VENTURE CAPITAL AND THE GROWING COMPANY
IBA Singapore 2007
Horacio Bernardes Neto
1.
INTRODUCTION
Venture capital is a type of private equity capital provided by professionals who invest
in financing new and rapidly growing companies at the early stage of development
(“start-ups”). Venture capital can also be provided to companies during different stages
of the life cycle of the business.
Venture capital investments involve higher risks and have a long-term orientation, but
offer the potential for above-average returns. It is an important source of capital for
start-up companies.
Innovative entrepreneurs tend to have intangible assets and ambitious growth plans that
require large amounts of financing, which will hardly be provided through traditional
alternatives. The need to offer high returns makes venture funding an expensive capital
source for companies and most suitable business having large up-front capital
requirements which cannot be financed by cheaper alternatives such as debt capital.
The majority of the venture capital comes from groups of wealthy investors, investment
banks and other financial institutions that pool such investments or partnerships. It is the
case of the venture capital funds, which are pooled investment vehicles that primarily
invests third-party investors’ funds in enterprises that are too risky for the standard
capital markets or bank loans.
Venture capital firms are comprised of General Partners (also known in this case as
"venture capitalists" or "VCs") who are the investment professionals which are former
chief executives at firms similar to those which the partnership finances and other senior
executives in technology companies, and the Limited Partners, which are the
investors, such as state and private pension funds, university financial endowments,
foundations and insurance companies.
Venture capitalists can be generalists, investing in various industry sectors, or various
geographic locations, or various stages of a company’s life cycle. Alternatively, they
may be specialists in one or two industry sectors, or may seek to invest in only a
localized geographic area.
Venture capital firms usually have strict requirements to select companies to invest in.
Companies with a solid business plan, a good management team, investment and
passion from the company founders, a good potential to exit the investment before the
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end of their funding cycle, and target minimum returns in excess of 40% per year shall
not encounter difficulties in raising venture capital.
Generally, venture capital investment is made in cash in exchange for shares in the
entrepreneurial company. However, far from being a passive financing alternative,
venture capitalists also foster the growth of the venture companies through their
involvement in the management of the company, strategic marketing and planning,
providing assistance in the development of new products or services.
Venture capitalists mitigate the risk of venture investing by developing a portfolio of
young companies in a single venture fund. Many times they will co-invest with other
professional venture capital firms (syndication).
Most entrepreneurial companies seek to raise venture capital to support or stimulate
economic growth. Other companies raise venture funding to establish credibility or to
access resource networks which their venture capital partners have developed through
years of experience.
Today's global business environment is increasingly competitive requiring decisiveness,
broader relationship networks, abundant financial resources, and a global presence in
order to compete effectively. The venture capital relationship can often bring that exact
mix of support in addition to financial funding.
2.
THE LIFE CYCLE OF EQUITY INVESTMENT, FROM THE SEED AND
START-UP CAPITAL TO EARLY AND LATER EXPANSION STAGES
AND BEYOND
Venture capital firms may provide financing for entrepreneurial companies at various
stages of their business life cycle. A venture capital financing may be provided before
there is a real product or company organized (so called "Seed Investing"). It also may
be provided for a company which already developed a product and engaged in initial
marketing activities (“Start-Up Investing”), or to a company in its first or second
stages of development ("Early Stage Investing"). Also, the venture capitalist may
provide needed financing to companies which already have a product or service
commercially available, but need help to grow beyond a critical mass to become more
successful ("Expansion Stage Financing").
Some venture capitalists focus on Later Stage Investing by providing financing to help
the company grow to a critical mass to attract public financing through a stock offering
(IPO). Alternatively, the venture capitalist may help the company attract a merger or
acquisition with another company by providing liquidity and exit for the company’s
founders.
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Moreover, there are also venture capital firms which provide Buyout Financing, a
capital to enable an acquisition of a product line, a company’s division or a whole
company, or Turnaround Financing for companies in financial distress (not earning
their cost of capital).
Some venture capital firms provide financing for public held companies, a type of
investment often called Private Investment in Public Equity (PIPE Deals). The venture
capital firms subscribe shares issued by the company, which are acquired with a slight
discount in relation to their stock market price. It provides the companies with quick
access to capital at a reasonable transaction cost. On the other hand, investors find these
investments attractive because they buy shares with a discount in relation to the stock
market price, and because it provides an opportunity to acquire a considerable position
without having to chase a rising stock price caused by their own purchases.
The venture capital investment is neither a short term nor a liquid alternative of
investment. An early stage investment may take 7 to 10 years to mature, while a later
stage investment may only take a few years, depending on the limited partners’ appetite
for liquidity.
