Marcel Peter Ernst Mader, B.Sc. Student Number: 10604391 Supervisor: Dr. G.T. (Tsvi) Vinig June 30, 2015
University of Amsterdam
Master’s Thesis in Business Administration
Entrepreneurship & Innovation
The Impact of Equity-Based Crowdfunding:
Do Venture Capitalists See a Need to Adapt Their
Investment Strategy?
Table of Content
List of Figures...III List of Tables...IV List of Abbreviations...V Abstract...VI
1. Introduction...1
1.1. Problem Set & Research Question...1
1.2. Aim of the Thesis...5
1.3. Thesis Structure...5
2. Literature Review...6
2.1. Venture Capital...6
2.1.1. Historical Overview...6
2.1.2. Classification & Definition...10
2.2. Providers & Types of Venture Capital...12
2.2.1. Informal Venture Capital...12
2.2.1.1. Family & Friends...12
2.2.1.2. Angel Investors...12
2.2.2. Institutional Venture Capital...13
2.2.2.1. Venture Capitalists...13
2.2.2.2. Corporate Venture Capitalists...14
2.3. The Venture Capital Investment Process...16
2.3.1. Pre-Investment Phase...17
2.3.1.1. Raising Capital & Competitive Advantage...17
2.3.1.2. Deal Generation...21 2.3.1.3. Deal Screening...22 2.3.1.4. Deal Evaluation...24 2.3.1.5. Deal Structuring...27 2.3.2. Post-Investment Phase...30 2.3.2.1. Monitoring...31 2.3.2.2. Value-Added Activities...32 2.3.2.3. Exit...32 2.3.3. Market Overview...33
Table of Content
2.4. Crowdfunding...37
2.4.1. Terms & Definition...37
2.4.2. Crowdfunding Campaign & Characteristics...38
2.4.3. Variety of Crowdfunding...40 2.4.3.1. Equity-Based Crowdfunding...40 2.4.3.2. Lending-Based Crowdfunding...41 2.4.3.3. Reward-Based Crowdfunding...41 2.4.3.4. Donation-Based Crowdfunding...42 2.4.4. Market Overview...42 3. Methodology...46 3.1. Research Design...46 3.2. Data Collection...47 3.3. Data Analysis...49 4. Results...50 4.1. General Findings...50
4.2. Equity-Based Crowdfunding & Investment Stage...51
4.3. Equity-Based Crowdfunding & Industry Focus...52
4.4. Equity-Based Crowdfunding & Geography...53
5. Discussion...54
6. Conclusion...56 References...VII Appendices...XVI Appendix A: Cover Letter (German)...XVI Appendix B: Questionnaire (German)...XVII
List of Figures
Figure 1: Venture Capital in the USA 09
Figure 2: Classification of Venture Capital 10
Figure 3: The Venture Capital Investment Process 16
Figure 4: Resources That Impact the VC’s Competitive Advantage 18
Figure 5: Venture Capital Investment Stages 19
Figure 6: Framework of Post-Investment Interaction 30
Figure 7: VC Investments & VC Backed Companies in Germany 35 Figure 8: Geographic Overview of Crowdfunding Platforms 42
List of Tables
List of Abbreviations
AI Angel investor
ARD American Research and Development
BN billion
BVK Bundesverband deutscher Kapitalbeteiligungsgesellschaften
(= Association of German Private Equity & Venture Capital Companies)
ch. chapter
CVC Corporate venture capital CVCs Corporate venture capitalists DACH Germany - Austria - Switzerland e.g. for example (Latin = exempli gratia)
GP General partner
i.a. among other things (Latin = inter alia) IPO Initial public offering
IT Information technology LP Limited partner
M&A Mergers & acquisitions
Mio. Milion
NVCA National Venture Capital Association ROI Return on investment
R&D Research and development PE Private equity
PPM Private placement memorandum
SBIC Small business investment companies SME Small and medium enterprises
UK United Kingdom
US United States
USA United States of America VC Venture capital
Abstract
After the financial crisis in 2008, the annual amount of capital invested by traditional venture capitalists (VCs) dropped dramatically and remained about €650 million in Germany until 2014. Around 2010, equity-based crowdfunding platforms entered the market enabling entrepreneurs a new opportunity of financing their ventures inde-pendently from VCs. Although the amount of capital is significant lower compared to VC, German platforms register high growth rates, counting almost €15 million in 2014, which is about half the amount VCs have spent in their seed stage invest-ments. Since VCs act as financial intermediaries and raise capital from investors to provide future returns on investments (ROI), differentiating themselves in their in-vestment strategies, which are shaped by the inin-vestment stage, industry focus, and geographical distribution of portfolio companies. While Mulcahy (2013) asserts bene-fits of VCs as myths, equity-based crowdfunding is assigned with benebene-fits for both the investor and the entrepreneur (Gajda & Mason 2013; Shane 2013 & 2015). Con-sequently, it becomes subject of discussions whether equity-based crowdfunding will complement VC or even incorporates the potential to outperform VCs in the future. Facing not longer only competition with other VCs, but also equity-based crowdfund-ing, this study examines the impact of equity-based crowdfunding and whether VCs see a need to adapt their investment strategy. Therefore, the study examines the statements and estimations of 16 VCs in an exploratory study. While the majority does not see any impact on the investment strategy, VCs who expect a significant relevance of equity-based crowdfunding, seem to abandon seed stage financing redi-recting their focus on start-up stage and later stage financings associated with short-er durations of involvement in portfolio companies.
1. Introduction
“New ventures require resources to succeed, and one of the most critical of these is financing.” (Mollick 2013, p. 2)
1.1.
Problem Set & Research Question
Financing new ventures can be realized through debt, equity, or a combina-tion of both (Isaksson 2006, p. 13). To reduce the risk of financing new ventures by debt, banks ask in return for a bank loan for cash flows and collaterals, e.g., bank deposits, inventory, real estate, equipment, vehicles, and other assets. While debt holders receive interest payments and are able to collateralize the debtor’s assets, private equity (PE) investors can lose everything in the case of default (Berger & Black 2011, p. 726). After the subprime-crisis in 2008, the banks’ willingness to pro-vide loans to small and medium enterprises (SME) declined by a quarter while the requested value of collaterals and interest rates increased by 34% respectively 54% for SME in the European Union. According to estimates, the funding gap in France, Germany, Italy, Spain and the UK, is anticipated to increase up to €2.5 trillion by 2020 (Gajda & Mason 2013, p. 11).
