Venture Capital Investing - Capitant

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FACULTY OF ECONOMICS AND BUSINESS

Venture Capital Investing Investing with Buy-back Options: A Financial Model

Glenn Gezels r0485730

Thesis submitted to obtain the degree of Master of Business Economics Promotor: Prof. dr. Francesca Melillo Assistant: Ph.D Jeroen Mahieu Academic year: 2016-2017

Contents Preface

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Executive Summary

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1 Introduction

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2 Literature Review 2.1 Entrepreneurship and Financing of Startups . . . . . . . 2.1.1 Impact of Entrepreneurship on Economic Growth 2.1.2 Barriers to Entrepreneurship . . . . . . . . . . . . 2.1.3 The Entrepreneurial Ecosystem in Belgium . . . . 2.1.4 Financing Options for Entrepreneurs . . . . . . . 2.1.5 Challenges of Financing Entrepreneurs . . . . . . 2.2 Venture Capital Financing . . . . . . . . . . . . . . . . . 2.2.1 Venture Capital: A Definition . . . . . . . . . . . 2.2.2 The Impact of Venture Capital . . . . . . . . . . 2.2.3 Organizational structure of VC Funds . . . . . . . 2.2.4 The Venture Capital Investment Cycle . . . . . . 2.2.5 Venture Capital Contracting . . . . . . . . . . . . 2.3 Performance of Venture Capital Investments . . . . . . . 2.3.1 Data and Methodological Issues . . . . . . . . . . 2.3.2 Financial Returns of Venture Capital Investments 3 Research Proposal 3.1 Background . . . . . . . . . . . . . . . . . . 3.2 The Proposal . . . . . . . . . . . . . . . . . 3.2.1 Proposal Example . . . . . . . . . . . 3.2.2 Research Question & Methodology . 3.3 Relevance of the Research . . . . . . . . . . 3.3.1 Potential Benefits of the Proposal . . 3.3.2 Potential Downsides of the Proposal iii

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4 Research Methodology 4.1 Introduction . . . . . . . . . 4.2 Research Design . . . . . . . 4.3 Building a Financial Model 4.3.1 The Outputs . . . . 4.3.2 The Inputs . . . . .

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5 Results and Discussion 5.1 Scenario 1 . . . . . . . . . . . . . . . . . 5.1.1 Description of the Scenario . . . . 5.1.2 The Inputs . . . . . . . . . . . . 5.1.3 The Outputs . . . . . . . . . . . 5.1.4 Discussion of Results - Scenario 1 5.2 Scenario 2 . . . . . . . . . . . . . . . . . 5.2.1 Scenario Description . . . . . . . 5.2.2 Inputs . . . . . . . . . . . . . . . 5.2.3 Outputs . . . . . . . . . . . . . . 5.2.4 Discussion of Results - Scenario 2 5.3 Scenario 3 . . . . . . . . . . . . . . . . . 5.3.1 Scenario Description . . . . . . . 5.3.2 Inputs . . . . . . . . . . . . . . . 5.3.3 Outputs . . . . . . . . . . . . . . 5.3.4 Discussion of Results - Scenario 3 5.4 Sensitivity Analysis . . . . . . . . . . . . 6 Conclusions & Recommendations 6.1 Conclusion . . . . . . . . . . . . . . . . 6.1.1 The Investor’s Perspective . . . 6.1.2 The Entrepreneur’s Perspective 6.2 Limitations of the Study . . . . . . . . 6.3 Suggestions for Further Research . . .

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Bibliography

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A List of Abbreviations

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B Important Terminology

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C The Engine 79 C.1 The Engine: Without Buy-Back Option . . . . . . . . . . . . . . . . 79 C.2 The Engine: With Buy-Back Option . . . . . . . . . . . . . . . . . 79

D Figures and Tables D.1 Terminology . . . . . . . . . . . . D.2 Assumption Sets - User-entered & D.3 Value Ranges - Inputs . . . . . . D.4 Input-Output Relationships . . . D.5 Overview of the User-Interface . .

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Preface About a year ago, I met Jurgen Ingels through the student finance society Capitant. Jurgen is one of the founders of Clear2Pay, previous Senior Investment Manager at Dexia Ventures and currently active as Managing Partner at the Private Equity fund SmartFin Capital. Together we discussed the issue about how investors and the government could potentially improve their role in supporting startups and have a larger positive impact on society. As a result of his previous experiences as a successful entrepreneur and investor; he formulated a proposal on how the process of funding new ventures could be improved, and thus generating better returns. Considering my high interest in the Venture Capital industry; I proposed that I would focus my master dissertation on researching his suggested method; backed by academic literature, industry reports and interviews. The aim of this research is to compare the hypothetical performance of his proposal, relative to the ’stateof-the-art’ approaches used by Venture Capital firms. I would like to thank Jurgen Ingels for giving me the opportunity to work together and providing valuable insights into the Venture Capital sector. Thanks go out to my promoters Francesca Melillo and Jeroen Mahieu for guiding me throughout the year. And finally, I want to express gratitude towards my parents, as without them, I would not have been where I am today. Leuven, 19/05/2017.

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Executive Summary The last ten years, the average returns of the Venture Capital (VC) industry have been disappointing. There is an emerging consensus among academics that average returns of VC funds do not exceed market returns. Critics attribute the disappointing performances to its “broken” investments model. Especially when investors look at the risk-return characteristics of this highly illiquid investment class, lower returns might limit the available funds going to young innovative companies. In turn, a lack of funding available for startups and entrepreneurs can have a significant negative impact on innovation, job creation, and overall prosperity. In an attempt to look for a way to increase returns in this industry, a slightly different investment model was proposed by a seasoned Belgian investor and entrepreneur. More specific, the proposal of the investment model would include the provision of a buy-back option to the entrepreneur on a percentage of the investor’s shares. The option would have a required rate of return and a flexible expiration date in which it could be exercised. The reasoning behind this model is two-fold. For the investors, their investments would receive an extra incentive to grow faster, likely to improve the success rates. In addition, a lower pre-money valuation could be negotiated as it provides an increased bargaining power. Also the liquidity of the VC fund would improve as funds would be returned faster, which in turn could be reinvested. For the entrepreneur, the buy-back option would work as an anti-dilution mechanism. This study extends existing research on VC financing by examining the current investment model and if including a buy-back option for the entrepreneur could improve the returns for a VC fund, and thus in turn increase the amount of financix

ing available for young innovative companies. By building a financial model based on existing academic research and the most recent industry reports; a combination between qualitative and quantitative research has been made. The creation of a “hypothetical” VC fund made observations possible between investing with and without a buy-back option. This study shows that including a buy-back option can improve the returns of a VC fund, given that certain conditions are met. First, providing a buy-back option should have a positive effect on the underlying performance of the VC’s investments. This can be assumed through the extra incentive for the entrepreneur to grow fast enough so he would be able to exercise the buy-back option. Second, the investor could negotiate a lower pre-money valuations by providing a buy-back option, which in turn results in a higher expected return. However, if the option is actually exercised, it would have a larger negative effect on the expected returns. This can be attributed to the few successful companies that are responsible for the majority of a VC fund’s return, which will cap the upside potential. From a financial return point-of-view, the buy-back option is interesting for the investor if the entrepreneur is not able to exercise it. Still, the overall liquidity of a VC fund would improve if a buy-back option is exercised, though coming at the cost of lower returns.

