Midterm

Conclusions of Using Multiples: Comparable Companies

Overall accuracy is mediocre: less than one third of the time within 15% + or - true value Forward looking multiples do better EBITDA best among firm value multiples Performance valuing smaller firms worse than valuing large firms Same basic lesson about relative merits of multiples seems to persist for all sizes of firm

Objectives of Investors

Buy-in at cheapest stage Influence, control, power to direct Opportunity for "coaching" "creating protégé" Informality & flexibility Staying "in the game"

Beware of inappropriate "comparable" transactions such as:

outdated deals deals involving more or less attractive Targets Takeover premiums for firms with large market shares or premium product lines tend to be higher use of different deal forms such as: - public deals (premiums and prices tend to be higher relative to private firm acquisitions) - hostile deals (premiums tend to be higher relative to friendly deals) - Stock vs. cash deals (premiums tend to be higher in cash deals because of tax repercussions) - mergers-of-equals(premiums and prices tend to be lower) - minority stock purchases (premiums tend to be lower)

Private Firm Incentives to Understate/Overstate

•A private firm has incentives to understate earnings: - To reduce taxable income by either lowering reported revenues or showing higher expenses. - A private firm does not have the same incentives to report higher income to its shareholders as a public firm does. •Incentives to overstate earnings can also occur - When the owner is trying to sell a business. - Revenue can be accelerated and expenses can be deferred. - Excess sales may be booked at the end of the current fiscal year and then reversed the following year. - Management compensation can also be understated.

Why has PE market and VC funds had such rapid growth?

- Technology has increased rapidly leading to more startups - Change in ERISA in 1979 allowing pension funds to invest 10% of there total capital in VC. - Large successes in VC in 1980s with Microsoft, Google, etc... - Reduction of Capital Gains Tax to 20% in 1981 Incentive Stock Option Law in 1981 allowed the resumption of the earlier practice of using stock options as compensation by deferring the tax liability to when the stocks were sold rather than when the options were exercised.

The VC Cycle

1) Capital is raised by selling limited partnership interests in a VC fund to outside investors (primarily institutional investors). •Limited partners generally do not pay the full price of their partnership interest immediately, but instead pay in installments as is needed by the fund. 2) Capital is invested in new ventures over the first three to five/six years. •The typical venture capital investment is held for approximately five years. •Beyond years five/six, few (if any) new investments are made in companies not already in the portfolio and the goal is to convert existing illiquid investments into cash. 3) As investments yield cash or marketable securities, distributions are made to partners, rather than being reinvested in new ventures. 4) After 3-5 years, a new fund is created and fund shares are sold and investment in new ventures begins. •Several Funds may be Concurrently in Existence **Success in raising capital for new funds is generally highly dependent on success of pastVC funds**

Question?? Why "Entrepreneurial" Business Situations Are Different? 4 Main Reasons and examples

1) More risk exposure to a single company (or small portfolio of companies) for the investors. This can lead to the following: Concept failure Execution failure Timing Competition/technology Follow-on financing exposure 2) More fluid, fast changing environment Requires quick responses Crisis intervention Uncertainty and limited information Scale issues 3) Small management teams Each person becomes critical Limited support resources Internal cohesion, team bonding Hard work, focus and sacrifice 4)Premium on Leadership The "buck stops" here Need to build an organization One leader, many constituencies Detailed organizational structure not yet in place

6 Ways a VC exits

1.Venture goes public through an IPO -clearly the most profitable and most desirable exit. A "home run" is a well-received IPO, an IPO that has a high offer price and immediately rises significantly in value. 2.Corporate acquisition -less profitable but more likely exit. 3.Forced redemption of VC's security holdings by the company -exercise of put option embedded in the convertible preferred stock (Buyback of VC equity by the company) 4."Living Dead" -a struggling low growth firm that lacks liquid assets. 5.Bankruptcy and/or Liquidation -investment losses are typically quite high, often 100%. Quite common abroad: 6. Selling equity stake to another venture capital firm

Question?? What percent of PE Market is made up of venture financing and what percent is due to buy outs?

