ISSUES GPs / LPs negotiate on in their agreement

1) what is the basis for calculating profit?

2)

FINS3623
V
Venture
C
Capital
i l
Week 2 Fund Raising and Fund Structure I
How VCs raise funds & relationships they have w/
their investors

Lecture Outline

R i
Review
off F
Forms off Financing
Fi
i

Funding a firm raises funds available to E firms at

various points in life cycle and how VC fits in their

Equity Financing
Debt Financing

Overview of VC Fundraising
What determines the inflow into VC markets?
VCs face in raising funds for 1st time
Diffi lti off first
Difficulties
fi t time
ti
funds
f d
structure in which VCs raise funds ( more
The Limited Partnership
p Structure legal
detail w3)
Compensation in Limited Partnership
2

F
Forms
off Financing
Fi
i off P
Private
i
Fi
Firms

E really like to hold on to ownership for as long as possible - but at some point they will need to raise SOME outside capital to fund the expansion of
the firm
--> restort to bootstrapping
bootstrapping (aka INTERNAL CAPITAL) = efforts of E to restort to all sorts of means to minimize his/her reliance on external capital. e.g. save,
use credit card, mortgage on home, family friends to raise capital
- 1st form of external financing of E (31% of all firms do this 1st)
- many aus companies dont actually need external capital (e.g. EDS went public without any external financing)

Sources of Equity
q y Finance

First stage: Bootstrapping

V i
Various
sources off internal
i t
l equity:
it

Own money, savings, credit cards, personal loans, family members,

tax rebates, second mortgage,
g g etc
Often a must before any other form of financing

A survey finds that bootstrapping contributes to about

31% off allll fforms off fifinancing
i
Median startup capital in the US: only about $10,000

Ross P
R
Perott started
t t d EDS iin 1962 with
ith $1000 ((about
b t $5000 iin ttodays
d
dollars).
No real VCs at the time. Despite this EDS went public in 1968
share price goes from
f
$16
$ to$160
$
dollars in a matter off days.
In 1984 he sold a majority stake of EDS for $2.4 billion to GM ($6.5
billion in todays dollars). Today it is a division of HP.
4

Bootstrapping rationale:
- dont want to introduce external
capital TOO EARLY or TOO
QUICKLY
even if you have a good idea,
dont want to take VC or angel $
too quickly
(1) --> give away too much

ownership of the business

- VC: this is too early, too risky, I

will need much ownership in the

business
--> kill the return of the E, boost
return of VC
- limit the incentive of the E to
work hard. (Moral Hazard)
(2) --> once the VC's $ is in the
business, they will be thinking
about EXITING, MINIMIZING
RISK --> not the right things to
think about when starting a
business

Sources of Equity
q y Finance
First stage: Bootstrapping

--> Introducing external capital

too early may hinder
entreprenrialship

AKA benefits of bootstrapping

Problems with obtaining external funds too early

Incentives to spend, expand and squander

Want to get the concepts right early on in the business. dont
Slower start is often a safer start want to have too many errors.
No opportunity for correcting errors and poor decisions
Venture capitalists are not that patientThey want a return from 5 years, if they dont see a

Outside investors can hinder the entrepreneur

They want to exit in 5 years

return they may want to terminate

may not be the best

Outside investors often prefer the safe proven routes learnt from
approach
previous investments, while the entrepreneur may prefer experimental - esp if you want to be
try-it
y fix-it approach in an uncertain environment
new and revolutionary

By bootstrapping entrepreneur can ensure very high returns

Conversely, VCs will want too much ownership at early stage = little
incentive/wealth creation for entrepreneur
If you have too much capital --> VC suddenly injects heaps of $$$ --> hard to
think carefully/straight/rationally of what to do --> spend too much5

good dicipline to have a limited amt of capital

Sources of Equity
q y Finance
==> once exhausted bootstrapping

Second Stage: Angel Investors/ Seed Capitalists

Invest own capital

Professional investors investing with their own funds - likes to be very involved, mentoring,
Often wealthy individuals, with a lot of experience: coaching, value add to the business and

E.g. investment bankers, lawyers, retired CEOs, retiredprepare it for funding from VC (been
through it, know what an attractive firm
scientists/engineers
looks like)
Investment objectives:

Reaping the initial high returns by getting in early

Timing is everything - adolecent, growth stage
Reaping returns from value adding activities
P
Prepare
th company for
the
f venture
t
capital
it l funding
f di

Market for angel investments (US figures):

Activity:
y around $
$12 billion in 2007
Number of investors: about 140,000 individuals
Acceptance rate: vary from 10 to 20% of all proposed deals
Most prominent ind
industries:
stries healthcare
healthcare, soft
software,
are and biotech
Industry based, invest in
industries...

