the right cycle is critical. (I.e. are we in a bubble now?) Venture Capital is still NEW Copyright 2009-17 Professor Gerome A. Hays
10 Year Fund Structure 1. Fund ConcepRon -‐ Target OpportuniRes
2. Raise Capital for investments
Years 1-‐5
3. Generate deal flow 4. Screen & Evaluate projects 5. Structure deals (valuaRon, etc.) Hopefully Raise New Funds
Years 2-‐10
Years 6-‐10
6. Mgmt of PorZolio Companies:
7. Cra` & Execute exit strategies
Copyright 2009-17 Professor Gerome A. Hays
Venture Capital Deal Terms Capital Call: when the venture fund calls upon the investors to deliver their investment funds; Deal flow: flow of business plans and term sheets involved in the venture capital investing process; Due diligence (in venture investing context): process of ascertaining the viability of a business plan Copyright 2009-17 Professor Gerome A. Hays
7
1/24/17
Venture Capital Deal Terms Seed Round: Pre-Series A Investments in the range of $250,000-$500,000. Series A Round: Considered the first institutional round of Venture Capital. Designates company ready for commercialization. $2,000,000 $10,000,000 range. Series B Round: 2nd Round of Institutional money. Designates company is ready for growth and expansion. $5,000,000 - $20,000,000 range.
Copyright 2009-17 Professor Gerome A. Hays
10 Year Fund Structure Capital Deployed 120
$100MM
$ in millions
100
$95MM Fees & Expenses
Pension Funds
80 Fund of Funds
60
Triples
$
Singles & Doubles
Corp. Alt. Assets
40
Walks
Endowments
20
< + 1x
Strike Outs
HNWI
0
3-5X 1-3X
How Deployed
How Raised
Copyright 2009-17 Professor Gerome A. Hays
10 Year Fund Structure Return Analysis
Capital Returned 200 180 160 140 120 100 80 60 40 20 0
$190MM
$95MM Home Runs
Fees & Expenses Triples
• 2X Return of Capital • $95MM Gain ($19MM “carried interest”) • 20-25% IRR to investors (depending on timing of investments and distributions).
Singles & Doubles Walks Strike Outs
How Deployed
How Returned
Copyright 2009-17 Professor Gerome A. Hays
8
1/24/17
Returns to Limited Partners Venture funds are seeking 22-‐25% annual returns of invested capital (as measured by Internal Rate of Rate (IRR) or Compound Annual Growth Rate (CAGR) Returns
+25% 0% -‐25%
1965
1975
1985
1995
2012
Copyright 2009-17 Professor Gerome A. Hays
Returns to Limited Partners Investment Type of Investment
Compounded Annual Rate of Return Sought
Expected Value after 10 years
$1,000,000
Traditional Asset Classes (Securities, Corporate Bonds, etc.)
8-12%
$2.15MM $3.1MM
$1,000,000
Private Equity
25%
$9.3MM
Copyright 2009-17 Professor Gerome A. Hays
Returns to Limited Partners How does a VC beat the S&P by 12-15 points over a 10-year period? Find 1 or 2 “Dream Deals” – A 20x’s return on invested capital Difficult to find….but when they’re found… they make an ordinary fund into an extraordinary fund.