30% VC financing // 60% Buyout

Anti Dillusion Protection: Full Rachet

A full ratchet provision states that if a company issues stock to a lower price per share than existing preferred stock, then the price of the existing preferred stock is adjusted (or "ratcheted") downward to the new, lower price. •This has the effect of protecting the ratchet holder's investment by automatically increasing his number of shares. •Of course, this occurs at the expense of any stockholders who do not also enjoy full ratchet protection.

Comparable Companies using Multiples

Above the Line: Capital Supplier These multiples are also frequently defined using "Enterprise Value" instead of PV(firm). Enterprise value = Value of Debt + Value of Equity - Cash Market to Sales Ratio = PV(Firm) / Sales EBITDA Multiple: PV(Firm)/EBITDA EBIT Multiple: PV(Firm)/EBIT -------------------------------------------------------------------------------- Below the Line: Equity Supplier Price to Earning Ratio= P/EPS = PV(Firm)/NI Market to Book Ratio= PV(Firm)/ NW

Question?? What do all the PE investors have in common?

Access to a large amount of equity capital Ability to diversify risk due to the size of their portfolios Willingness to make high risk investments Not precluded by regulation from making such investments Relatively long investment horizons Limited need for liquidity Financial sophistication

Rule 144A Private Equity Market

Bulk of these issues are by public companies that want to issue quickly without registration delays. (Private placements) The issues are usually underwritten and sold primarily to institutional investors in the US and abroad. These issues can only be freely traded among certain classes of institutional investors (QIBs) for the first six months after issue. After the six month period, the securities are typically required to be registered with the SEC before trading freely in public equity markets

Question?? What are the challenges of valuing a private equity firm?

Challenges: •Limited financial information exists in terms of historical data & depth of information. •Private firms often do not use outside auditors. - They often use less well-known accounting firms to produce accounting reports based on compilation (least rigorous) or review (more rigorous), rather than an audited report (most rigorous). •Thus, accuracy of financial statements is more of a concern for private firms. - A detailed analysis of industry norms by public firms and knowledge of their financial ratios will aid in spotting questionable expenses and revenues.

Methods of Private Equity Valuation

Discounted Cash Flow •Generally need at least three years of operating history and financial accounting information for the firm or a closely related firm. Comparable Companies (e.g. P/E or P/Sales or P/EBITDA of public companies) •Need similar publicly traded firms to implement this method. Comparable Transactions •Need other firms in the industry that have been through an IPO or an acquisition. Option Pricing Approach (use Option Pricing Formula to value Firm's Asset Options) •Technology investments and the flexibility to change current investment plans as well as product development, plant expansion, and contraction decisions are like Options owned by the firm! •Example, R&D expenditures gives a firm a future call option to commercialize the technology or to abandon the project altogether. Venture Capital Method (Explained below)

Sources of Early Funding

Entrepreneur's own funds "Friends and family" Independent angels Early stage VCs

Non Financial Multiples

Examples: - Firm Value/Reserves (Mining, Oil and Gas) - Firm Value/#Subscribers (Media, Telecommunications) - Firm Value/Square Footage (Real Estate, Retail) - Firm Value/#Clicks (or downloads) (Tech firms) - Firm Value/#PhDs or Firm Value/#Patents (Biotech) Popular for valuing firms with no meaningful income (e.g. tech start ups) In 2000: Firm value/customer (eyeballs) Amazon: $1,400, Yahoo: $2,038 (Fortune2000)

Question?? What kind of private firm represents and ideal investment opportunity?

Firms in high growth industries (above 15% per annum) ...that are many years away from the consolidation or maturity phase. Firms beyond their initial stage of investment in basic R&D...when technology investment is highly risky & market size is unknown. Firms beginning to commercialize their earlier R&D research...approximately 80% of venture capital money goes to building the infrastructure required to grow the business. Investments in manufacturing, marketing, sales and providing supporting fixed assets (such as warehouses and inventory) and working capital. Firms that in a short time (3 to 5 years) can reach sufficient size and credibility to be sold to a corporation or go public. Firms with strong management are critical...managers who can overcome problems, are sensitive, quick to adjust to changing market opportunities and have track records of successfully supplying a product that is attractive to the market. - Replacing management can seriously slow product development -causing competitors to out-race the firm in delivering product and thus gain a first mover advantage. - Serial entrepreneurs are in great demand. Both previously successful as well as not so successful!