Outside equity providers do not ask for any collaterals compensating higher risks with taking large shares of the companies in expecting higher future returns on the in-vestments (Gompers & Lerner 2001, p. 155). Even in high technology sectors, where companies possess high valuable intangible assets in terms of knowledge and know how, entrepreneurs - especially at early stages - lack tangible resources. „Conse-quently, entrepreneurs tend to rely on three primary sources of outside equity financ-ing: venture capital funds, angel investors, and corporate investors.“ (Denis 2003, p. 304) To avoid painful consequences because of uncertainty accompanied by ments in new ventures, VCs assess potential portfolio companies in the VC invest-ment process (Mollick 2013, p. 3 & 5 f.). Since the entrepreneurs’ capital shortage and the venture capitalists’ (VCs) ability of financing and offering valuable services result in a distribution of bargaining power in favor of the VCs during the negotiations and deal structuring phase, VCs are able to ask for large shares and high compensa-tions for the risks assumed (Mulcahy 2013, p. 82 f.).
Since the stock market provides higher returns than many VC funds and the amount of capital which is raised on based crowdfunding platforms increases, equity-based crowdfunding might becomes a serious alternative for financing young com-panies. While equity-based crowdfunding seems to be especially an option for first round financings, conducting subsequent rounds of fundings remains questionable - in contrast to traditional VCs, where several rounds of financing are usual and al-ready set up in the deal closing (Devaney & Stein 2012). E.g. Shane (2015) refers to the gap between the average amount of a VC deal respectively an equity-based crowdfunding investment, concluding VC and equity-based crowdfunding will com-plement each other. While the latter will focus on businesses that need smaller in-vestments and less operational assistance, VC remains focussing on high-technolo-gy companies with growth potential that require high commitment and several rounds of financing (Shane 2015).
While Erblich (2012) and Shane (2013 & 2015) see the VCs' advantages, next to providing capital, in the assistance of developing a young company based on experi-ence and providing access to the network of suppliers and customers that leverage the business, Mulcahy (2013) defines some benefits just mystic (Mulcahy, 2013, p. 83). Although claiming for themselves to stimulate and support innovation and eco-nomic growth, the business model of VC firms itself has not changed for the past two decades and seems to be broken (Mulcahy 2013, p. 83). VCs communicate the risks assumed reasonable for asking large shares with high discount rates, but in fact it is not their own risk, since VCs manage capital of investors while requesting, next to future carried interests, annual management fees that guarantee high fixed annual earnings. Furthermore, not every VC provides great advice and mentoring. While some VCs provide high quality mentorship, others do not undertake much more than money supply. The entrepreneur needs to check in advance the level of commitment the VC is willing and able to ensure, e.g., whether the board representative will be a partner or an associate. In fact, VC is not the primary source of financing young companies, since in the US only 1 to 2% of the emerging companies receive funding by VC (Mulcahy 2013, p. 81 f.).
Despite the success of a few VC-backed high-technology companies like Facebook, LinkedIn, etc., less money has been returned to VC fund investors (Erblich 2012).
Antagonizing these trends, VCs already start to raise smaller funds focusing on only a few companies with high growth potential to generate high returns rather than ask-ing for large fees (Mulcahy 2013, p. 83). Therefore VCs might take advantage of screening equity-based crowdfunding platforms also or even launch own platforms ensuring to identify promising new ventures without missing any golden opportunity (Erblich 2012, Shane 2013).
Although VCs would not exist without entrepreneurs, the bargaining power is dis-tributed in favor of the VCs since the entrepreneurs generally lack financial re-sources. With the advent of equity-based crowdfunding as new financing option, now entrepreneurs are able to redirect this balance of bargaining power with subsequent higher deal prices for VCs, which again leads to lower returns of VC funds (Devaney & Stein 2012 ; Mulcahy 2013, p. 83). Mollick (2013, p. 1) examines in the article “Swept Away by the Crowd?” the selection process of investment opportunities of both traditional VCs and the crowd on crowdfunding platforms, concluding that both parties assess entrepreneurial quality in similar ways, while crowdfunding even soft-ens the geographic and gender biases of VCs (Mollick 2013, p. 25-31).
Equity-based crowdfunding is associated with a democratization of capital, where every individual can be an investor participating with own capital in any company in-cluding accompanied equity and monitoring rights (Gajda & Mason 2013, p. 6; Mol-lick 2013, p. 10). Thereby, both private and professional investors can profit from eq-uity-based crowdfunding. Diversifying their portfolio at low costs, private investors can use social media, feedback information from the platform itself and other sources to conduct background checks on the companies and entrepreneurial teams to screen investment opportunities. Professional investors are able to extend their exist-ing portfolio benefitexist-ing from crowd based due diligences and risk-sharexist-ing with other investors as well as expertise from the crowd (Gajda & Mason 2013, p. 7).
Entrepreneurs can benefit from an open, market-driven valuation being on par in ne-gotiations with investors and without obligation of exclusivity. Since margins are di-vided by a multitude of transactions, the individual transaction costs are lower. Fur-ther benefits incorporate a proof of concept and test of market acceptance as well as
immediate customer feedbacks including the promotion of offered products and ser-vices by dedicated customers (Gajda & Mason 2013, p. 6).
Facing these problems, equity-based crowdfunding as the latest developed form of crowdfunding may define a valuable resource and opportunity for financing new ven-tures independently from institutional investors. Since the advent of equity-based crowdfunding in the US in 2009 and its diffusion across Europe shortly after, the in-vestment volume of mediating online platforms for equity-based crowdfunding fea-tures high growth rates resulting in more successful campaigns and increasing deal sizes. In the future, VCs might not only compete against each other any more in both raising capital for their VC funds and winning the most promising ventures, but also against equity-based crowdfunding offers. To have the continuing ability of attracting capital providers in the future as well, VCs need to establish a unique market position with the help of a successful track record. Since VC firms do not posses large man-agement teams and need to explore and exploit specific expertise to identify and de-velop promising new ventures to profitable exit strategies, the VCs’ investment strat-egy is often shaped by three categories: the investment stage, the industry focus, and geography of investment opportunities (Poser 2003, p. 51 f.).
So far, only several authors published short articles and comments in (online) news-papers and magazines whether crowdfunding and especially equity-based crowd-funding implies the potential to either substitute VC and to outperform traditional VCs because of its awarded benefits for both the investor and the entrepreneur, or that both forms can complement each other (Shane 2015).
There is a lack of profound scientific research about possible interrelations between equity-based crowdfunding and the business of VCs as a source of financing young companies and new ventures. To examine the implications of equity-based crowd-funding on the investment strategy of VC firms, the underlying research question of this thesis is expressed in the following way:
The Impact of Equity-Based Crowdfunding:
Do Venture Capitalists See a Need to Adapt Their Investment Strategy? An examination from the Perspective of German Venture Capitalists.
1.2.
Aim of the Thesis
The aim of the thesis is to elaborate whether venture capitalists see a need to adapt their investment strategy in terms of stage, industry, and geography as main driver for competitive advantage, because of the advent of equity-based crowdfund-ing as an alternative way of financcrowdfund-ing new ventures independently from institutional investors. Thereby, the examination will be based on an exploratory study from the perspective of venture capitalists for the German market.
1.3.
