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Entrepreneurial Finance
Module 6
Venture Capital and Private Equity:
The investment process
Chair of Entrepreneurial Finance
Prof. Dr. Reiner Braun
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Updated Schedule
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Financingyoung
companies
VentureCapital &
Private Equity
VentureValuation
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Financing relationships of a VC/PE firm
Investingsmart money(Equity & Help)
Return oninvestment
Money(Fundraising)
Successparticipation
Investors
PE / VC firm
Portfolio company
Refinancing
relat ionship
Financing
relat ionship
Source: Based on Schefczyk (2006)
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The investment process
Investors
Portfolio Companies
Investor Relations
InvestmentExit
InvestmentDevelopment
InvestmentStructuring
InvestmentDue
Diligence
InvestmentOrigination
Fundraising
Distribution
of Returns
Source: Fingerle, C. (2004): Smart Money - the Influence of Venture Capitalists on Portfolio Companies
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6.2 Investment Development
6.3 Investment Exit
Agenda
6.1 Investment Process
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Content of the Structuring Phase
Legally non-binding term-sheet: actual financial & legal terms related to a transaction
These terms are finally included in various legal documents such as
the shareholders agreement,
the articles of association,
the bylaws of the management team and supervisory board and
the employment contracts of the management team.
VC/PE firm Portfolio Company
about contractual agreements
financial instruments
additional investor rights
Negotiations
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Equity
Financial Instruments (1/3)
Shareholders share the same level of risk and return Additional rights can be given by shareholders agreement
Additional investor rights directly linked to ownership of stock
Usually issued as convertible preferred stock
Common stock
Preferred stock
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Debt
Financial Instruments (2/3)
has a lower priority than a senior loan in case of a
liquidation of the asset or company
enjoys higher priority than other loans or equity stock incase of a liquidation of the asset or companySenior debt
Subordinated debt
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Mezzanine
Financial Instruments (3/3)
Silent partner participates in profit and losses(maximally with amount of investment)
German tax law differentiates between:
typical silent partnership
atypical silent partnership (rather comparable to anequity investor)
according to the degree of entrepreneurial risk, return
and participation rights attributed to the silent partner
Allows lender to exchange debt for common shares at apreset conversion ratioConvertible debt
Silent Partnerships
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Financing an MBO/LBO Transaction
Financing requirements for a buyout consist of
Purchase price (company value) Net financial debt to be taken over Necessary investments Transaction costs
Financing secured by various capital forms
Equity Debt (A, B, C Senior, Junior)
Hybrid financing instruments (Mezzanine)
Source: Deloitte
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But
1)All exi
Where is the M of the Management Buy Out?
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Whats expected from the management?
Equity investment of 1 times annual salary
Negotiable Depends on institution Envy factor
Considerable upside reward for success
Total commitment to the project
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A d
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And now
The L of the Leveraged Buyout!
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Wh t b k l ki f ?
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Strong positive cash flow
Equity contribution of 30% to 40%
Repayment of Senior A typically within 7 years
First charge over assets as security
Financial and other covenants
Interest coverage of 2.5 to 3 times
Leverage of 3.5 up to 8 x EBITDA
Cash cover of at least 1
What are bankers looking for?
Source: Deloitte
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Additional Investor Rights Overview
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Additional Investor Rights - Overview
AdditionalInvestor Rights
2. Control Rights
1. Information Rights
5. Cash Flow Rights
6. Preemptive Rights 3. Management Covenants
7. Disinvestment Rights
4. Milestone Agreements
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1 Information Rights
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Information Rights
1. Information Rights
Many rights already defined by statutory regulation (e.g. 51a GmbHG for
GmbHs, 131 AktG for AGs) Ability to react on happenings within the company
VC/PEs define a catalogue of information (financial statements, budgets, non-financial information regarding company development)
Information provision in regular intervals, usually monthly
define the extent to which the VC/PEs have access toinformation of the portfolio company
Reduce post-contractual information asymmtries
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2 Control Rights (1/3) Voting Rights
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Voting Rights
2. Control Rights (1/3) - Voting Rights
Usually VC/PE firms hold a certain class of preferred stock and ask for aclass voting right:
Only holders of this type of preferred stock are allowed to vote on changesregarding the status of their class of stock without other investors having theright to intervene
measure the percentage of votes that shareholders have toeffect corporate decisions.