Venture Investment Process in a Typical Fund of 10-Year Maturity

First 2 Years: Fundraising Years 3-7: Investing, Value Addition, Portfolio Management Years 8-10: Harvesting, Realization/Exit After 3-5 years, a New Fund is created and new partnership interests are sold and the cycle begins all over again **Extremely Important** Success in Raising New Capital is Crucially dependent on Past Performance Buy Out funds are similar in nature

Question?? How do Private firms differ from public firms in several important dimensions

First, they operate under much looser accounting standards, especially if they are not incorporated. Second, managers are typically large shareholders, so manager & shareholder interests are intermingled - which can affect financial reporting decisions. Third, private firms lack timely market prices for their stock. Fourth, historical financial information and segment reporting may be unavailable.

Choosing Multiples Tips: Comparable Companies

Goal is to find firms with similar current and future profitability, size, growth prospects, technologies, levels of diversification, market share, product mix, risk,etc. When using below the line multiples capital structure (debt to equity ratio) matters as well Choose comparables carefully: Beware of poor comparables that are primarily selected to justify a lower or higher purchase price by producing a lower or higher multiple In evaluating comparables, realize that asset prices are functions of expected earnings and risk (more on it later). Comparables with very different risks due to different technologies or very different expected ROE or ROA (earnings) due to different costs or competitive environments from the subject company are close to useless. Multiples often show a lot of variation within even narrowly defined industries - Discard "outliers" when computing the mean - Alternate: use the median multiple among comparables - Simple average or weighted average of comparables? Use forward looking metrics of income - Forecasts of earnings, EBITDA, EBIT either from own estimates or from consensus equity reports -- E.g.: First Call, I/B/E/S (accessible through Bloomberg) This method gives you a public company valuation

Question?? Why do New Ventures face Grave Difficulty tapping Traditional Sources of Debt & Equity Capital (e.g. Bank Loans)?

High levels of uncertainty about R&D outcomes, product demand and profitability. High cash flow risk and firm valuation risk - Makes debt financing difficult. - Debt investment risk is made worse by limited control rights, usury laws, restrictions on financial institutions' investment risk, reorganization statutes and case law and bankruptcy costs. - Debt can also impose costly restrictive covenants on a startup and reduce capital available to grow the business. High information asymmetry about a firm's economic situation Entrepreneurs/Insiders know much more than outside investors. Unsecured nature of firm assets -a high fraction of intangible assets such as trade secrets, employee expertise or highly specialized (firm specific) assets - Loans are difficult to secure. - Such a firm also has high moral hazard risk (large agency problem) since it is investing a large fraction of its externally-sourced equity capital in new assets. Poor cash flow prospects in the short term - Expects a string of losses in the early years of product development and building market reputation and position Volatile conditions in industry, economy or financial markets - If the product market competition is intense there can be great uncertainty about potential market size or product success.

Question?? What are some of the risks of VC investment?

Historical returns are highly variable (high systematic and nonsystematic risks). There is huge estimation risk or uncertainty. There are severe moral hazard (agency) and adverse selection problems. Returns can be highly sensitive to overall market conditions. Risks of bankruptcy and liquidation are high. Early exit is nearly impossible or extremely costly and extended delay in exiting profitably is possible.

Maximizing Return Problem for VC and PE

How to maximize the return on the investment by choosing the optimal point to harvest the investment.

The Agency Problem for VC and PE

How to minimize the present value of all the agency costs (both the general partner -limited partner conflicts and the venture capital fund -entrepreneur conflicts).

The Sorting Problem for VC and PE

How to select the best venture capital organizations and the most promising entrepreneurial ventures.