Thesis Structure
Following an introduction in the problem set, the literature review in chapter 2 serves as introduction in the topic of VC and starts with a historic overview as well as a definition and classification of VC as a category of risk capital to finance compa-nies, before the main providers and types of VC will be examined and explained. To understand the current business model of VC firms, the VC investment process will be examined in detail from raising capital to exiting investments followed by a market overview of up-to-date facts and figures of the VC industry worldwide, in Europe, and particular Germany. Furthermore, addressing alternative opportunities of financing new ventures, equity-based crowdfunding will be explained in its context of the vari-ety of crowdfunding models followed a market overview of its development since the late 2000s.
While chapter 3 provides information about the methodology of the exploratory study that will be conducted gathering data that are needed to answer the research ques-tion, chapter 4 provides the results, which are thematically structured in general find-ings and findfind-ings according to the topics of the 3 hypotheses.
In chapter 5 the results of the study will be discussed against the background of both statistics of the German venture capital industry and statements of authors that are mentioned in the problem set about the perspectives and whether equity-based crowdfunding incorporates the potential to outperform traditional VCs Finally, a con-clusion summarizes essential insights of the thesis in chapter 6.
2. Literature Review
2.1.
Venture Capital
After a historic outline I will give an underlying definition of the term VC, be-fore I will move on with an overview of the types of VC as well as both institutional and informal providers of VC.
2.1.1. Historical Overview
The phenomenon of VC as a form of financing entrepreneurs by private in-vestors already existed in the Babylonian era as well as the medieval Europe. Wealthy private individuals invested in high-risky entrepreneurial projects with the in-tention of gaining future profit. An outstanding example is the financing of the voyage of Christopher Columbus by Queen Isabella of Spain in the 15th century (Landström
2007, p. 10). Later, in the nineteenth and early twentieth century, wealthy private fi-nanciers influenced the development of the industrial revolution and were significant-ly involved in the growth of new industries. Wealthy families like the Rockefellers, Vanderbilts, Whitneys, and Morgans invested in the growth of new industries such as steel, glass, petroleum, oil, banking, and the construction of railroads (Gompers 1994, p. 5; Landström 2007, p. 10 f.). Since the market for risk capital was unorga-nized and fragmented, and financing (new) ventures was mainly conducted by wealthy financiers, “Boston was perhaps the first area to possess some degree of organized venture capital.” (Florida & Kenney 1988, p. 312) For example, in the 1930s, the Rockefeller and Whitney families started hiring professional managers to identify investment opportunities in auspicious young companies (Gompers 1994, p. 5), which finally lead to the development of the modern institutional VC by the foun-dation of the first VC firm American Research and Development (ARD) by Karl Compton, president of Massachusetts Institute of Technology (MIT), Massachusetts Investors Trust chairman Merrill Griswold, Federal Reserve Bank of Boston president Ralph Flanders, and Harvard Business School professor General George Doriot (Gompers 1994, p. 5; Gompers & Lerner 2001, p. 146; Landström 2007, p.11). In the beginning ARD intended to finance commercial applications of technologies that were developed during World War II. Doriot was ARD’s president until 1972 and is called
the “father of venture capital” (Gompers 1994, p. 5), because of his ”focus […] on adding value to companies, not just supplying money.” (Gompers 1994, p. 5 f.)
In contrast to the provided equity from companies organized as limited partnership1
like ARD (Gompers 1994, p. 19), debt financing became common practice as well, when the US federal government tried to enhance small firm development in 1958. The administration authorized the establishment of Small Business Investment Com-panies (SBIC) to provide early stage financing for young comCom-panies (Gompers 1994, p. 6 f.). As a consequence SBICs arose across the country with a concentration in the areas of Boston, San Francisco, New York, Chicago, Connecticut, Minneapolis, and Texas during the next two decades (Florida & Kenney 1988, p. 302 f.). However this trend bared disadvantages. On the one hand SBIC managers often lacked indus-try expertise and had no ties that were beneficial for the entrepreneur, and on the other hand governmental guarantees made sure that SBICs could easily borrow money and to choose debt over equity for their investments while receiving tax bene-fits (Landström 2007, p. 12). Although SBICs brought several companies public dur-ing the boom at the stock exchange of the 1960s, the easy access to debt stimulated them to over-invest in risky projects and young SBIC-backed companies struggled or even failed to meet their interest obligations during the economic recession after the first oil embargo in 1973/1974 (Gompers 1994, p. 6 f.).
During the 1970s many SBICs were liquidated, because they were highly leveraged and not able to handle their own interest payments any more. While more than 700 SBICs accounted for 75% of all venture capital financing in the 1960s, only 250 were left in 1980 with a market share of 7% (Gompers 1994, p. 8).
The recovery and especially new increase of the VC industry in the US in the late 1970s and 1980s were mainly based on legislative changes. The Revenue Act in 1978 cut back capital tax gains from 49.5% to 28%, and later, with the Economic Re-covery Act in 1981, back to 20%. Especially the “prudent man” rule by the US
Limited partnership - LP: “Two or more partners united to conduct a business jointly, and in which
1
one or more of the partners is liable only to the extent of the amount of money that partner has invest-ed. Limited partners do not receive dividends, but enjoy direct access to the flow of income and ex-penses.[…] The main advantage to this structure is that the owners are generally not liable for the debts of the company.” Investopedia. Available from:
partment of Labor, which allowed pension fund managers to invest in high-risk assets including VC from 1979 on, had a huge impact on the development of the VC indus-try and until the mid 1980s, pension funds accounted for more than half of the $4 bil-lion that were invested in VC funds in the US (Gompers 1994, p. 10 & 12; Gompers & Lerner 2001, p. 147 f.).
On the one hand, venture capitalists were now flooded with money to invest in many ventures, but on the other hand, they had to adapt the time horizon of their invest-ments. Because “pension fund managers are obsessed with short-run performance” (Gompers 1994, p. 15), venture capitalists had to shift from the regular five to ten year investment lifecycle to a shorter one to realize returns earlier. While 25% of the venture capital was invested in the seed stage and 75% in the expansion and later stages in 1980, in 1988 the investments declined in the seed stage to 12.5% and the expansion and later stages to 67.5%. The residual 20% accounted for investments in leveraged buyouts (LBO), because of their shorter investment lifecy2
-cle compared to VC investments (Kaplan 1991, p. 312; Gompers 1994, p. 17 f.). As a consequence of the money flood, VC firms overvalued new ventures overesti-mating their growth potential. The spending of too much money combined with an early initial public offering (IPO) lead to a new bubble that finally burst in the mid 1980s. E.g. the market value of twelve publicly traded hard disk drive companies fell from $5.4 billion down to $1.4 billion including bankruptcy of several industry leaders (Gompers 1994, p. 18).
Until the early 1990s commitments to the VC industry declined. One reason was the loss of attractiveness of VC, especially for pension funds because of poor VC fund performances as a consequence of the bubble burst.
