How Corporations Issue
Securities
Topics Covered
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Definition of Venture Capital
Activities of Venture Capitalists
Organization Structure of Venture Capital
History of Venture Capital
Patterns of Venture Capital Investment
Cost of Capital for Venture Capital
Initial Public Offering
General Cash Offers
Rights Issue
Venture Capital
What is Venture Capital?
Venture Capital (VC)
Money invested to finance a new firm
(Please see, Heukamp, Liechtenstein and Wakeling (2007) p.68)
Since success of a new firm is highly
dependent on the effort of the managers,
restrictions are placed on management by
the venture capital company and funds are
usually dispersed in stages, after a certain
level of success is achieved.
What is Venture Capital?
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A VC has five main characteristics:
A VC is a financial intermediary, meaning that it takes the
investors’ capital and invests it directly in portfolio companies.
A VC invests only in private companies. This means that
once the investments are made, the companies cannot be
immediately traded on a public exchange.
A VC takes an active role in monitoring and helping the
companies in its portfolio.
A VC’s primary goal is to maximize its financial return by
exiting investments through a sale or an initial public
offering (IPO).
A VC invests to fund the internal growth of companies.
(1) What is a VC?
A VC is a financial intermediary, i.e., that they take
the investors’ capital and invest it directly in portfolio
companies.
Entrepreneurs
VC
Investors
The Flow-of-Fund in the Venture
Capital Cycle
Typically, a VC fund is organized as a limited partnership, with the
venture capitalist acting as the general partner (GP) of the fund, and
the investors acting as the limited partners (LP).
VC Funds
Managed by
General
Partners
(“VCs” or
“GPs”)
Limited
Partners
(Investors or
“LPs”)
Portfolio
Companies
“Exits”: Sale
of
Portfolio
companies
to public
markets
(IPOs) or to
other
companies
Private Equity Partnership
Investment Phase
Payout Phase
General Partner put
up 1% of capital
Mgmt fees
Limited
partners
put in
99% of
capital
General Partner get
carried interest in 20%
of profits
Partnership
Partnership
Limited
partners get
investment
back, then
80% of
profits
Company 1
Investment
in diversified
portfolio of
companies
Company 2
Company N
Sale or IPO of
companies
(2) What is a VC?
A VC will only invest in private companies. This
means that once the investments are made, the
companies cannot be immediately traded on a public
exchange.
- no simple mark to market
- no liquidity
- VCs tend to focus on high-technology
industries
- most VC firms specialize their funds by
stage, industry, and/or geography
VC is a Segment of Private Equity
Hedge Funds
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Hedge Funds are flexible investing vehicles that share
many characteristics of private equity funds, including
the limited partnership structure and the forms of GP
compensation.
The main differences:
Hedge funds tend to invest in public securities.
Private equity funds are long-term investors and hedge
funds are short-term traders.
Hedge funds investments are more liquid than those
for private equity investors, so that hedge funds can
offer their investors faster access to their money.
(3) What is a VC?
A VC takes an active role in monitoring and
helping the companies in his portfolio.
(4) What is a VC?
A VC’s primary goal is to maximize his financial return
by exiting investments through a sale or an initial
public offering (IPO).
(5) What is a VC?
VCs invest to fund the internal growth of
companies.
The investment proceeds are used to build new
businesses, not to acquire existing businesses.
Stages of Growth
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Early-Stage
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Seed/Startup
Early Stage
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Expansion Stage
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Later Stage
(Please see, Black and Gilson (1998) p.250)
What do Venture Capitalists do?
VC activities can be broken into three
main groups:
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Investing
Monitoring
Exiting
Investing
Investing begins with VCs prospecting for new
opportunities and does not end until a contract has
been signed. For every investment made, a VC may
screen hundreds of possibilities:
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A few dozen will be worthy of detailed attention.
Fewer still will merit a preliminary offer (preliminary offers are
made with a term sheet, which outlines the proposed
valuation, type of security, and proposed control rights for the
investors).
If this term sheet is accepted by the company, then the VC
performs extensive due diligence by analyzing every aspect
of the company.
If the VC is satisfied by this due diligence, then all parties
negotiate the final set of terms to be included in the formal set
of contracts to be signed in the final closing.