Most venture capital funds have a fixed life of 10 years, with the possibility of a few
years of extensions in case of private companies still seeking liquidity. The investing
cycle for most funds is generally 3 to 5 years, after which the focus is managing and
making follow-on investments in an existing portfolio. The Limited Partners have a
fixed commitment to the fund that is "called down" by the VCs over time as the fund
makes its investments. There can be substantial penalties for a Limited Partner that fails
to comply with a given capital call.
Venture capital funds are most interested in ventures with exceptionally high growth
potential, as only such opportunities are likely capable of providing the financial returns
and successful exit event within the required timeframe, which is achieved through the
reduction of agency costs and information asymmetry between the company and the
potential buyer.
Information asymmetry occurs when one party to a transaction has more or better
information than the other party. Agency costs are the costs incurred by an organization
that is associated with problems such as divergent management-shareholder objectives
and information asymmetry.
In this context, the total duration of a venture capital investment shall depend on several
factors, such as (i) the quality of the entrepreneurial firm; (ii) the stage of the company's
development at the time of initial investment; (iii) the nature of the firm's assets (e.g.,
high-technology); (iv) the structure of the investment, among others.
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Higher quality entrepreneurial companies have greater growth potential and are less
risky. Venture capitalists also certify the quality of the firms in which they invest
through their involvement and assistance in the management of the company (including
finding suitable legal and accounting advisors, securing distribution networks and
reliable suppliers, and making strategic decisions), which ultimately causes the
reduction of the cost of information asymmetry between the venture capitalist and the
company.
The stage of development of the firm will influence investment duration. The earlier the
stage of development, the longer the investment duration – it shall take more time to
venture capitalist to make the investment mature. Moreover, the agency costs associated
with investing in early stage firms are more pronounced.
The nature of the firm's assets will also influence investment duration. Specifically in
high technology industries, for instance, information asymmetry is higher than other
industries. For that reason, high-technology investments shall be longer than other
investments. Longer investment duration enables the venture capitalist to minimize the
pronounced agency costs between high-technology entrepreneurial companies and
potential buyers, maximizing the value of the company upon exit.
In respect of investment structure, the venture capital investment may be staged or
syndicated. Staging involves periodic capital flows to the entrepreneurial venture, rather
than a lump-sum amount of financing at the outset, contingent upon on-going
satisfaction of performance reviews. It allows closer monitoring, which causes the
reduction of information asymmetry.
Syndication involves more than one venture capital firm investing in an entrepreneurial
venture. It facilitates risk avoidance through risk sharing, enables better and more
informed investment decisions, and mitigates the hold-up problem inherent to a single
supplier of capital. The greater the number of investors, the better the signal to the
potential buyers that there exists less informational asymmetry associated with investing
in the venture. Therefore, staged or syndicated investments may reduce the investment
duration.
The agency costs associated with information asymmetry between entrepreneurs and
any potential buyer will be lower the longer the venture capitalist maintains a
relationship with the entrepreneurial firm. A more established entrepreneurial firm will
have a more efficient organizational structure, distribution channels and a better
developed relationship with legal and accountant advisors.
By the time of the exit of the venture capitalist, the entrepreneurial firm shall be
sufficiently mature so that the venture capitalist may not create significant additional
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value to the company. Once this stage is achieved, the entrepreneurial firm may have
access to other funding sources.
3.
THE ROLE OF BUSINESS ANGELS, VENTURE CAPITAL FUNDS AND
OTHER INVESTORS IN GROWING COMPANIES
Business angels (or Angel investors) are wealthy individuals who provide seed or startup financing to entrepreneurial firms usually in exchange for convertible debt or
ownership equity. A small but increasing number of angel investors are organizing
themselves into angel networks or angel groups to share research and pool their
investment capital.
They play an important role in the venture capital industry by filling a “financing gap”
existing between entrepreneurs and venture capital firms. Most entrepreneurs who do
not have a well structured business plan, or cannot meet with the strict requirements of
any venture capital firm to apply for financing, may seek funding from angel investors,
who may be more willing to invest in highly speculative opportunities, or may have a
prior relationship with the entrepreneur.
Many venture capital firms will only seriously evaluate an investment in a start-up
otherwise unknown to them if the company can prove at least some of its claims about
the technology and/or market potential for its product or services. To achieve this, or
even just to avoid the dilutive effects of receiving funding before such claims are
proven, many start-ups seek to self-finance until they reach a point where they can
credibly approach outside capital providers such as VCs or angels. This practice is
named "bootstrapping".