Chapter 1 Introduction The Venture Capital (VC) industry has proven to have a large beneficial economic impact on innovation, employment, and productivity growth (Berger & Udell 1998; Kortum & Lerner, 2000; Samilla & Sorensson, 2009). Many of today’s largest and most research active corporations such as Google, Apple and Intel have received early-stage funding from VC firms. The general public and policy-makers are starting to realize that startups and entrepreneurs form the basis for potentially large innovative multinationals which add value, jobs and prosperity to society (OECD, 2016). Though the VC industry had significant successes over the last 30 years, especially in the 90’s, returns have declined significantly (EVCA, 2013). There is an emerging consensus that average returns of VC funds do not exceed market returns (Da Rin et al., 2013; Cumming and Walz, 2010; and Krohmer et al., 2009). In turn, the available funds for young, innovative, and high-growth entrepreneurial firms have decreased and remain relatively scarce compared to financing options for large companies (Smith et al., 2011). Critics of the VC industry attribute the disappointing performances to its “broken” investment model (e.g. Kedrosky, 2009; AWT, 2011). In addition, previous work has identified that later-stage VC investments yield higher returns than early-stage investments within the VC industry, challenging the traditional risk-return relationship in finance theory (Flammang, 2015). These findings seem to be backed by results from the most recent EVCA (now called Invest Europe) report on VC 1

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returns where later-stage focused VC funds outperformed their early-stage focused peers (EVCA, 2013). And due to the relatively young age of the VC industry, it is worthwhile to investigate how this investment model might be improved in order to increase the returns of this investment class. Previous work has already identified potential improvements, creating additional value in the VC investment process (Spieringers, 2011). Within the VC investment process, an apparent problem that occurs is the disproportionate weight an entrepreneur gives to the amount of shares it is willing to give in exchange for an amount of funding during deal negotiations (Ingels, 2016). Typically, investors want a fair amount of shares of a young company for a given amount of investment. Often, during the first investment round, they try to negotiate for a low pre-money valuation. At the other side, a young high-potential company wants to hold on to its shares as much as possible and prevent dilution, and thus aims at a high pre-money valuation (Ingels, 2016). In order to mitigate these problems, Jurgen Ingels proposed a funding approach which could potentially improve the VC financing process, and thus its performance. The main research topic of this thesis is to test for the hypothetical performance of his proposal within a VC fund and analyse the impact it might have. The remainder of this paper is structured as follows: chapter 2 consists out of a literature review, regarding an overall background on the importance of entrepreneurship and the financing of startups, VC as a financial instrument and the performance of this investment class. Chapter 3 describes the proposal in detail to potentially improve the investment terms of VC financing rounds. Chapter 4 describes the research methodology used to obtain the results. Chapter 5 contains the results, the discussion and a sensitivity analysis. And finally, chapter 6 ends with some overall conclusions and remarks, together with a couple limitations of the research and recommendations for further research.

Chapter 2 Literature Review 2.1 2.1.1

Entrepreneurship and Financing of Startups Impact of Entrepreneurship on Economic Growth

Stimulating economic growth has been a dominating economic and political issue over the last decades. Sustained economic growth leads to higher average incomes, lower unemployment and higher living standards (Acs & Szerb, 2007). It is often the number one priority of political leaders of the biggest economies in the world. It is innovative activity, largely set forth by entrepreneurs, which is believed to be the most important component of long-term economic growth (Berger & Udell, 1998; Kortum & Lerner, 2000; Samilla & Sorensson, 2009; Valliere & Peterson, 2009). Both theoretical and empirical research on the contribution of innovation and entrepreneurship to economic growth has been well established in economic literature (Wong et al., 2005; Fritsch, 2008). The academic literature mainly focusses on two levels of observation, that of the firm and that of the region. A large body of literature on the firm-level which measures performance in terms of firm growth and survival, conclude that entrepreneurial activity is positively related to growth (Audretsch, 2002; Davidsson P., 2004; Sutton, 1997). These findings appear to be robust across Western economies and across different time periods (Carree & Thurik, 2010). A smaller body of literature also finds that that there is a positive relation between en3

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trepreneurial activity for regions and the economic performance of those regions (Acs & Armington, 2004; Audretsch, 2002). Encouraging and supporting entrepreneurship has also been high on the agenda of the US, EU (Europe 2020) and the OECD (OECD, 2016). Now also China, who once viewed it as a threat to the established system, recently took measures to encourage and facilitate entrepreneurship1 . By implementing preferential tax policies, social security subsidies and easier business registration procedures; they acknowledge entrepreneurial activity to be essential for maintaining economic competitiveness and achieving long-term success. The reasoning behind the relationship, is that entrepreneurs give rise to economic growth by introducing innovative technologies, products, services and new ways of doing business (Audretsch, 2002). Great examples are Larry Page and Sergey Brin (Google), Elon Musk (Tesla & SpaceX), Bill Gates (Microsoft) and Steve Jobs (Apple), to name a few. In doing so, they challenge existing firms, increasing the overall competitiveness and productivity level of an economy (Geroski, 1995). Consumers consequently benefit from lower prices and greater product variety (Koster et al., 2012). In addition, entrepreneurs create new jobs and decrease unemployment, both in the short- and long-term (Fritsch, 2008). These findings appear to be robust, as the same results are found for the US and for a number of European countries, as well as for a sample of 23 Organisation for OECD countries (Carree and Thurik, 2008). Other academics argue that also existing incumbents contribute largely to innovative activity as they invest large amounts in R&D activities. However, academics find that they are more responsible for incremental innovations to improve their own products (Acemoglu & Cao, 2011). Whilst they previously were reliable producers of also radical innovations, times have changed. Due to technological change, globalization, deregulation, shifts in the labour supply, variety in demand, and higher levels of uncertainty; a shift in industry structure has occurred (Thurik, 2009). Innovation, particularly in the biotechnology, information, and high-tech sectors; is now assumed to be spurred mainly by entrepreneurial activity (Berger 1

http://www.chinadaily.com.cn/china/2015-04/22/content 20510974.htm

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& Udell, 1998). New ventures invest relatively more in searching for new opportunities. This can be explained by the organizational inertia of existing firms, unable to adapt fast enough to technological changes; and/or by the fear of new ideas cannibalizing their own markets. The latter is referred to as “creative destruction” (Schumpeter, 1934). With the increased emphasis on quarterly results, many larger organizations tend to reduce spending on long-term research and development (R&D) and product development. Employees at these established firms sometimes come up with ideas, but often have to set-up their own business in order to be able to commercialize on them as their own employers would turn them down (NVCA, 2016).

2.1.2

Barriers to Entrepreneurship

Realizing the advantages of entrepreneurship, one has to understand the factors which inhibit it. Academic literature and industry reports have investigated which factors limit the level of entrepreneurial activity in a region. One of the most interesting works on entrepreneurship on the macro-level in recent history is the development of the Global Entrepreneurship Model (GEM). GEM is one of the most extensive global studies on analysing the level of entrepreneurship occurring in over 100 countries in the world. Started in 1999, with now over 17 years of data, it aims to explain entrepreneurial behaviour and attitudes of individuals, together with how a national context impacts entrepreneurship. One part of the GEM report is the assessment of the quality of all the countries entrepreneurial ecosystems (GEM, 2016). They examine the availability of entrepreneurial finance, entrepreneurship education, government policies and programs relevant to entrepreneurship, commercial and legal infrastructure, R&D transfer, physical infrastructure, internal market openness and dynamics, and cultural and social norms. Regarding barriers to entrepreneurship, they conclude that there are several factors which can influence the level of entrepreneurial activity. Overall, they found that: (i) The availability of funding, (ii) entrepreneurship education, (iii) the regulatory environment, (iv) fear of failure and (v) access to markets play a major role as barriers to the level and type of entrepreneurship

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(GEM, 2015/2016). Across all participating countries, they find that physical infrastructure, commercial and legal infrastructure, and social and cultural norms received the highest ratings of entrepreneurial ecosystem quality and have not attributed significantly in limiting the levels of entrepreneurship. On the other hand, those scoring lowest, and thus limiting levels of entrepreneurship, were entrepreneurship education in primary and secondary school, internal market entry regulations and burdens, and access to finance. Another study by Kritikos (2014), also found that regulatory obstacles hamper the creation of new firms. High regulatory may discourage entrepreneurs pursuing their ideas and making them choose for alternative career paths. These regulations also force new entrants to be larger and cause incumbent firms in naturally highentry industries to grow more slowly (Klapper et al., 2006). These findings appear to be robust, even after correcting for the the degree of protection of intellectual property, labour regulations, and the availability of financing. In addition, he also finds that only a few people have the drive and right personal characteristics to become entrepreneurs.