Sources of Equity
q y Finance

Second Stage: Angel Investors/ Seed Capitalists

Size of investment: from $50,000 - $100,000

Investment horizon:

Minimum 7 years to time of listing (or sale)

Average 12 years

Portfolio: often less than 5 firms

Key investment philosophies of modern angel investing:

Involvement, not just Investing

MENTOR, more involved than passive investor
Formal screening and selectivity
Maintaining strong financial resources

Deeper pockets allow diversification, continuous funding to avoid

dilution of ownership

Expertise-based
Expertise
based investing and leveraging intellectual capital
7

Once the firm grows past early stages, has a product, has a market --> full scale expansion phase
- seed capitalist is not enough
- once you expand you have a CAPITAL GAP --> where VC fits into the picture
- Reason that VCs have much more capital than angels cuz they are a INTEMEDIATED INVESTMENT VEHICLE --> they can access the pool of
investment capital in the financial system (e.g. super funds, instituional money) access that and channel that into a VC limited
partnership and reach adequate scale/ amass adequate amount of cash to provide startup with amounts of capital
- although Angels rich they are INDIVIDUALS and dont have the amount of capital required to fund expansion

Sources of Equity
q y Finance

Expansion Stage: Venture Capital

Overview of venture capital investments:

Raise capital and maintaining relationships with

Investors select and monitor investments and finally exit
Investors,
exit.
8

Sources of Equity
q y Finance

Overview of venture capital investments:

Flow of funds of VC/private equity investments

GPs manage the fund on day-day basis

- contribute very small amt of capital
- recieve fees for mgmting fund
- recieve LARGE share of profit of fund (e.g. 30%) even if they
contribute VERY SMALL AMT OF THE CAPITAL

LP = investors
- cuz they have limited liability (cant
lose more than what they contribute)
- contribute to 99% of the fund
- recieve 70/80% of the profit
- fund is then channeled through
PF companies
9

Sources of Equity
q y Finance

A summary

full scale --> really when VC come into

the picture
- important to understand that when
talking about VC/startup financing
- VCs dont typically fund small
projects --> step in when a firm is in
its EXPANSION stage.

10

Startups can also get debt capital...

Sources of Debt Finance

Bank Loans:

Overdrafts, commitments, term loans, etc.

Contribute to about 30% of funding
Difficult to obtain for start-ups as banks require

Stable cash flows

Collaterals in the form of tangible assets

Moral hazard and adverse selection:

Moral hazard: Borrowers have different risk appetite to lenders

Adverse selection: substantial information acquisition costs
The result is credit rationing (or debt gap)

Thus the Debt that they issue is almost like EQUITY

- no stable CF, no tangible assets, (cannot pay back assets, must be deferred assets), no assets to liquidate.
Debt instrument is almost like equity instrument (but EVEN WORSE), Equity instrument has upside
- give rise to more serious MORAL HAZARD and ADVERSE SELECTION --> more incnetnive to use the capital on
11 own purpose
- know that the Debt providers cant do anything about it to reclaim the debt
- charge really high interest rates --> adverse selection problem --> the only Es that take out the loan are the people who
dont care about what happens to the loan (spend on private benefits) only attract bad E --> banks stop lending --> market
breaks down --> banks stop lending

Sources
of
Debt
Finance
If you see Debt funding in startup --> it is usualyl in more exotic forms

More exotic debt financing sources:

All suitable
it bl tto llater-stage
t
t
bridge-capital
b id
it l fifirms
Debt financing mixed with E financing
Mezzanine funds:-=Hybrid
D/E securities to fund Entrepreneurial ventures

Provide
P
id d
debt
b fifinancing
i combined
bi d with
i h equity
i component
Debt is often in the form of unsecured, long-term and less
than senior
senior-rank
rank instruments

Venture lending:

Similarly, provides debt financing with some warrant

component
Often provides small debt amount that allows the firm to Some sort of convertibility of
D to E
continue
ti
tto operate
t until
til th
the nextt equity
it ffunding
di round
d
Requires the backing/guarantee of existing venture capitalist
Often requires blanket collateral over all assets
12

Guess the Venture

In 1995 a 28-year-old software developer Pierre Omidyar sat

down to write a code that would enable internet users to buy and
sell goods online.
Pierre decided to test the site by listing a single broken laser
pointer.
He was shocked when the item sold for $14.83. When he
contacted the winning bidder to ask if he understood that the
pointer was broken, the buyer replied: "I'm a collector of broken
laser pointers".
p
By 1996 the company was large enough to require the skills of a
Stanford MBA in Jeffrey Skoll, who came aboard an already
profitable
fit bl ship.
hi
By this time the business is making $50,000 per year Ongoing growth of business has
consistent CASH FLOWS
13

Problem of transaction sky rocket:

- you need funding/invest in warehouses, legal staff, servers, expansion classically is where the VC come
into play
- Investments 10x CF = clearly need external Financing (internal no where near nuff)
-

Guess the Venture

The site went from 250,000 transactions to 2 mill transactions in

1 year. E
Exponential
ti l growth
th in
i users that
th t required
i d matching
t hi
growth in investments

Development Expenses: $4.6 mil in 1998, $24.8 mil in 1999, $55.9

milil in
i 2000
Cash investment 10 times cash flow from operation in 1998 and
1999
All earnings are put back into the business

History of external financing

1997: $5 mil from Benchmark Capital for 20% ownership

1999: seasoned equity offer of $700 mil

490x return (highest return on any VC

1998: Initial public offering. Benchmark claims 49,000% return
deal)

The company originally

Th
i i ll ttraded
d d as Echo
E h B
Bay T
Technology
h l
G
Group
but is now known as..........