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2 Control Rights (2/3) - Veto Rights
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Annual budget
2. Control Rights (2/3) - Veto Rights
Appointment ofdirectors
Taking onadditional debt
Contracts ofother majorrelated party
Alteration ofcompany statues
Capital increase
Creation ofsubsidiaries
Issue of chargesover the companys
asset
Contracts with
othershareholders
Introduction ofcorporate pension
schemes
Changes in
the shareholderstructure
Managementcontracts
Financ ial aspec ts
Merger withor acquisition of
companies
Sale of a businessdivision
Investm ent and respect iv ely
d is investment aspects
Organizational asp ects Contracts of mater ial
inf luence
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2 Control Rights (3/3) - Board Rights - Definition
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Board Rights
2. Control Rights (3/3) - Board Rights - Definition
Board rights define membership in the supervisory board.
Exemplary responsibilities:
Hiring, evaluating and firing senior management
Advising senior management on general corporate strategies anddecisions and ratifies them
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3. Management Covenants (1/2)
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3. Management Covenants (1/2)
Define correct behaviorof the companys management.
For example, management promises to maintain adequate insurance to pay corporate debts and taxes in accordance with
normal terms
If a founder leaves the firm, he cannot work in the sameprofession for a couple of years and geographical location
Affirmative covenants
Non-compete clauses
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3. Management Covenants (2/2)
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3. Management Covenants (2/2)
Founders will forfeit granted shares or options
if they leave the employment of the company before vestingperiods expire (t ime vest ing )or
if certain milestones are not met (perform ance vest ing ).
The company is required to make representations andwarranties on:
its good standing,
the ownership of its technology and other assets,
full disclosure of all material information needed to makean informed investment decision,
Representations &warranties
Vesting
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4. Milestone Agreements - Overview
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Milestones
g
Contracts may specify measures to be taken contingent on certainpredefined events - these so-called milestones define importantsteps in the development of the company.
Financial nature Technical nature Conclusion of contracts
e.g.
Reaching certain salesand profitability numbers
Registration for an IPO
e.g.
Completion of design
Pilot production
Introduction of a secondproduct
e.g.
Acquisition of key customer
Conclusion of licensing
R&D contracts
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4. Milestone Agreements Most Relevant Milestone Agreements (1/2)
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g g ( )
VC/PE firm pays certain amount on top of the price itinitially paid for its stake if the company manages to achieve
pre-specified, mostly financial criteria within a time period.
Ratchet-down agreement:
transfer of shares from management to VC, if management
fails to meet a performance target within a specified time
Ratchet-up agreement:
transfer of shares from VC to management, if management
timely meets a performance target
Earn-out
Ratches
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4. Milestone Agreements Most Relevant Milestone Agreements (2/2)
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Moral hazard
Staging
g g ( )
capital needs are met through several financing rounds
additional financing only if pre-specified milestones are achieved if company fails to reach its milestones, the VC/PE firm is typically released from its
contractual obligation to provide further finance.
Threat that VC/PE firm may stop financing creates incentives for theentrepreneur to exert high effort and avoid high risks.
Adverse Selection
Staging lowers amount of capital at risk
resolve uncertainty about companys characteristics next stage financing with less information asymmetries
Hold-upBy keeping the initial financing rounds as small as possible thepotential payoff of a hold-up strategy is reduced drastically.
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5. Cash Flow Rights Liquidation Preference Definition
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Liquidation Preference
Liquidation preferences specify the amount and the orderin which holdersof different classes of securities get paid in the event the company is sold or
liquidated.
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5. Cash Flow Rights Liquidation Preference Implementation
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Additional elements Participating preferred stock
Preferred dividends are of somespecified percent that will be accrued onthe preferred stock and paid before anydividend can be paid to holders ofcommon stock.
Cumulative preferred dividends nothave to be paid out during normalbusiness operations but accumulate andare added to the liquidation claim of theVC/PE firm.
The venture capitalist
first receives the par value of thepreferred stock (plus the accumulateddividend, if present) and then
participates in the remaining
payments with the common stock asif he had converted.