2.1.3

The Entrepreneurial Ecosystem in Belgium

It is interesting to see how Belgium’s Entrepreneurial ecosystem is rated, according to the GEM report, on entrepreneurial activity. GEM makes a distinction between factor-, efficiency and innovation-driven economies. Belgium is classified as an innovation-driven economy. In 2014, the population amounted up to 11.2 million people with a Gross Domestic Product (GDP) of $534.7 bln. SME’s contributed 62% to the GDP. According to the World Bank’s ratings, Belgium scored 73/100 for doing business and a 95/100 to start a business. These scores rank us 43th and 20th respectively out of a total of 189 countries. In addition, according to the World Economic Forum, Belgium scores a 5.2 out of 7 on global competitiveness which ranks us 19th out of 140 countries. The best rated countries from the innovation-driven group are Israel, USA, Canada, Switzerland and Estonia.

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Also the Netherlands deserve to be mentioned as they score high on 10 out of the 12 different ecosystem indicators. To evaluate the entrepreneurial ecosystem of Belgium, they made use of a National Expert Survey (NES), giving a score on 12 different indicators which were mentioned earlier. A total of 62 countries participated in the survey of which Belgium scored relatively high compared to the average and median. A scoring system was used ranging from 1 (highly insufficient) to 9 (highly sufficient). The results from the NES for Belgium and its ranking can be found in figure 2.1.

Figure 2.1: Expert Ratings of the Belgian Entrepreneurial Ecosystem, Source: GEM Report 2015/2016 From the results, one can conclude that there is still room for improvements to increase the quality of the Belgian entrepreneurial ecosystem. Especially governmental policies regarding taxes and bureaucracy can be improved, together with the cultural and social norms, entrepreneurship education, internal market dy-

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namics and physical infrastructure. These could be incorporated in potential new policy measures.

2.1.4

Financing Options for Entrepreneurs

In order to develop innovative technologies and products, an entrepreneur needs capital. In general, a new venture can be financed by using equity capital (i.e. risk capital), debt capital, or a combination of both. Within these two financing classes, there are several additional options. A further description will be given for equity- and debt financing respectively. 3.1.4.1 Equity Financing Options Overall, there are several sources of equity financing. First and foremost, the main and initial financial resources come from the entrepreneur. Nearly all entrepreneurs invest their own money into their startups. This is necessary as it indicates confidence towards other financiers, often referred to as “having skin in the game” (Manigart & Witmeur, 2011). Second, family, friends and fans (or “fools”) can invest their money into the venture if they believe in the idea and/or entrepreneur. Third, a more recent form of equity financing has been crowdfunding. Online platforms such as Bolero Crowdfunding or Kickstarter have proven to be able to successfully launch products and services (e.g. Oculus Rift). Finally, there are four additional types of risk capital providers: business angels (wealthy individuals), VC funds, corporate investors and governmental institutions. Each of these four sources of capital have different characteristics and motives, however the explanation of these differences is not the main focus of this paper. VC financing will be further explained later. 3.1.4.2 Debt Financing Options Another way to obtain capital for a startup is through debt financing. An entrepreneur can again look to his family, friend and fans in order to get capital. Those who believe in the idea and/or the person can grant a him or her a loan. In addition, the Belgian government provides an incentive to lend money to en-

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trepreneurs by offering special types of secured loans (win-win loan2 ) which are financially attractive because of beneficial tax rulings for the investor. The second option is to ask a bank for a loan. However, banks are usually reluctant to provide loans to young companies and entrepreneurs who are involved in high-risk businesses because they require collateral (hard assets). In addition, entrepreneurs can also sometimes get cheap loans from the government to fund their business ideas. Finally, a recent development within the lending industry is peer-to-peer lending (e.g. Zopa3 ) through which entrepreneurs might be able to fund their businesses in the future. 3.1.4.3 Other Financing Options Another financing option which is neither equity not debt, are government grants and subsidies. In order to stimulate innovation and technological advances, the governments provides subsidies to companies who have to fulfil certain requirements in order to receive these subsidies. Also, doctorate students can get grants to do further research on high potential technologies or scientific developments. In addition, there are also “hybrid” financing options which are designed in such a way that they have characteristics of both debt and equity. The most common type of hybrid security is a convertible bond that has features of an ordinary bond but is heavily influenced by the price movements of the stock into which it is convertible. Another example, often used by VC funds, is convertible preferred stock. which pays dividends at a fixed or floating rate before common stock dividends are paid and can be exchanged for shares of the underlying company’s stock.

2.1.5

Challenges of Financing Entrepreneurs

Access to finance represents one of the most significant challenges for entrepreneurs and for the creation, survival and growth of small businesses (OECD, 2013). There are several reasons entrepreneurs have trouble finding funding for their startups. First, traditional lenders such as banks require collateral which these entrepreneurs 2 3

http://www.vlaio.be/maatregel/winwinlening http://www.zopa.com/

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often lack. This inhibits them from receiving a loan, even though these new businesses may have a high growth potential. Banks also often lack the skill to assess these projects and make informed investment decisions (Smith et al., 2011) The second reason reason relates to the high uncertainty about a startup’s future. Chances of success are quite low as survival rates show that the majority of startups fail within five years (E. Ries, 2011). Investing in startups entail higher risks compared to investing in well-established firms. These riskier investments often oppose the risk-averse investment policies and philosophies of pension funds, asset managers, corporate investors and wealthy individuals (W. Bygrave & A. Zacharakis, 2014). Thrid, looking at the performance of VC funds; they overall under-perform the most commonly used stock market benchmarks such as the S&P 500 and NASDAQ (EVCA, 2014). There is reason to believe investors will look at the average long-term return generated by VC funds. Comparing the lower average returns to the stock market benchmarks, it causes VC to be a less attractive investment opportunity, especially considering the higher risks involved. A fourth reason is that the investments made by VC funds are highly illiquid. Investments are fixed for a long time (often longer than 10 years) which makes it less attractive to a large group of investors. In order to realize a return, the investor has to exit the investment by either an Initial Public Offering (IPO), merger, acquisition or a buyout which can be time-consuming and difficult to achieve. Compared to investing on a stock exchange, where shares can be fairly easily be bought and sold, it is not the case for companies which are not publicly listed. Another problem entrepreneurs face in attracting capital is the difficulty in determining the value of the idea, patent or company. How do you determine the price that is going to be paid for a company which has not yet have any customers or income? Negotiating a fair value can be onerous for investors as for the entrepreneurs. In these negotiations, they also face the famous principal-agency problem (Jensen, M. & Meckling, W., 1976). The investor does not know if the en-

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trepreneur will act in his own interest or that of the company when finally having received the funding. However, the problem is two-sided as the investor can also act in his own interest when trying to force an exit to generate a return. In addition, there is also the risk of asymmetric and incomplete information which needs to be accounted for (Holmstrom, 1979). The investor or entrepreneur might know some valuable information which can be purposely withheld from one another. In order to mitigate these agency problems, well designed incomplete contracts are used which automatically realign incentives of both parties as much as possible. Finally, a sixth problem can be indicated as “the equity gap”. It occurs when the required amount of funding is too high for a Business Angel (BA) and too low for a VC. VCs prefer not to invest in projects that are too small because they need to assess and follow-up each investment they make which can become quite costly. It is hard to recover these costs from a small investment. The equity gap can also be explained by the fact that many sources of financing (including VC) are only available for companies with ambitions for strong growth; which does not necessarily coincide with the ambitions of a lot of other entrepreneurs. Of course, these six problems mentioned above are not the sole reasons why entrepreneurs have limited access to funding. Other problems can be attributed to cultural differences, lack of developed economic & venture capital markets, governmental regulations, legal infrastructure, economic downturns, etc. (Plagge, A., 2006).

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Venture Capital Financing

The previous section built the foundations to illustrate the importance of innovation and entrepreneurship as a source of economic growth. This section seeks to lay the foundation to understand the role of VC as a financial instrument which has a prominent role in supporting and growing young innovative companies (Kedrosky, 2009). In turn, VC stimulates entrepreneurship and innovation; and thus economic growth. A thorough understanding of VC is required; including but not limited to its background, why and how it is used, the investment process, and finally the performance of this type asset class.