14

O
Overview
i off VC Fundraising
F d i i

15

VCs have a complicated relationship with their Investors

Overview of VC Fundraisingg

The process of fund raising

g and fund
structuring is complex due to the nature of
VC investing
g Why complex relationship?

VCs invest in risky firms with moral hazard and

information asymmetry problems.
Investors in venture capital funds are investing in
investors in these types of firms
investors

Understanding fund raising and fund

structuring is central to understanding the VC
cycle.
Investors (i.e. LPs of VC funds) invest in a PARTNERSHIP which invests in these very problematic investments

- DOUBLE moral hazard problem / double agency

- 1) not only have to deal with the problem of investing in these really difficult to finace firms
- 2) also faced with additonal agent problem of VCist behavior --> very possible for VCs to raise a lot of $$$ from LP. e.g. raise $50m fund w/ 2%
fees, make $1m over life = "im set" --> agency issues --> need to make sure that the VCs work hard
--> VCs can simply calim that they are working hard and leave with your
1) ageny problem b/w INVESTORS and VCists
2) agency problem VCs face b/w VCs and the Entrepreneurs

Overview of VC Fundraisingg
Structure of this
relationship
affects
ff t the
th whole
h l
cycle

NB: relationship b/w VCs with investors

will affect the relationship b/w VC has
with the PF/Entreprenrial firm it is
investing in.

Why the relationship of VC and investors will also affect relationsihp b/w VCs and PF/E firms?
- PE funds have finite life of 10years --> after liquidated all investments and return capital to all investors
- Finite life of fund: affect E seeking funds from VC (attidue/relationship)
-

Overview of VC Fundraisingg

The structuring
g of p
private equity
q y funds in terms of
management fees, profit sharing rules, and
contractual terms between LPs and GPs also affects
other aspects of the venture capital cycle.
For example private equity funds have a finite life of
about 10 years, after which they must be terminated
How does this affect

The entrepreneur seeking to raise funds?

The behaviour of venture capitalists toward the
entrepreneurial firm?

If VC sees good venture to invest in: characterisitcs it needs to have to qualify: 1) something you must exit in 10 years time (usually actually 7)

Other way: E firm encounters some trouble, needs some time to recover, but ordinarily may recover in a few year time and get back to normal. But
cuz the 10 year time frame may just terminate the investment.
- VC may also try to dress up a firm, maximise its SHORT term profits, at expense of LONG TERM GROWTH in order to EXIT the firm.
e.g. 7 years into the fund, if VC makes certain amt of long term investment in R&D may be much more profitable in future.
- but you know that it is exiting next year, DEFERR expenses, accelerate income, boost Short term valuation, ignore LONG TERM PROFIT
potential - ultimately ST investor - only care about EXITING.

Limited Partnership AGreements which try to contract every possible way a VC can behave
opportunisticaly to rip off the LPs.
- many CHARACTERISTICS / FEATURES of the LP/GP partnership agreement

Overview of VC Fundraisingg

The structuring of private equity funds can be

understood
d
d as a response to an uncertain
i environment
i
with many information gaps

These structures
Th
t t
have
h
developed
d
l
d a variety
i t off
mechanisms to ensure that value is maximized

Unlike other investment funds

funds, VCs receive a very large share of many contract terms - bargain
the profit of the fund (20-30%)
over when drawing up of the
partnership agreement
- e.g. when EXIT when do VCs
receive the PROFIT
- immediately? or when all the
capital contributed by the LPs are
The timing of the profit distributions to the Venture Capitalists can returned.
vary across VC funds depending on the bargaining power of the -

Other features of p
private equity
q y funds can be seen as
attempts to transfer wealth between parties, rather than
efforts to increase the overall wealth.

Venture Capitalist.

Cuz so many MORAL HAZARD, RISK, INFO ASSYMETRY --> need appropriate incentive alignments
1) VCs get 20% of profits - unusually high, normal fund mgmers dont receive any profit only mgmt fees
- used to ALIGN LPs and GP interests

Macro level discussion (in readings)

What d
Wh
determines
i
the
h iinflow
fl iinto
venturee capital market?
ventu
a ket?

20

Supply-side
Supply
side
Factors

Demand-side
Factors

Factors affecting investors supplying funds to VCs

Demand: factors effecting demand of Es for VCs in

order to pursue E activities

21

MACRO LEVEL

What determines the inflow into venture

capital market?

