Venture and development capital
Introduction
Private equity:
• Investor side: investment activity that infuses equity nance in a target company usually
through new shares purchase in exchange for cash
• Invested side: infusion of funds to nance their start-up development and growth
strategies
• Investment activity: exchange of capital with the expectation to get it back with an
increase
The nancial structure of the deal can be leveraged or by pure equity (without debt)
Features of VC/PE investment: • New shares
• Outstanding shares (for buy-out)
• Target companies in the start-up and early stages
• Normally a majority stake in the equity capital
• Infusion of nance against new shares
• Infusion only as equity nance (no debt)
• Target companies with innovative business and revenue
models (incremental or disruptive innovation)
In VC investment, new shares are issued and exchanged against nancing while in a
buyout, outstanding shares are exchanged
-> Corporate innovation: scalp of the project and collaboration amongst institution
-> Social innovation: generate a positive impact on society with economically feasible
business models
In the US: VC = startup, growing, and turnaround
In EU: VC = start-up level
-> The US invests more and more in the same companies compared to the EU. This
shows a di erence between those regions. The US invests more in innovation while the
EU invests more in traditional sectors
VC: risky capital -> capital invested in a pro t-oriented project where there is a substantial
element of risk relating to the future creation of pro ts and positive cash ows
Risk allows to measure all the future incomes and their pro tability while uncertainty
doesn’t
Lenders have a legal right to interest independently of the success or failure while equity
stakeholders (such as VC) have a return depending on the growth and pro tability of the
business (return gained when exiting the business -> harvesting)
VC provides long-term and committed capital (money + management support)
Corporate venture capital (CVC): develop a new project inside a well-established
company
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Initial Coin O ering (ICO): fundraising not issuing and selling new shares but selling
contracts based on blockchain technology. Expectations of economic performance
generation such as a stream of cash
Entrepreneurial and Corporate Finance
CF:
Main di erences between EF and CF:
• Investment and nancing decisions are interdependent
In EF entrepreneurs and outside investors can put ≠ values on the same nancial
claims because they bear ≠ level of investment risk and ≠ level of diversi cation.
For this reason, conditions for nancing can in uence the nal investment decision
• The level of risk diversi cation a ects the entrepreneur’s investment value
Entrepreneur’s wealth is mostly represented by business ownership. No portfolio
theory due to concentration. VC can be partially diversi ed by investing in di erent
projects. Some are fully diversi ed if part of pension funds and so on
• Outside investors may be actively involved in a venture
• The parties have di erent information (and beliefs)
An information gap involves di erent assessments and beliefs on the venture
project between entrepreneurs and investors
Strong dependence on outside nance
Contract designing is a way to manage di erent beliefs and is a signaling purpose
• The parties may have di erent incentives from each other
The trade-o between risk transfer and incentive (lack of control can provoke an
entrepreneur’s lack of commitment to business management)
• New ventures can be under uncertainty
High-risk/uncertainty environment (stochastic approach needed)
• Harvesting the investment
No positive CF for several years and no trade of the stock, a liquidity event has to
be created and a ects the investment proposal valuation at the entrance stage
• Managerial exibility and real option (not covered in this course)
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Financial claim: economic right underlying a nancial capital
Capital structure: liability side of the company’s statement and it is usually a combination
of equity and debt nance
Contract theory: possibility to manage both information asymmetry and moral hazard
through suitable contractual structures (It is usual in VC to have covenants in the contract
to reach a speci c objective -> Contract’s role)
Signal theory: based on the opportunity to settle speci c targets that inform outside
investors and reduce venture uncertainty
Stochastic approach: means that you have not a single but a set of possible results for an
investment valuation (usual situation of investment valuation under high-risk conditions)
>< Deterministic approach
Systematic risk (not possible to eliminate through diversi cation)>< Idiosyncratic risk
(speci c risk for a given asset)
Competition always happens and you’re not the only one to think about your idea
-> Having competition and a bigger competitor is a good sign showing that the market
can and is ready to accept your idea
-> See Hungry House case in the notes
Business life cycle
VC invests in young companies: new ventures just established or set up in the previous
2/3 years
Business life cycle: a proper model to analyze the main topics related to the rst stages of
the business life
VC target companies show the same common features:
• Is an innovator (technology-based venture -> new technology developer or user)
• Single business venture (the project is a venture)
• The venture has already developed a product that gained rapid market acceptance after
being introduced
• Embodied as a legal entity (not possible for a VC to infuse capital into an individual)
• Often, the venture has already raised outside nance
Venture doesn’t raise all needed cash up-front
The objective is not invariable and can be changed from stage to stage (managerial
exibility)
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Elevator Pitch (EP): short oral presentation describing the basic characteristics of a new
venture and summarizing WHO, WHAT, WHY, and GOAL. It also contains the basics of the
nancial model
-> Opportunity for attraction of attention of potential investors
2. Start-up
3. Early growth 4.
= Scale-up
Development
stage
and expansion
5. Exit
Develop and
ne tunes the
business idea
but not in the
market
Establishement
of the business
(embodied in a
legal entity)
Business starts
to expand and
reach a
dimension to
compete
Following
growth stages
after early
growth.
Company starts
to be mature
and show some
track records
The company
become
attractive to PE
investors,
capital market
investors, and
non nancial
companies ->
tradability
Revenue
0 Beginning of
the revenue
generation until
the company
survival
(demonstration
of sustainability
Ends with the
economic BEP
• Rapid growth
of revenues.
• Reach the
nancial BEP
Stable
Cash ow
0 Negative
Negative
Positive
Positive
Activities
Investors
Entrepreneur,
FFF (family,
friends, fools),
personal loan,
bootstrapping
BA,
Government
grants,
incubators,
crowdfunding
platform, SAFE,
CVC
VC funds, CVC, VC funds,
contracts from
venture debt
industry, Cash
nance, Cash
from operations from operations
PE, Capital
market (IPO),
banks and
other lenders
Survival revenue: end of the startup state when the company’s revenues can prove that it
is possible to generate signi cant revenue
Economic break-even point (BEP): revenues cover operating costs. Operating income >=
0 (accounting measure). Move to the scale-up stage. The Economic BEP is the scale-up
stage (Don’t take account and investment costs into account)
Financial BEP: cash ow from operations is >=0 ( nancial measure). Start of the maturity
and expansion phase
-> Track records are important because generalist investors/lenders relay their investment
decisions mainly on historical data/ economic measures in addition to looking forward
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Relevant nancial measures:
Basic analysis:
• Business growth: represented by the size and the trend of revenues
• Economic result: shown as either operating income (di erence between revenues and
operating costs) or net income
• Financial result: given by cash ow generation/use (take into account investment
expenditure in cash -> no revenue growth without investment in advance)
Adding more:
• Financial need: measured in terms of the amount of capital required (for investment
programs of the revenue growth and support operating losses generated at the
beginning of the BLC)
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1. Product
study (R&D)
= Precompetitve
stage
• Business risk: the change from uncertainty to risk (risk is measured in St dev of
expected rate of return)
Cumulated CF (FCF∑) shows the net nancial position. When negative, it means that the
venture needs to raise outside capital ( nancial needs)
Technology life cycle:
• Fluid: infant technology that has still to show that is useful to develop an economic
activity
• Transition: the technology is economically feasible but there are some patterns that
compete to become the dominant one
• Speci c: a dominant pattern inside the technology is established
Venture scale: - hard companies: manufacture a standard product
- soft companies: o er either digital or tailor-made services
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Most of the universities have incubators and are able to raise funds for certain projects
Equity crowdfunding platform: give shares again money ≠ to other types of crowdfunding
platforms (max raising some 1M $)
VC role in venture nancing
Simple Agreement for Future Equity (SAFE): nancial contract (security) where an investor
exchanges money with rights for purchasing shares in the rst equity capital raising
Bootstrapping: situation in which an entrepreneur starts a company with little capital,
relying on money other than outside investment (personal nance, operating revenues)
Business Stage and
Technology stage
Stage feature
Finance for the stage
Finance typologies
Product development
(Tech in the uid stage)
Development of an
innovation and a
following business idea
Bootstrapping/ Family,
Friends, Fools (FFF)
Personal savings,
personal loan, relatives/
friends nance
Product development
(Tech in the transition
stage)
Feasibility study and
business plan
Seed (outside) nance
Government grants,
contracts from industry,
incubators, BA,
Crowdfunding, Seed
corn funds/ SAFE
Start-up
(Tech in transition
stage)
Build-up a business
Start-up nance
organization.