2.2.1

Venture Capital: A Definition

“Venture Capital” (VC) is a generic term used to illustrate capital investments in new and young, non-publicly listed companies with high growth potential. It is an investment class within a more broadly based Private Equity (PE) market which also covers a range of other stages such as bridge financing, replacement and turnaround capital. VC financing is used to support the pre-launch (or seed), startup or early stage development phases of a business (Invest Europe, 2016) in order to grow rapidly and generate a return for its investors over a long timehorizon, typically between five to ten years (Bygrave & Zacharakis, 2014). They try to do this not only by just providing the capital, but also through value-adding services such as strategic advice, hiring key employees, introducing stock option plans, using their business network, etc. (Sapienza, 1992). VC exists because young companies are, in most cases, unable to attract the required amount of capital they need from more traditional sources such as banks, due to the high risks and lack of available collateral. VC investments are characterized by their high-risk nature due to large information asymmetries, moral hazard, uncertainty and other risks. Other, more risk-seeking and capable investors, are willing to provide the capital in the hope of (mostly) generating a high return, or in other cases to diversify their investment portfolios or just to have access to this non-public type of asset class (Baeyens et al., 2006).

2.2. VENTURE CAPITAL FINANCING

2.2.2

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The Impact of Venture Capital

Despite the young age of the VC industry and that less than 1% of new startups are financed through VC, public companies with VC backing employ four million people in the U.S. and account for one-fifth of the market capitalization and 44% of the research and development spending of U.S. public companies (Gornall & Strebulaev, 2015). As of the 11th of May 2017, the five largest public companies in the world by market capitalization (1st: Apple, 2nd: Alphabet, 3rd: Microsoft, 4th: Amazon.com and 5th: Facebook) have received VC funding in their early stages. Combined, they have a total market capitalization of over $2.88 trillion and offer jobs to more than half a million people. Though the VC industry is still relatively quite small, academics argue it to have a large beneficial economic impact on innovation, employment, and productivity growth (e.g. Berger & Udell 1998; Kortum & Lerner, 2000; Samilla & Sorensson, 2009). For example, Kortum & Lerner (2000) find that VC has a larger effect on the production of patents than corporate R&D programs. Hirukawa and Ueda (2008) conform these findings based on results over a longer time series. They also find a positive relationship between VC financing and labour productivity within a VC-backed company.

2.2.3

Organizational structure of VC Funds

To understand why a VC fund does what it does, it is important to understand how a VC fund works, the way it is structured and why. For a high-level overview of a VC fund, see figure 2.2. Partnerships The most common way VC funds are structured is through limited liability partnerships (LLP). A VC fund is managed by the general partners (GP) who serve the interests of those who invest in the VC fund, the limited partners (LP) (Sahlman, 1990). During the ten years of the fund’s typical lifetime, the LPs trust the GPs to take investment decisions and monitor them on their behalf (Da Rin et al.,

14

CHAPTER 2. LITERATURE REVIEW

Figure 2.2: Venture Capital Fund Structure, Source: Smith et al. (2011)

2012). They are responsible for generating deal flow, screen for opportunities, negotiate deals, provide value-adding services and eventually finding a way to exit their investments. GPs are usually former successful entrepreneurs and/or industry experts who use their credentials and reputation to convince LPs to manage

2.2. VENTURE CAPITAL FINANCING

15

and invest their money into young companies. The LPs are mainly pension funds, high net worth individuals, corporate investors, insurance companies, banks, government agencies, sovereign wealth funds, academic institutions and family offices (EVCA, 2013). Agency Problems between LPs and GPs There are several potential conflicts which can arise between VCs and their investors: the GPs can use their money to invest in bad companies, be incapable of adding value, mismanaging the fund, etc. In order to mitigate these potential agency problems and to align incentives between investors and fund managers; the industry uses well-designed partnership agreements and compensation schemes. Overall, they contain the following provisions. First, the life of the VC fund is limited, usually between 5 to 10 years (Unger et al., 2010). However, they usually include extension provisions of maximum 3 years with 1-year increments (Sahlman, 1990). Second, the LPs usually provide around 98-99% of the investment capital while the GPs typically invest around 1-2% of their own money into the fund in order to have their own “skin in the game” (Smith et al., 2011). It aligns the interests of the LPs and GPs and reduces moral hazard. Third, GPs are not allowed to receive better private investment terms than those received by the LPs (Jeng & Wells, 2000). Lastly, several additional conditions are: restriction on the transfer of LP units; withdrawal from the partnership before the termination date; and LPs are not allowed to participate in the active management of the fund (Sahlman, 1990). Compensation Mechanisms In return for managing the pool of money, the GPs receive an annual management fee of 2-3% per year (Smith et al., 2011). This fee is justified as the VC firm has to finance its operations and compensation is required for their advice and value adding activities. Second, at the closing of the VC fund, the GPs receive carried interest between 20-30%, usually only after a certain hurdle rate is achieved (usually 8%, Smith et al., 2011)). This way, they also share in the potential upside of the fund (Barry, 1994).

16

2.2.4

CHAPTER 2. LITERATURE REVIEW

The Venture Capital Investment Cycle

The VC investment cycle consists of four phases, namely, fund raising, selection and investment, monitoring, and exiting the investment. Figure 2.3 illustrates the VC investment process and its relation to fund maturity. Raising and Closing the Fund The VC investment cycle starts with raising the necessary capital from LPs. In order to do so, the GP has to specify what its intentions are with the raised capital. The GP will need to answer questions such as: What type of companies will the VC fund invest in?; How many investments will the VC fund make?; What investment stage will it target?; What is the desired size of the VC fund?; When can the investors expect their money back?; etc. Regarding these questions, VC fund sizes can come in all sizes; ranging from a several million EUR (e.g. Volta Ventures) to over several billion EUR (e.g. 3i, August Capital, etc.). A VC fund usually also specializes itself by e.g. solely focussing on early-stage (seed & startup) or laterstage venture; or a mixture of both. In addition, they prefer to invest geographic areas close to where they are situated. Regarding the industry focus, VCs usually specialize themselves in a specific field, often ones with a high growth potential; like software, fintech or biotechnology. VC funds do this in order to make informed investment decisions and maximize their value adding capabilities. Finally, a funds life is limited (5-10 years) in which the GPs are required to generate a return on the LPs investment. After the GPs have secured enough capital from investors, the fund is closed and the VC firm can start to identify interesting investment opportunities. Deal Sourcing, Due Diligence and Deal Negotiations After the closing of the fund, the GPs have to evaluate business plans, perform due diligence and decide on which opportunities to pursue. When a promising innovative young company has been identified; they have to negotiate on the value and structure the deal. These deals are structured in investment agreements which are called “Term Sheets” in VC jargon. This process usually takes somewhere between 2 and 3 years before the whole pool of capital has been committed.

2.2. VENTURE CAPITAL FINANCING

17

Figure 2.3: Venture Capital Investment Process, Source: Smith et al. (2011)

Value Creation and Monitoring The next phase of the process for the VC firm consists out of monitoring the investments and providing value adding services. Typically a VC becomes intimately involved at the board level in the company he or she invests in, acting as a consultant and coach of the CEO; providing expertise, setting up partnerships, support the development and production, making introductions to key contacts who can help the company to become successful. This phase usually takes around 4 to 5 years. In addition, during this phase, the investment is staged meaning that

18

CHAPTER 2. LITERATURE REVIEW

the venture only receives a new fraction of the capital needed after successfully completing intermediate objectives or “milestones” (Barry, 1994).

Exit Strategies The last phase of the investment cycle consist out of the harvesting the investment. The ultimate goal is to grow the company to a point where it can go public or be acquired by a larger corporation. Because the life of a VC fund is limited, during the later years the VC is mainly focused on exiting their investments. The two main exit routes are an acquisition by a larger firm for either cash or shares in the acquirer (trade sale), and an initial public offering (IPO) in which the company issues shares to the public (Unger et al, 2010). In general, only a minority of the portfolio companies will be successful enough to take public (Berger & Udell, 1998). In contrast to a trade sale, an IPO keeps the firm independent and allows entrepreneurs to remain in control of their company after the VCs exit (Schwienbacher, 2008b). Alternatively, if a portfolio company does not do well, it may be put back to its original owners or liquidated. Overall, the majority of a VC fund’s return comes from one or two investments which perform extraordinary well (Berger & Udell, 1998).

2.2.5

Venture Capital Contracting

The Principal Agent Theory One of the most well-know issues in the field of business finance is the famous Principal-Agent Theory by Jensen & Meckling (1976, JF). One of the main problems facing entrepreneurs and investors are the objectives of principals and agents may not be the same & the principal may not be able to observe/control the agents actions. In modern corporations, agency conflicts arise because financing and management are separated (Berle & Means, 1932). For example, between financiers (shareholders, creditors) & managers; and controlling shareholders & creditors. VC financing is an excellent example and in order to mitigate these problems, they use well designed investment contracts, also called “Term Sheets”.