Business angels are increasingly occupying the space left behind by venture capitalists.
They are making more and larger investments into early-stage businesses, and
coalescing into networks based upon geography or sector.
There is a great potential for angel investors to serve as the patient, experienced, and
expert source of money required by many early-stage businesses, although it is unlikely
that they will be able to fulfill all of the companies´ finance requirements.
4.
GOVERNMENT
AND
OTHER
PUBLIC
REGULATORY
INTERVENTION IN VENTURE CAPITAL, INCLUDING PUBLICLYBACKED INVESTMENT SCHEMES
The governments seek to encourage additional funding to strategically important areas
that are presently unattractive to private sector investors and they also need
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simultaneously to attract experienced venture capitalists to manage the funds which they
support.
The primary role for governments in developing a functioning venture capital market is
considered by its practitioners and scholars to be restricted to the creation and
maintenance of conductive fiscal and legal environments for venture capital financing.
Many public programs have recognized the possible adverse effects of government
involvement in markets, mainly in concern of new venture investment, because this
would carry a material risk of market disruption through the potential misallocation of
capital and the consequent “crowding out” of private investors. However, government’s
direct intervention in the supply of venture capital has frequently been defended in
market failure arguments. According to this logic, public involvement is a contingent
response to private shortcomings. It is only considered necessary in those specific
conditions where the capital markets either refrain from investing or provide insufficient
finance for the available opportunities. Thus, the programs of government intervention
shall be seen as a temporary correction.
Public/private hybrid investment activity is typically directed towards areas where
private markets are believed to be under-developed or where “difficult” investment
activity, e.g. early-stage equity finance in technology ventures, has been increasingly
abandoned by private investors in favor of more lucrative, and less uncertain, later-stage
market opportunities.
These public backed schemes may vary according to the needs of the domestic
economy. However, there are basically three different kinds of structures: (i) structure
based on the different timing of public and private investments, which can create a great
leverage and benefit for the private investor; (ii) incentive structures based on capping
public investor’s profits and providing the public investment as a subordinated loan (a
loan that ranks below other loans with regard to claims on assets or earnings, in case of
default – riskier than unsubordinated debt); (iii) incentive structure that provides a
“down-side” guarantee against the failure of investments - such structure focus on
minimizing the costs of adverse selection (i.e. bad investments) to the investors, which
provides only very modest possibilities for altering that distribution of rewards.
5.
DEVELOPMENT OF EXIT STRATEGIES FOR ENTREPRENEURS
AND VENTURE CAPITALISTS
A venture capitalist may exit an investment through an initial public offering (IPO), a
merger or a sale to a potential buyer, secondary market sale, buyback, liquidation of
assets (in case of failure). The choice of the strategy depends on the market conditions
and industry trends since the venture capitalist’s target is to achieve maximum return.
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The initial public offering is the most glamorous and visible type of exit for a venture
investment. It usually offers more opportunities for valorization of the venture
company. Mergers and acquisitions represent the most common type of successful exit
for venture investments. In the case of a merger or acquisition, the venture firm will
receive stock or cash from the acquiring company and the venture investor will
distribute the proceeds from the sale to its limited partners.
Secondary market sales are also an alternative when venture capital firms transfer the
venture capital fund’s ownership to another venture capital firm.
The company may also be required to buy back a venture capital firm's stock at cost
plus a certain premium. Often a venture capital firm will put a redemption clause
(sometimes referred to as a "buy-back clause") in the investment terms which allows
them to exit their investment in the company in the event that an IPO or acquisition
does not happen within a designated time period or does not happen at all.
The venture capitalist may also partially exit the business, which may indicate the
quality of the entrepreneurial company and cause the mitigation of informational
asymmetry between the entrepreneurial company and any potential buyer.
6.
KEY TERMS AND PROCESSES FOR SEED AND VENTURE CAPITAL
INVESTMENT
Before effectively invest in an entrepreneurial company, the venture capitalist perform
several studies in order to confirm the economic viability of the business and to ensure
maximum returns upon exit of the business.
This pre-investment phase comprises the elaboration of a business plan, so as to
determine company’s operational activities and businesses, market conditions,
company’s strategies and elaborate financial projections. It also comprises a due
diligence process in order to verify company’s assets and obligations (including
contingent obligations) in order to enable the venture capital firm to identify the
company’s status.
The primary objectives of the due diligence process are to (i) understand how
management approaches problems, issues and decisions; (ii) confirm management's
representations and the investor's own perceptions regarding the company's technology
and market opportunities; (iii) identify key vulnerabilities and risks so that the
risk/reward outlook can be quantified; (iv) gain an intimate understanding of the
company and its market so that as a partner, the venture capitalist is prepared to counsel
management to anticipate and manage change.