Asset backed lending
Scale factor for hard
companies: manufacture
and distribution network
operations
BA, SAFE, CVC and
social funds,
crowdfunding,
accelerators, contracts
from industries,
government grants, ICO
Early growth/ Scale up Higher amount of capital
(Tech from transition to but lower investment
speci c stage)
risk
Scale factor: still before
the BEP
Fast/ Later growth
wages (development
stage)
(Tech in the speci c
stage)
Round 1 of nance:
(possibly) followed by
other rounds
Higher amount but lower (Following) rounds of
risk
nance. (5 possibly)
After BEP
Beginning of debt
nance raising
Expansion
Pro table business with
(Exit) (Established tech) expansion programs
Both equity and debt
nance
VC funds (pure), CVC,
contracts from industry,
Cash from operations
VC funds (following
rounds), Venture debt
nance, PE funds, P2P
lending platforms,
Working capital facilities,
Cash from operations
PE funds, Capital market
(IPO), Banks and lenders
Contracts from industry: nancial help from industry interested in using the product. They
don’t invest to make a gain but to get the technology
The government grants have to stop in the Start-up stage to follow the concurrence rules
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Very often during the transition stage, there is a turning point from uncertainty to risk: the
tech scenario is more consolidated, and the economic forecast becomes more feasible
and reliable
Deal Club: a pool of di erent BAs and putting their money together they can increase the
value of the investment. Also possible to have a Deal club between BA and VC funds
-> VC funds don’t invest on their own and use Deal Club in too early stage to have a rst
stake in the project without investing too much
Accelerating program: a program that takes start-up and help them to scale to the early
growth stage by supporting the growth and increasing the speed of the development
(mostly virtual support)
Identity card of a target company to invest for a VC:
• High-growth industry with: - transition tech and w/o uncertainty
- disruptive business model
• Good managerial team with track records
• Product/service ready for a clear market or just introduced (right time for a VC to o er
advice)
• Investment payback period between 3 and 9 years with an average of 6/7 years
• Geographical focus on the area where VC investors have operations -> need of physical
presence and support
The VC rst decides on the target industry before screening for good projects. Even an
outstanding project but out of the VC’s industry scope won’t be taken into account.
-> Easier to nd successful projects in fast-growing industries (young companies are
without track records = di culties to distinguish good from bad projects)
-> Growing industry means more risk but also a potentially higher return
-> VC prefers tech-based industries because they are disruptive (introduce tech breaks
that create either a new demand or a revamping of an already established business)
By making new rules of the game you don’t have to ght against the big of the world
VC enters directly after the start-up stage, at the beginning of the early growth stage to:
• Business risk: avoid uncertainty but bear a high level of risk
• Scale of investment: before the size of the investment may be too small (suitable to BA,
crowdfunding), and after may be too large.
-> The cost for the investment selection process (up to the signing): 200k/300k$/€
(high investment to cover those costs with the returns)
• Business growth: even still young, the company starts to show some (positive) track
records
-> The VC funds have to refer to investors and justify the investment. They need risk
measurement and track record
Corporate Finance (Capital market, debt, and equity market) and Banks/lenders nance
companies not before the development stage and when the technology is in the speci c
stage
Capital/Equity gap: after the start-up stage and before the development stage.
Bootstrapping/BA/crowdfunding cannot bear an investment size of more than 1M.
Financial markets only nance in the development/ expansion stage. This is the place
where VC enters the game
-> This period is crucial since a large amount of capital is required to keep/ increase the
growth rate. The ones not getting the funds enter the Death Valley and don’t overcome
the lifestyle cycle.
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Why do outside sources from nancial markets not invest in VC:
• Risk/duration pro le of the assets classes vs. risk appetite
• VC market is not attractive for unreal CF players
• Weight of the operating costs
• Illiquidity
• Passive and not active investors
The legal form of the business a ects:
• Liabilities of the owners (full/limited liability a ecting risk allocation among stakeholders)
• Income taxation (tax to the corporation or earnings passed to the owners)
• Ownership transfer (restriction to either the number of investors or sale of shares)
• Financial capacity (limited nancial capacity of the owners, nancial constraint from
nancial market judgment)
Choice of the organizational form consider: - growth potential
- factors a ecting available key nancing
resources
- proper equity contracts (≠ rights in order to
manage the high risk of the venture)
- illiquidity
Limited-liability-partnership (LLP) is usually the most suitable form to establish a legal
entity that is ready to host an outside investor such as a VC fund
Organizational
form
Ownership
rules
Tax treatment
Liabilty
Transferability
of ownership
Financial
capacity
LLP
Two or more
co-owners
Earnings pass
through,
exibility
concerning
allocation of
gains and
losses
Liability of
partners is
limited to the
extent of their
investments
Partnership
interests may
be transferable
through sale,
subject to
approval of
other partners
Limited by
combined
nancial
capacity of the
partners.
Partners may
disagree about
borrowing to
support the
venture
The regulatory framework is based on: - transparency
- retail investors protection
1. New/young ventures can conveniently raise capital by selling their securities mainly/
almost exclusively to accredited/sophisticated investors (SA and SEA)
2. VC investors are classi ed as sophisticated investors (SEC reg D)
3. VC rms can raise commitment conveniently only from accredited/ sophisticated
investors (ICA and SEC Act)
4. Accredited/sophisticated investors are interested in inserting VC asset class in their
asset allocations (ERISA)
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Death Valley: condition where companies must stop their growth due to a lack of capital
(Die or slow down their pace of development)
-> Clearly show the interdependence between investing and nancing decisions
5. The decision to go public implies strong requirements in terms of information
disclosure and transparency (SOA)
Accredited/sophisticated investors: either any professional investor or any person who
exceeds 1M worth and has an annual income of >200k in the last two years
Technological disruption of the legal framework due to: - Virtual marketplaces
(crowdfunding)
- Issuance of security/utility
tokens through ICO or Private placement (PP)
Legal framework and investors’ organization
-> The goal is not to know every rule and number but to have a better understanding of the
logic and the difference between the US and EU
In the US:
Investors in private equity were traditionally not directly regulated under the main laws that
rule the nancial system (it is an ordinary business activity)
For the PE/VC industry, the relevant regulatory framework is based on two key drivers:
- Transparency: affects securities issuance and trading
- Retail investor's protection: affects investors’ typologies
The main statement resulting from the application of the rules are:
• Venture can conveniently raise capital by selling their securities mainly exclusively to
accredited/ sophisticated investors
• VC investors are classi ed as sophisticated investors
• VC rms can raise commitment conveniently only from accredited/sophisticated
investors
• Accredited/sophisticated investors are interested in inserting PE/VC asset classes in
their asset allocation
Accredited/sophisticated investor: either professional investors or any person who exceeds
1M$ worth and has an annual income of > 200K$ in the last two years
Rule 504: if you raise funds under or up to 1M in 12m months you are exempted from
transparency rules (interesting for new companies that don’t need too much capital at the
beginning, no need for transparency -> logic of crowdfunding)
Rule 505: under those conditions, you cannot sell before 6 months
Rule 506: under those conditions, you cannot sell before 12 months
Closed-end mutual funds are not viable, due to the AMC’s BoD responsibilities on NAV
estimate (Net Asset Value: market value of the capital invested in portfolio companies)
-> Limited partnership is the safe harbor offered by the SEC to avoid both securities acts
and ICA but only possible to raise funds from sophisticated investors not requiring the
protection of the SEC
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Shifting from a stand-alone investment risk valuation to a portfolio of investment risk
assessment allowed asset managers to invest also in the so-called « alternative
investment »
-> The risk of each investment in the pension funds, life insurance, … (low-risk appetite ->
prudent man rule) is not observed individually but the portfolio as a whole (diversi cation
allows the investment in PE/VC). This enabled a relevant ow of capital to invest in VC
since those institutions are allowed to invest in VC.