Two Discounts that are used for Venture Capital Method: Illiquid Discount

Illiquidity Discounts for stocks without an active public market can be quite high from 30% to 40% or more compared to prices of active publicly traded stocks. This is based on the price discounts for unregistered stock of companies with listed stock. In practice, illiquidity (or marketability) discounts for private firms varies substantially based on their characteristics: Private firms tend to have lower discounts when they: •have substantial liquid assets and other marketable assets. •have strong balance sheets and cash flows. •are more likely to go public in an IPO or be acquired. •are larger in total asset size.

Comparable Transactions: Takeover Premium for M&A

In case of M&A transactions, instead of the purchase price, takeover premium can be used also. - Example:Target firm's estimated takeover premium = [Comparable's takeover premium / Comparable's book value of assets] Avg x Target's book value of assets. Takeover premium for the target company is thus as follows: (takeover offer price -one month ago market price) /one month ago market price

SCORS (Small Corporate Offering Registrations)

Informal broker market for small corporate offering registrations (SCORs) sold directly to investors under SEC regulation D (Rules 504 -506) 504: capital raising up to $1M within a 12-month period 505: capital raising up to $5M within a 12-month period 506: capital raising >5M within a 12-month period Exempt from SEC registration Requirements

Angel Capital Market Investor

Investments in small, closely held companies by wealthy individuals, many of whom have experience operating similar companies. They may take substantial ownership stakes and may be active in advising the company, but generally they are not as active as professional managers (e.g. VCs) in monitoring and rarely exercise control. The dollar size of these investments tends to be modest. Investments are often arranged by informal matchmakers or through angel networks.

Angel Financing (Investment Range, Control Rights?, Returns compared to VC?, Do they bring value outside of cash?)

Investments tend to be in the $250,000-$1,000,000 range. Angels do tend to conduct comprehensive due diligence Angels tend to contract & negotiate less thoroughly than VCs Angels don't tend to actively monitor extensively Angels tend to have weaker control rights Angels often don't bring any added value beyond the money they supply. Angel returns also tend to be much less successful than VCs.

Syndication of VC firms

It allows risk sharing by venture capital funds -their individual capital contributions to a venture are reduced, allowing each fund to have greater diversification across ventures (a typical fund invests in 10 to 20 ventures). •Syndication is more common for first round investments, when risk of failure is highest. Allows independent assessments by different venture capitalists of the prospects of a start up firm, before any of them invests capital •Syndicate members tend to be of similar levels of experience •Allows the general partners to have greater capital raising capability-for current and follow up needs of the ventures •Brings together more venture expertise and connections to investment bankers, consultants, attorneys, managers, etc. •Quid pro quo: Get referrals on other potentially profitable deals •Lead venture capital firms tend to maintain their proportional ownership stake throughout the various investment stages of a venture. •In later investment stages, experienced venture capitalists tend to syndicate with other similar and less experienced venture capital firms -increasing the size of the syndicate •As venture capital funds have got larger in size (more experienced), syndication has become less important as individual funds have more capital to invest and as they seek larger sized investments.

Characteristics of a Private Company and the need for VC

Large investment or expenditure requirements relative to revenues - No publicly traded securities - No publicly observable or determined share prices Minimal disclosure requirements -may not have quarterly or audited annual financial reports Minimal liquidity -often due solely to the company being willing to buy back its shares at an arbitrarily determined price Minimal collateral (tangible and easily salable assets) Limited sales and profit and operating histories - Limited debt capacity

Equity Crowd Funding

Large numbers of investors make small equity investments in small businesses or start-ups Expands family and friends' investment stage Traditional progression of early-stage funding Example: Kickstarter(funding portal): Raised $311M for 30,000 projects Market is small in comparison to the other PE segments

Question?? The Dominant form of Organization for companies that invest in private equity?

Limited Partnership

Two Discounts that are used for Venture Capital Method: Minority Holding Discount

Minority Holding Discount (or minority interest account) on the stock prices of firms with a majority shareholder are common when a new investor takes a minority position. •This discount reflects the fact that minority shareholders can be at the mercy of a majority stockholder - and thus bear serious agency risk. •One estimate of the minority discount is based on an estimate of publicly traded stocks' control premium: minority discount = 1 - 1 / (1 + control premium) •Example: for an estimated control premium of 40%, this formula yields a minority holding discount of 30% from its publicly traded stock price.