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Should the venture capital firm have interest to continue negotiations and to invest in
the company, the parties may execute a Term Sheet which may outline the key financial
and other terms of a proposed venture capital investment. Such Term Sheets are usually
not meant to be legally binding and may also contain some conditions to be met before
the investment is completed. It also shall serve as basis for the drafting of the
investment documents and, therefore, the more detailed the Term Sheet, the fewer
issues to be agreed upon during the drafting process.
The Term Sheet may include the following terms: (i) the type of shares to be subscribed
by the venture capital firm; (ii) the valuation of the company, obtained in accordance
with the due diligence process; (iii) reinvestment of dividends; (iv) liquidation
preferences; (v) redemption clause (which entitles the venture capitalist to exit the
investment in the company in the event that an IPO or acquisition does not happen
within a designated time period or authorizes the founders to buy back its own shares
from the investor); (vi) preemption rights on new shares issue; (vii) right of first refusal,
co-sale and tag along rights; (viii) drag along rights; (ix) consent rights (veto power);
(x) voting rights; (xi) participation in the board of directors; (xii) information rights;
(xiii) exit events; (xiv) confidentiality; (xv) intelectual property assignment; (xvi) noncompete rights; (xvii) exclusivity for the venture capital firm; (xviii) Liquidation
preferences (the amount payable to the venture capitalist upon a sale of the company in
priority to any payments made to the entrepreneurs); (xix) participation rights (right to
participate along with entrepreneurs in the sale proceeds remaining after the payout of
the liquidation preferences, usually capped at a multiple of the purchase price of the
shares subscribed by the venture capitalist); (xx) management cave outs (provisions
whereby a certain amount or percentage of future sale proceeds will be set aside for
management and other designated employees, and are structured so that any liquidation
preferences of the preferred stock are subject to these initial carve outs. It ensures the
retention of the management members and main employees in case of sale of the
venture company).
Generally, the main documents required for an investment round in venture capital
financing are a Subscription Agreement, a Shareholders' Agreement and an Articles of
Association or Bylaws. The Subscription Agreement will usually contain details of the
investment round, including number and class of shares subscribed for, payment terms
and representations and warranties about the condition of the company. The
Shareholders' or Agreement will usually contain investor protections, including veto
powers, rights to board representation, drag-along provision, put and call options, as
well as non-compete restrictions. Finally, the Articles of Association/Bylaws will
include the rights attaching to the various classes of shares, the procedures for the issue
and transfer of shares, the holding of shareholder and board meetings, quorums, veto
powers for specific decisions and attributions of the management of the company
(Board of Directors and/or Executive board).
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7.
THE ROLE OF LEGAL ADVISERS
Besides financial provision, venture capital can also include managerial and technical
expertise, providing business advice, access to networks, commercial development and
legal support. In fact, the pre-investment phase involves the employment of
accountants, lawyers and industry specialists. Investing in early-stage business, for
example, frequently entails higher risk because they often have unproven business
models, less experienced management and fewer tangible assets.
In this context legal advisers must act independently, acting as technical consultants and
conducting the due diligence processes, which shall involve rigorous analysis, multiple
meetings and interviews with management, at both the investor's and company's offices.
Simultaneously with the due diligence process, the venture capitalist and management
will negotiate terms of the investment. Legal advisors may actively work on the
drafting the term sheets and the investment agreements (Subscription agreements,
Articles of Associations/Bylaws and Shareholders Agreement). Also, the incorporation
of venture capital funds requires the participation of legal advisors.
Legal advisors may also actively contribute for the preparation of the entrepreneurial
company for the capital markets. The modifications in the company’s management
structure, the creation of stock option programs and the adoption of corporate
governance standards shall be implemented under the supervision of a legal advisor.
8.
VENTURE CAPITAL IN BRAZIL
Brazilian private equity and venture capital markets are growing.
According to a research performed by the Fundação Getulio Vargas’ Private Equity and
Venture Capital Study Center (GVcepe) and Endeavor Institute, the amount of capital
committed for the private equity (PE) and venture capital (VC) funds has raised from
US$ 5.6 billion in 2004 to US$ 16.7 billion in 2007.
In comparison with the United States 2007 PE and VC markets, which amounted to
US$ 400 billion, the Brazilian market is still modest, but with a very promising growth
capacity.
This increase may be attributed to the current global liquidity and the improvement of
Brazilian economic scenario.