Dodd-Frank Act requires investors with more than 150M$ AUM to register with the SEC as
« investment advisors » and get the license, the other ones need to pass the scrutiny
VCs are organized as an investment company that invests its own capital to buy shares
like the limited partnership legal entity
-> Limited partnership -> GPs (provide capital + management) -> managers (provide no
less than 1% of the investment capital + Management of the under-management capital)
-> LPs (provide funds for investment activity, not involved in the
management of the partnership) -> subscribers (provide 99% of the capital)
Limited partnerships are not speci c to nancial institutions and are an ordinary
organizational form
-> Linked partnership agreement (LPA): the contract that rules the relationship between
the two parties. The LPA is necessary because both LPs and GPs’ claims and
responsibilities are inside the same legal entity and there is no legal separation like in
Europe
The GPs enter the investment through a limited liability partnership. This construction
enables them to limit their personal risk and the risk of investors suing them
GPs must invest their own money in the LP to show their commitment (incentive
alignment). In the US it must be at least 1% of pooled money under management
In the EU:
Investing in PE/VC is a nancial activity and is regulated under the general framework of
the two main acts that affect the nancial system (Banking Act and Financial Services Act)
In the EU, the Alternative Investment Funds Management Directive (AIFMD) is the key
regulation that mainly affects VC/PE activity with two main features:
• The focus is on the nancial actors (AMC in this case) and not on the securities and
transparency (as in the US)
• AIF refers to vehicles that invest in several alternative asset classes (not only PE and
VC but also RE, Hedge,…)
AIFs are reserved for professional investors. The fund can be closed-end (determined
amount needed) or open-end funds (no limit in investment collected)
In light of the AIFMD, the best and most common way to carry out a VC activity is on a
double-level investment scheme: - Asset Management Company (AMC): acts as the
investment manager
- The investment vehicle (closed-end fund CEF):
embodied in a suitable legal entity, which acts as the investment capital
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AMC (managers -> GPs): a nancial institution that promotes sets up and manages
investment funds. The AMC must subscribe at least 2% of the asset under management
(for incentive purposes)
-> A passport allows an AMC to run its activity in the EU and is compulsory for both
European and non-European AMCs
CEF (subscribers -> LPs): a peculiar legal entity that allows aggregating money from a
pool of investors, either professional or retail. The AMC promotes the CEF settlement and
it is in charge of managing the fund’s pooled capital
-> Funds are open to retail or professional investors
Legally separation of the interest between the subscribers and the managers in the ≠
entities (subscribers through CEF and managers through AMC)
-> Pretty close to an IPO with all the regulations
CEFs are under domestic supervision due to legal reserve on retail investors’ protection
The minimum share of subscription for AIFs is 500K
Funds reserved to retail investors are more regulated (Key Information Document, Retail
investor protection)
In the EU, an investor is professional when it is: - a nancial institution
- a large undertaker with own funds > 2M
- a government or other public bodies
- an entity that invests mainly in nancial
instruments
VC investors are mainly organized as CEF managed by an AMC that invests the capital
owned by the fund’s subscribers, like the fund legal entity in Europe (trust instead of fund
in the UK
The AMC is a service company (service is creating and managing the fund)
Code of rules (minimum requirements set by the law) ≠ LPA (market practice)
Depository bank (e.g. BNP) -> current account: provides custody to the investment capital
and administratively manages all the cash in ows and out ows of the fund’s money
-> The AMC Board of Directors (BoD) is charged with managing the AMC. Managers act
as executive directors
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Advisory company: if you want to invest in a venture in another country you can hire an
advisory company to work there on your behalf (or move the facility to the country, which is
costly) -> often applied for small or medium VC
Technical committee: direct monitoring of the investment activities (act on behalf of
subscribers and give opinions) (the difference between technical and investors committee
is that technical has experts while investors are represented by investors)
-> Reinforcement of the relationship between the two parts
-> Advisory company and technical/investors committee are voluntary while the depository
bank is mandatory
Why regulations?
• Managers and their compensation -> not regulated, it's given to the parties - incentive
alignment
• Subscribers/ managers/entrepreneurs need to organize their relations -> 1. Yes because
they x the rules of the game for complex relations/ need to protect subscribers (mainly
retail investors but also institutional investors) 2. No, because the market should be left
free, unmovement towards the rules also in the US
• ≠ geographic areas: different ways to rule the relationship -> ≠ expertise & risk attitude, ≠
stages in the industry, ≠ legal traditions
• LPs/GPs: investors protection when LPs are retail investors -> clue
• Government/VC industry -> support to the industry -> equity gap
The VC investment ow and life cycle
Subscribers: provide the funds to run the VC business buying certi cates (securities) by
the VC investment vehicles. The main investors are: - Financial institutions (pension funds,
insurance companies, banks, and asset managers)
- Endowments
- Non- nancial corporations
- High-wealth individuals
-> We stressed that banks start to nance from the development stage (directly) but, can
(indirectly) invest at a previous stage through a VC funds subscription
Managers: are in charge of promoting rst and running after the investment activity of the
investment vehicle
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Entrepreneurs (through portfolio companies): bring the business idea to rise and develop
the VC industry. They play a pivotal role both in nurturing the market with attractive
investment opportunities and supporting the start of their business idea through
bootstrapping (FF&F) nance
Investment capital: the mutual fund raised to carry out the investment activity
Deal ow: the pipeline of possible investment
Bootstrapping (FF&F): in the pre-competitive stage, the personal nance invested in the
project by the entrepreneur and her family, friends, fools
Stage A: development of the fund concept
• Fundraising activity: managers go on a roadshow to present the investment
opportunity to potential investors. They need to be attractive to potential subscribers
and they aim to raise their capital commitment.
-> The IRR promise is really important (should be attractive but still achievable,
importance of manager’s reputation (track records))
-> The manager xed a minimum level of commitment, a threshold, that needed to
be reached before starting the fund. Usually, the managers continue the fundraising
until a year from the fund’s vintage. If the minimum commitment isn’t reached within
a certain period, the fund project is aborted
-> Investment strategy: - Megatrend -> sustainability
- Industry value -> new technologies (according to the
window of opportunity) in combination with managerial innovation in order to create new or
disrupt BMs
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• Generate a deal ow: the pipeline of possible investment given by a set of
entrepreneurs/ventures who/which represent investment opportunities
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-> Dif culty in managing the promise of deal ow to investors and the selection of
deal ow to venture without the certainty of investors’ commitments
-> The manager can suffer reputational risk if he doesn’t manage the fund well
Capital commitment: an agreement between managers and subscribers when the laters
decide to invest a certain amount of money in the fund
Capital call: when managers call subscribers’ partial/whole commitment. Subscribers must
provide the requested amount of capital within a short time after the notice
Vintage year: the year of the rst capital call or the rst investment made by the fund, even
though some activities start months earlier
Deal structure: allocation of risk and return as well as rights and obligations of the
entrepreneur and the outside investor. A deal is ruled by a nancial contract
Due diligence: a formal and structured activity that aims to check the reality and
consistency of a speci c item
Stage B: closing the fund
• The fund is closed when managers reach at least the minimum size of the fund, the
threshold.
-> Institutional funds: subscribers provide a capital commitment enough to close the
fund. Managers ask for a rst call of capital (+- 40%) at the setup. Following calls for
capital are asked when managers need more money to make investments
-> Retail funds: managers call 100% capital at the setup. Managers don’t run a
series of capital calls for two main reasons: - individual (retail) investors have a
reputational risk
- operational costs related to following
capital calls could be too high due to the high number of subscribers
The relationship between managers (AMC, GPs) and subscribers (CEF, LPs) is regulated
by a speci c contract. In the AMC-CEF scheme, it is mainly the fund's book of rules and
also possibly some speci c service contracts. In the limited partnership, standards rely on
the contract between GPs and LPs with key covenants (Limited partnership agreement
LPA)
Stage E: Harvesting/relationship with nancial institutions
At the end of the investment stage, successful companies become interesting
opportunities for investment banks and PEs wanting to invest in well-established
companies.
-> Important to maintain a strong relationship with the nancial community in order to have
good exit opportunities (liquidity events)
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Stage F: distribution proceeds
After the liquidation stage, when all companies have been sold or closed (value down to 0)
managers must return both the investment and the principal capital gain to subscribers,
net of their carried interest
-> A VC investment portfolio mostly contains 20 ≠ ventures
Gross capital gain = AUM at time F (2Bn) - AUM at time 0 (1Bn) = 1Bn
-> First you give back the initial investment before considering the capital appreciation.
After full redistribution, the fund is closed.