Leveraged buyout: „The acquisition of another company using a significant amount of borrowed
2
money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being ac-quired are used as collateral for the loans in addition to the assets of the acquiring company. The pur-pose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.“ Investopedia. Available from: < http://www.investopedia.com/terms/l/leveragedbuy-out.asp> [10 December 2014].
Figure 1: VC in the USA. Own figure with data from: NVCA Yearbook 2015, pp. 35-37.
During the 1990s the activity in the market changed when inexperienced venture capitalists disappeared and several IPOs lead to dramatically increasing returns, which in turn attracted corporate investments and public agencies, e.g. General Mo-tors Investment Company, California Public Employees Retirement System, to enter the venture capital market. In 1999 more than $65 billion were pledged in US VC funds while VC investments reached their all-time peak with $105 billion and 8.042 deals in 2000 (Gompers & Lerner 2001, p. 148-150).
Until the 1980s VC remained as US phenomenon. Despite individual companies in Europe in the 1970s, the development of a European VC industry started in Great Britain from the 1980s on. In the late 1980s the worldwide volume of VC doubled, because of the growth of the European VC industry, which increased from $9 billion up to $29 billion (Bygrave & Timmons 1992, p. 70; Landström 2007, p. 13). This growth was based on the establishment of secondary stock markets enabling the op-portunity of an IPO for fast growing ventures to enable the opop-portunity for returns on the venture capitalists’ investments (Landström 2007, p. 13).!
2.1.2. Classification & Definition
Ways of financing new ventures are either equity (ownership), debt (loan), or a combination of both. Financing new ventures by debt, e.g., bank loans, generally require collaterals. “Because such firms are typically not yet profitable and lack tangi-ble assets, debt financing is usually not an option.” (Denis 2003, p. 304) Equity fi-nancing is expensive and requires high returns to compensate the risk of the invest-ments. While PE investors can lose everything in case of default, debt holders re-ceive interest payments and are able to collateralize the debtors’ assets. These as-sets include bank deposits, inventory, real estate, vehicles, etc. (Berger & Black 2010, p. 726). The market of PE as risk capital can be divided into informal VC, insti-tutional VC, and other PE. While informal VC refers to AIs, instiinsti-tutional VC refers to VC funds and corporate investors. Larger deals and investments at later stages in mature companies, with tangible assets and already healthy and stable cash flows are subsumed as other PE (Schwartz 2010, p. 13 f.; Isaksson 2006, pp. 16).
Figure 2: Classification of Venture Capital. Adapted from: Isaksson, Studies on the venture capital process 2006, p. 16.
“Winston Churchill once described Britain and America as ‘two countries separated by a common language.’ […] [While venture capital] in the US refers only to
invest-ment in the shares of privately-held companies at an early stage of a company’s de-velopment, […] in continental Europe it refers to investment at all stages of a compa-ny’s development.” (Cressy 2008, p. 2)
Consequently, there does not exist one single accepted definition of VC. Although lit-erature shows consensus, definitions of VC vary in terms of specific attributes. The following examples serve as underlying definitions of this thesis.
“VENTURE capital (VC) refers to investments provided to early-stage, innovative, and high-growth start-up companies. […] Typically VC investments are seed-stage investments whereby financing is provided to research, assess, and develop an initial concept before a business has reached the start-up phase.” (Cumming 2012, p. 1)
“Venture capital is a specific form of industrial finance – part of more broadly based private equity market, that is investments (with private equity) made by institutions, firms and wealthy individuals in ventures that are not quoted on a stock market, and which have the potential to grow and become significant players on the international market […].” […] [Therefore] Venture capital […] is primarily devoted to equity or eq-uity-linked investments in young growth-oriented ventures […].“ (Landström 2007, p. 5)
2.2.
Providers & Types of Venture Capital
Following only the main sources of VC will be examined prioritizing institu-tional investors, especially venture capitalists (VCs). Other financing sources, e.g., debt financing via bank loans and credit cards, or the development of a venture by natural equity growth - so called bootstrapping - are out of the scope of this thesis and will not be introduced.
2.2.1. Informal Venture Capital
Providers of informal VC, whether they are family, friends, acquaintances, colleagues, or angel investors, are complementary to institutional VC. Distinguishing characteristics are the businesses they invest in, the amount and the moment of in-vestments (DCU Ryan Academy 2013, p. 3).
2.2.1.1. Family & Friends
Family and friends invest in the businesses of someone they know and therefore, the money is also called love money. Typically, family and friends provide small amount of money in the very early phases (DCU Ryan Academy 2013, p. 3).
2.2.1.2. Angel Investors
Next to institutional VC, informal VC exists with the provision by angel in-vestors (AI), also called business angels, or just angels, as well. The term angel has its origin in the philanthropic nature of this kind of money. In the early past, wealthy individuals financed projects of individuals or for common welfare out of altruistic mo-tives (Landström 2007, p. 8). Nowadays the momo-tives are not exclusively altruistic any longer - instead of just spending, they invest it in young companies to obtain future profits. Therefore, next to various nuances, a widespread definition in the literature covers AIs as wealthy individuals “[…] who provide capital to a private business, owned and operated by someone else who is not a friend or family member.” (De-Gennaro 2009, p. 55) Additionally, distinguishing informal VC provided by AIs from institutional VC needs to highlight the following characteristics: “Although angels per-form many of the same functions as venture capitalists, they invest their own capital rather than that of institutional or other individual investors.” (Lerner 2000, p. 515) AIs are often entrepreneurs themselves and do not rely on extensive due diligences pro-viding less bureaucratic and faster investments in young growing companies (Cressy
2008, p. 4). Though AIs invested accumulated as much as around $30 billion annual-ly in the 1990s (Bygrave & Timmons 1992, p. 310), the individual investment in a company is generally smaller than from a VC (Cressy 2009, p. 4). Searching for the big hit, AIs conduct half of their investments at the seed stage of entrepreneurial firms. Thereby they invest about 100 times as many in high-tech firms as VCs do. Because investing at early stages of a company involves risk about the further devel-opment and potential future profits, “Almost half of the investments return absolutely nothing!” (DeGennaro 2009, p. 55).
2.2.2. Institutional Venture Capital
“As the name suggests, financial intermediaries […] are entities that interme-diate between providers and users of financial capital. […] [Therefore, financial in-termediaries] hold relatively large quantities of financial claims as assets.“ (Green-baum & Thakor, 2007, p. 43)
2.2.2.1. Venture Capitalists
According to Metrick and Yasuda (2011), the venture capitalist is charac-terized by five main parameters, which distinguish them from other investors like indi-vidual angel investors and angel groups.
