Entrepreneurial Finance Issues:Entrepreneurship Roundtable

Dr. Michael J. Robinson, CFA, ICD.DHaskayne School of Business

The University of CalgaryDecember 5, 2012

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 StudyPhase 1 by Elder and Robinson (2007)

Figure 1 Alberta’s GDP as a Percentage of Canada’s GDP

10.00%11.00%12.00%13.00%14.00%15.00%16.00%17.00%

2002 2003 2004 2005 2006

Source: Statistics Canada, 2007.

Alberta Private Equity Markets StudyPhase 1 by Elder and Robinson (2007)

Figure 5 Alberta’s Percentage Share of Canada’s Reported VC Disbursements and Deals

0.00%1.00%2.00%3.00%4.00%5.00%

1999 2000 2001 2002 2003 2004 2005 2006

Total Disbursements Number

Source: Thomson Macdonald, 2007 and Thomson Financial, 2006.

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 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

Extreme Information Asymmetry inPrivate 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

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 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 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

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 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 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 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)

Histogram of PrivateEquity Financing in Alberta

Figure 1: Distribution of Private Equity Financing in Alberta: April-July 2003

Distribution of Private Equity Capital Raised by All Firms in Alberta

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Histogram of Investments by IndividualsFigure 2: Distribution of Individual Investor Use of Exemptions: April-July 2003

Distribution of Individual Use of Private Equity Exemptions

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Informal Investors Usage of Exemptions Table 9 Panel B

Panel BApril-July 2006

Exemption Used Number of Investments

Dollar Value of Investment

Average Investment

Amount

Median Investment Amount

Individual Investors Relationship Capital: 1,334 $42,531,914 FFBA 10.30% 3.90% Opportunity Based 2,762 $49,535,958 Capital: OM 21.40% 4.50% Angels: 7,147 $389,784,504 Accredited Investors 55.40% 35.50% Angels: 13 $6,495,959 Sophisticated Investors 0.10% 0.60%

35 $353,9500.30% 0.00%

2 $37,5000.00% 0.00%

32 $4,048,3000.20% 0.40%11,325 $492,788,08587.80% 44.90%

Purchaser Outside Alberta $18,750 $18,750

Total Individuals $43,513 $20,000

$499,689 $450,000

Other Exemptions $126,509 $20,000

Private Issuer $10,113 $5,000

$17,935 $10,000

$54,538 $25,000

$31,883 $17,250

Non-Individual Investors Exemption Usage Panel B

Summary of Individual and Non-IndividualInvestor Exemption Usage: April-July 2006

Exemption Used Number of Investments

Dollar Value of Investment

Average Investment

Amount

Median Investment Amount

Non-Individual Investors Relationship Capital: 85 $6,204,066 FFBA 0.70% 0.60% Opportunity Based 287 $11,250,487 Capital: OM 2.20% 1.00% Institutions: 1,168 $545,527,821 Accredited Investors 9.10% 49.70% Institutions: 15 $12,248,078 Sophisticated Investors 0.10% 1.10%

3 $470,0000.00% 0.00%

20 $28,356,8200.20% 2.60%1,578 $604,057,27212.20% 55.10%

Total Individuals and 12,903 $1,096,845,356Non-Individuals 100.00% 100.00%

Private Issuer $156,667 $200,000

Total Non-Individuals $382,799 $50,000

$85,007 $20,125

$816,539 $458,398

Other Exemptions $1,417,841 $78,740

$39,200 $5,521

$467,061 $59,000

$72,989 $30,000

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/)

PRIVATE EQUITY INVESTOR NETWORK DEVELOPMENT By: Lina Zhang (B. Comm Student) [2012]

PRIVATE EQUITY INVESTOR NETWORK DEVELOPMENT By: Lina Zhang (B. Comm Student) [2012]

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

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)

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 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

Example of a Risk Grading Metric

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

• 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

• 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

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

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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

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