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At stage F we know the duration of the fund
The goal of the manager is achieved when the asset is tradable
Agency theory in the VC industry: LPA (in the US) and Code of Rules (in the EU)
Two players: - Principal
- Agent
-> Agency contract with subscribers as principals (willingness but no expertise) and
managers are the agents
Theory helps to manage behaviors between parties
-> Incentive alignment in order to avoid misbehavior from the agent
GPs-Managers (principal) / entrepreneurs relationship (agent)
-> Entrepreneurial/innovation ecosystems (also the role of the public sector, i.e. promoting
incubators)
Active investors -> principal supports the agent: 1. All the capital needed to complete the
project
2. Resources necessary (people, talents
from outside,…)
3. Board service
In the VC fund’s life cycle, the stages ABF are related to the rst relation (subscribersmanagers) while the stages CDE are related to the second relation (managersentrepreneurs)
The investment process - Part A
Stage C: investment selection process: main steps
1. Screen Business Plans (BP)
2. Business evaluation and due diligence
3. Negotiate deals and staging
4. Additional capital calls
5. Contract signature and invest funds (deal closing)
1. Screen BP: funnel approach: starts from hundreds/thousands of investment proposals
(deal ow) and ends with few investment opportunities deserving an investment valuation
activity (rule of thumb: 1000 proposals -> 10 investments)
Funnel approach: 1. Touch point between VC (deal ow) and companies
-> This touch point should be a direct contact thanks to - relations in the ecosystem
- website
- accelerating programs
A rejection does not mean that the project is bad but more that it is not coherent with the
fund investment strategy (industry typology, business cycle stage, technology stage,…)
Industry focus: industrial/business value
Industrial value: focus on a mega trend where there is a cumulation between technology collate several techs-and managerial innovations in order to disrupt an existing sector/
market or create a new market -> scalability and potential of growth
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Allocation strategy: superior selection ability (allocate capital on a bunch of brilliant new
ventures)
-> High operating costs from the proposal to real opportunity (money and time spent by
AMC)
2. Business evaluation and due diligence: analysis of the selected business plan and xing
milestones
≠ Typologies of due diligence: - Technology risk
- Competitive/business risk (market risk -> lack of market for
the product) ( rst reason for the venture failure)
- Management risk (execution, complete the team)
- Legal and scal risk
- Investment risk (lack of money to complete the project)
Milestones: speci c and veri able performance benchmarks
-> Used to: - Reduce uncertainty and assess the level of risk of the project
- Complete information on the project and the entrepreneur’s ability
- Increase possibilities to raise nance
- Estimate the expected cash ow and the expected IRR
⚠ Difference between business milestones and nancial/economics milestones. They are
different but sometimes linked ( rst revenues are linked to BEP,…) and should all be taken
into account
Typical business milestones:
-> Milestones are an application of the signal theory and are necessary to include clear
and numerical targets in the Investment Agreement contract (the deal contract)
Round nancing: the needed capital is not raised and injected inside the business within a
single round at the beginning but is phased through different rounds of nance related to
the entrepreneur’s ability to reach milestones
Advantages of rounds of nance and milestones for investors:
• Handle with asymmetric information
• Decide to stop the project if it does not work (stop loss - fail last)
Advantages of rounds of nance and milestones for entrepreneurs:
• Sell the shares at subsequent higher prices (management of dilution effect)
• Having an external supervisor to his own activity helping to avoid time and money
waste if the business idea doesn’t work
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3. Negotiate deal and staging: term sheet and proposed valuation
VC invests in new ventures subscribing equity capital -> buy new shares, not outstanding
ones
Term sheet: re ects both the entrepreneur and investor’s mutual understanding of the
deal. Contains an agreed-upon valuation and sets out the amount of investment that is to
be made as well as the ownership claims the investor will receive
-> Preliminary and non-binding agreement (no commitment to close the deal)
-> Both the share price and amount of new shares depend on the equity value in the term
sheet
Post money valuation (PMV): equity value for an outside investor
-> Price of share post investment * outstanding number of shares
or Investment / % ownership
-> PMV is the basis for the capital against share agreement
PMV incorporates: - Investment (round of capital)
- Number of new shares
- Share price
The PMV only becomes real if the transaction is approved and occurs
Pre-money valuation (PreMV): equity value for the previous shareholders
-> PMV - Investment
PreMV is relevant for old shareholders because it calculates:
• The new value of their stake and the new price of shares after the investment
• The dilution effect due to the reduction of their stake consequent to the issuance of
new shares
The price of the shares is not observed in a market, such as CF but is derived by the terms
of the deal
The investment process - Part B
Negotiate deal and staging: equity valuation
• Valuing the share price: investment section stage -> share’s buy price
• Measuring the expected performance for the investment in terms of both IRR and cash
multiplier (relevant for the subscribers -> managers agency contract)
• Fixing value goals for the management/entrepreneur of the venture based on milestones
(entrepreneur’s agency contract)
Value = present worth of the right to receive (risky) future cash ows and it depends on the
holding period, cash generated, and risk underlying the future cash ow
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Price: the result of a negotiation -> observed in capital markets (this is real)
Fair Value: theoretical concept applying a model to x a fair value -> estimates given by
the set of information at disposition, applying a given model DDM (this is theoretical)
Fair Value
—>
Price
↓
negotiation ↓
Term-sheet
investment agreement
Valuation methods: • Empirical methods: rely on observations of prices of comparable
assets inside the nancial markets
-> Rely on multiples ( multiple at equity level are more useful for the exit value, for e.g. in
the case of IPO)
-> EV/P: Where? Public companies/capital markets or private companies/transaction
market
What? Equity prices -> share price or operating prices -> asset side/enterprise
EV = EqV + Dmkt
Why? Matching numerator and denominator -> levered with levered values and
unlevered with unlevered values (EBITDA with EV or NI with EqV)
• Analytical methods: rely on a complex process based on business/
project fundamental data analysis to assess the company’s fair value
Capitalization table: refer to the Amazon case
Investment Agreement: a legal contract that binds both parties to the deal after both the
entrepreneur and investor have reached an agreement on deal structure and value,
starting from the term sheet. Inside the IA, the BP plays an important role in xing
milestones as well as handling information asymmetries
-> The term sheet is empirical and moves through an analytical stage to the investment
agreement
Dilution effect: when the venture issues new shares to raise outside capital, it implies that
the already existing shareholders always decrease their ownership stake
-> The value of the ownership stake for old shareholders is negatively affected only when
a down-round is present
Amazon example:
Feb 95 -> 100K
582528 new shares
(200K). (1165056 new shares)
0,1717/share
0,1717
2years later
Feb 97 -> 200K
30000 new shares
6,6667/share
1165065/30000 = 38,8352 -> dilution multiple
The objective is to maximize the dilution multiple to suffer a lower dilution effect
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How to increase this multiple: - Sound economics (revenues)
- Tech development units’ appreciation for the business
- A demand exists
- A growing management team
- All other things decreasing asymmetric information and
increasing the rm value
Round/stage nancing is the most effective way for the entrepreneur to handle the dilution
effect
Cash multiplier: relation between cash in ow received at the liquidity event and cash
out ow originally invested at time 0 -> CFtL/CFt0
Protection on downside:
• Preferred stocks: a privilege in case of bankruptcy
• Liquidation clause: at the liquidity event, either a cash call or conversion to a common
• Anti-dilution/ratchet clause: either to receive free of charge or to buy shares at the
lowest price in order to keep the % ownership equal to the initial investment
->Full ratchet calculation: (PMV - New Investment - Previous investment) / Entrepreneurs
shareholding
->Weighted average ratchet calculation: - weighted value of series A that takes into
account the anti-dilution provision (proportion of the A investment * A investment +
proportion of the B investment * B investment)
- (PMV - New Investment - Diluted value of A) /
entrepreneur’s shareholding = price per share for the entrepreneur
- use the price per share to calculate the share
needed for A and B
-> Page 155-156 of the book
Option for upside:
• Option to put additional money: at an already xed share price. Outside investors will
exercise the put when the current PMV is higher than the xed price
• Converting preferred stocks: conversion into common stocks at company expense
(usually at the liquidity event)
-> With a cap, the amount of convertible shares of the debt holders is calculated by taking
the PreMV cap and dividing it by the number of shares held by the entrepreneur to nd the
price per share (and then dividing the debt by the price to nd the number of shares)
-> With a discount, the number of convertible shares has to be calculated between equality
of the PMV coming from the % ownership and investment of the investor and the
shareholding and amount of debt held by the entrepreneur and lender depending on their
common % ownership
-> Page 158 of the book
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Investment performance:
• IRR: measure of return (comprise the time value and it can be compared with IRR
measures from other asset classes)
-> Expected IRR from the investment -> consistency with IRR promise to LPs
-> The oor for a negotiation
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• Cash multiplier is a measure of the volume (how many times the investor multiplies his
capital invested, regardless of maturity)
Investment decisions inside VC do not only rely on the industry and nancial evaluation
but also consider a broader range of factors, among them entrepreneur/management team
assessment plays a key role
Causes that positively in uence investment decisions:
• Document presence (information package) -> business valuation
• Size of the team (organization) -> entrepreneur assessment process