Market Size of Private Equity Market

PE Market more than one quarter the size of both the market for commercial and industrial bank loans and the market for commercial paper. Over the last 30 years, fastest growing segment of the corporate finance market. In a number of recent years, private equity capital raised by partnerships has exceeded capital raised in IPOs. About 30% of total private equity is venture financing, 60% is buyout (LBOs/MBOs) financing

Question?? What are the major private equity Investors?

Private and public pension funds (supply over 50% of funds) Corporations Bank holding companies (venture capital subsidiaries) Investment banks Insurance companies University endowments and foundations Angels- Wealthy private individuals investing in their individual capacities in closely held companies/startups

Organized Private Equity Market

Professionally managed equity investments in unregistered securities of private and public companies. Private equity managers acquire large ownership stakes and take an active role in monitoring and advising portfolio companies. In many cases they exercise as much control as insiders or more.

Objectives of Entrepreneurs

Raise start-up capital Advice and support Contacts and networks

8 Stages of investment in private firm - Seed Stage - Startup - Early Development - Initial Expansion - Profitable but Cash Poor - Rapid Growth - Mezzanine Investment - Liquidity Stage

Seed Stage-preceding formation of a complete management team or completion of product or service design. Startup-Companies under a year old. Early Development-Market studies and prototype development are promising. Initial Expansion-Firm is successfully selling product and getting positive feedback from customers. Profitable But Cash Poor-Capital needed for further expansion. Rapid Growth, Near Liquidity Point-Commercial bank credit available. Mezzanine Investment-Firm needs capital as it proceeds with an exit plan. Liquidity Stage-Cash-out or Exit through an IPO or an acquisition.

US Private Equity Market

Shares of unregistered equity securities in public companies and privately held companies in the US and abroad. Examples: Firms already private or going private Buyouts - LBOs/MBOs Early-stage ventures / Startups Firms in financial distress (often delisted) Public firms needing equity quickly or without public notice Private placements Corporate divestitures

Limited Partnership Takedown Schedule

Takedown Schedules: Limited partners typically are required to invest a certain amount at the onset of joining the partnership, but can phase in the remainder of their investment over time (Most funds require an initial cash commitment of 25% to 33% with the remainder paid at fixed dates in the future or as is needed).

Question?? How do both buyout and vc firms organize there organization?

The commonest prevailing structure is a limited partnership (LPs) with a fixed termination date. **Limited Partnerships represent 80% of this fundraising** It has venture capitalists (or a buyout firm personnel) who act as general partners and outside investors who are the limited partners (with limited liability). Some other setups include: Limited liability companies (LLCs) Captive funds - Corporation or Bank owned - Cisco, Intel, Microsoft, Google, Johnson and Johnson, SmithklineBeecham, GE, Goldman Sachs, B of A, JP Morgan-Chase, Morgan Stanley, etc. Some independent private companies, mainly in VC A few publicly traded investment companies (independent & captive small business investment companies SBICs), mainly in VC

Using Multiples

The key assumption is that for comparable firms/transactions these two measures move in fixed proportion to each other They are usually setup as Value of Asset / Income to the Asset Multiples are particularly useful when cash flow information is very imprecise Multiples are generally used for two purposes: Cross check a firm valuation that we do using discounted FCFF projections Form an alternate terminal value estimate

Small Public Offerings

There are reduced registration requirements for small public stock offerings. Small public issuers with revenues less than $25 million can use a shorter SB-2 registration form Small public issues of stock under $5 million in value qualify for an even less disclosure under Regulation A

Consultants/Gatekeepers

They are hired by PE firms to check out the various VC firms and help with the decision making process as to which firm to work with. Many pension funds, endowment funds and other LPs interested in VC and Buyout investments use gatekeepers to help them choose their private equity fund investments. (Consultants or Gatekeepers are basically Investment Advisers to investors/LPs) -Reverse of the first point above