First, the VC firm acts as financial intermediary between the capital of investors and portfolio companies (Metrick & Yasuda 2011, p. 3). The structure of the VC firm is generally organized as a limited partnership, where the investors as limited partners (LP) provide the capital. Mostly they are institutional investors like insurance compa-nies, pension funds, universities and other corporations. The VC firm acts as general partner (GP) and manages the fund to invest the capital in young companies with high growth potential (Vance 2005, p. 142). Second, the VC firm only invests in pri-vate companies that are not listed on a public exchange (Metrick & Yasuda 2011, p. 3). While banks ask the debtor to define assets, which can be collateralized in the case of default (Berger & Udell 1995, p. 357), the VC firm provides private equity and receive in return a specific amount of shares, depending on negotiation terms and the company’s valuation (Fluck 1998, p. 388). In contrast to informal investors like angel investors, a VC firm focuses only on investments in a few industries, which en-ables to gain expertise and a widespread network to monitor and guide the
develop-ment of the companies (Vance 2005, p. 143). Third, a VC firm plays an active role in monitoring and advising the portfolio companies. Because VC firms are more tolerant to risk than banks or angel investors, they ask for a higher return on investment (ROI) as compensation, depending on the company’s development stage (Vance 2005, p. 143). To control these risks assumed, VC firms play an active role in the companies’ decision processes and claim representation in the management’s board (Vance 2005, p. 141-143). Fourth, the goal is to maximize financial return either through sale or an IPO as exit strategy (Metrick & Yasuda 2011, p. 3). Even before the contract for an investment is signed, the VC has already elaborated an exit strategy (Vance 2005, p. 143). Fifth, the investment in internal growth of the portfolio company refers to build new business and not to acquire existing ones (Metrick & Yasuda 2011, p. 3-6). The success of VC firms is determined by the profit after the lifetime and liquidation of a VC fund of around 7 to 10 years. Therefore VC firms seek for companies with the highest growth potential. The rate of return depends on the development stage of the individual company. While companies in the seed and early stages include higher risks, which will be compensated with a rate of return about 60%, companies in ex-pansion or later stages are asked for around 30% (Vance 2005, p. 144).
2.2.2.2. Corporate Venture Capitalists
As an alternative to traditional VCs, corporations also provide risk capital. Therefore, corporate venture capital (CVC) is defined as “[…] a minority equity in-vestment by an established corporation in a privately held entrepreneurial venture.” (Dushnitsky 2012, p. 157) Disclosing similarities as well as distinguishing differences to traditional VCs, Maula (2001, p. 9) defines CVC as “[…] equity or equi-ty-linked investments in young, privately held companies, where the investor is a fi-nancial intermediary of a non-fifi-nancial corporation. The main difference between ven-ture capital and corporate venven-ture capital is the fund sponsor.” In contrast to tradi-tional VCs, “[…] the only limited partner [of the corporate venture capitalists] is a cor-poration, or a subsidiary of the corporation.” (Landström 2007, p. 7) Just as VCs, CVCs invest in only independent and privately held companies asking for a minority equity stake in exchange. Since the only fund sponsor is the corporation, or a sub-sidiary of it, and there is no obligation for payments to third parties in the future, the motives of investment decisions are rather strategic objectives than financial returns (Dushnitsky 2012, p. 9 f.). Therefore, next to strategic alliances and mergers and
ac-quisitions (M&A), CVC is used as strategic tool, which can be executed either inter-nal, like traditional research and development (R&D) with the funded venture inside the organizational boundaries of the company, or external in independent and au-tonomous units. Like the way of the management of the new entity, the CVC fund it-self can be managed either internal or external (Landström 2007, p. 7 f.).
In its present form, the business of CVC exists almost as long as VC does. In its de-velopment it is characterized by numerous ups and downs. CVC activities flourished in the 1960s, the early 1980s, the 1990s and since the beginning of the twenty-first century in 4 waves, because of opportunities for diversification, legislation changes, the growth through technological advancements, like the Internet and Web 2.0 in3
-cluding accompanied new business models (Dushnitsky 2012, pp. 161-164).
Web 2.0: “The second stage of development of the Internet, characterized especially by the change
3
from static web pages to dynamic or user-generated content and the growth of social media.” Oxford
Dictionaries. Available from: <http://www.oxforddictionaries.com/definition/english/Web-2.0> [11 No-vember 2014].
2.3.
The Venture Capital Investment Process
The VC investment process has been the focus of numerous research activi-ties. While several authors start the process with the deal generation phase, Gom-pers and Lerner (2006, p. 3) choose a more comprehensive approach describing the VC investment process as a cycle with three major steps. It starts with raising money for the VC fund, followed by investing and monitoring, and concluding with the exit of investments to be able to return the capital including capital gains to investors. While raising capital and exiting investments focus on the interaction between VCs and fund investors, the phases of investing and monitoring examine the interactions be-tween VCs and target companies - so called portfolio companies. Again these inter-actions can be divided into a pre-investment phase and post-investment phase (i.a. Zacharakis & Shepard 2007, pp. 177-192; De Clercq & Manigart 2007, pp. 193-218).
Figure 3: The Venture Capital Investment Process. Adapted from: Wright & Robbie, Venture Capital and Private Equity: A Review and Synthesis 1998, p. 535; Bender, Spatial Proximity in Venture Capital Financing 2011, p. 21.
Examining the structure of the VC investment process more detailed, following the different steps will be introduced with the help of an in-depth analysis of the activity bundles according to existing literature (i.a. Tyebjee & Bruno 1984, pp. 1052-1054; Bygrave & Timmons 1992, pp. 10-16; Fried & Hisrich 1994, pp. 31-35; Poser 2003, pp. 47-81; Zacharakis 2010, pp. 10-25; Bender 2011, pp. 21-41) in the following chapters.
Next to raising capital, the pre-investment phase includes the deal flow generation as the search for investment opportunities, followed by deal screening as a brief exami-nation of the business plan. The evaluation with the help of a more in-depth due dili-gence is followed by the stage of deal structuring to negotiate the terms of the deal, before finally the interactions with the portfolio companies take place actively in the post investment phase by monitoring and adding valuable services (Zacharakis 2010, pp. 10-25). While around 60% of the time invested is spent on post-investment activi-ties, choosing the right investment opportunities in the pre-investment phase is cru-cial to improve the overall performance of the VC fund (Landström 2007, p. 177).
2.3.1. Pre-Investment Phase
2.3.1.1. Raising Capital & Competitive Advantage
To be able to make investments in new ventures and start-ups, VC firms need to establish a fund and to raise capital from investors. The fundraising can be seen as a “[…] marathon self-promotion exercise […]” which requires to prepare a business plan, called private placement memorandum (PPM), that includes the skills, experience, track record, and network of the VCs' management teams. The process of fundraising lasts up to one year (Pearce & Barnes 2006, p. 10). Since VC firms generally compete against each other both in fundraising and attracting auspicious new ventures, they need to achieve a competitive advantage to attract financially strong investors. According to figure 3, to achieve a unique proposition VC firms dif-ferentiate themselves using their resources based on qualifications, investment strat-egy and the structure of the VC fund (Poser 2003, p. 50).
Figure 4: Resources that impact venture capitalists’ competitive advantage. Adapted from: Poser, The Impact of Corporate Venture Capital 2003, p. 50.