• Prior start-up (track records) -> entrepreneur assessment process
• Entrepreneurial prominence (track records) -> entrepreneur assessment process
Investment Economics
Managers, who act through the AMC, and subscribers, who pool their interests in the
investment vehicle (the CEF) develop several relationships that can be represented
through the agency theory
-> Subscribers are the principal, and managers are the agent and the relationship is
regulated under an agency’s contract
-> The economics of the fund (underwriting fee, management fee & carried interest to
managers) are used for incentive alignment as well as for reducing agency costs
The CEF is the origin of all the revenues and costs for both the subscribers and managers
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A CEF shows as revenues:
• Capital gain/appreciation from investments in the portfolio (stages E and F of fund LC)
• Dividends and interests from the investment portfolio (stage D but unusual for VC)
• Interest on liquidity not invested yet (from stage C)
A CEF show as costs:
• Losses from investment portfolio (stages D & E)
• Interest paid on loans (stage D but unusual for VC)
• Underwriting fee to AMC ( one time at the beginning - stage B)
• Management fee to AMC (regular basis - from stage C to the end)
• Carried interest to AMC (stage F)
• Administrative costs (from stage B to the end)
The AMC receives revenues and costs generated by the management of the CEF
An AMC shows as revenues:
• Underwriting fee from the CEF (once at stage B)
• Management fees from the CEF (from stage C to the end)
• Carried interest from CEF ( stage F)
An AMC shows as costs:
• Operating costs
• External consulting costs
At the end of the end CEF life, subscribers receive proceeds in terms of:
• Investment capital repayment
• Hurdle rate
• Capital appreciation less carried interest
The management fee is due per year and it's calculated as a percentage of the CEF’s net
asset value (NAV). The amount could be in a range between 2 and 3%
-> It is crucial that this amount only offsets the overall running operating costs of the
management activity run by the AMC. The bottom line of the P&L statement of the AMC
should be zero. In order to align both subscribers’ and managers’ interests, the carried
interest is the right way for managers to match their willingness to become wealthy.
-> The right balance between management fee and current interest is of high importance
The Net Asset Value (NAV): is the capital of the fund at its market value. It is a nancial
assets measure and it is not the fund’s assets' book value
The hurdle rate: due only at the liquidation of the fund. It is a xed return offered to
subscribers in case of capital gain. The hurdle rate is distributed before the other proceeds
and the return could be in a range between 5 and 7%
-> First waterfall of the capital appreciation in order to subtract the minimum return offered
to subscribers before the distribution of net capital gain among parties
-> A different option for the hurdle rate: instead of taking the market capitalization into
account, you can take the NAV and make compounded capitalization
The carried interest: due on the liquidation of the fund. It is a percentage ( 20-30%) of the
difference between the actual IRR and the hurdle rate, if any
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Clawbacks: included in the LPA/book of rules, it requires the GP to return « excess
distributions » to the partnership in case of early carried interest followed by loss in the
CEF
IRR is the key nancial metric to measure the return on the investment and determine the
return split among managers and subscribers
T represents holding period of investment
CI represents NAV at the end
CO represents the investment capital invested today
The breadth of the investment performance is regularly measured by calculating a cash
multiple
Cash multiple (x) = CashIn/CashOut
Gross IRR on all investments: considers only out ows and in ows, realized and nonrealized, both at the portfolio and single investment level (before any costs to GPs and
banks)
-> Net IRR unrealized: estimation since the return has not been made yet (Highly present
in the US due to the obligation of the everyday NAV estimation obligation)
Net IRR to the investor on realized/unrealized: computed at two levels
• Net IRR from all cash exchanges among investors and fund net of investment
management costs (management fee, carried interest, consulting costs,…)
• Net IRR from valuation (expected in ows) of partially realized and non-realized
portfolio, net of relevant costs
-> As portfolio is wholly realized and distributed, net IRR is calculated on a cash-to-cash
basis (stage F)
The same return a the end of year 10 with an investment divided of the rst years of the
fund instead of an individual investment at T0 drastically increases the IRR(even more with
over-the-year returns)
(See Excel)
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+ See Excel le
-> Two simpli cations not present in the fund cash ow statement:
• Depository bank fee (annual cost) between 0,001-0,005% -> negligible
• Return from liquidity investment (during the investment period)
Cost of Capital Part A
From an investor's point of view, the cost of capital refers to the required return on an
existing security. It is used to evaluate a project/venture as it is the minimum return that
investors expect for providing capital to the company, thus setting a benchmark that the
project has to meet. This approach is consistent with the typical CF framework of
assessment where the investors are assumed to be fully diversi ed
In a VC deal, there are different typologies with different risk positions
• Subscribers: fully diversi ed investors, they bear only the market risk
• VC portfolio and VC managers: partially committed investors, they suffer a part of the
speci c risk in addition to the market risk (in case managers are not yet high-wealth
individuals)
• Entrepreneurs and the deal itself: fully committed investors (no diversi cation), they
suffer the overall risk of the venture (speci c + market risk) -> speci c risk affects the
business risk
The cost of capital for the market risk shows only the trade-off between expected return
and risk borne by VC fund subscribers assumed to be fully diversi ed
VC rms try to buy their stakes at prices (invested cash) lower than their fair values (NPV
> 0)
The cost of capital is connected with the IRR promise that managers made to their
subscribers at the fundraising stage (A). Managers will promise a superior IRR to
subscribers if they believe to be able to beat the market in terms of assumed generated
return in the light of the risk borne
The cost of capital for subscribers is the minimum threshold for xing the proper discount
rate for the venture valuation
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In its capital allocation activity, VC relies on a superior screening and selection ability,
which implies that it has both an industry focus and an ability to manage the business risk
The total risk for a venture is measured in terms of variance/standard deviation
The total risk of a nancial asset can be split into two parts:
• Speci c (business) risk: random and not connected with the economic system
• Systematic (market) risk: uniformly distributed and strictly connected with the economic
trend
The systematic part of the total risk is represented by the level of covariance (volatility in
common) of the asset with the economy
Diversi cation allows for reducing, and at least eliminating the speci c risk of every single
investment if there is a low level of covariance amongst a group of investment
In case of full diversi cation, each investor holds a market portfolio that is composed of
every nancial asset inside the market in order to fully exploit the diversi cation bene t
-> A fully diversi ed investor considers only the systematic part of the total risk of a given
asset and does not ask for any compensation for bearing the diversi able part of the risk
See Excel le
VC assets offer higher total risk but low correlation -> net bene t in terms of lower beta risk
for the new market portfolio
The CoC on CAPM can be compared with the statistics of annualized IRR distribution to
subscribers/LPs of VC funds
The compensation for bearing the market risk is the threshold in the VC industry
-> The threshold= cost of capital, through the CAPM, in the CE environment
LPs/Subscribers’ side: net IRR -> CF environment: compensation for bearing systematic
risk (total diversi cation) -> assumption for subscribers
GPs/Managers’ side: Gross IRR -> EF environment: x a benchmark (consistent with the
IRR promise) for making investment decisions
-> Connection between gross and net: net IRR is the actual returns (Gross IRR - costs)
Actual returns (realized: stage E&F)
Forecast returns (unrealized: stage C&D): built top approach from net to gross
+ annexes
Cost of Capital Part B
Hurdle (target) rates (referred to gross IRR): high discount rates that VCs use to take into
consideration the IRR promise made to subscribers plus additional items. They are target
gross returns for their investments. In the case of a single optimistic scenario, VCs refer to
hurdle rates also to offset the positively biased forecast provided by entrepreneurs in their
BPs
-> Hurdle rate for investment = target rates (to avoid confusion with LPs hurdle rate )
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Market rates (referred to net IRR): rate of returns (cost of capital) required by completely
diversi ed investors and based on the asset’s contribution to the systematic risk. The
market does not pay additional returns if an investor decides not to diversify
Actual returns ( net or gross IRR): historical payoffs from VC realized (disinvested)
portfolios. They depend on industry life cycles and capital market cycles and they are
partially biased by the IRR measure that does not consider the investment size
RORs are even higher than gross IRRs which must be constant with promised IRR to
subscribers because managers try to offset biased nancial plans inside the BPs asking
compensation for bearing the investment total risk instead of only the market risk. Those
RORs do not match with expected claims but they match with optimistic results
-> Since it is dif cult to nd the right numbers in the startup BP, increasing the ROR helps
reduce the risk, as we go on with the life of the startup, the uncertainty decreases as well
as the ROR does
Most of the risk in new ventures is diversi able -> rm-speci c (a single biotech is a lottery
ticket but a portfolio of 100 biotechs has a beta of 0,75 -> betas for new ventures are often
not higher than betas for mature companies)
Build-up approach:
Effort: if gross VC returns are in the range of 25-30% then management fee values
between 1-2 points of gross IRR and carried interest values between 6-8 points of gross
IRR
-> In total GPs will take around 10 points of the realized gross IRR for their managerial
effort
Illiquidity: after 2007 it has been clear that investors ask a price to bear illiquidity. It is not
yet true that illiquidity implies a negligible return. An average amount between 4-5% can be
considered a consistent estimate of illiquidity discount