Placement Agent

This is a financial intermediary that works on behalf of the PE firm looking to raise cash. They Sell limited partnership interests primarily to institutional investors & sometimes to wealthy retail clients (LPs) An Investment bank can also be hired to help locate funds for VC firms

Informal Private Equity Market

Unregistered securities are sold to institutional investors & accredited (wealthy) individuals The number of investors is typically larger and the minimum investment smaller than in the above two cases. Ownership is not concentrated among outside investors; insiders remain the largest and only concentrated shareholders. There is no lead investor that takes an active role in negotiating the terms of the investment. It is similar to the public market for small cap stocks. Equity is issued through agents who shop it around in a manner similar to underwriters using a best efforts contract.

Private Equity Market Changing Landscape (pre 1970 - post 1980)

Until the late 1970s, private equity investments were undertaken mainly by wealthy families, industrial corporations, and financial institutions investing directly in issuing firms. Since 1980, much of the investment has been by professional private equity managers on behalf of institutional investors. The dominant form of organization for these financial intermediaries is a limited partnership.

Additional VC responsibilitys

VC firms do pretty much everything you can think of once they take a stake in a company...below are 3 things that are not obvious •Be a major shareholder for at least the first six months after IPO, while the lock-up restriction is binding •Liquidate investment or distribute shares to limited partners after the lockup expires •Report to limited partners on fund performance - While early successes and losses are observable, the complete return is not known until the fund termination date since prior to exit many private equity investments are valued at the venture's last equity round valuation, given the lack of secondary market prices.

Anti-dilution Protection: Weighted Avg. Ratchet

Weighted average provisions are generally viewed as being less harsh than full ratchets. •In general, the weighted average method adjusts the investor's price downward based on the number of shares in the new (dilutive) issue. •The actual mathematical equation used may vary from deal to deal, but a common form is as follows: New price = (A+C) / (A+D) * old price, A = # of shares outstanding before the dilutive issue C = $ investment in the dilutive round / old price D = # of shares actually issued in the dilutive round

Comparable Transactions

When there are recent M&A transactions (or IPOs) in a Target's industry or a related industry then these prior M&A purchase prices (or IPO offer prices) can be used to estimate a purchase price or market value for a Target or its equity. Scale the purchase price (or IPO offer price) by an accounting number such as firm assets or a cash flow figure (e.g. sales, net income, operating income, or operating cash flow). - Example: Purchase Price/Book Value, Purchase Price/Sales, Purchase Price/FCF, Purchase Price/EBITDA Compute the average/median ratio based on acquisition prices across related M&A deals or IPO offer prices in the industry or related industry - Alternatively market share prices (which are generally higher) for IPOs can be used also The average ratio so computed is multiplied by the subject company's metric (asset size, FCF, sales, operating income etc.) to obtain a takeover price or IPO offer price for the subject company.

Above the Line Multiples: Comparable Companies

Yield Firm Value (Below the line yield Equity Value) EBIT & EBITDA multiples are less dependent on firm leverage (debt) than P/E multiples - Includes payments to both debt and equity EBITDA more likely to be a positive number than earnings - Likely to yield a multiple for young, growth firms P/E multiple more subject to manipulation than P/EBITDA

Limited Partnership Compensation to Fund Managers

•Compensation to the fund manager can be at the end of the life of the fund (a residual claim) or they can share in all the cash flows as the fund exits (cashes out) from each company in its investment portfolio. (see more on carried interest and clawback below.)

Question?? What is the current state of the VC Market?

•Early stage investing markedly down •Additional rounds of 'careful' investment in existing ventures •Extensive due diligence of new ventures •Times-to-Exit could extend from 3-5 years to 5-7 years or even more •Both Buyouts and VC are on the uprise with more then $30Billion for VC and $332Billion for Buy Out

Tax Implications of Limited Partnership

•Income is not subject to corporate taxation, instead income is taxable to the individual partners as it is distributed (conduit treatment) •Partnerships can distribute securities without triggering immediate recognition of taxable income by the partnership itself. •Partnerships must meet several conditions to qualify for this tax treatment: 1.A fund's life must have an agreed upon date of termination. 2.Transfer of partnership units is restricted. 3.Withdrawal from a partnership before its termination date is prohibited. 4.Limited partners cannot participate in active management of a fund if their liability is to be limited to their partnership investment.