Liquidation preference - Basic structure
VC/PE firm receives its initial investment back
before other investors receive any payments
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5. Cash Flow Rights Dividend Preference Example Participating Preferred Stock
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Common Stock
VC/PE firm investment inconvertible 2m EUR (50% of common stock)
Trade sale after 5 years 5m EUR (100%)
Cumulative dividend (10%) 0 EUR
Repayment of investment 0 EUR
Pro rata repayment ofremaining assets
2.5m EUR
Total repayment to VC/PE firm 2.5m EUR
Total repayment to VC/PE firmas % of trade sale
50%
Participating preferred stockwith cumulative dividend
1m EUR
2m EUR
1m EUR
4m EUR
80%
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5. Cash Flow Rights Antidilution Protection
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Share dilution/percentage baseddilution provisions
Capital increases, stock dividends andstock splits
Keep the percentage of the venturecapitalists shareholding constant
Preemptive right
Price dilution/price based dilution provisions
Sales of shares at lower valuations indownrounds
Adjust the price per share paid bythe VC to a lower level
Full ratchet and weighted averageratchet
Trigger
Intent ion
Design
Antidilution rights
protect the shareholdings of the VC/PE firmagainst share and price dilution
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5. Cash Flow Rights Antidilution Protection
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Full ratchet Weighted average ratchet
The venture capitalists average cost per
share will then equal the lower price pershare given to the new investor
The venture capitalists average cost per
share will then equal the average priceper share given to all investors
The lower the valuation in the next financing round, the higher thedilutive costs of raising additional capital
old sharesconversion price
original investmentFree shares -=
Conversion Price = New price
old sharesconversion price
original investmentFree shares -=
outstanding shares+
Conversion Price =
old price x
new investmentold price
outstanding shares + new shares
If the venture sells shares at a lower price,the venture capitalist receives
additional shares for free
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5. Cash Flow Rights Example for Full-Rachet Dilution Protection
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ConversionPrice of
Preferredshares
First RoundCommon SharesSeries A Preferred Shares $1.00
7,5002,500
7,5002,500
75.00%25.00%
SharesIssued(000s)
CommonShares AfterConversion
Percent ofCompanyOwned
Capitalization No Dilution Protection
Second RoundCommon SharesSeries A Preferred SharesSeries B Preferred Shares
$1.00$0.50
7,5002,5002,000
7,5002,5002,000
62.50%20.83%16.67%
Second Round Capitalization Full Ratchet Dilution Protection
Common SharesSeries A Preferred SharesSeries B Preferred Shares
$0.50$0.50
7,5002,5002,000
7,5005,0002,000
51.72%34.48%13.79%
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5. Cash Flow Rights Example for Weighted Average Anti-Dilution Protection
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ConversionPrice of
Preferredshares
First RoundCommon SharesSeries A Preferred Shares
$1.007,5002,500
7,5002,500
75.00%25.00%
SharesIssued(000s)
CommonShares AfterConversion
Percent ofCompanyOwned
Capitalization No Dilution Protection
Second RoundCommon SharesSeries A Preferred SharesSeries B Preferred Shares
$1.00$0.50
7,5002,5002,000
7,5002,5002,000
62.50%20.83%16.67%
Second Round Capitalization Weighted Average Dilution Protection
Common SharesSeries A Preferred SharesSeries B Preferred Shares
$0.917$0.50
7,5002,5002,000
7,5002,7272,000
61.34%22.30%16.36%
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6. Preemptive Rights
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Requires the portfolio companys management to offer the stock for
sale to the venture capitalist at the same price and terms negotiatedwith a third party.
Limits the liquidity of shares of the management
Goals of the venture capitalist
Option to increase its stake in the company
Possibility to control the composition of the shareholder group
Right of FirstRefusal
Management must merely define the minimum price and terms it willaccept for the sale of stock to third parties. The venture capitalistthen has the option to purchase the stock at these minimum termsfor a designated period of time.
From the perspective of the venture capitalist, less attractive as itdoes not control the shareholder structure as effectively as the rightof first refusal.
Right of FirstOffer
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7. Disinvestment Rights (1/2)
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Right of the VC/PE firm to participate in any sale of stock by themanagement (usually on a pro rata basis)
Protection against a sell-out by the companys management
Requires the management to sell their shares to a third party if
the VC/PE firm sells his shares Ensures that the management is not capable of upsetting
an exit possibility by not participating in a trade sale
Tag-along right
Drag-along right
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7. Disinvestment Rights (2/2)
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Entitles the VC/PE firm to sell the stock to the company
The company is required to repay the initial investment plusa minimum interest rate to the VC/PE firm
Exercisable at the will of the VC/PE firm but usually onlyafter a certain event has occurred
Entitle VC/PE firms to require their portfolio company to registerits shares for sale to the public.