-> Managerial effort removes the CF assumption that there are no costs, or they are
negligible for investing and trading securities
-> Illiquidity removes the CF assumption that securities are always liquid and there is no
cost for illiquidity
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Results show that a 10% estimate for the managerial efforts (fees + carried interest)
implies a gross IRR in the range of 25%-35% that is consistent with the target IRR usually
adopted by managers
There is a reconciliation between market risk-based return on one hand and target IRR
(hurdle rate) requested for an expected return (linked to a speci c claim, in terms of gross
IRR) on the other hand
In the case of nancials forecasted by entrepreneurs, practitioners offset the optimistic
bias increasing the size of their hurdle rates, up to 50% and even more! That re ects the
case of total risk bearing (either partially or fully committed)
-> CAPM CoC reasonably estimates actual VC returns for LPs
Gross IRR: • Cost of the industry -> management of illiquidity
• Different risk positions
The nancial forecast inside the BP
Funnel approach: Business evaluation and due diligence -> Elevator Pitch +Business Plan
Elevator Pitch (EP):
• Oral presentation (only a few minutes) backed by a hard summary
• Describes the basic characteristics of a new venture
• Summarize WHO, WHAT, WHY, and GOAL pursued
• Contains the basics of the nancial model
-> Opportunity to attract the attention of a potential investor ( + starting point of a quick
scan without spending money)
Business Plan (BP):
• Written document
• Describes internal and external variables involved in starting a new venture
• Summarize the purpose and overriding strategy of the venture
• Details on operation, nancing, marketing, and management
-> A set of hypotheses and assumptions on an investment opportunity (+ starting point of
the valuation of an investment opportunity and VC spend money for it)
As a venture progresses, the BP assumptions/hypotheses are tested. In general, meeting
the expectations would lead probably to no revisions and no changes of direction. Failure
to achieve a milestone or nancial protection would signal the need to re-examine
expectations and re-evaluate the merits of the venture
In the start-up stage, ventures’ BP is normally based on weaker hypotheses/assumptions
in comparison to plans for well-established companies due to the lack of track records.
Planning a new business requires more effort than for an established business but its
contribution is lower. It is also very dif cult to link the entrepreneur/management
performance with data inside the plan because they are often too volatile due to external
reasons
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Main features for a credible BP:
• A clear (both time and money) and irreversible commitment from the entrepreneur
• Evidence of reputation (track records, personal experience, prior prominent working
environment) and certi cation (mentor, actors involved in the plan)
• Frequent pitfalls inside a BP
• A clear view of the customer needs the venture would address
• A clear and narrow target market to serve
• Relying on an entrepreneurial team that doesn’t have the critical expertise on venture
needs
• Failing to recognize threats, competition, and potential problems
Business plans are developed to:
• Attract outside funding
• Give concrete targets for ownership structure/terms in the investment agreement
• Set out benchmarks against which progress can be measured (measure a business
idea)
• Attract key personal
• Handle with management’s compensation scheme
Equity investors focus on:
• Share price, dilution effect
• Upsides from the business/venture
• Expected/target IRR
Debt investors focus on.
• Debt service capacity vs. debt service requirement
• Assessment of default risk
• Covenants to protect debt service capacity
Debt service capacity: the ability of the venture to generate positive cash from the
operations in a given interval
Debt service requirement: the minimum cash necessary for the venture to be compliant
with the debt obligation in a given interval
Outline of a typical BP for outside investors:
1. Executive Summary
2. Background and Purpose of Venture: history, present days, goals, stage of the
business
3. Market Analysis: competitive, regulatory, and risk factors to forecast sales
4. Products and Services: value proposition, pros and cons, advantages, intellectual
property issues
5. Development, Production, and Operations: description of the process, how long
before starting up? Risk?
6. Organization and Management: management team -> What do we need? What do
we have?
7. Ownership and Control: legal and control aspects
8. Financial Information: nancial model, assumption, nancial projections, support of
projections, nancial statements for n years, nancial needs)
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Financial forecast features:
1. It must be speci c ( gures connected with clear milestones) and it must sound clear
and explicit
2. Principles of nancial forecasting
a) Integrate the nancial statements
b) Time span enough to cover the investment duration
c) Time interval coherent with the stage of the venture
d) Check consistency
Forecast is more important, even if it is less reliable, for new businesses (in EF) rather
than for established ones (CF)
Forecast is a very important tool to manage risk (but not uncertainty) during the project
development
The main purpose of forecasting activity is to measure the risk that the venture will bear in
order to properly manage it when it happens
Assigning risk measures from nancial data:
1. Assessing risk using historical data (very applied in CF) -> take the previous years’
growth compared to the average to calculate ST Dev (no steady state in VC thus
not applicable)
2. Sensitivity analysis (every single relevant variable at every single trial, each
variable is considered independent): the goal is to discover what are the most
important variables that in uence the nal result (see Excel le)
3. Scenario analysis/stress test (in a trial, multiple variables at the same time, variable
as dependent): starting from the base case and changing the most sensible
variables, analysts generate a set of different and new scenarios
-> In the VC industry, at least 3 scenarios: Development efforts are successful and
the product faces weak competition, Successful development efforts are offset by
erce competition, Development efforts are not successful and the project is
abandoned
4. Simulation (stochastic approach): based on the distribution of key sources of
volatility (key variables) and their relations with the nal outcome
Discrete approach: a bench of possible outcomes generated through a scenario analysis
Stochastic approach: all the possible outcomes under a given interval of con dence
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Importance of BPs is different in the VC funding context:
• VCs in the US: early stages venture and non-capital intensive industries (soft
companies) -> less importance and prefer shorter documents
• VCs in Europe: later stages venture and capital-intensive industries (hard companies)
-> BPs are more important for giving funding and are more in favor of longer
documents
Regardless of the VC funding context, nancials play an important role in receiving VC
funding (pro format statements on a 3-5 year period)
The nancial forecast inside the BP - Part B
Financial information: section in the BP where you can nd the business economics and
the nancial data
The nancial information contains 4 sections:
• Pro forma balance sheet
• Pro forma income statement
• Pro forma sources and uses of funds (cash ow statement)
• Further nancial data
-> Pro forma = forecasted
The nancial plan is based on a set of
• Assumptions: something that is accepted as true in the best management’s belief (own
belief)
• Hypothesis: based on known facts (e.g. fundamental data analysis) but not yet proved
(e.g. taking the target in ation ratio from the ECB)
Main steps in the forecasting activity:
1. Generate a set of assumptions and hypothesis
2. Design the venture’s business model
3. Forecast the venture’s sales (revenue model)
4. Forecast the business structure needed to generate future sales, both investments
in assets and the operations cost structure
5. Assess the nancial need and how to nance it
6. Assess the risk linked to the forecasted economics
The forecasting model is usually spanned across:
• An explicit forecasting period: results of several analytical assumptions and hypotheses
on the business model
• An implicit forecasting period: results of only a few assumptions and hypotheses about
the possible trends of economics as they result at the end of the explicit forecasting
period
It is important to establish a connection between the time span of the forecasting model
and the length of the outside investment as well as between the time interval for the
forecasting model and stages of the business life cycle that might be covered
The usefulness of the nancial forecast in the BP for VC investors:
MOIC: Multiple on invested capital
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BP read with the VC’s eyes:
1. A VC starts to look at the income statement because she wants to understand two
main nancial targets (forecasted turnover at liquidity event and forecasted
economic operating margin at liquidity event -> EBIDTAL)
-> Important targets since enterprises are valuated as multiplier
2. If both sales and EBITDAL gures are satisfying VC passes to discuss the
underlying assumptions and hypothesis
3. Starting from the entrepreneur’s nancial plan, a VC develops her own different
scenarios which refer to different assumptions on BM economics (usually VCs
develop at least two new scenarios, which are called neutral and failure scenarios,
in addition to the entrepreneur’s one)
4. After the income statement understanding, a VC analyses gures that refer to the
asset side of the pro forma balance sheet
5. The upper area of sources and uses of funds (CF statement) allows to assess two
basic nancial measures (operating cash ow -> cash spread from operations w/o
considering the capex but after taxes and funds used -> cash used in operating
activities which are the cash absorbed by operations considering the capex)
6. The lower area of sources and uses offends allows to manage the nancial
structure
• These are the sources and uses of outside nancial capital
- Minimum cash balance: minimum cash that you need to run the day-by-day
activity
- Equity nance raising: cash in ows through the sale of new shares
- Debt nance: consider both debt raising and debt repayment
If
the
sources exceed the uses, you have free cash in excess which can be used
•
for both
- Future investment nancing
- Pay cash to shareholders
A possible liquidity event depends also on the business size (scalability) and its margin
generation level (as a percentage of sales; value creation)
Free cash ow (FCF) is the cash generated by the business activity after the capex and
both the interest and tax payments. A positive FCF means that you have money to payback both debt holders and equity holders. A negative FCF means that you must raise
outside nance to ll the de cit from the business activity.