2.3. PERFORMANCE OF VENTURE CAPITAL INVESTMENTS

19

Convertible Securities The most common form of VC investment is convertible preferred stock (De Vries & Van Loon, 2005). Preferred stock use allows for ex post flexibility in the (re)allocation of control rights and the right to decide on exit. Furthermore, it provides protection against the downside risk of investment by providing seniority rights over straight equity (Schwienbacher, 2008a). That is, preferred stock gives the VC a superior claim to the cash flow and distributions in liquidation in the event that the venture is unsuccessful. The conversion feature provides participation on the upside (Barry, 1994). The conversion price commonly is a function of performance, so that if a venture is unsuccessful, the VC stands a better chance of recovering the investment. At the same time, the increased conversion price following good performance increases the incentives to the EN (Barry, 1994).

2.3

Performance of Venture Capital Investments

Calculating financial returns of VC investments is essential in order to evaluate the performance of VC funds and their impact on the portfolio companies. However, academics and industry professionals have emphasized the limitations of reliable data available to make realistic conclusions from research. It is important to highlight these issues before proceeding with reviewing the academic and industry literature regarding returns.

2.3.1

Data and Methodological Issues

Below, an overview is given of the most relevant academic literature (in my opinion) regarding issues on VC performance data and research methodologies. Gross vs. Net Returns It is important to make a clear distinction between “net returns” and “gross returns”. Gross returns are the returns a VC fund receives after having successfully exited their investments. To compensate the GPs for their effort, time and own investments; the gross returns are redistributed between the LPs and GPs. The

20

CHAPTER 2. LITERATURE REVIEW

realised net returns refer to the returns that the LPs receive after subtracting the management fees and carried interests of the GPs as discussed earlier. The distinction is important because they lend themselves to answering different questions (Da Rin et al., 2011). Calculations of gross returns focus on the performance of the underlying companies, enabling comparisons across industries, geographies, investment stages and other company characteristics. Net Returns can be used to compare the performance of different VC firms and examine difference in expertise, organizations structures and different investment strategies.

Data Reliability and Availability Issues Within the VC industry, there are almost no obligation whatsoever to make financial statements or results publicly available, with the exceptions of publicly listed PE funds (e.g. Gimv) and fund-of-funds. In addition, most of this data is often highly sensitive. Therefore, it makes accessing reliable data regarding VC investments and returns a difficult task. Most of the research in academic literature is based on databases which are composed of LPs and GPs providing data voluntarily. From this lack in available and accessibly data, a second main data issue arises. At the moment, the reliability of available data is compromised as positive performances are more likely to be reported, also referred to as “reporting bias”. A study by Phalippou and Gottschalg (2009) found that funds who did not report their performance were overall five percentage points lower than their peers who did report. This performance bias affects all databases currently available (e.g. ThomsonOne, VentureXpert, Preqin, VentureSource, etc.). A third issue regarding the reliability of data is referred to as “survivorship bias”. Databases concerning VC investment rounds and their valuations are biased. A company has a greater incentive and more possibilities to raise funds when its valuation has increased. The return calculated on this data is therefore likely to be biased upwards relative to actual returns (Da Rin et al., 2011). Up to this date, most of the academic research regarding returns have been done at the fund level. However, research has also been done at level of the LP and even LP portfolios

2.3. PERFORMANCE OF VENTURE CAPITAL INVESTMENTS

21

(LPs invested in multiple VC funds).

2.3.2

Financial Returns of Venture Capital Investments

A Measure of Venture Capital Returns The most commonly used measure of a VC funds return is the Internal Rate of Return (IRR). It is used by most academics and VC professionals; therefore it will also be used in this thesis. The IRR is the discount rate which makes the Net Present Value (NPV) of cash flow stream equal to zero (equation 2.1). T X t=0

CFt =0 (1 + IRR)t

(2.1)

The IRR measure is practised the most, but there are several shortcomings. To summarise, (i) IRR assumes dividends can be reinvested at the same IRR, (ii) IRR overstates the variability of the true rate of return and (iii) the IRR of aggregated and disaggregated cash flows differ (Da Rin et al., 2001). The choice of performance measure may affect incentives for decisions regarding exits and the timing of investments. Other measures, but less-used, include the public market equivalent measure (Kaplan & Schoar, 2005) and/or the modified IRR measure (Philippou, 2008). A second popular measure of return is the Cash-on-Cash (CoC) multiple. CoC multiples compute how many times the invested capital has been multiplied when it is returned at the exit of the fund. CoC multiples do not take into account the investment duration and is favoured more by practitioners than academics (Da Rin, 2013). Overall Venture Capital Returns One of the most referenced academic works on the performance of VC funds is that of Kaplan and Schoar (2005). With a database of 577 VC funds raised between 1980 and 2001, they reported an average IRR of 17%. They also find a median return of 13%. There are two important things to note on these results, (i) the

22

CHAPTER 2. LITERATURE REVIEW

database used also suffers from the reporting bias as described before, and (ii) the returns are not corrected for risk. Other academic papers find similar results using the same methodology. Rhodes-Kropf (2004) find an average IRR of 19.3%. Ljungqvist and Richardson (2003) find an average IRR of 14.1% using data from VC funds betweem 1981 and 1993. However, Robinson and Sensoy (2011), who used data up to 2010, found an average IRR of 9% and a median of 2%. Also the EVCA, using data on 752 funds from from 1980 until 2013, reported lower longterm annualized returns (net IRR = 1.68%) compared to market benchmarks. In addition, they all find high standard deviations between the IRRs of individual VC funds ranging from 47% (Robinson & Sensoy, 2011) to 59% (Kaplan & Schoar, 2005).

Even considering the differences in findings across academics regarding the IRR of VC funds; overall there is a growing consensus between academics that the returns from the VC industry do not exceed market returns such as the commonly used benchmarks S&P 500 and NASDAQ (Cumming & Walz, 2010; Krohmer et al., 2009). In addition, these academics note that there is a large divergence between the best performing VC funds, the “average” VC funds and the worst-performing ones. The returns are also not normally distributed (skewed to the right) with a larger lower tail generating large negative returns. That being said, these returns have not even been corrected for risk and lack of liquidity.

An additional research topic of academics is if the returns generated by VC funds persist. In other words, are good performance results from VC fund managers based on ’luck’ or ’skill’ ?. Overall, Kaplan and Schoar (2005) find considerable persistence across VC funds. They find that good performing VC funds are more likely to also perform well in the future. In addition, they find that IRRs of VC funds are higher, the more a VC firm has managed funds. Also regarding, the size of the fund, they find a concave relationship with performance. On the other side, Phalippou (2010) and Lerner et al. (2009) find that poor performing fund are likely to perform bad again.

2.3. PERFORMANCE OF VENTURE CAPITAL INVESTMENTS

23

EU and US Venture Capital Returns The EVCA, recently renamed to Invest Europe, compared the returns on US en EU venture funds based on a five-year rolling IRR (EVCA, 2013). Using a sample on 752 VC funds from 1980 until 2013, they found US VC funds to have an average net IRR of 5.86% and European VC funds an average net IRR of 1.32% (see figure 2.4).

Figure 2.4: Five-year rolling IRRs for Europe and the US

24

CHAPTER 2. LITERATURE REVIEW

Chapter 3 Research Proposal 3.1

Background

VCs are usually more experienced in negotiating a term sheet compared to entrepreneurs (Feld & Mendelson, 2011). Of course VCs have to negotiate term sheets multiple times which gives them an advantage over the inexperienced entrepreneur. This can cause some inefficiencies in the negotiation process as some entrepreneurs tend to be too focused on giving up as few shares as possible. However, a VC term sheets contains a lot of other important items such as the liquidity preferences, certain control rights, etc. which are often given lower weights in negotiations by inexperienced entrepreneurs. In order to deal with this issue, Jurgen Ingels (GP of the PE fund SmartFin Capital and successful entrepreneur), came with an interesting approach which might be used in investment rounds. The proposal is futher explained below, together with the potential benefits and downsides.

