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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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entrepreneurial finance issues entrepreneurship roundtable

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
Talk Subtitle:What a VC Will Not Tell You
  • A venture capitalist (VC) is an institutional investor seeking to maximize their return (either financial or strategic) from investing in private firms
  • The VC world is full of unique terms, practices, and behaviours that define the unwritten rules of the game
  • A VC will not tell you how to play the game, but if you are willing to listen they will help guide you through the pitfalls each developing firm encounters
  • Unfortunately, VCs will invest in only about 1 in 100 firms they encounter so the remaining firms must seek other development capital and guidance

Alberta Private Equity Markets Study

Phase 1 by Elder and Robinson (2007)


Alberta Private Equity Markets Study

Phase 1 by Elder and Robinson (2007)

risk exercise
Risk Exercise
  • This exercise involves a question I was asked as part of my job interview with the BDC VC division.
  • The question is as follows:

“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?”

people products and markets
People, Products and Markets
  • The risk elements you have identified in the preceding exercise fall into three main categories:
    • People – Does the firm have the correct management team in place, and will they behave appropriately?
    • Products – Can the firm effectively deliver the described product on time and on budget, i.e. is the product technically feasible?
    • Markets – Will customers be willing to purchase the product once it is completed? Are there competing products being developed “under the radar” that will place the firm at a competitive disadvantage?
more academically
High degree of uncertainty in private equity investments creates significant capital market imperfections

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 rationed

More Academically
extreme information asymmetry in private equity investment situations
Information asymmetry in this investment situation has two dimensions:

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 problems

Extreme Information Asymmetry inPrivate Equity Investment Situations
people issues on a more practical level
People Issues on a More Practical Level
  • A seasoned U.S. early stage investor, Thomas Churchwell (2002) notes that without access to smart early-stage capital, and other experienced advisors, 80% of start-ups will fail. By way of contrast, a more professionally backed start-up will have an 80% success rate.
  • The easiest way to describe the problem is that a new entrepreneur does not know what they do not know. I have been involved with advising several new entrepreneurs and there is a progression that they must work their way through if they are to become successful. Implicit in the preceding statement is the notion that a failure to make this progression will likely lead to significant difficulties for the entrepreneur and his/her firm. A failure to seek advice, and then listen to the recommendations, significantly lowers the chances of a firm succeeding.
sources of private equity financing
Sources of Private Equity Financing
  • Informal Investors
    • Relationship Capital
      • Entrepreneurs Capital
      • Friends and Family Capital
      • Business Associates Capital
    • Opportunity Based Capital
    • Angel Investors
      • Novice Angels
      • Experienced Angels
  • Formal Investors
    • Venture Capitalists and other Private Equity Investors
private equity market participants
Informal Investors

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 risk

Private Equity Market Participants
private equity market participants1
Formal Investors (Strategic Partners)

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 risk

Private Equity Market Participants
characteristics of informal investors
Characteristics of Informal Investors
  • Source: A Profile of Angel Investors, Morrissette, The Journal of Private Equity, 2007.
  • Estimates from the US suggest that there are approximately 400,000 business angels investing $50 billion in capital each year in over 50,000 firms
  • This is estimated to represent approximately 70% of the capital being provided to new US ventures
characteristics of informal investors1
Characteristics of Informal Investors
  • Average age of an angel investor is 47-50 years
  • Distribution of ages is as follows:
    • Under 35 years old – 11%
    • 35-44 years old – 33%
    • 45-54 years old – 31%
    • 55-64 years old – 19%
    • Over 65 years old – 6%
characteristics of informal investors2
Characteristics of Informal Investors
  • Average investment size is about $75,000 with one study finding the following distribution:
    • Investment under $25,000 – 20%
    • Investment between $25,000 and $99,000 - 40%
    • Investment between $100,000 and $250,000 - 25%
    • Investment over $250,000 – 15%
  • Most angels have three deals in their portfolio and make an investment every 18-24 months
  • Most angels prefer to invest close to home (within one or two hours driving time)
characteristics of informal investors3
Characteristics of Informal Investors
  • Extent of Due Diligence is minimal and based on informed business judgment and an assessment of the quality of the entrepreneur
  • Investment structure tends to be simple (common stock)
  • Angel likes to provide hands-on advice to the entrepreneur
  • Investment horizon is typically five years or more
  • Annual ROI expectations are typically between 20%-30%
  • Like to co-invest (80-90% of deals have multiple angels)
conclusions of study
The study documented a series of behaviors followed by angel investors: The study results provide support for:

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
possible trouble with angels
Possible Trouble with Angels
  • Beware the one-hit wonder
    • See the business model that gave them success in the past as the correct one in all situations
  • Beware the Angel looking to steal the firm
    • Will fund with debt knowing you will not attract any more equity capital and try to take you over when you are in trouble
  • Beware the disgruntled deep-pocketed Angel
    • “Sue him for sport”
    • Implication for entrepreneur and his/her family members
overview of vc financing issues
Why do VC firms exist?

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 opportunities

Overview of VC Financing Issues
how venture capital works
How Venture Capital Works
  • VC investment fills a void between corporate and government sources of funds for innovation, and the money an innovator can raise from the informal equity markets
  • VC funds are not typically targeted to basic research, but more to commercialization
  • Most VC funds are structured as 10 year limited partnerships with capital provided by institutional investors
  • With a 5-7 year investment horizon for early-stage firms, this means the VC must make these investments in the first few years of the life of their fund
  • The last 2-3 years of the life of a fund are spent on harvesting the investments
  • The J-Curve reflects how VCs deploy their capital over time
how a vc spends their time after 4 5 deals the vc is fully committed
How a VC Spends their Time(After 4-5 deals the VC is fully committed)
  • Soliciting Business – 10%
  • Selecting Opportunities – 5%
  • Analyzing Business Plans – 5%
  • Negotiating Investments – 5%
  • Serving as Directors and Monitors – 25%
  • Acting as Consultants – 15%
  • Recruiting Management – 20%
  • Assisting in Outside Relationships – 10%
  • Exiting Investments – 5%
how do vc firms operate
VC firms perform extensive due diligence to reduce information asymmetry between the entrepreneur and themselves

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 manner

How Do VC Firms Operate?
how do vc firms view risk
Management Team

Product/Market Issues

Stage of product/market development

Degree of competition

Technology Issues

Financing Issues

How much money and time is required until commercial sales are realized

How Do VC Firms View Risk?
myths about vcs
Myths about VCs
  • VCs have no loyalty
    • They have a high degree of loyalty to the capital
  • VCs make very high returns
    • The returns from VC investments over the past decade have been very low
  • All VCs are the same
    • Top 10% of VCs make most of the industry profits
  • VCs like to do seed deals
    • US VCs stopped doing seed deals 10 years ago
vc deal killers
VC Deal Killers
  • Problems with the capital structure
    • Overhanging debt or poor record of share ownership
  • Inappropriate governance structure
    • If there is a convoluted shareholders agreement, or other weird governance structure, the VC will take a pass as it is too much work to clean up
things to never say to a vc
Things to Never Say to a VC
  • Why do you want to start this firm?
    • I want to make a lot of money
    • I want to be in charge
    • The market is so large that all I need to get is 1% of the industry sales
  • Correct Answer:
    • I want to build a world class company that is bigger than myself
vcs behaving badly
VCs Behaving Badly
  • The last dollar in gets 100% of the firm
    • A less than reputable VC may stretch a firm out over time as the cash is being burned and then scoop up the firm for a much reduced price once the firm runs out of cash
  • Who does the VC work for
    • Beware the VC firm that is new and looking to make an impression on its limited partners (LPs)
      • This can cause the VC to take an investee firm public too quickly resulting in problems for the firm down the road
      • Alternatively, the VC may distribute its shares in the investee firm directly to the LPs when it knows there is negative information forthcoming about the firm
how to avoid vulture capitalists
Some VCs give the industry a bad reputation by their actions

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 behave

How to Avoid Vulture Capitalists
issues for you to consider
Issues for You to Consider
  • Do you have the personality and patience to be a CEO and to build a firm?
  • If so, then work to build a team:
    • Co-researchers
    • Key management personnel
    • Board of advisors
    • Board of directors
    • Capital providers
    • Customers and/or strategic partners