Mechanism to exit: help the VC/PE firm to realize anexit where the management still hesitates to undertake anIPO.
Registration rights
Redemption right
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Financing an MBO / LBO Transaction
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Management is seeking to execute an MBO
Vendor is prepared to accept a price of EUR 20 mil
Business turns over EUR 30 mil and achieves a profit after tax of EUR 2 mil
Business has no existing debt or cash
Management believes that the company will be able to make profits aftertax of EUR 4 mil in five years time when the company will have cash of
EUR 16 mil and in total will be worth EUR 56 mil
They have told the potential investors that they
are able to invest EUR 250.000
want to own 40 % of the company
Company Data
Example for deal structuring of a MBO
The effect of various types of finance on the eventual return to the investor
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Financing an MBO / LBO Transaction
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MBO Company Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Earnings before interest and tax 2.0 2.4 4.02.8 3.2
0.0 0.0 0.00.0 0.0 0.0
3.6
Interest
0.0 0.0 0.0 0.0 0.0 0.0Tax
Earnings after interest and tax 2.0 2.4 4.02.8 3.2 3.6
0.0 2.4 5.2 8.4 12.0 16.0Cash Balance
Value of the Company(10 times earnings before interest and tax) 20.0 40.0
Plus cash
Cost of acquisition
Proceeds available on exit
20.0
0.0
0.0
56.0
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Financing an MBO / LBO Transaction
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Investors accept terms and invest EUR 19.75 mil in return for 60% of thecompany
In five years time they will receive back 60% of EUR 56 mil = EUR 33.6 mil
IRR = 11% per annum
Management then converts EUR 250.000 into EUR 22.4 mil
Example for deal structuring of an MBO: OPTION A
The effect of various types of finance on the eventually return to the investor
Option A Cash(in mil) %
IRR(in %) Proceeds
Investors ordinary equity 19.750 60 11.2 33.600
0.250 40 145.7 22.400Managements ordinary equity
20.000 100 56.000Total Option A
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Investors do not accept terms and pay the same price as the managementfor the ordinary shares otherwise the risk that management makes profiton the investment and investors make substantial losses, is too high
(e.g. if company was worth only EUR 30 mil after five years, thenmanagement would receive 12 mil for a profit of EUR 11.25 mil, whileinvestors would receive 18 mil for a loss of EUR 1.75 mil)
Hence, if management pays EUR 250.000 for 40% of common shares, theinvestors should pay EUR 375.000 for 60% making a total of common stockof EUR 625.000. The investors could then invest the remaining EUR 19.375mil in preferred shares, which must be redeemed at the time of the sale ofthe company
When company is sold for EUR 56 mil, investors would receive back EUR19.375 plus 60% of EUR 56 mil less EUR 19.375, which is in total EUR41.35 mil management would receive EUR 14.65 mil
Now investors would have a return of 16%, which is still too low
Example for deal structuring of a MBO: OPTION B
The effect of various types of finance on the eventually return to the investor
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Financing an MBO / LBO Transaction: OPTION B
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Option B Cash(in mil) %
IRR(in %) Proceeds
Investors preference shares 19.375 19.375
0.375 60 21.975
Managements ordinary equity 0.250 40 14.650
20.000 100 56.000Total Option B
Investors ordinary equity
19.750 41.350Investors total 15.9
125.7
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Financing an MBO / LBO Transaction
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Another possibility is to introduce debt to the transaction
With pre-tax profits of EUR 3 mil by year 2, the company could afford to payinterest in around EUR 10 mil of debt and still covers the interest aroundthree times (profit is three times interest rate)
Lender will ask for a covenant that interest is always covered more thantwice
IRR would turn to over 25%, as investors would only have to pay EUR9.375 mil instead of EUR 19.375 mil
Example for deal structuring of a MBO: OPTION D
The effect of various types of finance on the eventually return to the investor
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Financing an MBO / LBO Transaction: OPTION D
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Option D Cash(in mil) %
IRR(in %) Proceeds
Investors preference shares 9.375 15.090
0.375 60 14.883
Managements ordinary equity 0.250 40 9.922
20.000 100 56.000Total Option B
Investors ordinary equity
9.750 29.973Investors total 25.2
108.8
With 10% cumul. dividend
10.000 16.105Bank debt (10% cum. Interest)
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Contingent Structure of Venture Capital/Private Equity Contracts
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Financial and controlrights of entrepreneur
Company performance
VC/PE firm relinquishesseveral financial and control
rights
VC/PE firm obtains extensivefinancial and control rights
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Effects of Typical Venture Capital/Private Equity Contractual Agreements
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Applicable Not applicable
Reduce risk of
Effects
Contractual rights
managerial
opportunism
Disinvestment rights
competitive
opportunism
unfavorable
decision taking
exit
obstruction
Preemptive rights
Cash flow rights
Milestone agreements
Managementcovenants
Control rights
Information rights
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Literature
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Kaplan, S. / Strmberg, P. (2003): Financial contracting theory meets the real world: an empiricalanalysis of venture capital contracts, in: Review of Economic Studies, 70 (2), pp. 281-315.