Sensitivity (what if) analysis: detecting the key/most sensitive variables
Scenario analysis: developing alternative scenarios changing different assumptions but
always based on the same business model
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Forecasted Revenue assessment
It is very common to build a nancial model starting from a revenue forecast. Many other
variables of the model are linked to revenue forecast. Amongst them:
• Target level of sales or rates of sales growth: determine the capital expenditure in
terms of both investment in production capacity and the necessary size of the inventory
• Sales revenues are very often controlled by the venture’s management. They are
in uenced by several outside factors, such as demand behavior, competition actions,
external shocks
• The target level of sales or rate of sales growth affects the operating cost structure
and, indirectly, the operating margin level
• Revenue is a key driver affecting operating cash generation
Two main approaches can be applied to revenue forecast:
• Top-down approach
• Demand side approach
• Market size, market value, and market shares are the input to forecast revenues
• It is a suitable approach when the venture operates in an already existing market
• Consistency issue: are the venture capabilities and resources adequate to serve the
market?
Bottom-up
approach
•
• Supply-side approach
• Output size, interns of business facilities, and target price level are the input to
forecast revenues
• It is a suitable approach when a venture is in front of a Green eld market
• Consistency issue: is the venture able enough to stimulate a potential demand, for
example in terms of customer willingness to buy the product?
Business Model (BM): contains the revenue forecast
-> A key part of it is the revenue model (RM) that shows the relationship amongst all the
relevant variables which determines the forecasted revenues
The business model designs and shows the relationship existing amongst all the relevant
variables that affect the revenue generation (RM), operating costs, and invested capital
Assumptions: a belief that something will happen, although there is no proof
• Venture’s entrepreneur or management team generates several assumptions to
forecast economic variables such as sales, costs, Capex, inventory days,…
• Assumptions are considered in the best entrepreneur’s or management's belief
• Assumptions usually refer to managerial actions such as sale price setting, cost
cutting, and Capex decisions,…
-> During the investment valuation process, outside investors might generate different
assumptions that re ect their own different beliefs and expectations on the venture
development
Hypothesis: an idea of something that is based on a few known facts or evidence, but that
has not yet been proven to be true or correct
• Hypothesis refers to outside factors, such as in ation rate, interest rate, and
demographic trends,… that are not under the venture’s management control
• They affect economic variables forecast (e.g. sales) and interact with their underlying
assumptions (e.g. forecasted in ation rate for sales in nominal term)
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• A hypothesis is very often based on external sources such as data from comparables
(yardstick approach), information from external institutions (competitive intelligence
companies), public authorities forecasts (both domestic and international)
-> During the investment vacation process, outside investors check and review
entrepreneurs’ hypotheses as well as generate their own
Yardstick approach: comparability analysis. Generate some benchmarks but cannot
understand the drivers underlining the observed result
On-the- eld approach: expert panel, interviews, observation on the eld
Fundamental analysis: a business model must be designed
-> Forecasted data in nominal terms: used because future cash ows are referred to rates
of return. The rate of return, shown in terms of interest rates, are given in nominal term.
The theoretical framework of new venture valuation
The forecasted performance can be top-down, starting from the capital invested and
moving to the IRR and forecasted Cash multiplier
The forecasted performance can be bottom-up, starting from the sought IRR and moving
to the implicit investment
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Valuation methods:
• (Relative) empirical methods
• Comparable companies (refer to publicly traded stock prices)
• Comparable transactions (refer to private companies’ market prices)
• Hybrid methods
• Venture capital (a single scenario) method
-> Discount forecasted cash ows in the nancial plan at target/sought IRR
positively biased
-> Difference with DCF: - Rely on company’s forecast
- High WACC to balance the risk
First
Chicago
(three
scenarios)
method
•
-> Discounted expected cash ows from the scenario analysis at target/sought IRRopportunity cost of capital
-> Expected cash ows/ (1+r)^t with r= opportunity cost of capital: ≠ CAPM
• Analytical methods
• DCF method
-> In EF, the CEQ approach is better than the RADR approach that is applied in CF
-> The RADR discount rate depends on time and risk while the CEQ discount rate
depends on time only
-> DCF applies comparable for benchmarking activity, capital markets data, and beta risk
measures
-> Comparables apply fundamental data for EV = E + NFP (Net Financial Position) and
gure out the basis of calculation (EBIDTA x, Sales,…)
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The investment ow’s three most important uses for VC activity:
• Valuing the share price
• Investment selection stage: share’s buy price
• Portfolio management stage: valuing the NAV of the fund
• Way out stage: share’s selling price
• Measuring the expected performance for the investment in terms of both IRR and cash
multiplier (relevant for the subscribers-managers agency contract)
• Fixing value goals for the management/entrepreneur of the venture based on
milestones (relevant for the managers-entrepreneurs agent contract)
-> In the course, unless otherwise speci ed, we are going to focus on the valuation
process during the investment selection stage (C)
Expected cash ow: mathematical average of possible outcomes, weighted by their
probabilities
-> In discrete scenario analysis (judgmental approach), probabilities of different outcomes
can be different
-> In simulation (stochastic approach), the probability for each trial is the same (trials are
equally weighted)
Cost of capital is the rate of return, that if realized, would make the investor indifferent
between investing and not investing in the claim
A measure of risk: the standard deviation of holding period returns (HPR)
Cost of Equity (with nancial structure)
• rE = rF + βE(rM-rF)
• The cost of Equity depends on the market component of risk, not on the total risk
Cost of Debt (with nancial structure)
• rD = rF + βD(rM-rF)
• The cost of debt depends on the market component of risk, not on the total risk
Cost of Assets (w/o nancial structure)
• rA = rF + βD(rM-rF)
• The cost of assets depends on the market component of risk, not on the total risk
In the CAPM, the risk is measured as the standard deviation of the holding period returns
from the forecasted plan. We can measure both the expected CFs and their standard
deviation but to calculate both the holding period returns and their standard deviations we
need to know the value of the project today (V)
-> In the VC market it is not possible to assume that NPV=0 (it is not a perfect market, very
often new ventures don’t have a market price)
-> The standard deviation of the holding period returns depends on the cost/value of the
project
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In the application of the RADR method, there is an inherent simultaneity:
• To calculate the value of the project discounting E(CF) you need a return (the discount
rate)
• To calculate the discount rate you need to know the standard deviation of the holding
period returns (the risk measure of the project)
• To calculate the standard deviation of the holding period returns, you need to know the
value of the project today
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For new ventures, it would be unusual to have a public market where they are traded and
we can observe comparable prices, it is thus not possible to rely on comparable numbers
The CEQ method solves the inherent simultaneously of the RADR because it does not use
the standard deviation of the holding period returns
+slides on Cash Flow
New ventures valuation: explicit forecast
Explicit forecast: result of an analytical process, given several; speci c assumptions and
hypotheses on both the business plan and the nancial plan
1st and 2nd implicit forecast: affects the forecast after the time period covered by the BP/
liquidity event. In the implicit forecast, only a few assumptions on the growth trend and
other key variables are considered (not a full analytical process). Given to the stage in the
venture life cycle, it could be suitable to split the period into two parts. The 1st stage still
refers to a fast-growing company/industry and the 2nd stage refers to a more stable/
