Private Equity and

Venture Capital

Lecture 2:

different types of VC firms

VC firms and other investors

• There are a total of 7 different types of VC firms in additional to angel investors:– private independent venture capital partnerships– private small business investment companies– public venture capital companies– venture capital subsidiaries of large corporations– state venture capital funds– university related incubators & private sector incubators– investment banking firms

Private independent VC partnership

• Limited partnership: tax benefits

• 10 years life, 2 year extension

• Two types of PIP:– wealthy families-venrock associates,– institutional investors -- KPCB,

• two types of funds: usually $2-5 million– traditional vc funds- investing in seed, or startups– turnaround or LBOs

VC firms and VC funds

VC Firm

VC fund

VCfund

VCfund

VCfund

VCfund

VC limited partnership

• · çÏ Õ Í ¶×ʵ Ä Ô ËÓ ª

l i m i ted pa r tn eri n vst 99%

pr ofi t 75- 80%

g en er a l pa r tn eri n vst 1%

pr ofi t 20- 25%

VC limited partnershipthe VC fund

LP GP

General Partners: How their Income structured

• Angel investors: managing and investing their own money

• Venture Capitalists-- GPs: managing and investing others money

• GP income:– management fees: 1.5 -2.5% of the money they

managed, offices, telephones, computers, other costs

– Carriage: carriers -- 20/80. Now, it’s higher: 25/75 common. Even 30/70

VC firms and VC funds

VC Firm

VCfund

VCfund

VCfund

PC-2PC-3 PC-4

Pc-1

PC-5

The agreement of PE partnership -1

• Fund sizes, investment maximum and minimum.

• Number of investors, GP contributions• takedown schedule: both GP and LP do not

like to pay the committed capital immediately• first amount to be disbursed at closing: 10-

33%, the dates of the subsequent payments may be set in the agreement.

The agreement of PE partnership -2

• The control of LP: – if 51%+ LP agree can replace a GP– GP cannot invest in area beyond their expertise– no fault divorce

• the control of GP:– if LP pay late, a late fee is charged– condition on LP’s share transfers

The agreement of PE partnership -3• Management of the fund

– size on any one investment, prevent GP from attempting to salvage a poorly managed investment

– GP cannot have any share before LP get back their original capital, GP share as a call option

– percentage of the fund can be invested in one deal– limit GP’s attempt to leverage the fund, limit the debt to a

percentage– limit GP to coinvest between funds. GP’s attempt to salvage the

troubled investment– limit GP to re invest profits

The agreement of PE partnership -4• GP activities-- 5 restrictions

– 1. Restrict GP to invest personal fund into the firm, may pay more attention, may not like to pull out if necessary

– 2. Restrict on GP to sell their shares of the fund to others, reduce the incentive of the GP to monitor

– 3. Restrict on future fundraising until a % of fund invested: additional fund require additional attention of the GP

– 4. Restrict on GP for their other activities– 5. Restrict on hiring new GP with less experiences

The agreement of PE partnership -5

• Types of investment– limited size in any given investment class– cannot invest into public securities– cannot invest into other PE funds– cannot invest into areas with little expertise– restrictions on foreign investment– restrictions on LBO

SBICs

• Created in 1958, licensed and regulated by SBA• invested companies, ie. Apple, federal express, intel, cray

research, etc.• because of SBA, investment from SBIC is more restrictive than

other VC• some of the SBIC invest as equity, others as debt• government provides loans three times of SBIC’s paid in capital• four times of it if they are MESBIC -- minority enterprise small

business investment companies

Public venture capital companies

• Public vs private companies-- different concepts

• Some Big public vc firms called BDC -- business development companies

• some are SBICs

• because of they are public companies;– different tax treatment than other VC– have to concern their stock prices– publicly available information

Benefits to corp VC subsidiary-1• Characteristics: only One LP!!!• Derive attractive financial returns• develop technology licensees, manufacturing rights, supplier

agreements• control supplier uncertainty• identify flourishing industries• spin off businesses• generate new products• learn the dynamics of a particular marketplace• gain exposure to new markets and technologies

Benefits to the corp vc subsidiary2• Product marketing rights:

– small firms are often happy to have larger corp sell their products.

• Acquisition candidates:– GE wanted to acquire a CAD/CAM co, but bit low, later, it acq

uired a similar co.

• a window on technology– the most notable benefit that large corp invest in small firm is t

he window to gain new technological development– the last decade, the biggest 10 AUS electronics corp did this.

Benefits to the corp vc subsidiary3• Motorola focus on looking for technologies that are

going to have a major impact on our core businesses. Just as Cisco tends to acquire entire products, we tend to look at technology suppliers.

• These startups feel that the VCs don't understand their technology. High tech companies, on the other hand, may be able to understand the genius of what the entrepreneurs are doing. These companies have their own engineers who are experts in the field.

Benefits of corp vc to investee co

• An established customer base

• credibility with customers and suppliers

• credibility with bankers and other financial sources

• general assistance in managing the business

• a merger partner

• additional capital a flexible financing package

• investing in its employees to start their own co.