Thereby, qualifications include all skills of the VC firm’s management team to man-age the whole investment process from raising capital to exiting and returning the capital to the investors of the VC fund. Both an experienced VC management team with specific expertise and a track record based on past achievements help to attract investors (Poser 2003, p. 50 f.).
Investment Strategy
The investment strategy of a VC fund defines a main driver for competitive advan-tage and is based on the excellence of management expertise, experience, and analysis proficiency to generate deal flow as well as to conduct the process of due diligence, monitoring and advising entrepreneurs and start-ups. Criteria that are often used to shape an investment strategy are the investment stage, the industry, and the geographical region of potential investment opportunities (Poser 2003, p. 51 f.).
The investment stages (figure 4) describe the particular stage of development of the start-ups. Since building a new business is a process of capital intense activities through several development stages, VC firms provide capital at different stages.
Figure 5: Venture Capital Investment Stages, own figure based on: Metrick & Yasuda 2011, Ven-ture Capital & The Finance of Innovation, p. 15 f.
In the seed stage, new companies require only a relatively small amount of money to prove the business concept. Therefore, the capital is often provided by family and friends (Bruno & Tyebjee 1985, p. 65). For companies in the startup stage, that are less than one year old and still before commercialization, VC firms provide money for product development, to conduct market research, and to build management teams (Bruno & Tyebjee 1985, p. 65). Companies up to three years in business are also as-sociated to the early stage. Early stage financing is used to test product pilots or funding of the production. Those companies have already a solid business plan and start conducting business. Seed and startup financing is often conducted by family, friends, or angel investors. If so, the first round of investment in this stage by a VC often takes place as other early stage financing (Metrick & Yasuda 2011, p. 15 f.). The mid stage or expansion stage requires working capital to the initial expansion. Companies already produce and ship while accumulating inventory, but are mostly not profitable yet. The capital is used to expand production and marketing efforts as
well as improving the product development. “The […] [venture capital firm’s] role in this stage involves a switch from a support role to a more strategic role.” (Metrick & Yasuda 2011, p. 15) Venture capital firms typically finance these activities by second and third round financing (Bruno & Tyebjee 1985, p. 65 f.). Companies in the later stage have already reached a stable growth rate. Even they might be still not prof-itable at this stage, they at least produce positive cash flow and plan to go public in the following six to twelve months (Bruno & Tyebjee 1985, p. 66).
Comparing the stages between the USA and Europe, there is a need to highlight some differences in the division of the stages. First, the seed stage refers to the same activities in both the US and in Europe as it is in the start-up stage as well, al-though the start-up stage is also called early stage in the US (NVCA 2015, p. 98). The main difference is defined by combining the activities of the expansion and later stages of the US in just one stage named later stage without a direct link to a pend-ing or planned IPO or another exit strategy in Europe (NVCA 2015, p. 99 & 101, EVCA 2015, p. 28).
Summarizing, the lifecycle of a start-up is determined by an early stage, a mid stage, and a late stage, but the required capital of these development stages does not au-tomatically correspond to the definition of the financing rounds. “Each financing event is known as a round, so the first time a company receives financing is known as the
first round (or Series A), the next time is the second round (or Series B), and so
on.” (Metrick & Yasuda 2011, p. 16)
Next to concentrating on investment stages, VC firms often focus on specific indus-tries. Adding value to a portfolio company requires particular industry expertise, rele-vant market information and an efficient network (Kaplan & Strömberg 2001, p. 7 f.; Metrick & Yasuda 2011, p. 9 f.). Generally operating with small staffs, VCs often focus on specific industries and fewer investments with promising high potential in contrast to AIs. This type of companies often occurs in the health care and information tech-nology (IT) sector including hardware, software and communications, where compa-nies with technological advantages possess high growth potential (Metrick & Yasuda 2011, p. 16-18).
VC firms often focus on geographical regions for their investments. VC firms play an active role in the post-investment phase of the investment process to develop the in-vestment with the help of monitoring and advice to add valuable services (Denis 2003, p. 305). Since VCs send board representatives to attend recurrent meetings, spatial proximity ensures less waste of time due to extensive travel activities (Wright & Robbie 1998, p. 547). Next to the spatial proximity, an investment in a specific re-gions is accompanied synonymously with growth expectations because of, e.g., su-perior infrastructure or other valuable criteria (Poser 2003, p. 53). Differences in the geographical dispersion is extremely evident in the US. Traditionally, California alone counted with $28.1 billion for around 70% of all VC investments in 2014 followed by Massachusetts with $4.6 billion (~12%) and New York with $4.3 billion for around 11% (NVCA Yearbook 2015, p. 32).
Finally, the terms and structure of a VC fund are important details. The most com-mon form to avoid double taxation is a limited partnership. It is crucial to determine the contract design regarding management fees, profit sharing rules, and other con-tractual terms since all terms influence the behavior of VC firms. Congruously wrong incentives can cause unintended impacts like ‘grandstanding’ - rushing young com-panies to an IPO, even if they are not ready. Generally, VC funds are self-liquidating funds with a maturity of around ten years to be able to cancel investments in under-performing companies, often called as ‘living dead’ or ‘zombies’ (Gompers & Lerner 2006, p. 23 f.). VC firms get mainly compensated by two components. While the management fee of around 2%, “[…] calculated as a percentage of the committed capital, the level depending on size of the fund and the reputation of the venture capi-talists […]” (Poser 2003, p. 55), covers all basic costs like salaries, office space etc., the carried interests as substantial share of profits, guarantee a benefit in case of a positive development for all parties (Gompers & Lerner 2006, p. 24).
2.3.1.2. Deal Generation
The deal generation is closely linked to the VCs' strategy in terms of the preferred investment stage and deal size as well as the availability of information, and recruitment of executives with skills consistent to the individual corporate strate-gy. Competing against each other, VC firms try to “[…] obtain access to viable projects which can be funded at entry prices which will generate target rates of return
[…]” (Wright & Robbie 1998, p. 536). Therefore, venture capitalists have to identify investment opportunities (deals) in form of start-ups and/or business ventures (Gom-pers & Lerner 2006, p. 7). Typically VCs receive hundreds of proposals for invest-ment opportunities, of which 90% are rejected (Vance 2005, p. 144). Since only a small fraction of the residual 10% gets funded, VCs need a high quality and quantity of deals to be successful. Therefore it is crucial to ensure a high number of deals per unit of time - defined as deal flow (Poser 2003, p. 58). Again the deal (flow) genera-tion can be conducted through either an active (proactive) or passive (reactive) deal flow model, where the passive deal flow model considers a more hierarchical ap-proach. While seeking potential investments is conducted at the junior level man-agement and takes place through industry events, advertising, network events, and on the Internet, the senior level management makes investment decisions and nego-tiates the terms of condition of the contracts. In contrast, the origin of an active deal flow model is the network of the VCs’ senior level management using domain experts for an active search for investment opportunities. Again the passive deal flow model is similar to business incubators and contains receipting unsolicited business plans 4
because of their reputation. Contrary, an active deal flow model addresses solicited business plans (Vinig & de Haan 2002, p. 2 f.), but requires increased costs and high level industry expertise (Wright & Robbie 1998, p. 536). Finally, next to domain ex-perts, VCs expand their networks with fellow VCs, lawyers, headhunters, consultants, bankers, and other business partners (Poser 2003, p. 59 f.).