Supply-side factors: related to the availability

of funds earmarked to VC/PE investments

Who invest in VC and PE funds

Pension funds, insurance funds, endowment funds,

wealthy individuals, governments, etc.

Why do institutional investors invest in VC/PE?

Alternative asset classes that promise high potential Not so much in Australia
returns
B t mostt importantly,
But
i
t tl they
th offer
ff valuable
l bl diversification
di
ifi ti
opportunities when combined with traditional assets

22

1) Relative level of capital gains tax and income tax

- when investing in VC the most important form of gain is CAPITAL GAINS
- if capital gains tax <<< income tax = more incentive for people to put $ into
assets which have more returns in capital gains (e.g. VC type investments)
- e.g. institutional investors

What affects the supply of capital to VCs?

- number of factors in the reading

What determines the inflow into venture

capital market?

Oth specific
Other
ifi supply-side
l id ffactors:
t

Capital gains tax:

Clarification of Prudent
Prudent Man rule

Lower than income tax

Institutional investors are tax exempt or pay low taxes
Many pension funds etc.. prohibitied from investing in
VCs --> must invest other's $ in what a prudent man
would.. --> if hold small portion REDUCES RISK

Common law countries

In 1979,
1979 the US govt.
govt ruled that a small allocation into
Venture funds was not contrary to the rule

Compulsory or incentivised pension contributions

Performance of the public market

Encourage exit route for VC and PE investments

Australia: super annuation became COMPULSORY --> FLOOD of capital into

investment
23
institution industry --> increase supply of funds in VC.

What determines the inflow into venture

capital market?

Demand-side factors: demands of

entrepreneurs to obtain funds

= more opportunities of Entrepreneurship

Economic growth
Capital gain tax, R&D tax incentive Better (than earning salary) and start own business

Determines the incentive for startup

Supply versus demand factors

C.F. being employee in firm

R&D can write off R&D , rebates --> encourage to start

own venture

Supply factor curves are much more elastic

24

What determines the inflow into venture

Supply much more ELASTIC than demand factors
capital market?
Expected
Return

D
Demand
d

- supply of VC, small increase in expected return of VC asset

will lead to a very large quantity of funds supplied.
However, change in Expected return in demand
(Entrepreneurs) wont lead to large influx of E wanting to start
own business

Supply

Quantity
of funds
25

MICRO LEVEL

What determines the inflow into venture

capital market?

Mi
Micro
ffund-level
dl
l ffactors:
t

A newly established fund is like a startup firm

Incrediblyy difficult to raise fund

Needs to overcome substantial agency costs and information
asymmetry
Needs to establish expertise
p
and network

As there is no external market to trade VC fund contributions,

Hypersensitvity to performance /
reputation is critical in fund raising
Performance persistence
If good performer = extremely easy to Investors in Venture Capital are hypersensitive to performance
raise fund

VC funds that hold larger stakes in firms that have recently gone public
raise funds with greater probability and raise larger funds
funds.
Inadequate = money pulled away very Reputation in terms of age and size is also an important factor.
fast
Extremely difficult for investor to get access to top performing VC fund --> so

sought after
- if you take out the top quartile VC investment funds = VCs will perform VERY
26
BADLY 0% or negative risk adjusted returns
explaination
- lot of junk VCs
- not enough good entreprenurs

Past performance V.S. Future performance

Importance
p
of Reputation
p
Future-fund
Performance

Bottom

Past-fund
Performance

Medium

Bottom Tercile

61%

22%

17%

Medium Tercile

25%

45%

30%

Top Tercile

27%

24%

48%

Main points
- poor performing VC fund last period will also be bottom
S
Source:
K
Kaplan
l and
dS
Schoar
h
[2005]
performer in next period 61% chance
- poor performing fund last year only has small 17% chance of
performing next year
persistence - top funds tend to be top funds, poor funds
tend to be poor funds
- 1st time raising funds in this kind of market = difficulty

VC skill set only certain ppl have.

Top

High correlation b/w past

and future performance

If you perform well, more likely to attract DEALFLOW

e.g. good entrerpreneur has good idea, get REFERRED to
you. Good cycle --> if you do well, more good referrals
27

VC will raise a number funds over time

- clear positive relationship b/w fund sequence and the performance of the fund
- the firms that can raise the 10th fund must be sucessful in the past
--> lot of junk at the start

Importance
p
of Experience
p
IRR and Fund Sequence Number

The more funds you

raised/managed, the higher the
return

25

20

IRR

15

10

0
1

10

11

Sequence Number

Source: Kaplan and Schoar [2005]

NB: also a graph with number of firms VS. sequence of funds

- rapid decrease graph...
28

Again infomation problems etc..., people cant verify who you are...
Q: how are you ever going to raise a fund?

