Entrepreneurial Finance Issues:
Entrepreneurship Roundtable
Dr. Michael J. Robinson, CFA, ICD.D
Haskayne School of Business
The University of Calgary
December 5, 2012
Talk Subtitle:
What a VC Will Not Tell You
 A venture capitalist (VC) is an institutional investor seeking to
maximize their return (either financial or strategic) from
investing in private firms
 The VC world is full of unique terms, practices, and behaviours
that define the unwritten rules of the game
 A VC will not tell you how to play the game, but if you are
willing to listen they will help guide you through the pitfalls
each developing firm encounters
 Unfortunately, VCs will invest in only about 1 in 100 firms they
encounter so the remaining firms must seek other
development capital and guidance
Alberta Private Equity Markets Study
Phase 1 by Elder and Robinson (2007)
Figure 1
Alberta’s GDP as a Percentage of Canada’s GDP
17.00%
16.00%
15.00%
14.00%
13.00%
12.00%
11.00%
10.00%
2002
Source: Statistics Canada, 2007.
2003
2004
2005
2006
Alberta Private Equity Markets Study
Phase 1 by Elder and Robinson (2007)
Figure 5
Alberta’s Percentage Share of Canada’s Reported VC Disbursements and Deals
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
1999 2000 2001 2002 2003 2004 2005 2006
Total Disbursements
Number
Source: Thomson Macdonald, 2007 and Thomson Financial, 2006.
Risk Exercise
 This exercise involves a question I was asked as part
of my job interview with the BDC VC division.
 The question is as follows:
“You have just made a $3 million investment in an
early stage firm. What are the issues about the
investment that will cause you to lose sleep at
night?”
People, Products and Markets
 The risk elements you have identified in the preceding
exercise fall into three main categories:
 People – Does the firm have the correct management
team in place, and will they behave appropriately?
 Products – Can the firm effectively deliver the described
product on time and on budget, i.e. is the product
technically feasible?
 Markets – Will customers be willing to purchase the
product once it is completed? Are there competing
products being developed “under the radar” that will place
the firm at a competitive disadvantage?
More Academically
 High degree of uncertainty in private equity investments
creates significant capital market imperfections
 Uncertainty has three main dimensions:
 Information asymmetry and agency risks (People)
 Technological uncertainty (Products)
 Market uncertainty (Markets)
 Risk mitigation practices followed in the public capital markets
are less effective in private equity context
 Due to above risks, private equity capital is rationed
Extreme Information Asymmetry in
Private Equity Investment Situations
 Information asymmetry in this investment situation has two
dimensions:
 Adverse Selection – Entrepreneurs have private information
about the investment which will lead to poor quality firms being
overrepresented in the market
 Moral Hazard – Entrepreneurs will engage in behaviours that are
detrimental to investors following an investment
 Taken together, these two dimensions of information
asymmetry create a high degree of agency risk in the private
equity marketplace
 Even without explicit wrongdoing on the part of the
entrepreneur, a firm can experience agency problems
People Issues on a More Practical Level
 A seasoned U.S. early stage investor, Thomas Churchwell (2002) notes that
without access to smart early-stage capital, and other experienced
advisors, 80% of start-ups will fail. By way of contrast, a more
professionally backed start-up will have an 80% success rate.
 The easiest way to describe the problem is that a new entrepreneur does
not know what they do not know. I have been involved with advising
several new entrepreneurs and there is a progression that they must work
their way through if they are to become successful. Implicit in the
preceding statement is the notion that a failure to make this progression
will likely lead to significant difficulties for the entrepreneur and his/her
firm. A failure to seek advice, and then listen to the recommendations,
significantly lowers the chances of a firm succeeding.
Sources of Private Equity Financing
 Informal Investors
 Relationship Capital
 Entrepreneurs Capital
 Friends and Family Capital
 Business Associates Capital
 Opportunity Based Capital
 Angel Investors
 Novice Angels
 Experienced Angels
 Formal Investors
 Venture Capitalists and other Private Equity Investors
Private Equity Market Participants
 Informal Investors
 Two types of informal investors are:
 Wealthy individuals (angels) who wish to invest and
add value to the firm through their experience and
network of connections
 Less wealthy individuals who wish to invest passively in
private firms managed by people they know, or in
private firms located close to them
 Informal investors have less ability to mitigate both market
and agency risk than formal investors, but will tend to
screen on agency risk
Private Equity Market Participants
 Formal Investors (Strategic Partners)
 Institutional investors that specialize in investing in
situations with high uncertainty and asymmetric
information
 The most common type of formal investor is a venture
capitalist (VC) which will specialize in certain industries or
investment situations
 Researchers note that VCs are more concerned with
market risk than agency risk
 VCs will use stringent screening procedures to mitigate
market risk and will use hands-on governance and
monitoring mechanisms to manage agency risk
Characteristics of Informal Investors
• Source: A Profile of Angel Investors, Morrissette, The
Journal of Private Equity, 2007.