Performance Measures for Limited Partners

•Internal Rate of Return •Investments are recorded at cost unless marked up (a significant following transaction) or down •Distribution of individual investment returns should be studied •Extreme outliers should be accounted for

Limited Partnership Voting Rights

•Limited partners generally have the right to vote on key issues such as: 1.amendments to the limited partnership agreement 2.dissolution of the partnership before the termination date 3.extension of the fund's life (typically 1-2 years) 4.removal of any general partner 5.valuation of the portfolio

Methods of Understating Earnings

•Private firms often give senior managers above normal compensation, benefits and perquisites. These benefits and perks are legitimate tax deductible expenses, but they also add to executive compensation. - Principals in private companies typically have higher compensation per dollar of sales than managers in publicly held firms. -- Carefully examine the sensitivity of executive compensation to sales - what does this ratio look like relative to the industry? --Compare key employee compensation to actual work, responsibilities and expertise. --Examine whether family members are employees and what their responsibilities, training, experience and compensation are? •Travel, entertainment, auto & personal insurance expenses and pension contributions, each divided by sales tend to be higher at private firms than comparable public firms. •Fees and compensation paid to separate businesses owned by the principals or where a principal is significant employee can also be in excess of market rates.

Question?? What are the incentives of the VC financial structure

•The need to terminate the fund at the end of 10 to 12 years imposes a healthy discipline on fund managers. •It forces the venture capitalists to take the necessary but painful steps of: - refusing additional rounds of capital for weak ventures - terminating underperforming ventures (often termed "the living dead", "zombies" or "numnuts") through the exercise of their putablepreferred stock (redemption rights). - using their board power to force a sale of the company.

Legal Structure of Limited Partnership

•The structure of limited partnerships is strongly influenced by US tax laws that allow conduit tax treatment provided certain organizational structures are used. •US securities laws & regulations also influence limited partnership structure by placing limits on number of limited partners (less than a couple hundred). •Approval of changes typically requires a 2/3rds majority of limited partners. •Almost all venture and buyout funds are designed to be self-liquidating after ten to twelve years.

VC Staggering of funds

•Venture Capitalists generally make equity investments in a company in phases, based on pre-agreed upon milestones representing particular design, production, marketing, sales and profitability goals. •This significantly limits the equity risk exposure of the venture capitalist by giving him/her a renege option on the committed level of equity investment in the private venture. •It gives the venture capitalist greater power over an entrepreneur's operating and financial decisions. - Sets operating milestones before more capital is forthcoming - Limited partners put up capital in stages -they commit to supply a certain total amount of capital on demand (with several weeks to several months notice) over the life of the partnership - Puts entrepreneurs on a short leash -minimal free cash flow - Highlights problems in firm and encourages rapid correction - Limits venture capitalist's risk •In later stages, the size of venture capital investments tends to go up, as a firm's prospects brighten and the uncertainty is reduced. •The duration between staged investments also rises with firm maturity and success level.

Question?? What are the two forms of compensation a VC fund receives? Includes Carried Interest and Clawback

•fixed annual management fee over the fund's life, typically in the order of 2% of invested capital (ranges from 1% to 3% and sometimes levied on committed capital) •profit participation or "carried interest" which is typically 20% to 30% of the fund's realized gains •Carried interest (% of profits or gains) of GPs is either paid without restriction (when LPs receive distributions) or is only paid after LPs have received at least their cumulative capital investment (with a minimum return of say 5-10%) (The latter payment arrangement is related to Clawback). •More on Clawback: If GPs are subject to clawbackand they realize losses later on some of their investments, they may have to return some of their earlier-received distributions, to LPs depending on the profit sharing rule.