3.2

The Proposal

The proposal can be summarised as follows; the GPs gives the entrepreneur a buy-back option during the investment round on the shares he is buying into a company. It enables the entrepreneur to buy-back a certain amount of the shares 25

26

CHAPTER 3. RESEARCH PROPOSAL

from the investor at a later stage. To be more specific, the buy-back option has an expiration date of e.g. 3 years with a required annual rate of return of e.g. 20%. The percentage of shares which can be bought back from the investor depends on the negotiations between the investor and the entrepreneur. For purpose’s sake, the benchmark will be set at 50% throughout the rest of this thesis. In order to exercise the option, the entrepreneur can raise capital at a later stage by selling his own shares to a new investor or through debt financing. With this “new” money, the option can be exercised. This method only works if the value of the company rises sufficiently, larger than the required annual rate of return; or the venture has to qualify for debt financing. The more the value of the company rises before the expiration date, the less shares the entrepreneur has to sell to a new investor in order to exercise the option. As the buy-back option also works as an anti-dilution mechanism for the entrepreneur, it can be assumed that this method provides an incentive for the managers of the company to grow as fast as possible, coinciding with the interest of the investing partners. For the investing partner, it also provides the opportunity to negotiate on a lower pre-money valuation in exchange for giving the buy-back option. To clarify, the pre-money valuation refers to the value of the company before the money of the VC is invested. In turn, the post-money valuation equals the pre-money valuation plus the invested capital. In addition, the proposal assumes that the entrepreneur is able to find a second investor willing to participate in a new funding round. Normally this will not be a problem because when the value of the venture grows more than the required rate of return, it spikes the interest of other investing parties (Ingels, 2016). The buy-back option can be seen as a complementary clause in the agreement made between the investing partner and the entrepreneur.

3.2.1

Proposal Example

Say we have a startup company valued at 1.000.000 EUR with 100,000 shares issued. This means the price per share is 10 EUR. The startup raises an additional 1,000,000 EUR from an investor who also receives 100,000 shares at 10 EUR per

3.2. THE PROPOSAL

27

share in a seed round. The total amount of shares issued is now 200,000 with the venture valued post-money at 2,000,000 EUR. Now both parties each own 50% of the shares. The entrepreneur also received a buy-back option on 50% of the shares the investor received at a required annual return of 20%. With this buy-back option, the entrepreneur has an extra incentive to grow as fast as possible because then it can buy a percentage of its own shares back.

Three years later, a second investment round (Series A) takes place with the venture now valued at 15,000,000 EUR. The entrepreneur is seeking to raise an additional 5,0000,000 EUR of capital and wants to exercise his buy-back option as the ventures value has increased significantly more than the required annual return. He first raises the capital with a total post-money valuation of 20,000,000 EUR and a total amount of shares adding up to 266,667. The entrepreneur and the first investor now each own 100,000 shares (37.5%), and the second investor 66,667 shares (25%).

Next, he wants to exercise the buy-back option. This means he has to pay 500,000 EUR plus the annual required return of 20%. With the option exercised after 3 years, the entrepreneur has to pay 864,000 EUR in order to buy-back the 50,000 shares (50% of 100,000 shares) of the first investor. If the entrepreneur and second investors use the same price per share of 75 EUR, the entrepreneur now needs to sell 11,250 of his shares in order to exercise the option. At the end, the entrepreneur now owns 138,480 (52%) shares, the first investor 50,000 (19%) shares and the second one 78,187 (29%). The second investor has paid a total of 5,864,000 EUR, partially in new shares (85.27%) and a part in existing shares (14,39%). Of course, there is an assumption that somebody wants to pay for the existing shares of the entrepreneur. Note that the entrepreneur could also buy-back the shares by using debt.

After three years, the first investor has already received 864,000 EUR back which she can re-invest, or return to the shareholders, and still has 19% of the ventures equity. In addition, the entrepreneur has gained an additional 14.5% in equity.

28

3.2.2

CHAPTER 3. RESEARCH PROPOSAL

Research Question & Methodology

In order to research the potential significance of Jurgen’s proposal, a top-down approach is used to make a comparison between the performance of a hypothetical VC funds with and without using the buy-back option. The research question that needs to be answered is that if using a buy-back option for the entrepreneur during a first investment round could improve the returns for the VC. In addition, the liquidity of the VC fund would also be improved as the investor would receive a share of its investments back faster. Also the potential benefits and downsides of the proposal are investigated. These are explained in more detail in section 3.3. In order to answer this research question, a financial model was be constructed based on the most commonly used VC funding mechanism, the limited partnership as explained in the previous chapter. The hypothetical VC funds, its performance and to be used assumptions, will be constructed based on a literature review and industry reports concerning e.g. the median net Pooled Internal Rate of Return (IRR), success rates of VC portfolio companies, average life of a VC funds, the investment horizons, amount invested per startup, etc. At the end, a sensitivity analysis will be made in order to analyse the impact of varying two control variables: (i) the buy-back percentage and (ii) the required annual rate of return in order to exercise the option.

3.3. RELEVANCE OF THE RESEARCH

3.3

29

Relevance of the Research

Academics and industry specialists have shown that VC plays a significant role in fostering economic growth (Berger & Udell 1998; Kortum & Lerner, 2000; Samilla & Sorensson, 2009; Frontier Economics, 2013; NVCA, 2016). Therefore, investigating the structure of VC investing by looking at an alternative funding mechanisms can provide valuable insights.

3.3.1

Potential Benefits of the Proposal

Potential Benefits for the Investor There are a couple of potential benefits which can be identified for the investor: • If the option is exercised, the investor will have received an annual return of 25% on the 50% of the total investment. For example, if the option is exercised in the first year, the investor already recovers 62,5% of its investment back. If the company keeps on growing sufficiently, the remaining 50% of the purchased shares is expected to still generate an adequate return when there is an exit. • A second benefit is the increased liquidity of the funds resources. Assuming the entrepreneur can exercise the buy-back option, the investor will receive its invested funds back faster, which in-turn can be re-invested in new ventures or for follow-on investments. This could be interesting in particular for government backed funding initiatives. • The use of a buy-back option for entrepreneurs can be used as extra bargaining power for the investor to negotiate a lower pre-money valuation. • The entrepreneur is expected to have an extra incentive to grow as fast as possible, potentially increasing the success rates, which in turn can create a higher IRR for the fund. • The investor is able to show results and build a track-record faster compared to another VC fund. This way, “good” and “bad” investors can be identified

30

CHAPTER 3. RESEARCH PROPOSAL early-on. Of course, this is a benefit for good investors and a downside for bad ones. • The buy-back option can be included at each investment round which allows for greater flexibility in negotiating the valuation of the venture in an investment round between the investor and the entrepreneur.

Potential Benefits for the Entrepreneur There are also some potential benefits for the entrepreneur: • The buy-back option works as an anti-dilution mechanism for the entrepreneur. The more the value of the venture increases, the less of his own shares he has to sell in order to exercise the option. • The option allows space for initially giving a larger percentage to the investor(s), increasing its potential for success as many entrepreneurs initially desire to keep a majority stake. Many startups do not succeed because they are under-capitalized and the entrepreneur wishes to stay the majority shareholder. Initial negotiations are often made in function of the shareholder percentage instead of the required means in order to succeed (Ingels, 2016). • The option can be used at every capital increase and provides enough flexibility in negotiations. The expiration date, shareholding- and price increase percentage can all be negotiated. • It can be assumed that the entrepreneur will be working towards exercising the option, meaning that the value of the company needs to increase enough. If he cannot find a second investor, it can be a sign that a subsequent financing round might not be desirable. Potential Benefits for the Economy Finally, there are also potential benefits for the economy in general:

3.3. RELEVANCE OF THE RESEARCH

31

• Critics of the VC model have argued that the model might be broken (Kedrosky, 2009; AWT, 2011). Returns of VC investments have been disappointing over the long-term, especially with regards to the high risks being taken (EVCA, 2016). Given the impact that VC has on innovation and economic growth, an improved VC model could generate higher returns and thus positively influence the amount of commitments towards VC funds and consequently startups.