The Challenge
g of First Time Funds

Fundraising is particularly challenging for first

time funds
Investors are reluctant to invest in an
unproven team
Then how do you raise a fund without a track
record when
record,
hen to obtain a track record you
o
need to have a fund?

29

The Challenge of First Time Funds

This challenge of first time funds is

addressed in several ways
ways.

Identify investors who are not purely motivated by

Green technology: investor who aint want $ but interested in innovation in Green Tech.
returns e.g.
e.g. investor who wants to support innovation in particular industry
VCs arise from other large isntitutions
Who are they?
e.g. arise from bank/ IB
- use the name of bank as a verification of
Establish alliance with
ith e
existing
isting instit
institutions
tions
their quality
Recruit a lead investor or special limited partner

SPecial limited partner = investor who is very EXPERIENCED who's support will certify
the quality of the fund . In return = provide SLP concessions (wont charge too high fees),
give them more profits

30

30

Defining the players in the VC fund raising process

Key provision/terms in GP/LP agreement: governs their relationship

The Fund Raising Process.

31

"venture capital limited partnership" VCLP:

GPs are the VCs

Who are the Players?

y

The General Partners (The Venture Capitalists)

Responsible for day-to-day

y
y management
g
of fund
Usually invest a small amount of own capital 1%
For first
first-time
time funds and established funds invested
amounts can be larger. invest more to signal their COMMITMENT

GPs supposedly have UNLIMITED LIABILITY

- HOWEVER, in practice, GP/VCs get around this by many means
- e.g. set up a company to act as a general partner.
- so the company has a unlimited liablity in partnership level, they
have limited liability in company level
- other insuranes which indemnify them.

NB: dont want GP invest TOO much of their own personal

capital
- become too RISK ADVERSE

32

Who establishes p
private equity
q y funds?

Individuals Ex- successfull entrepreneurs

Financial institutions

Banks
Investment Banks
Pension and other fund managers
A d th
And
their
i employees
l

Corporations "corporate Venture capital funds"

Governments e.g. Israel
33

Who are the Players?

y

Limited Partners (LPs)

These are a wide array of individual and

institutional investors.
investors They include:

Need established relationship w/ GP

- Top funds will be choosy who their
LPs are.

- Those who will be interested in

investing in a SERIES of funds in future
- wont hassel them to fund mgmt

Wealthy Families even corproates

Pension Funds
Endowments
Wealthy individuals

Established relationships are necessary to invest

in top-flight funds
P t
Partners
can also
l b
be S
Special
i l Li
Limited
it d P
Partners
t
or
a Friend of the fund.
Friend = have special terms
34

Fund that specicailly set up to

invest in other VC funds
2 reasons why a FoF is set up
1) if you want to get access to a
TOP flight fund, can invest to a
fund of fund (who has access to
the top fund) so you can get
access
2) e.g. small university (with
$200m endowment) want to invest
Agents which help LP choose which VC/GP to
in BUYOUT fund. only a small
invest in.- provide advice
proportion to go BUYOUT fund. Investment Advisors or Gate Keepers
$10m min. Use the FOF to SCALE
Provide advisory services to clients.
UP the investment --> get
EXPOSURE to the buy-out fund
Usually set up Funds-of-Funds.

Who are the Players?

y

3) opposite: $5b super annuation

fund. Incredibly large funds -->
problem these face = e.g. may
have $50m allocation to VC, VC
funds are only $50/$100m. Very
difficult/time consuming to
spread out, to find 15 funds to
spend your $50m allocation
- FOF can SCALE DOWN this very
large fund on behalf of the super
large funds.
also charge Carry e.g. 10% and
MGMT fee
what you are really paying for is
ACCESS to a VC who knows
what to invest in

Funds-of-Funds invest as a Limited Partner in many

different VC and Private Equity Partnerships.
Typically major investment banks undertake this role
A fund-of-funds is sometimes established to invest in a
single fund.
A fee is charged to investors.

35

Structure of Limited Partnerships

p

especially 1st time VCs

- lots of scope to take your $
and simply argue that the
investments were bad

Initial investors (LPs) in a private equity fund are

anxious to avoid opportunistic behaviour by the
general partners
PROBLEM: investors have limited
Investors have liability limited to the extent of capacity to intervene with the
capital they provide.
partnership
lose LP status --> as long as they
B t limited
But
li it d partners
t
can nott b
be iinvolved
l d iin th
the -are
remain UNINVOLVED with the
day to day management of the firm, otherwise operations of the business
they lose their limited liability status.
==> in order to minimize their risk
Thus, the limited partnership structure for
of this behavior must RELY on
venture capital
p
investing
g is the crucial
the LIMITED PARTNERSHIP
mechanism for limiting the behaviour of venture AGREEMENT
capitalists
-> long/complex documents which
spell out the rules in which the VCs
must
invest
36
-> many clauses, classifications,
which try to avoid agency/moral
hazard risks

Structure of Limited Partnerships

p

In U.S.
U S private equity funds
funds, each LP must be an
accredited investor, which is a person or legal
entity that meets certain net worth and income
entity,
qualifications and is considered to be sufficiently
sophisticated to make investment decisions
about complex securities
General Partners are responsible for the day
day-toto
day management of the firm, and have unlimited
liability.
liability

37

accredited = understand
sohpsitcated securities
CANNOT be retail investor

Structure of Limited Partnerships

p
Normal corporation have many
mechanisms to manage many
agency risks
- e.g BoD, ...

take over market --> you get to earn

good premium = implicit protection
against the behaviors of mgmt

Oversight mechanisms found in corporations, e.g.