• sign a collaborative research contract

Problems in corp vc subsidiary• Contradictory inv goals of the vc and the present corp• unwillingness on the part of the vc to invest in 7-10 yrs.• Conflicts of interest and legal problems• inconsistent goals of the corp and the entrepreneur of the new co.• limited investment opportunities• the difficulty of acquiring the funded company• complication involved in obtaining tech from the funded

company

• differences between organizational requirement for the corp and the investment portfolio.

State venture capital funds

• Originally from Massachusetts, (such as CDFC-- community development financial corporation) Connecticut, later other states

• state funded to promote high tech, startups, and other socially beneficial projects

• state government promote the programs by– private sources will get tax benefits– state money promotions

University related incubators• Incubators: provide low cost laboratory and office space,

state-of-the-art technical expertise and equipment, administrative supports, computer and library facilities.

• Contacts with the vc, bankers, government officials.

• Sharing ideas and contact among entrepreneurs

• 1984, 40 incubators in the states, now about 400, especially in PA, IL, NY.

• I.e. University city science center in Philadelphia. Affiliated with 28 universities and colleges in PA. To house 100 small co in its I million squ ft space.

Investment banks and boutiques

• Investment banks usually invest in large amounts

• boutiques in a smaller scales: $1-10 million

• commonly used arrangement in equity transactions is the so-called lehman formula -- 5-4-3-2-1:

• 5% for the first million dollars of capital raised, 4% of the next, and so on.

• Ex. The fees for a $3 million deal would equal to $120,000

FVP: background• The existence of intermediaries b/w GP,LP• Angels investing $20-30 billion• Venture Capital Partnerships• why families would like this idea:

– tax benefits: 39% income tax, but 28% capital gain tax, 14% if invested into small business and long term

– federal inheritance taxes, 50% on individuals > $18 million assets. Gifts to children < $ 10,000/year, generation-skipping tax to grandchildren > $1 million

• 1992, 3% of the families with > $1million net assets control 44% of US household financial assets

Fox venture Partners• A $100 million fund: fund of fund concept

• sources of fund: wealthy families

• have to commit at least $2 million

• why vc like this idea:– 1. The LPs may be valuable information source

– 2. Avoiding vc dependent too heavily on institutional investors

– 3. Less restrictive terms from families

– 4. Want to involve in subsequent round of investments

Fox Venture Partners• FVP intended to invest $5 MM each in 20 funds

– 35% well known funds– 40% specified by region or industry– 20% new funds– 5% international funds

• this is different from buyout funds ($20 MM in minimum)

• 1994, 100.4 billion in PE, $32 billion in VC, the rest: 5% mezzanine, 2% distressed debt purchase

• 362 fund in PE, among them, 194 VC

FVP: history of fund of fund• Gatekeepers managed $18 billion of PE

funds, about 18% of the total

• they provide advisory services to some clients

• they serve as linkage between the VCs and the startups

• providing the first screening for the venture capital firms, charge a service fees

The Concept of Fund of Fund

VC Firm

VCfund

VCfund

VCfund

VC-2VC-3 VC-4

VC-1

VC-5

Fox Venture Partners• The resistance from the wealthy families:

– 1. Information asymmetries, the one who need the service may not appreciate it.

– 2. Agency problems, family financial managers…– 3. Lack of resources, not using a lead investor, limited

resource to market the idea.– 4. Ineffective marketing. Not show their track records– 5. The structure of the proposed incentive scheme.– The size of the proposed compensation.

Fox Venture Partners

• The challenges that FVP faces:– the educational role: the FVP will teach the families

about the funds– potential competitors are lots: on the concept of funds

of funds– since families now hired their financial managers, the

similar agency problems in the institutional investors appeared as well

Yale University endowment origin

• Yale was established in 1701 by 10 Connecticut clergymen.

• The endowment started 1818, divinity school to offer theological instruction, several alumni made large gifts.

• Yale use the money on land and building, and to invest in corp, railroad bond, equities

• by 1899, the endowment reached $5million

Yale U. endowment history

• 1930, yale endow held 42% in equity, other U had only 11%

• later 1930,then treasurer, Tighe decided to reduce equity %

• but stock market booming in 1950-60, end of 1960, the trustee wanted to increase the equity portion and to contract out the portfolio management to an outside advisor

• by bear market: 1969-1979, yale’s endowment declined by 46%

Yale investments office -1997

• David swensen: 15 employee office

• investment philosophy: different from other U.

• David likes Keynes maxim: worldly wisdom teaches us that it is better for reputation to fail conventionally then to succeed unconventionally. But he is willing to take the risk of being different. Not following the crowd.

David Swensen’ s philosophy-1

• Strongly believed in equity: whether public or private– equities are real stream of income , bands are a

contractual sequence of nominal cash flow– $1 invested in end of 1925 in corp stocks worth

$1371 by end of 1996, but only $34 in T bonds , $14 in T bills

• hold a diversified portfolio, risk can be reduced by diversification rather than time the market

David Swensen’ s philosophy-2• Increasingly seek opportunities in less efficient markets: why?

– The difference b/w 25 and 75th percentiles:• fixed income fund mg: minimal

• common stock mg: 3% per annum

• private equity mg: 15% per annum

• to utilize outside managers for all but most routine or indexed investment– the managers have the max autonomy– but the selection process is long and careful– incentives: not by the size of the management but by the

performance