3.3.2

Potential Downsides of the Proposal

Though there are several potential benefits, there are also some downsides to the proposal. Potential Downsides for the Investor • A large part of the returns a VC fund makes usually comes from one or two out of ten investments (W. Bygrave & A. Zacharakis, 2014). Providing a buy-back option to the entrepreneurs of these investments, who will be the only ones with the potential to exercise the option, can cap the upside of these returns for the investor. • Some investors do not like too complex investment deals, like including a buyback option, which might be problematic for the first investor in subsequent investment rounds. Potential Downsides for the Entrepreneur • Receiving a call option is not bad in itself, however if the entrepreneur can not exercise the option before the option’s expiration date, it is worthless to him. And when he has initially accepted a lower pre-money valuation than he otherwise would have accepted; the VC now holds more shares than he otherwise would have had. This is an obvious downside for the entrepreneur. • The second potential downside for the first investor also holds for the entrepreneur regarding the complexity of investment deals, which are not favoured by a lot of investors.

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CHAPTER 3. RESEARCH PROPOSAL

Chapter 4 Research Methodology 4.1

Introduction

The set-up of this chapter is mainly focused on how a financial model was built in order to be able to answer the main research question: “Would the expected performance of a VC fund improve, if it would include a buy-back option for the entrepreneur during investment rounds?”. By making a financial model, it is possible to simulate a VC fund and represent the proposal, as in the previous chapter, and test variations of the inputs to see how they will impact the results. In other words, under which conditions is the buy-back option interesting to use, if at all; and under which conditions it might not be. In addition, by building a model, the fixed and variable assumptions can be continuously updated if more accurate and reliable data becomes available from the VC industry or academic research. This dissertation distinguishes itself from a typical one, which often uses a regression analysis to look for correlations between different variables to test a hypothesis. Here, a top-down approach is used to make a model of a “hypothetical” VC fund and its investments to look at the expected differences in performance. All the used assumptions, the variables, and used data will be documented. The aim of the model is to serve as an interactive tool, suited for investors, where the assumptions and inputs can be changed to be able to perform a sensitivity analysis. It can also be used as a presentation tool, and/or directly produces content for 33

34

CHAPTER 4. RESEARCH METHODOLOGY

presentations. This chapter is structured in a way so that it easy for the reader to understand how the model was built, and thus how the outputs were generated and the research question answered.

4.2

Research Design

In order to build a financial model, one first has to determine the model’s purpose. In this case, the purpose of the model is to look if using a buy-back option for entrepreneurs could potentially improve the performance of a VC fund. Knowing the model’s purpose, one has to define “the outputs” which we want to get out of the model. To specify, the desired outputs of our model are the expected exit values and returns of the “hypothetical” VC fund, with its specifications entered by the user; with and without using the buy-back option. These outputs will enable us to analyse the differences in expected returns given certain sets of assumptions. In order to calculate these expected returns, “the engine” will have to do the necessary computations using fixed- and user-entered assumptions and other variables; or in other words, “the inputs” of the model. To be able to do these computations, the latest version of Microsoft Excel was used. For an overview of what the engine looks like, see figures C.1 and C.2 in the Appendix. In the next section, all the variables and assumptions for the inputs and equations which were used to compute the expected returns will be elucidated, including references to academic research and industry reports. The financial model was made in such a way that the user can interact with it. In other words, a user-interface was made wherein the inputs can be changed to see an immediate change in the outputs. To get a clear overview of the basic physical layout, a representation of the high-level structure can be found in figure 4.1. The actual user-interface of the financial model can be found in the Appendix (see figure D.5)

4.3. BUILDING A FINANCIAL MODEL

35

Figure 4.1: High-level Structure of the Financial Model

4.3

Building a Financial Model

In order to clearly see what we need as inputs for our model, it is essential to first clearly define what we want as our outputs. Only this way a clear structure can be derived. A more detailed explanation will be given on each variable.

4.3.1

The Outputs

The main question a VC investor will ask himself is if the expected return of including a buy-back option in a VC term sheet will be higher than when not using it in investment rounds. Therefore, the output measures of this model will be the expected returns of investing with and without the buy-back option, keeping all else equal, though allowing different assumption sets to be used. Of course, there are different ways in which one can measure returns. The two most popular measures of returns in VC are the Internal Rate of Return (IRR) and the Cashon-Cash (CoC) multiple (Da Rin et al., 2011). To be able to calculate these, one needs to know the exit value of the investments. Below, an overview and brief

36

CHAPTER 4. RESEARCH METHODOLOGY

explanation is given on the model’s outputs and return measures. Note that each measure of return will be given for an investment with and without using the buy-back option. 1. The Internal Rate of Return The first crucial formula to understand is the one of the Internal Rate of Return (IRR). The IRR is the standard measure used by practitioners and industry associations, and is also commonly used in academic studies (Da Rin, 2013). It is defined as the discount rate which makes the Net Present Value (NPV) of a stream of cash flows equal to zero.

NP V =

T X t=0

CFt =0 (1 + IRR)t

(4.1)

2. The Cash-on-Cash Multiple A second way to measure a fund’s return is the cash-on-cash multiple. Cashon-cash (CoC) multiples compute how many times the invested capital has been multiplied when it is returned at the exit of the fund. CoC does not take into account the investment duration and is favoured more by practitioners than academics (Da Rin, 2013). CoC =

V alueExit Investment

(4.2)

3. The Expected Exit Value To calculate the IRR and CoC multiple, one needs the final (expected) exit value of the investments. This value is a function of the underlying performance of the investments made, which in turn depend on a series of assumptions and variables (the “inputs”) which will be further explained later. Using this output, it will be easier to visualise the differences in the expected exit values with and without the buy-back option. V alueExit = f (Assumptions, V ariables)

(4.3)

4.3. BUILDING A FINANCIAL MODEL

37

Gross vs. Net Returns The output of the model will both show expected “gross returns” and “net returns”. It is important to make a clear distinction between the two. Gross returns refer to the returns earned by a VC fund from investing in portfolio companies. It measures the entire return generated by the VC investments. Net returns are the returns received by the LPs after the GPs have been compensated. These compensations usually exist out of management fees and carried interest.

4.3.2

The Inputs

In order to understand the inputs of the model, we need to frame it in the VC fund context. In Chapter 2, a model was given of what a VC fund looks like (see figure 2.2). A modified version of this figure (see figure 4.2) was made in order to understand what the objective is of the model. The inputs can be distinguished into three different segments, namely (i) the fixed assumptions, (ii) the user-entered assumptions and (iii) the VC fund’s & option’s variables. A description is given below. 4.3.3.1 The Fixed Assumptions The expected returns of a VC fund are largely determined by the assumptions the model is based upon. Using academic literature and industry reports; an attempt was made to create as much as a realistic scenario as possible. These include the returns generated from each investment (class) the VC fund has made. Bygrave and Zacharakis (2014) made a distinction into four different classes which we also use. 1. VC Investments Classes First of all, assumptions have to be made regarding the expected success rates of the investments made by these VC funds. The investments made by the VC are segmented into four different classes. These classes are: Homeruns, Walking Wounded, Living Dead and Write-Offs. The general common rule of thumb for VC funds is that out of 10 startups, two are big successes that produce excellent financial returns. These are referred to as the

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CHAPTER 4. RESEARCH METHODOLOGY

Figure 4.2: Overview of the VC model “Homeruns”. Two investments are failures in which the total investment has to be written off. These are called the “Write-Offs”. Three investments are “Walking Wounded”, which produce a small return. And finally, three investments are “living dead”, meaning that they may be viable companies but have no prospect of growing big enough to produce a satisfactory return on the venture capital invested in them. In table 4.1, an overview is given of the investment classes en their respective weight in the model. These values are set as the benchmark on which later small adjustments can be made by the user by putting in other assumptions. However, these are relative to the base assumptions made here.