Macqurie, large fund mgmt of IBs,
Powerful Boards of Directors,
Directors Market for corporate exercise a lot of power in
management of these firms
control, powerful outside shareholders, are not in
place for these p
p
partnerships.
p
non of these mechanisms exist
A series of contractual provisions and covenants
govern the fundraising process and governance of theother than the contracts
partnership.
in regular, company -->
No liquid market for partnership interests exists, and Investors
simply Sell "wall street walk"
limited partners are frequently restricted from selling --> partnerships NO real
LIQUID market for partnership
partnership interests.
interests
Consequently the primary remedy for limited partners --> restrict protection from
is legal action triggered by a violation of covenants.
damages of opportunistic VCs
More on this next week.
LEGAL action only --> least desired way to resolve dispute

38

e.g. X Ventures typical example:

VC firm/partnership raises 1st fund "Vintage year" of fund (year fund made first investment) - doesnt meant that it is has $100m in its
account - rather: it has $100m COMMITED by investors IF NEEDED
- more fund it raises, the more committed capital it is able to raise in subsequent vintage years.

Cash Flow Schedule

Co
Commitment
e

KEY terms in partnership agreement

Commitment refers to the maximum amount of

capital that an individual LP agrees to invest in a
fund. The commitment generally includes
management
g
fees charged
g by
y the GP,, as well as
other fund expenses.

"$ committed by the LPs"

But, LPs disburse committed capital in

STAGES

Why?

Stages
39
- 1) E dont need to invest all the capital up front - invest in stages
- 2) effeciency perspective: inefficienct for cash sitting in VC acccount not being used --> depress IRR if they hold onto the committed capital in their
bank account --> Rather: CALL the $ when needed "TAKE DOWN SCHEDULE" / ""CAPITAL CALLS"

Take down refers to :

- 1) Schedule of capital calls VC makes to the LPs
- 2) refers to the SINGLE payment by LP to the VC ... aka. CAPITAL CALL
--> usually VC finalizes terms of investment into Entrepreurail firm, typically 10-20 LPs in the fund. LPs will wire the $ the next day and channeled
into the E firm

Cash Flow Schedule

Takedown

This term is used in two ways.

First, in reference to a schedule of transfer of capital in phases

in order to complete a commitment of funds
funds.
Second, and more commonly, in reference to a single
payment by an LP of a portion of a total commitment of
cap ta
capital.
Takedown is synonymous with drawdown and capital call.

Relatively large
large, early payments from LPs are inefficient inefficiient --> JIT drawdowns
because cash waiting to be invested earns minimal
interest, which depresses the funds overall returns.
Consequently, just-in-time drawdowns of capital as needed
have become the norm
40

Controversial issue: mgmt fees they charge

Compensation
p
Structure

Good GP: charge 2.5% of

committed capital EVERY YEAR in
fees
- FIXED RETURN per year

Management Fee

This is a fee charged

g by
y the GP to the LPs.
Management fees in a private equity fund typically
range from 1.5% to 2.5% of committed capital,
depending on the type and size of fund.
This fee structure differs from that of mutual fund
managers, which invest in public markets and on
average earn less than 1% of assets under
managementt

41

GP shares a substantial profit of

the fund
GP and LPs negotiate when this
CARRY is paid --> cuz affect the
wealth transfer b/w the 2 parties
e.g. require to give back all the
commited funds before paying

the CARRY
--> others dont

Compensation
p
Structure

e.g. pay back all the MGMT fees

before the GPs get CARRY
--> others dont
DEPENDS ON THE BARGAINING
POWER OF VC and LP

Carried Interest

Carried interest is the GPs share in the profits of

a private equity fund.
S
Sometimes
ti
a ffund
d mustt return
t
the
th capital
it l given
i
to
t
it by the LPs before the GP can share in the
profits of the fund.
fund
The GP will then receive 20% of the net profits as
carried interest,
, although
g some successful firms
receive 25%-30%. This fee is also known as
carry or promote.
Many funds require repayment of management
fees from investment proceeds before the GP can
receive any carry
carry.
42