2.3.1.3. Deal Screening
The deal screening describes a quick review of the characteristics of the investment opportunities and the business plans (Landström 2007, p. 177). While a German VC firm receives about 400 investment proposals per year, only up to 5% of the generated deal flow gets finally funded (Bender 2011, p. 26). Since VC firms re-ceive a large amount of business proposals, the purpose of the screening phase is to reduce the list and to identify only the most promising opportunities (Bender 2011, p. 26). For this brief screening VC managers spend only 10 to 15 minutes to check
Incubator: „An organization designed to accelerate the growth and success of entrepreneurial com
4
-panies through an array of business support resources and services that could include physical space, capital, coaching, common services, and network connections.“ Entrepreneur, Business Incubator:
Definition. Available from: <http://www.entrepreneur.com/encyclopedia/business-incubator> [08 De-cember 2014].
whether the key factors of the particular opportunity align with the VC firms’ individual investment strategy (Sweeting 1991, p. 610; Yung 2012, p. 317). According to Fried and Hisrich (1994, p. 32) many VC firms check investment volume, industry and technology, stage of investment, and geographic location as VC firm-specific key fac-tors first before a generic screen follows (Tyebjee & Bruno 1984, p. 1056 f.).
The investment volume must match the target range of the VC firm. While on the one hand, too small investments are not interesting because of disproportionate expendi-ture of time in relation to potential financial returns, on the other hand, too large in-vestments imply too much risk requiring diversification, e.g., by syndicating with other VC firms. At the same time, these cooperations with other VC firms enable the oppor-tunity to get a second opinion and to enlarge the upper limit of the investment fund (Bender 2011, p. 27; Tyebjee & Bruno 1984, p. 1056).
The focus on specific industries and technologies is a result of small staffs in VC firms. Both the pre-investment and post-investment activities of the investment process require specific experience and the management team cannot provide high level expertise in all sectors at once. Hence an investment in a company is concur-rent an investment in a specific industry or technology the VC firm associates with future growth potential (Tyebjee & Bruno 1984, p. 1057).
Furthermore, each stage of investment has its own characteristics, requirements and challenges (ch. 2.3.1.), and necessitates specific support and skills of the manage-ment team. According to the investmanage-ment strategy, VC firms often focus on invest-ments in a specific stage of development (Bender 2011, p. 28; Tyebjee & Bruno 1984, p. 1057).
Finally, the geographic location of an investment opportunity is an important aspect as well. In the post-investment phase, the VC firm plays an active role in the invest-ment developinvest-ment by claiming board seats to advise and counsel the entrepreneurial company’s management team. Spatial proximity assures a time efficient organization of attending regular meetings as well as providing ongoing support. Similar to the fo-cus on specific industries, investments in a specific geographical region are syn-onymic investments in the development of particular regions with expected growth potential (Tyebjee & Bruno 1984, p. 1057; Bender 2011, p. 28).
Investment opportunities, that does not match the firm-specific preferences, get im-mediately removed from the list of investment opportunities (Riquelme & Rickards 1992, p. 505 f.)
Venture proposals that pass the firm-specific screen become subject to the generic screen, which embraces the review of the business plan against the background of already existing internal expertise and the skills of the entrepreneur (Fried & Hisrich 1992, p. 32). Based on this statement, Robbie and Wright (1998) highlight „[…] the viability and novelty of the project; the integrity, track record and leadership skills of management; and the possibility for high returns and an exit […]“ (Robbie & Wright 1998, p. 539) as the three dimensions of the generic screen.
While the firm-specific screen is more judgmental without weighting up criteria, the generic screen - similar to the in-depth due diligence later - defines a more analytical and balanced approach (Riquelme & Rickards 1992, p. 505 f.). Already MacMillan et al. (1985, pp. 120-123) identify the entrepreneur’s personality and experience, both the characteristics of the product/service and the market, as well as finally financial considerations as the main criteria that drive investment decision making. The impor-tance of the entrepreneur is highlighted by Muzyka et al. (1996, p. 282) as well, whereby VC firms prefer a good management team, even if the business model promises only reasonable financial returns. While these main criteria remain equally important to VC firms around the globe, Vinig & de Haan (2002, p. 2) examine sub-criteria in a comparative study of Dutch and US VCs, that alter in their relative impor-tance. For example, while Dutch VCs rank the relative importance of innovativeness of products higher, for US VCs are proprietary rights more important.
2.3.1.4. Deal Evaluation
Only the proposals, that pass the initial screening, will be analyzed and validated more detailed. VCs know much less about the parameters and characteris-tics of the start-up and its environment than entrepreneurs. Consequently, the en-trepreneur and managers of the start-up are generally able to take advantage of their knowledge at the expense of the investor. To overcome this kind of information asymmetries, the VC firm conducts a process of due diligence (Poser 2003, p. 61 f.; Gompers & Lerner 2006, p. 127 f.). The term due diligence defines an in-depth analysis of screening, evaluation, and valuation of potential investment opportunities
to determine the attractiveness as well as risks and issues concerning the potential investment opportunity (Poser 2003, p. 62; Landström 2007, p. 177).
Since investing in start-ups and entrepreneurial ventures is defined by a high level of uncertainty, the main task of the evaluation process is to reduce risk (Zacharakis 2010, p. 19). Therefore the expenditure of time for the due diligence can be seen as a tool to minimize risk. To protect these opportunity costs, VC firms require exclusivity for the period of time of the due diligence (Pearce & Barnes 2006, p. 34). But there does not only exist risk because of other VC firms, risk encompasses internal risk, external risk, and execution risk. While internal risk describes the difficulties regard-ing the assessment of the entrepreneur’s human capital and the monitorregard-ing of the en-trepreneur’s post-investment activities, external risk contains both the market acces-sibility of the product/service and the reaction of market competitors. The execution risk results from the challenge to develop a winning strategy for the product or ser-vice (Kaplan & Strömberg 2004, p. 2180-2184; Zacharakis 2010, p. 19). “As such, due diligence is a cost/benefit trade-off; how much effort and time should VCs commit to reduce […] risk.” (Zacharakis 2010, p. 20)
Following up with the screening phase, in the evaluation phase, VC firms check the investment opportunities for several characteristics also, but in a more in-depth man-ner. In an early work, already Tyebjee and Bruno (1984, p. 1059) collected data with the help of a questionnaire and identified five crucial factors:
✦ Market attractiveness (size, growth, access to market), ✦ Product differentiation (uniqueness, patents, profit margin), ✦ Managerial capabilities (skills in business functional areas), ✦ Environmental threat resistance (product lifecycle, entry barriers),
✦ Cash-out potential (realization of future capital gains through IPO, Sales, M&A).