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The increase of private equity and venture capital investment in Brazil is reflected on
the capital markets. 28 out of 72 initial public offerings (IPO) which took place in the
São Paulo Stock Exchange (BOVESPA) from 2004 until the second quarter of 2006
were carried out by companies which received private equity and venture capital
funding.
Some of the Brazilian internationally recognized companies received venture capital
funding, such as Natura (cosmetics), GOL (aviation), ALL (logistics), CPFL (energy),
Dasa (Medicin and esthetics), Submarino (department store), UOL (internet), Lupatech
(industrial valves and metals), Gafisa (real state) and Totvs (software).
Independent organizations (i.e. not related to banks or industrial sectors) are the
majority in the Brazilian private equity and venture capital markets, summing up to
70% of the existing players. Governmental organizations account for 8.5% of the
market through BNDESPar (investment arm of BNDES – Brazilian Development Bank)
and Financiadora de Estudos e Projetos (Finep).
The Ministry of Science and Technology also stimulates the entrepreneurial innovation
through several programs, among then, the INOVAR Project. It aims to promote the
development of small and medium size technology based business through the creation
of mechanisms for financing, especially venture capital.
Since 2003, the Brazilian Securities and Exchange Commission (CVM) is setting out
the regulatory framework for the private equity and venture capital markets – CVM
Normative Ruling No. 391/03 promoted the creation of venture capital funds, which
leads to more transparency between the investor and the fund management and the
establishment of firm fund governance rules and alternative dispute resolution
mechanisms such as arbitration.
CVM Normative Ruling No. 391 provides for the formation, operation and management
of venture capital investment funds. Firstly, in order to operate, those funds must be
registered before CVM. Only qualified investors (which, pursuant to CVM Normative
Ruling No. 409, are financial institutions, insurance companies, individuals or entities
with financing investments in excess of R$ 300,000.00, investment funds for qualified
investors, among others) are authorized to invest in such funds, with a minimum
subscription amount of R$ 100,000.00. Closely-held companies (companhias fechadas)
which receive financing from such funds shall adopt corporate governance standards,
such as: (i) prohibition to issue founders’ shares (partes beneficiárias); (ii) 1-year
mandate for all Board of Director’s members; (iii) adoption of arbitration to settle
corporate-related conflicts; (iv) annual auditing of company’s financial statements by an
independent accounting firm; (v) publicity in respect of agreements with related parties,
shareholders’ agreement and stock option programs.
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The Brazilian PE and VC firms present very strict requirements for investing in
entrepreneurial companies. Approximately 1 or 2 out of 300 investment proposals
presented to the venture capital firms per year are elected to receive capital funding.
Despite of the expressive market growth recently experienced, there are still few PE and
VC funds in Brazil. Also, the PE and VC investing is not a widespread alternative of
investment. Those factors may justify the unexpressive number of selected projects.
However, this scenario is expected to change with the increase of venture capital funds
playing in this market.
The UBS investment bank estimates the existence of US$ 100 trillion floating
worldwide, out of which US$ 600 billion shall be directed to PE and VC investments all
over the world. Brazil is expected to receive an inflow of US$ 2 to 3 billion for
investment.
Moreover, specialists contend that investment opportunities in China and India are
performing beyond investors’ expectations, which may cause the emersion of a new
investment round aiming at new investment alternatives.
The popularization of the PE and VC as an investment alternative, more professional
entrepreneurs and a new generation of entrepreneurs concerned about corporate
governance rules shall certainly contribute for the growth of the Brazilian market and
for the improvement of Brazilian economy.
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Venture Capital and the Growing Company
– Chris Ashworth, Head of European M&A at O’Melveny & Myers LLP,
London
O’Melveny & Myers
1000+ attorneys
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13 offices
3 continents
23 languages
Business angels
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Who are they?
Angels not cherubs
Not a Dragons Den
Why do they do this?
Count your fingers !
Typical angels
• Business background
• Motivation – financial and the challenge
• Role following investment
• What do they provide to the company?
• The exit
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UK experience
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Invest in groups – why?
How many out there?
Typical size of investment
Percentage of equity
The gap between the investor and the
company’s perception of value
• Time period to effect investment
• Get a good business plan
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Examples
• Mix Pix - a computer games company
• Twenty One Net – net surfing on a train
• Padlife – modular design
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The venture industry
• The BVCA – a major player
• The story of growth
• Investment stage – buy out -v- expansion -vstart up
• The investment professional sector and
advisers
• The importance of exits – AIM
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Role of Government
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The importance of the tax regime
The professional associations
The universities and R&D establishments
The business angel community
The Government regional and targeted funds