Compensation
p
Structure

Distributions and Clawbacks

As investments are exited,

exited funds are distributed back to
LPs. These are known as distributions
The Limited Partnership Agreement (LPA) specifies how
and when these distributions take place.
The timing and form of distribution (cash vs. securities) will
also be defined. This includes clawback provisions, which
give LPs the right to reclaim a portion of carried interest
disbursements to a GP for early profitable investments if
there are significant losses from later investments in a
portfolio.
These issues can become very complex in negotiation of
the partnership agreement. See examples to follow.
43

Complexity
p
y of Profit Distributions

The
e bas
basic
c idea
dea is
s ssimple:
pe

Over life of fund there are EXITs of Entreprenurial firm OHHH

EXIT PROCEEDS = aka "liquidation proceeds" = amt of
cash/traded assets recieved upon PF company's liquidation event
e.g. IPO, M&A, bankruptsy

Investors Commit $100m

Exit Proceeds are $200m
Profit = $100m
A GP with
ith 20 percentt carried
i d interest
i t
t gets
t $20m
$20
and LPs get $80m
Si l right?
Simple
i ht?

No! Many complex provision make this

calculation complex.
44

Invested Capital = how much investors commit to the fund - mgmt fees - committed capital NOT YET invested
mgmt fees = mgmt fee % * investor commit to fund * No. years

Complexity
p
y of Profit Distributions
profit IMPORTANT to calculate CARRIED INTEREST

First,, what is profit?

p
i.e. what is the basis for
calculating profit?

COMMON 1ST ISSUE:

WHAT IS THE BASIS for calc. profit?

2) COMMITTED CAPITAL; or

1) INVESTED CAPITAL?
70% of funds use (1) invested
capital

Investors Commit $100m

$
mgmt fees / year
Over the 10 year life of the fund they pay $25m in fees 2.5%
charged to LPs
((2.5% x 100m)) x 10.
Therefore invested capital is only $75m
If exit p
proceeds are $200m,, is p
profit ((1)) $200-$75 or is
it (2) $200-$100?
70 % of funds use (1) 30% of Funds use (2)
1) invested capital (committed less mgmt fees) capital basis for profit
Which would a GP prefer? 2) committed capital basis for profit
GP obviously prefer (1) profit on INVESTED funds
LOLOLOL costs = profit to the GPs
- even if earn $0 still making profits

45

The Timing of Carry

ANOTHER ISSUE GP/LPs negotate on
20%: require GPs to return ALL
commited capital

Who gets what

what, when?

24%: require GPs to return INVESTED

capital (COmmitted capital - fees
stuff not invested)
48%: only require GPs to return SOME
portion of invested capital

max security
Approx 20% of funds require the return of committed capital
before collecting
g carry
y
Approx 24% of funds require the return of invested or contributed i.e. after the mgmt fees
- mgmt secure its fees
capital before collecting carry
A
Approx
48% off funds
f d require
i the
th return
t
off a portion
ti
off invested
i
t d
capital before collecting carry

Priority Returns or Hurdle Rates

Priority return seems to be like

a ONE OFF thing... not yearly
8%

Preset rate of return that the LPs must receive before GPs can
collect carry (about 45% of funds have hurdle rates)
Catch-up Provision: VCs can receive a greater share of profit
once hurdle rate has been met. potential for greater carry

"PRIORITY RETURNS / HURDLE RATES"

- = preset rates of return that LPs have to provide to the GP before they can collect carry
- e.g. 8% --> have to return committed capital AND 8% BEFORE GPs can collect CARRY

--> TOTAL return of 8%

46

46

Catchup provision:
- If GP gives LPs propority returns, then GPs are then allowed to collect profits to CATCH UP to CORRECT profit share
AFTER the priority returns/hurdles have been met

The Timingg of Carryy

Terms of partnership agreement

Consider a $100m fund with carry of 20% (with

committed capital being the basis for profit)
Priorityy returns of 8% and 100% catch up
p
provisions.
For simplicity, NB: completelly unrealistic
All Committed capital is drawn down on day 1 of
the fund. i.e. $100m invested in DAY ONE of the fund

At year 1: $108m exit proceeds

At year 2: $2m exit proceeds
At year 3: $10m exit proceeds

How would this profit be distributed each year?

47

+ $108m
exit

-$100m
0

Given
- Carry = 20%
- Priority = 8% (100% catchup)
- agree GP have to payback
ALL committed capital b4 carry
+ 8% priority return
@ year 1
- $108m exit, GP has returned
ALL committed capital,
additonal return required is $8m
--> $108 goes ALL to the LP
--> GP gets $0
LP = $108
GP = $0
@year 2
- $2m profit
- might think that now it is SPLIT
cuz priority provision met
NB: CATCHUP PROVISION ->
GP is entitled to disprotionally
collect profit to their TRUE
profit/distribution RATIO
- after $2m profit --> TOTAL
profit = $10m (2 + 8)
- out of the $10profits GP has
rights to 20% (per agreement)
i.e. $2m --> entitled to
"Catchup" to it
LP = $0
GP = $2m

