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3Si invests in breakthrough innovations within early-stage ventures that can disrupt markets. We build our portfolio based on compelling people, transformative ideas, significant intellectual property, deep market understanding, and the opportunity for capital efficiency and leverage. 

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Venture Capital And Private Equity Basics

August 13, 2016

First of all, some key definitions need to be provided:

 

Private equity: interested in large-scale investments, usually tech ideas that can revolutionise. They refocus the mission of the company, sell off noncore assets, freshen product lines, optimise assets, take on leverage and often replace management. They obtain profit after exit (SBO, IPO, trade sale).

 

Business angels: usually former entrepreneurs or wealthy individuals with cash and expertise. They are less structured compared to VC, with no formal timetable, buy a small equity stake and typically without a seat on the board. They invest less capital, than VCs, and have possibly pre-existing relationships with entrepreneurs, which makes the due diligence shorter. Angels want the thrill of being involved. Usually, they provide help at the very early, bridging the gap of a raw idea and a point of maturity.

 

Venture Capital: they have active participation in the development and management of start-up business, including a seat on the board in most cases. They have some knowledge of the industry or business area, and extensive experience in starting and growing a business. They mostly fund game-changing ideas, investing large amounts of capital in equity of private companies with a clear exit plan. They are looking for companies with excellent teams, with low leverage and high growth potential. Requested return is very high to compensate for many failures.

 

There are major risks when investing in entrepreneurial firms; the most important ones are uncertainty about future, information gaps, soft assets (unique but hard to value) and volatility of current market condition (market dynamism, regulation and competition). How do investors overcome this pitfalls? They asses risks in industry, enumerate and set clear goals (financial milestones, earn outs) and timelines to reduce information gaps, communicate clearly what the firm’s assets both hard and soft are and think critically about financial and product market cycles and the challenges they post to the company’s business model.

 

Why and who invests in VC's?

 

Most importantly, VCs offer high returns; which used to be 30%, recently closer to 15-25%. On top of that, it allows investors to diversify making investments with a long-term horizon (alternative investments, least correlated with the stock market). Mostly, VC’s finance R & D and also creates employment. However, VCs consume a lot of time on due diligence, post investment monitoring which is not worth it, especially if a small stake of your portfolio is invested in VC.

 

Furthermore, there are no benchmarks and available statistics for this type of investing and it is rather illiquid. Thus, who invests in VCs? Pension funds (long term horizon, no need for liquidity) banks and also the reinvested gains. The typical investors’ requirements to invest in a VC fund are quality market analysis, the focus of the investment strategy, the composition of the management team, the company’s track record, the structure of the fund and detailed terms and conditions. The usual measures of performance are multiples such as DPI, RVPI, RR and PIC. The most important parts of a PPM are: size of the fund, term, returns investment strategy, GP’s commitment, hurdle rate and carried interest.

 

How does a VC work?

 

Venture Capitalists  find new investment opportunities and spend more than half of their time monitoring around 10 investments for which they are personally responsible. Of these, 5 are companies they helped found and on whose board of directors they serve. They visit the companies quite often, including lots of calls and also work on the company’s behalf by attracting new investors and evaluating strategies etc. If a company fails, the majority of VCs believe that it’s managerial failure, which leads to management replacement. In the same way real estate is about location, VC investing is all about management team.

 

Apart from that, VCs look mainly for segmented markets with an unfilled market need, business plans with not just slightly better, but significantly superior products, which have winning selling strategy (advertising etc.), maximise financial resources (cash needs are usually underestimated) and create an effective organisation both managerially and structurally. Finally, the right timing and luck is needed for success. To sum up, the VC process includes the first contact, in depth analysis of business plan, negotiation and deal closing, monitoring and control and exit. Due diligence is the most important one (the most costly as well) and the deal flow can be active, semi –active or passive (wait for business plans to arrive instead of identifying and approaching targets).

 

More definitions before we proceed:

 

Pre-money valuation is the value of the company before the current round of financing; that is the value of the existing shares at the price offered in this round of financing.

 

Post-money is just the pre- money plus the money raised.

 

Carried interest is the increase in value of all the money invested just before the round. Given that there are multiples rounds of financing, dilution occurs and thus VCs have to purchase higher fraction of shares, to retain the desired fraction with the specific IRR they are targeting.

 

Valuation techniques

 

VC, First Chicago Method and fundamental (two periods, 2 WACCs) are used as the traditional ones are not that applicable to early stage companies with even negative free cash flows. The venture capital method reflects the process of investors, where they are looking for an exit within 3 to 7 years. First an expected exit price for the investment is estimated. From there, one calculates back to the post-money valuation today taking into account the time and the risk the investors takes. The return on investment can be estimated by determining what return an investor could expect from that investment with the specific level of risk attached. The Venture Capital method is used in valuations of pre revenue companies where it is easier to estimate a potential exit value once certain milestones are reached.

 

The Fist Chicago method requires different future scenarios (best, mid and worst case), estimating the divestment price for each scenario using multiples, determining required return and calculate weighted sum. Lastly, probabilities of each scenario are estimated and the weighted sum of valuation is calculated. Furthermore, given the expected IRR, we can find the EV of the company at exit; then we can estimate the fraction required (we also know the pre-existing shares) and also the number of shares to buy in order to find the estimated price per share of this round (maximum a VC would offer). We can compare the pre-money valuation, post-money and also calculate the value created for pre-existing investors (carried interest).

 

Term sheet

 

These are the rules VC proposes to entrepreneurs in order to invest in their companies. VCs have the upper hand here, unless the entrepreneurs have offers from other VCs or an extremely attractive company/idea. The most important terms included are the vesting schedule, liquidation preference, conversion, anti-dilution, right of first offer and co- sale. Liquidation preference specifies which investors get paid first and how much they get paid in the event of a liquidation event such as the sale of the company. Liquidation preference (waterfall) helps protect venture capitalists from losing money by making sure they get their initial investments back before other parties. If the company is sold at a profit, liquidation preference can also help them be first in line to claim part of the profits.

 

Venture capitalists are usually repaid before holders of common stock and before the company’s original owners and employees. Anti-dilution protects an investor from dilution resulting from later issues of stock at a lower price than the investor originally paid. Multiple is usually set to 1 maximum 2, except in extreme case scenarios, when a company is desperate for cash. Co-sale or tag-along right is a contractual obligation used to protect a minority shareholder. If a majority shareholder sells his or her stake, then the minority shareholder has the right to join the transaction and sell his or her minority stake in the company.

 

Buy-outs

 

The exciting world of by-outs include MBOs, MBI, Bimbo, LBO, P to P, Buy & Build and Recaps. Buy outs usually result from family companies and privatisations. Managers running companies, which they know perfectly, identify its potential for asset optimisation, and given they don’t have the financial capacity to buy it, they are sponsored by a financial investors (company is either private or public). If it’s listed and it’s a hostile takeover, manager might offer a bear-hug (too good to reject) bid like in the case of Nabisco. Buy and build strategy involves a platform company, which with the guidance of a financial investor (e. g. PE), it grows tremendously while mostly acquiring other competitors. Fragmented market is ideal for this kind of strategy. SBO is just when a PE sells to another PE. Recap involves receiving more leverage in order to pay dividend to shareholders.

 

 

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