mature expansion trend
Valuation model’s features
• Must be based on expected future cash ows: no accounting measures, not only
entrepreneurs’ business plan/success scenario CF (CFs must be EXPECTED)
• The discount rate must be constant with market returns (under the hypothesis of full
diversi cation): positively biased rates to compensate positively biased CFs result in
more distant payoff to be rejected incorrectly
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• It must deal with different CFs and different levels of risk: CF linked to nancial claims
can have different levels of risk, so the model recognizes it and manages different
discount rates consistent with risk levels. It is the same for time
• It must manage complexity related to information gathering: the right balance between
the reliability of the model and the amount of data and information you need to manage
it
-> Implicit value in new companies often weights more than explicit value because the bulk
of the claim value is expected after the liquidity event
• In the rst step, we refer to market value, which means the benchmark return must be
consistent with market returns (Net IRR for subscribers)
• In terms of market data, we apply the historical approach referring to time series of
relevant variables (risk-free rate, M portfolio return, correlation/covariance between
returns, beta risk), consistently with practice in corporate nance
• In the second step, we build up the benchmark by adding factors related to VC
investments (managerial effort + illiquidity + IRR promise -> from net IRR for subscribers
to gross IRR at investment level
-> No market equilibrium hypothesis anymore
Explicit forecast CF:
• Starting from the forecast inside the BP
• Is the BP positively biased? If yes, let's develop at least two additional and new
forecasts based on « normality » and « failure »
• An array of cash ows for the claim under valuation is usually generated
Implicit forecast (continuing) CF:
• The entity is assumed ongoing concerns after the end of the explicit period
• Valuation based on multipliers. Two different approaches:
• Multipliers based on expectations about CF trends (EDITDA/OCF growth inside the
industry, P/E ratio) (fundamental approach)
• Multipliers based on expectations about market prices for the venture’s equity at the
end of the holding period (VC approach)
• As a starting point, a cash ow measure based on normality is generated at the end of
the forecasting period (corresponding to the liquidity event)
Volatility coef cient (VC) of forecasted CFs in single scenario = σ(CF)/ Mean CF
TTL Risk ratio (HPR risk/MKT portfolio risk) = σ CF / σ Mkt based on HPR
Free cash ow: CF to all investors (due to no debt inside the venture’s liabilities)
In case of CEQ approach, scenario analysis is applied in order to assess volatility
measures for cash ows with the same holding period. So, the CF volatility is amongst
scenarios, with the same HP, and not for a time series as for the RADR approach. The
volatility measure (σ) for each holding period is necessary to gure out the beta risk
measure for the corresponding risk discount (RD)
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Elements common to both RADR and CEQ approaches:
• Cash Flows estimation
• Risk-free rate estimation
• Market portfolio return (risk premium) estimation
RADR -> The asset under valuation is publicly traded or has a real comparable
CEQ -> when RADR is not applicable (assuming NTBFs and new ventures as private
companies, it is often very dif cult to nd a real consistent market comparable)
Estimating the risk-free rate:
• The holding period (HP) of the risk-free rate must be consistent with the holding period
which corresponds to the liquidity event of the target
• By convention, a risk-free asset corresponds to a sovereign issue with AAA rating
• Given a suitable issuer, we can alternatively focus on
• HP consistent single maturity bond
• Issues term structure
Estimating the market risk premium under the hypothesis of long-term cash ow measure:
• A suitable proxy of the market portfolio: usually a well-diversi ed general stock market
index (S&P500, Europe 600, MSCI all-country world index)
• A long-run historical average of market portfolio returns: consider a statistically
consistent time period that shows expectations for future market returns
CEQ approach:
• Beta systematic risk measures: for each HP a speci c Beta risk for the cash ow is
calculated
• Standard deviation of asset cash ow (given a speci c holding period)
• Standard deviation of market returns (given a speci c holding period)
• Correlation of cash ows with market returns (assumed constant for all the HPs)
Applying the CEQ approach:
1. We already have risk free rate, market portfolio returns, and their volatility
2. Scenario analysis as a way to infer cash ow volatility for each holding period
3. Compute the standard deviation on venture cash ows for each HP
4. Compute the correlation coef cient between market portfolio returns and expected
cash ows from the venture or, as rule of thumb, apply a benchmark data of 0.1957
5. Calculate the beta
6. Compute the risk discount (RD)
7. Compute the CEQ CF
8. Discount the CEQ CF at the risk-free rate to gure out its present
Caveat for valuing high-risk cash ows: CEQ approach works well when variation
coef cient of cash ows is not too high and when correlation with market returns is low
+ Annex about DCF RADR approach
In case of fast-growing companies (start and scale up), very often the explicit forecasting
period does not cover up to the point that neither the venture is expected to become more
stable or at the liquidity event. For this reason, it is necessary to split the implicit
forecasting period into two stages which imply different treatments
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1st stage: starting from CT, few assumptions on Ct are developed in order to represent a
road toward a relative stable condition. Assumptions are normally focused on revenue,
operating costs ratio, and CAPEX trend
2nd stage; it is consistent with the continuing/terminal value in the DCF model, in fact, at
time L the venture will be already established and mature enough
Two different approaches estimating terminal value:
• VC Method: assume a sale at the liquidity event (T). The terminal value (TV) is the
expected price for the sale at T. This approach relies on the relative valuation and it is
consistent with the outside investor’s (VC rm) investment strategy (exit at the liquidity
event)
• Growth rate: estimate the continuing value (CV) assuming a constant growth rate g. In
this case, the implicit forecast value is considered ongoing concern. This approach is
consistent when at T the company has already reached a stable condition and a
constant growth is a viable assumption
VC method (relative valuation): you consider the expected selling price for the entity (EV)
at the liquidity event (way out time). We refer to the entity prices of comparable companies
that are either publicly traded or sold in the transaction market
-> To estimate a multiplier:
• Consider a suitable comparable with a disclosed price (P) and a fundamental economic
variable such as its sales, its EBIDTA,… (X)
• The multiplier is equal to P/X
• We assume the target company has the same ratio
• The expected EV for the target company is given by P2 = X2*(P1/X1)
The TV value should be discounted to its PV
In a valuation at enterprise level (indirect method), the capital structure is not considered.
We can infer a PMV including the market value of the NFP at time 0
In order to obtain Equity Pre Money Value, new outside equity nance must be considered
In a valuation at equity level (direct method), the new capital structure (new debt after new
equity) to nance cash balance must be considered directly in the FCFE measure that we
refer to gure out the Equity Value. So, DCF direct method provides an Equity PMV
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Growth rate can be forecasted relying on either fundamental analysis or market
observation
Fundamental analysis:
• Revenue growth rate, top-down approach: expected revenue growth rate as in the
maturity stage calculate the reinvestment expenditure through the turnover ratio CF
measure must be net of reinvestment expenditure consistency check through ROI
measure
• Revenue growth rate, bottom-up approach: output constraints; nance for new
investments affects the expected revenue growth rate
CF growth rate model (equity multipliers): you assess the growth rate g through the
observation of both cash multipliers (P/E) and expected cash returns (r)
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Continuing value estimation:
1. Decide which is the variable (sales, earnings,…) to use for estimating the
continuing value
2. Forecast the variable using appropriate methods and data
• A single growth rate at the end of the explicit value period in a single-stage implicit
forecast period
• Two different growth rates in a double-stage implicit forecast period: one during the
rst stage, the other after the end of the rst stage
3. Estimate continuing value using the growth rate