+ $10m exit

+ $2m exit

--> GP takes $2m (from CATCHUP) and split the rest 80/20
KEY: THE REST
i.e. split the $8m
NOT SPLIT THE $10m 80/20

The Timingg of Carryy

The LP agreement requires the return of committed capital + priority

return
LP = $6.4m
GP = $1.6m + $2m
Year 1: total profit = 8m, priority return =8%
The LP receives all of $108m
Year 2: total profit = year 1 + year 2 profit = 8m +2m = $10m. The
priority return has been satisfied, but GP has 100% catch-up provision:
The GP can take as much as is needed to catch
catch them up
up to the
80:20 profit split.
The GP is entitled to receive 20% of $10m, or $2
Year 3: total profit = 10+10 = $20mil, priority return and catch-up
provisions have been satisfied
The GP gets $2m
$2m, the LP gets $8m
What happens if Year 2 distribution is $10m?

@ year 3
- $10 exit/profit
LP = $8m
GP = $2m
- All the priority returns have been met
- usual 20/80 GP/LP split

48

invest 50m initially, invest another $50m which return is 0%

More on Clawbacks

aka. invested capital must be repaid

to LPs before GPs can get CARRY

A $100m fund has 20% carried interest, where

profit is based on committed capital. c.f. invested capital
Carried interest can be collected as long
g as
invested capital is repaid (no priority returns) min. amt of return???
Three years into the funds life

Contributed capital is $50m and; Contributed capital = amt INVESTED by the fund
The fund receives its first exit of $60m
How would carried interest be distributed?

$10m profit can be divided 80/20 between LPs and GPs

LPs get total of $58m and GP gets $2m
NB: see problems

PROBLEM: if for the rest of the life, the investment COMPLETELY FAILS completely written off
- now drawn the FULLcommitted $100 and invested
- but now fund COMPLETELY written off --> LPs only recieved $58m
- GP already collected $2m carry --> not fair for GP to collect $2m if fund has made substantial loss
--> CLAW back agreement --> clawback the $2m carry which the GP collected
-->

More on Clawbacks

Fast forward to the end of the funds life:

There were no more exits

Contributed capital is now the full $100m
But the LPs have only received $58m

According to the rules the contributed capital

must be repaid
p
before carry
y is distributed.
LPs are entitled to clawback the $2m carry
initially collected by GPs

50

INVESTOPIA
Es should seek to hold onto their venture for as
long as they with their own capital/family friends.
- cuz VCs will demand high control, ownership
(especially earlier)
- wont be in control
Funding gap
- gap between later-staged VCs and seed funding
(intermediate/early stage)
- cuz VCs want to invest at least few million. Early
firms with e.g. $250k seed capital may now need
additional $1m for early stage devlopment (critical
time)
--> filled by early stage VCs, and angel
investors (e.g. retired VCs, ppl with
enthusiasm in particular technology)
VC aim: to liquid event & exit
- from early stage to exit (e.g. liquidity event,
IPO, M&A)
- looking to exist from
Forming investments
- Investments occur through pooled investment
structure e.g limited partnership. ......

Issues:
NOTES ON THE P.E. FUNDRAISING PROCESS
Conflict with existing strategic partners
- process for which PE groups raise capital is OBSURE
- fear that existing strategic LPs will distort investment decisoins
- good reputation: raise over weeks, less known = fundraising can be which are promising cuz of potential compete with longstanding
painfully slow
clients.
1) challenges of 1st time funds
- using the instutitons to get stellar records, realize that their ties
2) overall level of PE
are no longer required
Fund of funds / intermediaries
3) hire a "lead investor" aka. special limited partner. Contribues
- intermediaries give advice to LPs to make investment decisons, but substantial capital. Special LP benefits in at least 2 ways: recieve
do not acttively manage funds themselves...
extra carry, lower mgmt fees.
Placement agents
- may be costly for GPs to hire a) lower returns b) special LP may
- similar role to GPs, close ties to leading investors
have powerful control, monitoring the fund. c) get less fees from
SLP.
1) challenges of 1st time funds (what i dont know)
- 1st time GPs make larger investments to signal their commitment
- investment advisors AKA. "gatekeepers": advisory services to
clients (yet still make hte ultimate decisision whether to invest) while
having discretionary control over other client's assets.
--> combine smaller investors into "funds of funds"
Way to get around this challenge?
Determinants of Fundraising activity
- 1) ID investors who not totally motivated by fins return, instead
- fundraising dynamics --> insight into competiive advantages
seek STRATEGIC BENEFIITS from fund. e.g. want to simulate local - SUPPLY v DEMAND
economy. Other corporations might have R&D interests --> VC in
supply = desire of institutional investors to commit capital
advanced technology etc...
(SUPPLY $$$)
demand = number of entreprenurs who want PE (DEMAND $$$)
- 2) Establish alliance with existing isntitutions, ties with IBs, existing
PE groups.