Monitoring
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Once an investment is made, the VC begins
working with the company:
Through board meetings
Recruiting
Regular advice
Together, these activities comprise the
monitoring group (Please see, Kaplan and Stromberg
(2004) p.2194).
Exiting
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VCs plan their exit strategies carefully,
usually in consultation with investment
bankers:
Historically, the IPO has been the source of
the most lucrative exits.
The main alternative to the IPO is a sale to a
strategic buyer, usually a large corporation.
The Key Players in the VC Industry
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VC firms (small organizations, averaging about ten
professionals, who serve as the GP for VC funds)
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general partner (GP)
VC fund (a limited partnership with a finite lifetime, usually
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limited partner (LP)
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committed capital (total amount of capital promised by
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ten years plus optional extensions of a few years)
the LPs over the lifetime of the fund)
early-stage, mid-stage, late-stage fund, multistage fund
the fund has been closed (once the GP has raised the full
amount of committed capital and is ready to start investing)
vintage year
capital call = drawdown = takedown (periodic
capital provisions)
Who are the LPs?
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Historically, just under half of all committed
capital comes from pension funds.
The next two largest groups are financial
institutions and endowments/foundations,
each with about 1/6 of the total.
Individuals/families and corporations make up
the remainder, and are more fickle than the
other types. These types of indirect corporate investment
(individuals/families) as an LP should not be confused with
direct corporate VC investment (business angels) in portfolio
companies (please see, Morrissette (2007) p.54).
Committed Capital by LP Type
Investment vs. Fundraising
Example: Sierra Ventures
Fund Name
Vintage Year
Committed Capital
(previous funds information omitted)
Sierra Ventures V
1995
$100M
Sierra Ventures VI 1997
$175M
Sierra Ventures VII 1999
$250M
Sierra Ventures VIII 2000
$500M
Sierra Ventures IX 2006
$400M
Compensation structure
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Management fees (most commonly 2% of the
committed capital every year, this fee remain constant or in
most cases the fee drops somewhat after the 5 year
investment period is over)
Carried interest (often referred to simply as the
carry).
Fees: definitions
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Annual management Fees
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Level: 2%
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Basis: committed capital or net invested capital
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lifetime fees = The total amount of fees paid over the
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investment capital = committed capital - lifetime fees
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lifetime of a fund
invested capital = cost basis for the investment capital of
the fund that has already been deployed at a given point
Net invested capital = invested capital - cost basis of all
exited and written-off investments
Example 1:
ABC Ventures has raised their €100M fund, ABC Ventures I,
with management fees computed based on committed capital.
These fees are 2 percent per year in the first five years of the
fund, then fall by 25 basis points per year in each of the
subsequent five years. The fees will be paid quarterly, with
equal installments within each year.
Problem
Given this description, what are the lifetime fees and
investment capital for this fund?
Solution
Lifetime fees = committed capital x (2% x 5 + 1.75% +
1.5% + 1.25% +1% + 0.75%)= €100M x 16.25% =
€16.25M
Investment capital = committed capital – lifetime fees =
€100M - €16.25M = €83.75M
Carried Interest: definition
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The carried interest definition: % of the realized
fund profit, defined as cumulative distributions in
excess of carry basis, that gets paid to GPs
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Level: 20 to 25-30
Basis: committed capital or investment capital
Example 2:
Sunny Bird Ventures is considering two alternative carry
structures for its SBV II.
1)
25% carry with a basis of all committed capital
2)
20% carry with a basis of all investment capital
Committed capital = €100M
Management fees = 2.5% of committed capital every year
Fund duration = 10 years
Problems:
a)
b)
Suppose total cumulative distributions for 10 years =
€150M. How much carry would GP get under 1 and 2?
For what amount of exit proceeds would these 2 structures
yield the same amount of carry?
Solution:
a) Carried interest (1) = 0.25 x (150-100) = €12.5M
Lifetime fees = committed capital x (2.5% x 10)= €100M x 25% =
€25M
Investment capital = committed capital – lifetime fees = €100M €25M = €75M
Carried interest (2) = 0.20 x (150-75) = €15M
b) Let Z be defined as the total proceeds from all investments.