Copyright 2009-17 Professor Gerome A. Hays
9
1/24/17
Returns to Limited Partners
$250,000 2010
2012
Copyright 2009-17 Professor Gerome A. Hays
Returns to Limited Partners
$12.5MM 1999
2004
Copyright 2009-17 Professor Gerome A. Hays
Returns to Limited Partners
$6.7MM 1997
1999
Copyright 2009-17 Professor Gerome A. Hays
10
1/24/17
Returns to Limited Partners Measuring the return of a fund Project 1
Year 4
Year 5
Year 6
Year 7
Year 8
-1MM
-1MM
0
0
2MM
-.5MM
-3MM
0
0
3MM
-1MM
0
0
0
0
Project 2 Project 3
-2MM
Project 4 Project 5 Project 6
-5MM
Year 9
Year 10
IRR 0% -4.8%
5MM
9.4% -15.9%
-.4MM
0
0
0
-.2
-2MM
-3MM
0
0
0
45MM
0
0
0
0
10MM
67.3% -10.6%
PEFORMANCE OF FUND (Weighted Average)
21.04%
Copyright 2009-17 Professor Gerome A. Hays
Setting up a Venture Fund Ex. John and Ann are two accomplished entrepreneurs that want to raise a small fund to transform micro businesses w/ compelling technologies into high growth companies. They are seeking to raise $20MM for the fund. They’ve told prospecRve investors that their plan is to back 20-‐25 companies over the life of the fund (10 year fund life). The Name of the Fund: mBiz Ventures
Copyright 2009-17 Professor Gerome A. Hays
Setting up a Venture Fund John & Ann Set up “Mgt Company” LLC to serve as General Partner
mBiz Ventures LIMITED PARTNERSHIP
Investment
Investment
Investment
Investment
Investment
Investment
Investment
Investment
Limited Partners
Pension Funds; Endowments; Fund of Funds; High Net Worth Individuals
Investment Copyright 2009-17 Professor Gerome A. Hays
11
1/24/17
Setting up a Venture Fund A typical fund structure: 1% Capital Contribution by Venture Fund Partners; 99% Capital Contribution by Limited Partners. 2% Annual Management Fee for 5-7 Years (10 year fund).
Copyright 2009-17 Professor Gerome A. Hays
Setting up a Venture Fund In John and Ann’s case: For a $20MM fund, John and Sara would contribute $200,000; and LPs would contribute $19,800,000. A 2% management fee would mean John and Sara would have $400,000 per year to cover operating expenses.
Copyright 2009-17 Professor Gerome A. Hays
Venture Fund Payout Math John and Ann will earn 20% of the profits of the fund (called Carried Interest). The LPs will earn 80% of the profits. Profits are determined as excess amount after all capital contributed by investors is repaid.
Copyright 2009-17 Professor Gerome A. Hays
12
1/24/17
Venture Fund Payout Math Ex. Suppose the following assumptions for John and Ann’s fund: Ø 5 year management fee (2% of total fund, each year); Ø John and Ann invested the full $18,000,000 in the first 5 years; Ø A total of $52,000,000 was returned to the fund by the time the fund was closed. Ø Return Multiple is calculated as follows: Total Returned / Total Invested.
Copyright 2009-17 Professor Gerome A. Hays
Venture Fund Payout Math Total Capital Returned to Fund Total Capital Invested Total Management Fees Paid (5 Years)
$52,000,000 -$18,000,000 -$2,000,000
Fund Profits
$32,000,000
Invested Capital Returned to John & Ann John & Ann's Share of Fund Profits Total Returned Return Multiple Invested Capital Returned to LPs LP's share of Fund Profits Total Returned Return Multiple
$200,000 $6,400,000 $6,600,000 33.00 X $19,800,000 $25,600,000 $45,400,000 2.293 X
Copyright 2009-17 Professor Gerome A. Hays
Managing the Fund (& Portfolio) The expectation of taking VC money is that the VC team will provide “Value Added” support to accelerate success: - Strategic Advice - Mentoring/Support - Networking Stage of the company impacts level of value add (i.e. earlier the stage, higher value)
Copyright 2009-17 Professor Gerome A. Hays
13
1/24/17
Managing the Fund (& Portfolio) Having time to devote to all companies in portfolio is nearly impossible (about 2 hrs per week per company….hardly enough time to provide value) Strategy & Approach: Top performers – Leave them alone Worst performers - Jettison Fence sitters – Make a decision (These companies present the greatest challenge to the fund) Copyright 2009-17 Professor Gerome A. Hays
Managing the Fund (& Portfolio) Deal Syndication (when VCs band together to invest in a project) is becoming a growing trend. Helps solve 3 challenges: 1) Increases value add to portfolio companies; 2) Provides access to greater deal flow; 3) Spreads risk / (Ultimately results in greater returns) Copyright 2009-17 Professor Gerome A. Hays
Harvesting the Portfolio Venture Funds are reliant upon “liquidity” events in order to convert the value of their holdings into cash. Event Scenarios: IPO, Sale for cash, Sale for stock of publicly traded company (We’ll discuss later in the semester) If markets are “bearish”, liquidity events are virtually non-existent (unless heavy discounting is involved) Copyright 2009-17 Professor Gerome A. Hays
14
1/24/17
End of Lecture
Any Questions?
Copyright 2009-17 Professor Gerome A. Hays
15