 Estimates from the US suggest that there are
approximately 400,000 business angels investing $50
billion in capital each year in over 50,000 firms
 This is estimated to represent approximately 70% of
the capital being provided to new US ventures
Characteristics of Informal Investors
 Average age of an angel investor is 47-50 years
 Distribution of ages is as follows:
 Under 35 years old – 11%
 35-44 years old – 33%
 45-54 years old – 31%
 55-64 years old – 19%
 Over 65 years old – 6%
Characteristics of Informal Investors
 Average investment size is about $75,000 with one study
finding the following distribution:
 Investment under $25,000 – 20%
 Investment between $25,000 and $99,000 - 40%
 Investment between $100,000 and $250,000 - 25%
 Investment over $250,000 – 15%
 Most angels have three deals in their portfolio and make an
investment every 18-24 months
 Most angels prefer to invest close to home (within one or two
hours driving time)
Characteristics of Informal Investors
 Extent of Due Diligence is minimal and based on informed
business judgment and an assessment of the quality of the
entrepreneur
 Investment structure tends to be simple (common stock)
 Angel likes to provide hands-on advice to the entrepreneur
 Investment horizon is typically five years or more
 Annual ROI expectations are typically between 20%-30%
 Like to co-invest (80-90% of deals have multiple angels)
Histogram of Private
Equity Financing in Alberta
Figure 1: Distribution of Private Equity Financing in Alberta: April-July 2003
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
50
00
0
15
00
00
25
00
00
35
00
00
45
00
00
60
00
00
80
00
00
10
00
00
0
30
00
00
0
50
00
00
0
Percentage of Total
Distribution of Private Equity Capital Raised by All
Firms in Alberta
Amount Raised
Histogram of Investments by Individuals
Figure 2: Distribution of Individual Investor Use of Exemptions: April-July 2003
Distribution of Individual Use of Private Equity
Exemptions
50.00%
40.00%
FFBA
OM
AI
30.00%
20.00%
10.00%
0.00%
00 000 000 000 000 000 000 000 000 000 000 000
0
5 1 5 2 5 3 5 4 5 6 0 8 0 00 00 00 00 00
1 2 3 4 5
Dollar Amount of Investment
Informal Investors Usage of Exemptions
Table 9 Panel B
Panel B
April-July 2006
Exemption Used
Individual Investors
Relationship Capital:
FFBA
Opportunity Based
Capital: OM
Angels:
Accredited Investors
Angels:
Sophisticated Investors
Private Issuer
Purchaser Outside Alberta
Other Exemptions
Total Individuals
Number of
Investments
Dollar Value of
Investment
Average
Investment
Amount
Median Investment
Amount
1,334
10.30%
2,762
21.40%
7,147
55.40%
13
0.10%
35
0.30%
2
0.00%
32
0.20%
11,325
87.80%
$42,531,914
3.90%
$49,535,958
4.50%
$389,784,504
35.50%
$6,495,959
0.60%
$353,950
0.00%
$37,500
0.00%
$4,048,300
0.40%
$492,788,085
44.90%
$31,883
$17,250
$17,935
$10,000
$54,538
$25,000
$499,689
$450,000
$10,113
$5,000
$18,750
$18,750
$126,509
$20,000
$43,513
$20,000
Non-Individual Investors Exemption Usage
Panel B
Summary of Individual and Non-Individual
Investor Exemption Usage: April-July 2006
Exemption Used
Non-Individual Investors
Relationship Capital:
FFBA
Opportunity Based
Capital: OM
Institutions:
Accredited Investors
Institutions:
Sophisticated Investors
Private Issuer
Other Exemptions
Total Non-Individuals
Total Individuals and
Non-Individuals
Number of
Investments
Dollar Value of
Investment
Average
Investment
Amount
Median Investment
Amount
85
0.70%
287
2.20%
1,168
9.10%
15
0.10%
3
0.00%
20
0.20%
1,578
12.20%
12,903
100.00%
$6,204,066
0.60%
$11,250,487
1.00%
$545,527,821
49.70%
$12,248,078
1.10%
$470,000
0.00%
$28,356,820
2.60%
$604,057,272
55.10%
$1,096,845,356
100.00%
$72,989
$30,000
$39,200
$5,521
$467,061
$59,000
$816,539
$458,398
$156,667
$200,000
$1,417,841
$78,740
$382,799
$50,000
$85,007
$20,125
Conclusions of Study
 The study documented a series of behaviors followed by angel investors:
The study results provide support for:
 Angel investors prefer to invest close to home (lowers their monitoring risk)
 Angel investors prefer to invest in industries they understand (lowers their
market risk)
 Angel investors prefer to invest in firms with more tangible assets (lowers
market and agency risk)
 There are other significant informal investors who can provide capital
 Where to find angel investors?