Sahlman, W. (1990): The structure and governance of venture-capital organizations, in: Journal ofFinancial Economics, 27, pp. 473-521.
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Agenda
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6.2 Investment Development
6.3 Investment Exit
6.1 Investment Process
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Roles of the VC/PE firm in the Investment Development Phase
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Monitor
Protecting the valueof the investment
Coach
Enhancing the valueof the investment
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Approaches towards the Coaching Functions of the VC/PE investors
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VC/PE firms do notinterfere with thedecisions of themanagement of aportfolio company andfollow a laissez-fairepolicy
VC/PE firms are activelyinfluencing themanagement of theportfolio company
Involvement of the VC/PE firm
Hands-offapproach
Hands-onapproach
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Investment Development
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FOCUS on VC
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Certification as Indirect Activity of Venture Capitalists
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Venture capital-backed companies benefit from the reputation of their venture capital firms
Transmission ofvaluable signals about a portfolio company to third parties:
Customers
Suppliers
Investors
Personnel and management
Investment banks
Accountants
Reduction of asymmetric information and transaction barriers
certification
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Resource Provision Table of Venture Capitalists
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Social resources
Resource categories
Technological resources
Financial resources
Managerial resources
Personnel resources
Physical resources
Organizational resources
Reputational resources
Resource provision by venturecapital firms
(
/ )
Some resources provided No resources provided
Source: Fingerle,C. (2004): Smart Capital the Influence of Venture Capitalists on High Potential Companies.
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Stages and Value Adding Activities
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Financial engineering
Extent of activity
Early stage Later stage
Hands-on coaching
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Performance and Extent of Involvement
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Potential write-off Living dead On-track High-flyer
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Performance and Extent of Involvement Contrary Opinions
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(need for oversight argument)Extent of venture capitalists involvement depending
on performance
high low
Extent of venture capitalists involvement depending on
performance (prospect theory argument)low high
Living dead On-trackPotential write-off High-flyer
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Prospect Theory
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Assumptions The value function
Value is defined in terms ofgains and losses and evaluatedto a reference point (deviations)
Value function has a differentshape for gains and losses
Value function is concave forgains
Value function is convex andsteeper in the area of losses
Utility gainof venture capitalist
Value increaseof portfolio company
Reference point
Utility lossof venture capitalist
Value decrease
Utility loss
Utility gain
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Investment Development
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FOCUS on PE
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Different Categorization for Value Drivers in PE Transactions (1/4)
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Operative support /restructuring
Strategic orientation
Reduction of agencycosts
Mentoring
Financial arbitrage
Financial engineering
Financial value drivers
Operative and strategic
value driver Corporate governance
Source: Own diagram based on Berg/Gottschalg (2005)
General conditions
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Different Categorization for Value Drivers in PE Transactions (2/4)
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Source: Own diagramme based on Berg/Gottschalg (2005)
Operative support / restructuring through
Cost reduction, efficient management and
increase of margins (outsourcing, cost control,overhead reduction)
Optimizing capital employment(working capital management and reduction)
Improving personnel and decision makingprocesses (increasing productivity and
competence) Contribution of managerial resources
Strategic orientation through
Reorientation of markets and products(price policy, improving customer service,distribution channels, redefining target groups)
Focus on core competences
Operative support /restructuring
Strategic orientation
Operative and strategicvalue driver
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Different Categorization for Value Drivers in PE Transactions (3/4)
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Source: Own diagramme based on Berg/Gottschalg (2005)
Reduction of monitoring costs through
interest alignment (share ownership,
performance-related compensation) Strict monitoring (reports and boards) and
disciplining effect of debt (preventing empirebuilding)
Mentoring support by private-equity investors
through:
Contribution of industry know-how andmanagement expertise
Contribution of social and industry networks
Reduction of agencycosts
Mentoring
Corporate Governance
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Different Categorization for Value Drivers in PE Transactions (4/4)
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Source: Own diagramme based on Berg/Gottschalg (2005)
Financial arbitrage: no value creation(buy-low and sell-high; leveraging company pricechanges due to changes in market prices,identification and correction of mispricing)
Financial engineering: no value creation but valueshift (often on the account of creditors)
Above average proportion of debt
Tax deductibility Leverage effect
Reduction of agency cost of free cash flow
Financial arbitrage
Financial engineering
Financial value drivers
Entrepreneurial Finance Summer Term 2015
Value transfer hypothesis
Conflict in Theory: Value Transfer versus Value Creation
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Basic hypothesis: no creation of new value within a buyout transaction
- just a value transfer in favor of the private equity companies.