We can see that the formulas for carried interest under structures I
and II are:
Total carried interest under structure I = 0.25 x (Z – 100) Total
carried interest under structure II = 0.20 x (Z – 75)
We next solve for the Z that equates the carried interest under
both structures:
0.25 x (Z – 100) = 0.20 x (Z – 75) ⇒ 0.25Z – 25 = 0.20Z -15 ⇒
0.05Z = 10 ⇒ Z = 200
When total exit proceeds = Z =200M, then both structures would
provide 0.25 x (200-100) = 0.20 x (200 -75) = €25M in carry
VC COMPENSATION (IN$ THOUSANDS)
Top-Tier Venture Capitalists
The History of Venture Capital
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The modern organizational form of VC dates
back only to 1946.
American Research and Development Corporation
(ADR), began operations in 1946 as the first true VC
firm (by George Doriot, as open-end funds). Unlike
modern funds, it was organized as a corporation and
was publicly traded.
The U.S. government began its own VC efforts as
part of the Small Business Act of 1958, which was
legislation that created the Small Business
Administration and allowed the creation of Small
Business Investment Companies (SBICs).
The History of Venture Capital
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An important milestone for the VC industry came in the
1960s with the development of the limited partnerships
for VC investments. Limited partnerships are by far the
most common form of organization in the VC industry.
Total VC fund-raising in the U.S. was still less than $1B a
year throughout the 1970s. The next big change for VC
came in 1979, when the relaxation of investment rules for
U.S. pension funds led to historically large inflows from
these investors to the asset class.
Investing activity rose sharply to $3B in 1983 and
remained remarkably stable through the 1980s. From
$2.2B in 1991, it rose gradually to $4.1 B in 1994
(preboom period).
U.S. VC Investment ($ billions)
Boom era
Post-boom
era
Investment by Stage
Investment by Industry
Percent of VC dollars invested
Pre-boom = 1980-1994, Boom = 1995-2000, Post-boom = 2001-2009
U.S. VC Investment by Region (2008)
100% = $28 billion
The Global Distribution of High-Tech Private-Equity Investment,
2007, Top-20 Countries, in $Billions
Source: PWC Global Private Equity Report 2008.
Fund-Level Returns: Data
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Venture Economics
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Freedom-of-Information-Act (FOIA) requests
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Collects data from GPs, publishes vintage-year specific
quartile performance data while keeping anonymity of
individual funds
Forces public pensions to disclose performance of their fund
holdings
Private Equity Performance Monitor
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Collects, packages and sells fund-specific performance data
for a fee.
Assigns quartile rankings to funds
Industry Returns
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Industry returns are constructed as timeweighted returns
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Nice for comparison with market indices
Nice for making risk adjustments
3 sources:
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Sand Hill Econometrics (SHE): portfolio comp level
Cambridge Associates (CA): fund level
Venture Economics (VE)
A Gross-Return Index
Kleiner Perkins Returns
Cost of Capital for VC
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Historically, annualized VC return index raw return is
superior to those of public stock market indices.
Individual investment outcomes vary greatly.
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Venture = investments with high variance in outcomes
30-40% go bankrupt
20-25% return 5 times or higher
What should investors expect to earn from investing in VC?
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Not the entrepreneurs!
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Not the venture capitalists!
Model
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Our starting point is the Capital-Asset-Pricing Model
(CAPM). It states
ri = Ri = Rf + β(Rm – Rf) ,
where
ri is the cost of capital for asset i,
Ri is the expected return for asset i,
Rf represents the risk-free rate,
Rm is the return on the whole market portfolio,
β, or “beta”, is the level of risk for asset i.
The difference (Rm – Rf) is called the market
premium.
Risk
We make a key distinction between two kinds of
risks that are potentially present in any investments.
1.
2.
•
•
Beta risk = market risk = non-diversifiable risk =
systematic risk = “covariance”
Idiosyncratic risk = diversifiable risk = firm-specific
risk = residual risk = “variance”
Why should we care which kinds of risks it is?
Should investors demand higher returns for holding
all risks?