According to the findings of Tyebjee and Bruno (1984, p. 1059), also MacMillan et al. (1985, p. 122 f.) examine similar criteria discovering the importance of the personality and experience of the entrepreneur next to product and market characteristics, and finally financial considerations.
“There is no question that irrespective of the horse (product), horse race (market), or odds (financial criteria) it is the jockey (entrepreneur) who fundamentally determines whether the venture capitalist will place a bet at all.” (MacMillan et al. 1985, p. 128)
Thereby the product and market characteristics refer to the size and growth rate as well as existing entry barriers. While an already functioning prototype is beneficial to test the accessibility of the product in the target market, a unique value proposition as well as proprietary rights can be sources for competitive advantage. Financial con-siderations refer to the rate of return and the time to break even as well as implica-tions for possible capital gains through different exit strategies like an IPO, sale or acquisition by another company (MacMillan et al. 1985, p. 121 f.).
A special emphasis lies on the personality and experience of the entrepreneur as the outstanding factor of business evaluation (MacMillan et al. 1985, p. 128). Next to leadership abilities, the track record is important as well as communication skills, in-dustry experience, and all kinds of management skills (MacMillan et al. 1985, p. 121). Therefore VC firm executes face-to-face meetings to proof entrepreneurs with what-if scenarios, conduct reference checks on capabilities, and interviews about the en-trepreneur's past performances (Zacharakis 2010, p. 20). While intangible assets (here: the entrepreneur’s personality, experience, management skills), similar to con-ventional M&A transactions, define a source for future success, also tangible assets, e.g., financials, accounts, receivables, patents, are important for a proper evaluation (Harvey & Lusch 1995, p. 7).
These tangible assets are used to choose an adequate valuation method considering both the general objective of future capital gains, according to the golden rule of in-vestment “buy low, sell high” (Pearce & Barnes 2006, p. 6), and circumstances that affect the development of future cash flows. Since the latter has an impact on the valuation of new ventures, consequently VCs try to face the trade-off between risk and reward with the help of applying multiple valuation methods. Next to the financial and accounting information, VCs conduct more detailed sensitivity analyses of the business plan with regard to future expectations for the business (Wright & Robbie 1998, p. 539 f.).
While the whole due diligence is very time consuming and lasts between six weeks and six months or even longer (Fiet 1995, p. 196), almost half of the time is spent on the evaluation of the entrepreneurial team’s human capital (Zacharakis 2010, p. 19 f.). Thereby the due diligence does not only influence the investment decision in gen-eral, but also drives the terms of the investment, which will be discussed in the stage of deal structuring.
2.3.1.5. Deal Structuring
In case of a positive evaluation and promising due diligence, VCs and en-trepreneur get together to establish and negotiate the terms of the investment. There-fore deal structuring refers to the relationship between VCs and entrepreneurs and includes financial aspects like the valuation of the venture as well as contract terms including additional investor rights, that are individually designed terms as protection against agency risks (Sahlman 1990, pp. 503-517; Zacharakis 2010, p. 22). All nego-tiation results are set out in legal documents, e.g., shareholder’s agreement, articles of association, and employment contracts (Zacharakis 2010, p. 22; Bender 2011, p. 32).
Even the final stage of the pre-investment phase is a critical one where still around 20% of the deals fail in the negotiations (Fried & Hisrich 1994, p. 34). Since time is the most valuable asset and due to the time expended in the evaluation and due dili-gence in particular, a failure at this point of time is harmful for both VCs and entre-preneurs and carries sunk costs (Zacharakis & Shepherd 2007, p. 177; Zacharakis 5
2010, p. 22). The outcome of the negotiation depends highly on the bargaining power of both parties. “Some investors want to get everything, and give nothing. Some owner-entrepreneurs want to take everything and give nothing.” (Vance 2005, p. 163) Although providing capital, VCs are not in a prevailing position per se. The en-trepreneur may have several financing opportunities, checks whether the VC firm fits to the venture and its future expectations, and improves his/her relative bargaining power by gaining knowledge about the issues of the deal structuring (Vance 2005, p. 192; Bender 2011, p. 31).
Sunk cost: “A cost that has already been incurred and thus cannot be recovered. A sunk cost differs
5
from other, future costs that a business may face, such as inventory costs or R&D expenses, because it has already happened. Sunk costs are independent of any event that may occur in the future.”
Examining financial aspects, the valuation of the company is an important issue and an accurate valuation is necessary to prevent overpayment, which can destroy the expected ROI (Vance 2005, p. 150). The valuation of a new venture differs from the valuation of a mature corporation, because of its uncertain environment and growth potential. The lack of track record makes a valuation based on, e.g., Price/Earnings (P/E) ratio , according to public companies, difficult (Zacharakis 2010, p. 22). First, 6
adequate methods are valuations based on discounted cash flow (DCF), EBITDA , 7 8
revenues , similar companies or a combination of those as well as on the value of 9 10
intellectual property and other assets (Vance 2005, pp. 165-176). First, the valuation determines the share of the venture for a specific amount of capital and therefore has a direct impact on the return. To reduce risks and uncertainties that might have a negative influence on future returns, all information of the due diligence must be in-corporated in the valuation (Bender 2011, p. 33). Second, the funding requirements determine the volume and moment of funding. While the volume follows from the val-uation of the venture, the VC commits capital in several stages. As a control mecha-nism, staging prevents misuse, e.g., spendings for the entrepreneur’s own interests, and waste of money as a mean to reduce risk and uncertainty as well as an incentive for the entrepreneur’s performance. If the entrepreneur needs more capital than
Price/Earnings ratio: “A valuation ratio of a company’s current share price compared to its
per-6
share earnings. Calculated as: Market Value per Share / Earnings per Share.” Investopedia. Available
from: <http://www.investopedia.com/terms/p/price-earningsratio.asp> [12 April 2015].
Discounted cash flow: “A valuation method used to estimate the attractiveness of an investment
7
opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.” Investopedia. Available
from: <http://www.investopedia.com/terms/d/dcf.asp> [12 April 2015].
EBITDA multiplier method: “EBITDA is Earnings Before Interest Taxes Depreciation and Amortiza
8
-tion. It is used to estimate the amount of cash generated by operations independent of its financing or tax strategy. For a profitable company, a value can be estimated by benchmarking the ratio of market value to EBIDTA.” (Vance 2005, p. 166).
Revenue multiplier method: “Companies can generate revenue at a time when they still have min
9
-imal or negative cash flow. The revenue valuation method is based on a ratio of the market value to revenue for comparable companies.” (Vance 2005, p. 168).
Similar companies: “Comparison to comparable early stage companies provides another way for
10