Consequently, there must be stakeholders that are negatively affected by the
transaction, e.g.
Employees: value transfer due to personnel cost reduction BUT no
empirical confirmation
State: tax saving of portfolio company due to high leverage, yet post-
buyout tax payments could be higher and all related buyout parties have to
be considered
Debt providers: due to increased leverage, worse creditworthiness and
increased default risk, yet covenants buffer the risk (change-of-control-
clause)
Diverging opinions within scientific empirical research
Value transfer hypothesis
Source: Lowenstein (1985) and other studies
Entrepreneurial Finance Summer Term 2015
Value creation hypothesis
Conflict in Theory: Value Transfer versus Value Creation
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Value creation hypothesis
Basic hypothesis: there is a creation of new value within a buyout transaction
Value creations emerge due to improvements within the portfolio company
Among others due to reduction of agency costs, disciplining function of debt
and better monitoring systems (see also slides before)
Or due to increase in entrepreneurial flexibility and reduction of bureaucracy
Majority of empirical studies confirms that buyout transaction are subject
of significant value increases due to an increase in profitability and
productivity
Scientific studies confirm the value creation hypothesis, nonetheless, in
most cases value increases are caused by a mixture of value transfer and valuecreation
Source: Meier et. Al. (2006), Wright et. Al. (1996) and others.
Entrepreneurial Finance Summer Term 2015
Evaluation of Value Creation A Practical Approach
Operational effects
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Source: Achleitner et al. (2010)
Value creation EBITDA growth Free cash flow (FCF)effect
Multiple effect
EBITDA at entrycompared to EBITDA atexit.
EBITDA serves as abasis for valuing acompany (assumingunchanged EBITDAmultiples).
Cash flows that are beinggenerated on a companylevel over the holdingperiod.
Amongst others, free cashflow is used for payingdown debt or for payingdividends.
This illustrates the de-leverage effect, not theleverage effect.
EBITDA multiplesrepresent the enterprisevalue as a multiple ofEBITDA.
Change in EBITDAmultiples between entryand exit impacts theenterprise value.
Increase in equity valuefrom a GPs point of view.
EBITDA effect can be
further split into sales
effect and EBITDA
margin effect.
Entrepreneurial Finance Summer Term 2015
Evaluation of Value Creation ExampleSales Effect
( Sales) x Margin @ Exitx EV/EBITDA @ Exit
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Entry 4 years Exit
Sales (m) 100.0 150.0
EBITDA Margin (%) 10% 15%
EBITDA (m) 10.0 22.5
EV/EBITDA (x) 10.0 12.0
Enterprise Value (m) 100.0 270.0
Net Debt 70.0 5
Equity 30.0 265.0
EBITDA Effect
( EBITDA) x EV/EBITDA @ Exit
Margin Effect
( Margin) x Sales @ Entry
x EV/EBITDA @ Exit
+
=
Multiple Effect
( Multiple) x EBITDA @ Entry
FCF (De-leveraging) Effect
( Net Debt)
Total Value Creation = Equity
Money Multiple = Equity @ Entry / Equity @ Exit
Entrepreneurial Finance Summer Term 2015 Page 64
Literature
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Berg, A. / Gottschalg, O.F. (2005): Understanding Value Generation in Buyouts, in: Journal of
Restructuring Finance, 2 (1), pp. 9-37.