Estimating VC Cost of Capital
To estimate VC cost of capital according to CAPM model, we use
historical aggregate VC industry return data and estimate the
following equation:
Rvc, t - Rf,t = α + β(Rm,t – Rf,t) + evc,t,
where β, Rvc,t, Rm,t, and Rf,t are as defined before, except that
previously the return variables represented expected returns,
while here they represent realized (= historical) returns for period
t. The new elements in this equation are α, or “alpha”, the
regression constant, and evc,t, the regression error term.
Alpha represents the unexpected portion of the return, and
positive alpha is interpreted as skills of portfolio managers.
CAPM Estimation Results
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Two data sources
Beta is smaller than 1 here, but CAPM is not perfect,
and we will make further adjustments.
Adjustment (1):
The Fama-French (1993) Model
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The Fama-French (3-factor) Model has become part of a
standard tool kit for cost of capital estimation (much like CAPM)
in the last 25 years.
It is based on empirical observations that certain styles of
investments, such as “small stocks” or “value stocks” do not fit
CAPM model well.
Now the equation is
Rvc, t - Rft = α + β * (Rmt – Rft) + βsize * SIZEt +
βvalue * VALUEt + evc, t
where α, β, Rmt, Rft, evc, t are defined as in the CAPM, SIZEt and
VALUEt are the returns to portfolios of stocks that capture
correlations with these styles, and βsize and βvalue are the
regression coefficients on these returns.
Adjustment (2):
The Pastor-Stambaugh (2003) Model (PSM)
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Another relevant issue for VC is that investors may require
premium for illiquid investments.
The PSM model incorporates this illiquidity risk as the additional
factor to the Fama-French 3-factor model.
The equation is
Rvc, t - Rft = α + β * (Rmt – Rft) + βsize * SIZEt +
βvalue * VALUEt + βliq * LIQt + evc, t
where LIQ is the new liquidity factor, βliq is its regression
coefficient, and all other variables are as defined before.
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More sensitive the return on an asset is to the change in this
liquidity factor, the higher premium the investors demand when
liquidity factor return is high in the economy.
Final Estimation Results
***, **, and * Indicates statistical significance at the 1, 5, and 10% level, respectively.
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Market beta is now close to 2.
Alpha is no longer significantly different from 0.
Using both sets of estimates and taking the mid-point,
rVC = 15%
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0.04 (rf) + 1.63 * 0.07 (Market) – 0.090 * 0.025 (size) – 0.68 * 0.035 (value)
+ 0.26 * 0.05 (liquidity) = 14.1% (SHE estimates)
0.04 (rf) + 2.04 * 0.07 (Market) +1.04* 0.025 (size) – 1.46 * 0.035 (value) +
0.15 * 0.05 (liquidity) = 16.6% (CA estimates)
We use 15% as the cost of capital for VC in this course.
Types of Factor Models
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Single Factor Models
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Capital Asset Pricing Model (CAPM) and Market Model
Multi-factor Models
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Macroeconomic Factor Models – prespecify
macroeconomic indicators such as interest rates,
inflation, exchange rates (e.g. Arbitrage Pricing Theory)
Statistical Factor Models – extract from historical timeseries and cross-section of stock returns (e.g. Principal
Components or Factor Analysis)
Fundamental Factor Models – use firm-level attributes
and market data, like P/B, P/E, industry, momentum,
trading activity, etc. (e.g. Fama-French, Carhart, BARRA)
Fama-French (1993) Three-Factor
Model
E(Ri) – rf = βi,m [E(Rm) – rf] + βi,SMB E[SMB]
+ βi,HML E[HML]
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SMB is return spread between small-cap and
large-cap
HML is return spread between high ΒΕ/MVE
and low BE/MVE
Carhart (1997) Four-Factor Model
E(Ri) – rf = βi,m [E(Rm) – rf] + βi,SMB E[SMB]
+ βi,HML E[HML] + βi,UMD E[UMD]
UMD (momentum factor) is return spread
between high prior returns portfolio and low
prior returns portfolio
Initial Public Offering
(IPO)
Initial Offering
Initial Public Offering (IPO) - First offering of stock
to the general public.
Underwriter - Firm that buys an issue of securities
from a company and resells it to the public.