 Angel investors tend to like to work together
 There is a formal angel network in Alberta called the Alberta Deal Generator
(http://www.dealgenerator.com/)
 There is an affiliation of angel investors in Canada called the National Angel
Capital Organization (http://www.nacocanada.com/)
PRIVATE EQUITY INVESTOR NETWORK DEVELOPMENT
By: Lina Zhang (B. Comm Student) [2012]
PRIVATE EQUITY INVESTOR NETWORK DEVELOPMENT
By: Lina Zhang (B. Comm Student) [2012]
Possible Trouble with Angels
 Beware the one-hit wonder
 See the business model that gave them success in the past
as the correct one in all situations
 Beware the Angel looking to steal the firm
 Will fund with debt knowing you will not attract any more
equity capital and try to take you over when you are in
trouble
 Beware the disgruntled deep-pocketed Angel
 “Sue him for sport”
 Implication for entrepreneur and his/her family members
Overview of VC Financing Issues
 Why do VC firms exist?
 VCs operate in environments characterized by high agency costs and
high uncertainty
 In these situations, a VC’s relative efficiency in selecting and
monitoring investments gives them a comparative advantage over
other investors
 VCs are more active in industries where there are high information
costs, e.g. software/biotechnology
 VCs will also tend to specialize in certain types of industries, or
investment situations
 Even within their area of specialization, many VCs prefer more mature
investment opportunities
How Venture Capital Works
 VC investment fills a void between corporate and government sources of
funds for innovation, and the money an innovator can raise from the
informal equity markets
 VC funds are not typically targeted to basic research, but more to
commercialization
 Most VC funds are structured as 10 year limited partnerships with capital
provided by institutional investors
 With a 5-7 year investment horizon for early-stage firms, this means the VC
must make these investments in the first few years of the life of their fund
 The last 2-3 years of the life of a fund are spent on harvesting the
investments
 The J-Curve reflects how VCs deploy their capital over time
How a VC Spends their Time
(After 4-5 deals the VC is fully committed)









Soliciting Business – 10%
Selecting Opportunities – 5%
Analyzing Business Plans – 5%
Negotiating Investments – 5%
Serving as Directors and Monitors – 25%
Acting as Consultants – 15%
Recruiting Management – 20%
Assisting in Outside Relationships – 10%
Exiting Investments – 5%
How Do VC Firms Operate?
 VC firms perform extensive due diligence to reduce
information asymmetry between the entrepreneur
and themselves
 VC firms use extensive contracting to reduce
possible agency costs
 VC firms use extensive monitoring to maintain
access to information
 VC firms structure their investments to reduce risk
and to allow for an exit in a timely manner
How Do VC Firms View Risk?
 Management Team
 Product/Market Issues
 Stage of product/market development
 Degree of competition
 Technology Issues
 Financing Issues
 How much money and time is required until
commercial sales are realized
Example of a Risk Grading Metric
Myths about VCs
• VCs have no loyalty
– They have a high degree of loyalty to the capital
• VCs make very high returns
– The returns from VC investments over the past
decade have been very low
• All VCs are the same
– Top 10% of VCs make most of the industry profits
• VCs like to do seed deals
– US VCs stopped doing seed deals 10 years ago
VC Deal Killers
• Problems with the capital structure
– Overhanging debt or poor record of share
ownership
• Inappropriate governance structure
– If there is a convoluted shareholders agreement,
or other weird governance structure, the VC will
take a pass as it is too much work to clean up
Things to Never Say to a VC
• Why do you want to start this firm?
– I want to make a lot of money
– I want to be in charge
– The market is so large that all I need to get is 1%
of the industry sales
• Correct Answer:
– I want to build a world class company that is
bigger than myself
VCs Behaving Badly
 The last dollar in gets 100% of the firm
 A less than reputable VC may stretch a firm out over time as the cash
is being burned and then scoop up the firm for a much reduced price
once the firm runs out of cash
 Who does the VC work for
 Beware the VC firm that is new and looking to make an impression on
its limited partners (LPs)
 This can cause the VC to take an investee firm public too quickly
resulting in problems for the firm down the road
 Alternatively, the VC may distribute its shares in the investee firm
directly to the LPs when it knows there is negative information
forthcoming about the firm
How to Avoid Vulture Capitalists
 Some VCs give the industry a bad reputation by their
actions
 Trying to take advantage of investee firms
 Try to impose their will, i.e. they arrogantly believe in their
own strategies
 How to avoid vultures
 Perform due diligence on the VC firm
 Try to form a syndicate of investors to make all VCs behave
35
Issues for You to Consider
• Do you have the personality and patience to be a
CEO and to build a firm?
• If so, then work to build a team:
–
–
–
–
–
–
Co-researchers
Key management personnel
Board of advisors
Board of directors
Capital providers
Customers and/or strategic partners