Dotzler, F. (2001): What do venture capitalists really do, and where do they learn to do it?, in:Journal of Private Equity, 5 (1), pp. 6-12.
Easterwood, J. / Seth, A./ Singer, R. (1989): The impact of leveraged buyouts on strategicdirection, in: California Management Review, 32 (1), pp. 30-43.
Lowenstein, L. (1985): Management Buyouts, in: Columbia Law Review, 85 (4), pp. 730-784.
MacMillan, I. / Kulow, D. / Khoylian, R. (1988): Venture capitalists' involvement in theirinvestments: extent and performance, in: Journal of Business Venturing, 4, pp. 27-47.
Meier, D. / Hiddemann, T. / Brettel, M. (2006): Wertsteigerung bei Buyouts in der Post Investment-Phase - Der Beitrag von Private Equity-Firmen zum operativen Erfolg ihrer Portfoliounternehmen imeuropischen Vergleich, in: Zeitschrift fr Betriebswirtschaft, 76 (10), pp. 1035-1066.
Wright, M. / Wilson, N. / Robbie, K. (1996): The longer term performance ofmanagement buy-outs, in: Journal of Entrepreneurial and Small BusinessFinance, 5 (3), pp. 312-334.
Entrepreneurial Finance Summer Term 2015
Agenda
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6.2 Investment Development
6.3 Investment Exit
6.1 Investment Process
Entrepreneurial Finance Summer Term 2015
Exit Possibilities (1/2)
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Liquidation
Buyback
IPO
Trade Sale
Secondary Sale
Pros/cons according to perspective
Dependent on
Capital market situation
Overall economic conditions
IPO window forsector/industry
Comparable M&A activity andnumber of potential buyers
Source: EVCA (2002)
Entrepreneurial Finance Summer Term 2015
Exit Possibilities (2/2)
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Investee company is bankrupt and the VC/PE firm has to
write off the complete investment.Liquidation
Repurchase of the VC/PE firms stake by the entrepreneurs.Buy Back
Initial Public Offering is the first sale of stocks by a privately
held company to the public. Issued stocks are then tradedon the stock market.
Sale of the VC/PE firm's stake to another financial investor.Secondary Sale
Purchase of the investee company by another corporation.
IPO
Trade Sale
Entrepreneurial Finance Summer Term 2015
VC/PE Firms Role in the Exit Process
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Decision on exit route
Advice helping the company to grow in line with exit decision
Validation of expected price
Selection of key advisers
Entrepreneurial Finance Summer Term 2015
Success Factors in an IPO
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Speed, co-ordination, and timeliness
IPO team working together to raise the companys public profileand awareness of the impending flotation
Generation of a perception of scarcity amongst potentialinvestors
Positive market view of the companys future
Favorable exogenous factors
Source: EVCA (2002), Entrepreneurship Education Course, Modul 8, Exit: IPOs and Trade Sales, p. 9.
Entrepreneurial Finance Summer Term 2015
Evaluation of a Public Sale
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Advantages Disadvantages
Limited to High Flyers
Strong dependence on stock
exchange conditions/IPO
window
No full investment reduction
possible
Higher costs and time
expenditure
Higher exit proceeds
Lower potential for conflicts
Higher reputation
Possible triggering of a takeover
Flexible investment reduction Participation in future value creation
of the portfolio company
Source: Paffenholz, G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.114
Entrepreneurial Finance Summer Term 2015
Benefits and Downsides of Public Quotation for the Company
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Access to a potentially unlimited sourceof capital
Currency for acquisitions(the companys own stock)
Better reputation - impact on
relationships with all key businessconstituents(employees, customers, suppliers)
Financial rewards for the companysfounders and stock option beneficiaries
Benefits
Cost/inconvenience of uncertain andlengthy IPO process
Ongoing reporting obligations of a publiccompany
Hard to satisfy short/medium-term
market expectations withoutcompromising the companys long-termprospects
Exposure to systemic market risks,which can affect a companys stockirrespective of its own performance
Unsolicited take-over offers
Downsides
Source: EVCA (2002)
Entrepreneurial Finance Summer Term 2015
Definition Lock-up
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Lock-up
Agreement between underwriters and existing shareholders notallowing the existing shareholder to sell any shares for a certain
specified period of time.
