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Entrepreneurial Finance Issues: Entrepreneurship Roundtable. Dr. Michael J. Robinson, CFA, ICD.D Haskayne School of Business The University of Calgary December 5, 2012. Talk Subtitle: What a VC Will Not Tell You.
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Dr. Michael J. Robinson, CFA, ICD.D
Haskayne School of Business
The University of Calgary
December 5, 2012
“You have just made a $3 million investment in an early stage firm. What are the issues about the investment that will cause you to lose sleep at night?”
Uncertainty has three main dimensions:
Information asymmetry and agency risks (People)
Technological uncertainty (Products)
Market uncertainty (Markets)
Risk mitigation practices followed in the public capital markets are less effective in private equity context
Due to above risks, private equity capital is rationedMore Academically
Adverse Selection – Entrepreneurs have private information about the investment which will lead to poor quality firms being overrepresented in the market
Moral Hazard – Entrepreneurs will engage in behaviours that are detrimental to investors following an investment
Taken together, these two dimensions of information asymmetry create a high degree of agency risk in the private equity marketplace
Even without explicit wrongdoing on the part of the entrepreneur, a firm can experience agency problemsExtreme Information Asymmetry inPrivate Equity Investment Situations
Two types of informal investors are:
Wealthy individuals (angels) who wish to invest and add value to the firm through their experience and network of connections
Less wealthy individuals who wish to invest passively in private firms managed by people they know, or in private firms located close to them
Informal investors have less ability to mitigate both market and agency risk than formal investors, but will tend to screen on agency riskPrivate Equity Market Participants
Institutional investors that specialize in investing in situations with high uncertainty and asymmetric information
The most common type of formal investor is a venture capitalist (VC) which will specialize in certain industries or investment situations
Researchers note that VCs are more concerned with market risk than agency risk
VCs will use stringent screening procedures to mitigate market risk and will use hands-on governance and monitoring mechanisms to manage agency riskPrivate Equity Market Participants
Angel investors prefer to invest close to home (lowers their monitoring risk)
Angel investors prefer to invest in industries they understand (lowers their market risk)
Angel investors prefer to invest in firms with more tangible assets (lowers market and agency risk)
There are other significant informal investors who can provide capital
Where to find angel investors?
Angel investors tend to like to work together
There is a formal angel network in Alberta called the Alberta Deal Generator (http://www.dealgenerator.com/)
There is an affiliation of angel investors in Canada called the National Angel Capital Organization (http://www.nacocanada.com/)Conclusions of Study
VCs operate in environments characterized by high agency costs and high uncertainty
In these situations, a VC’s relative efficiency in selecting and monitoring investments gives them a comparative advantage over other investors
VCs are more active in industries where there are high information costs, e.g. software/biotechnology
VCs will also tend to specialize in certain types of industries, or investment situations
Even within their area of specialization, many VCs prefer more mature investment opportunitiesOverview of VC Financing Issues
VC firms use extensive contracting to reduce possible agency costs
VC firms use extensive monitoring to maintain access to information
VC firms structure their investments to reduce risk and to allow for an exit in a timely mannerHow Do VC Firms Operate?
Trying to take advantage of investee firms
Try to impose their will, i.e. they arrogantly believe in their own strategies
How to avoid vultures
Perform due diligence on the VC firm
Try to form a syndicate of investors to make all VCs behaveHow to Avoid Vulture Capitalists