Spread - Difference between public offer price and
price paid by underwriter.
Prospectus - Formal summary that provides
information on an issue of securities.
Underpricing - Issuing securities at an offering price
set below the true value of the security.
Motives For An IPO
Percent of CFOs who strongly agree with the
reason for an IPO
Source: Brau and Fawcett (2006) JACF
The Top Managing Underwriters
January – December 2008
Underwriter
J.P.Morgan
Barclays Capital
Citi
Deutsche Bank
Merrill Lynch
Goldman Sachs
Morgan Stanley
RBS
Credit Suisse
UBS
Value of Issues
($billion)
Number of issues
$455
401
309
309
241
228
220
214
205
204
1210
1041
986
807
852
584
661
712
682
867
Average First Day IPO Returns
Russia
Argentina
Austria
Canada
Denmark
Chile
Norway
Netherlands
France
T urkey
Spain
Portugal
Nigeria
Belgium
Israel
Hong Kong
Nexico
UK
USA
Finland
Italy
Australia
New Zealand
Indonesia
Philippines
Iran
Poland
Cyprus
Ireland
Greece
Germany
Sweden
Singapore
Switzerland
S. Africa
Bulgaria
T hailand
T aiwan
Japan
Brazil
Sri Lanka
Korea
Malaysia
India
China
165 %
0
20
40
60
80
100
return (percent)
Source: Loughran, Ritter and Rydqvist (1996) PBFJ, extended and updated on www.bear.cba.ufl.edu/ritter
Initial Offering
Average Expenses on 1767 IPOs from 1990-1994
Value of Issues
($mil)
Direct Avg First Day
Costs (%)
Total
Return (%) Costs (%)
2 - 9.99
16.96
16.36
25.16
10 - 19.99
11.63
9.65
18.15
20 - 39.99
9.7
12.48
18.18
40 - 59.99
8.72
13.65
17.95
60 - 79.99
8.2
11.31
16.35
80 - 99.99
7.91
8.91
14.14
100 - 199.99
7.06
7.16
12.78
200 - 499.99
6.53
5.70
11.10
500 and up
5.72
7.53
10.36
All Issues
11.00
12.05
18.69
IPO Proceeds in the US and First
Day Returns
Source: J.R. Ritter, Some factoids about the 2008 IPO market. www.bear.cba.ufl.edu/ritter
General Cash Offers
Seasoned Offering - Sale of securities by a
firm that is already publicly traded.
General Cash Offer - Sale of securities open
to all investors by an already public company.
Shelf Registration - A procedure that allows
firms to file one registration statement for
several issues of the same security.
Private Placement - Sale of securities to a
limited number of investors without a public
offering.
Underwriting Spreads (2008)
Total Direct Costs of Raising Capital
Rights Issue
Rights Issue - Issue of securities offered only
to current stockholders.
Example 1:
Xstrata needs to raise £4.1 billion of new
equity. The market price is £6.23/sh. Xstrata
decides to raise additional funds via a 2 for 1
rights (buy two new shares for every one)
offer at £2.10 per share. If we assume 100%
subscription, what is the value of each right?
Example 1: Cont.
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Current Market Value = 1 x £6.23 = £6.23
Total Shares = 2+ 1 = 3
Amount of new funds = 2 x £2.10 = £4.20
New Share Price = (6.23+4.20) / 3 =
£3.48
Value of a Right = 3.48 – 2.10 = £1.38
Rights Issue
Example 2:
Lafarge Corp needs to raise €1.28
billion of new equity. The market price
is €60/sh. Lafarge decides to raise
additional funds via a 4 for 17 rights
offer at €41 per share. If we assume
100% subscription, what is the value
of each right?
Example 2: Cont.
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Current Market Value = 17 x €60 = €1,020
Total Shares = 17 + 4 = 21
Amount of funds = 1,020 + (4 x 41) =
€1,184
New Share Price = (1,184) / 21 = €56.38
Value of a Right = 56.38 – 41 = €15.38
Web Resources
www.nvca.org
www.evca.com
www.avcj.com
www.pwcmoneytree.com
www.vnpartners.com/primer.htm