Entrepreneurial Finance Summer Term 2015
Definition Grandstanding
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Grandstanding
Young venture capital firms take their portfolio companies public
earlier than established venture capital firms in order to built up
reputation and successfully raise capital for new funds.
Source: Gompers, P. (1996): Grandstanding in the venture capital industry, in: Journal of Financial Economics, 42 (1), S. 133-156, p. 133
Entrepreneurial Finance Summer Term 2015
Trade Sale
Sale of the portfolio company to
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p p y
As the buyer has a strategic interest in the firm, usually all shares of the company have to besold, i.e. the entrepreneurs have to sell their shares alongside the other financial investors.
conflicts of
interest
Competitor horizontal integration Supplier/customer vertical integration
Probably prefers a complete sale Might have a strong interest to resist
a trade sale
AcquirerCurrent
managementteam
Entrepreneurial Finance Summer Term 2015
Phases of a Trade Sale
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Identificationand selection ofpossible buyers
Initial contact
Distribution of
informationmemorandum
Contribution ofletter of intent
Due diligenceby potentialbuyers
Start ofnegotiations
Form ofcontract andcontact closing
Source: Paffenholz,G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.122.
InternalProcessing
Agreement onexit strategy
Analysis ofcompany
If necessary
restructuringmeasures
Preparation of adata room
Identification ofBuyers
Valuation/Negotiations
Entrepreneurial Finance Summer Term 2015
Success Factors in a Trade Sale
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A leak may trigger adverse reactionsfrom employees, customers or suppliers
Such reactions may spook the
purchaser into seeking to renegotiate orabandoning the deal
Other potential buyers have lower
interest in targets widely known to be upfor sale
If sale does not take place, desire to sellmay be seen as indication for vendorslack of confidence in the businessfuture, negative spiral
Secrecy
If potential purchaser sense that otherparties may be interested, this will help to
create a sense of urgency
maximize the price
ensure that acquirers remain honest
(i.e. do not continually try to renegotiate)
Competition
Source: EVCA (2002)
Entrepreneurial Finance Summer Term 2015
Advantages Disadvantages
Evaluation of a Trade Sale
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Advantages Disadvantages
High potential for conflicts
Limited number of potential
buyers
Obligation to accepted non-cash
or payment by installments Obligation to grant guaranties
Higher exit proceeds, but also
possibility to exit in case of a
moderate development
Immediate and complete exit
possible
Easier, quicker and cheaper
transaction (compared to an IPO)
Source: Paffenholz,G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.120
Entrepreneurial Finance Summer Term 2015
Influence of Exit Strategy on Growth Strategy
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Company needs to be well-rounded and
capable of thriving as an independent
entity
Build an IPO-ready mentality
Main requirements are
quarterly budgets and forecasts accounting standards for publiccompanies
disclosure standards for publiccompanies
public relations conference tour
IPO
Company does not have to be a
complete firm and may lack entire
functions
Purchaser may only be interested in one
function
At least one aspect of the companyshould be directed to achieve the
best in class
Trade Sale
Source: EVCA (2002)
Entrepreneurial Finance Summer Term 2015
Mini Quiz
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?Would you as investor prefer a trade sale or an IPO as exit route?
Entrepreneurial Finance Summer Term 2015
Advantages Disadvantages
Evaluation of a Secondary Purchase
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g g
Low potential for high returns
Reservation of potential buyers
Small number of market
participants
Possibility to exit even if portfolio
company is still immature
Low potential of conflicts
Simple and quick transaction
Rarely problems to identify relevantpotential buyers
Source: Paffenholz,G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.124
Entrepreneurial Finance Summer Term 2015
Recommendation Readings
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Brian Burrough and John Heylar (1990): Babarians at the Gate: The fall of RJR Nabisco.
Sebastian Mallaby (2010): More Money than God: Hedge Funds and the Making of a New Elite.
Daniel Schfer (2006): Die Wahrheit ber die Heuschrecken. Wie Finanzinvestoren die Deutschland AG umbauen.
Paul Jowett and Francoise Jowett (2011): Private Equity: The German Experience.
Stephan Eilers, Nils Koffka, and Markus Mackensen (2012): Private Equity: Unternehmenskauf, Finanzierung,
Restrukturierung, Exitstrategien.
Eli Talmor and Florin Vasvari (2011): International Private Equity.
Entrepreneurial Finance Summer Term 2015
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