4.3. BUILDING A FINANCIAL MODEL

39

Table 4.1: Fixed Assumption - Benchmark Investment Classes Weights

2. VC Investment Class Returns A second very important assumption that needs to be made is the magnitude of the expected performance of each investment class. The “Write-offs” obviously do not generate any returns so the IRR is not applicable. The “Living Dead” are assumed to just recover their initial investments at an IRR of 0%. The “Walking Wounded” will perform not to the standards a VC is expecting, however they will still generate a decent return at an IRR of 5%. Finally, the “Homeruns” are the ones who are mainly responsible for the vast majority of a VC fund’s returns. Therefore, the IRR of this investment class is set at 20%. Table 4.2: Fixed Assumption - Benchmark Investment Class Returns

3. VC Fund Returns The combination of the investment classes and their returns eventually also provide an assumption on the overall gross return of the “hypothetical” VC fund. With these combination, an IRR of 7.32% for the whole fund is achieved. This assumption seems reasonable as it lies in between results of the latest academic research on VC returns (Kaplan & Schoar, 2005; Robinson & Sensoy, 2011) and the industry reports (EVCA, 2013; NVCA, 2017). The value also lies slightly higher than the average long-term market return of 7%. This can be justified because VC investing entails higher risks which should result in a higher average return according to traditional finance theory.

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CHAPTER 4. RESEARCH METHODOLOGY

4. VC Fund Investment Process & Lifetime A big simplification is made regarding the investment process of the VC fund. First, all the investments are made after two years the fund was closed. Second, the lifetime of the fund is limited to 10 years after which all the investments have made an exit or are written-off. This also means that the VC will be active in each investment for about 8 years. These assumptions were made based on the investment process of VC provided by Smith et al. (2011), depicted in the literature review (see figure 2.3). 5. Buy-Back Option Expiration/Exercise Date The buy-back option could have a flexible expiration date if their is a mutual agreement on the number of years in which the option can be exercised. The option could expire after a year or even after eight years. However, in the research proposal, the assumption was made to look at an option with an expiration date of three years, which would be exercised at the day of expiration by the best performing investment class. 6. Other Fixed Assumptions There are several other fixed assumptions. First, if the scenarios in which the buy-back option is exercised, it is assumed that the entrepreneur was able to find the required capital. Second, it is also assumed that the total fund size is spread evenly across the number of investments made. Third, if the required rate of return on the buy-back option is lower than the actual annual return of the investment classes, the option is exercised. Fourth and last, it is assumed that the amount returned to the investor after the option has been exercised can be reinvested at the same fund’s IRR. 4.3.3.2 The User-Entered Assumptions The user will be able to change some of the assumptions regarding the weights and returns of each investment class respectively. 1. Investment Class Weights - Assumption Sets Because the buy-back option provides an extra incentive to the entrepreneur to grow the company as fast as possible, the assumption is made that the weights of the more successful investment classes can be increased and those of the bad performing ones decreased. An overview of these assumption sets can be found in table 4.3. The magnitudes

4.3. BUILDING A FINANCIAL MODEL

41

of these improvements can be changed by the user if desired within the worksheet “Assumption Sets” of the Financial Model. Table 4.3: Investment Class Weights - Assumption Sets

2. Investment Class Returns - Assumption Sets It can also be assumed that the IRR of the investment classes would improve because the investor would have more bargaining power to negotiate a lower pre-money valuation. In addition, the extra incentive as said before could also have this positive effect. An overview of the assumption sets with improved returns can be found in table 4.4. The user is free to play around with these return assumptions and can be updated in the future. Table 4.4: Assumption Sets - Investment Class Returns

4.3.3.3 The Input Variables The input variables of the model are segmented into 6 different categories: (i) the VC fund’s characteristics, (ii) the VC fund’s compensation structure, (iii) the characteristics of the buy-back option, (iv) the investment return characteristics, (v) the investment class characteristics and finally (vi) the assumption sets. A further description is given below for each category. 1. The VC Fund’s Characteristics The first thing the user will need to do is to fill in the characteristics of the VC fund. These are the variables regarding the size of the fund, the number of investments, investment focus, etc. These

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CHAPTER 4. RESEARCH METHODOLOGY

variables are chosen as they are taken from the most recent EVCA report on the performance of the PE industry. The same ranges are used as the ones in that report (EVCA, 2013). An overview of these variables and value ranges can be found below in table 4.5. These variables will have no impact on the returns of the VC fund, however results from academic research could be implemented in the future to make the model more realistic. As academic research and industry reports have shown that there are significant differences in the performance of e.g. European and U.S. VC Funds or Early and Later stage VC funds (EVCA, 2013). Table 4.5: VC Fund Characteristics - Input Variables

2. The Fund’s Compensation Structure The second part of the inputs exists out of the compensation structure of the VC fund. These are required in order to be able to compute the expected net returns. The value ranges for these variables are taken from the textbook from Smith et al. (2011) wherein the compensation structure of VC funds is elucidated. These variables include the management fees charged by the GPs, the division of the funds shareholder percentages, the carried interest and the hurdle rate. The hurlde rate is the return percentage that needs to be achieved before the GPs receive any carried interest.

4.3. BUILDING A FINANCIAL MODEL

43

Table 4.6: VC Fund Compensation Structure - Input Variables

3. Buy-Back Option Characteristics The characteristics of the buy-back option are probably the most important ones for the financial model. The period of the option is fixed (3 years) and it is assumed that the entrepreneur will exercise it at the end of its expiration date, only when the value of that investment has grown more than the required return on the buy-back percentage. The user will also be able to change the required return on the buy-back option as the buy-back percentage of the investor’s shares. Table 4.7: Buy-Back Option Characteristics - Input Variables

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CHAPTER 4. RESEARCH METHODOLOGY

Chapter 5 Results and Discussion The results of the financial model provided in this chapter are largely based on the buy-back option characteristics as provided in the research proposal (Ingels, 2016). These results illustrate the main goal of this thesis; providing an answer to the research question. A distinction is made between three different scenarios wherein their outcomes are elucidated. The scenarios can be further segmented into two categories, (i) assuming that the buy-back option is exercised and (ii) assuming that the buy-back option will not be exercised. These scenario’s illustrate the most important outcomes in order to make conclusions. The financial model can produce over six thousand different output tables, however to be able to answer the research question only three are required. The build-up of this chapter is structured in a logical way. First, a description is given of each scenario. Next, before the outputs of the model are given, an overview and brief explanation of the model’s inputs is given. At the end of each scenario, discussion of the results is given.

5.1 5.1.1

Scenario 1 Description of the Scenario

In the first scenario, the investor (VC fund) will have given a buy-back option to the entrepreneur during the first investment round. As a VC fund usually makes the majority of its returns out of one or two extraordinary performances, it is 45

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CHAPTER 5. RESULTS AND DISCUSSION

assumed that only these best-performing investments will be able to find the resources to exercise the option at the end of the option’s duration (3 years). These investments are overall, as a general “rule of thumb”, 20% of the investments a VC fund makes. This assumption was set as a benchmark (W. Bygrave & A. Zacharakis, 2014). Three years after the initial investment was made, the option is exercised, and the VC received 50% of the investment back including a nice return, and he keeps what remains of his shares. Normally, providing a buy-back option would provide an extra incentive for the entrepreneur to grow the business as fast as possible which could have a positive influence on the success rates of these investments and their IRR. In addition, a lower pre-money valuation could be negotiated by the investor which would also have a positive impact on the IRR of these investments, assuming that the eventual exit outcomes would be the same. However, in this first scenario we assume that their is no change in the underlying performance of the investments. This way, the differences in expected performances can be analysed while keeping all else equal.

5.1.2

The Inputs

The inputs of the financial model are divided into three parts. The first part (see table 5.1) contains the VC fund’s characteristics, the fund’s compensation structure and the characteristics of the buy-back option. The second part (see table 5.2) includes the assumptions on the underlying performance of the investment classes, in other words the expected IRR of those investments. The last part (see table 5.3), contains the assumed weights of the investment classes which also have an impact on the expected exit value. It is important to point out that when the required rate of return on the percentage of the buy-back option is lower than the yearly return of the best performing investment classes (the “Homeruns”), the option will be exercised. In this scenario, this is the case. The same methodology is used for the next two scenarios. If an input and/or output has changed, this is indicated in bold to clearly indicate the differences between the scenarios.

5.1. SCENARIO 1

47

Table 5.1: VC Fund Inputs, Part 1 - Scenario 1 VC Fund Characteristics VC Fund Size Vintage Year Industry Focus Stage Focus Geographic Focus Number of Investments Life Time VC Fund Investment Horizon Years before 1st Investment

50 Million EUR 2014 Fintech Seed/Early Europe 10 10 Years 8 Years 2 Years

VC Compensation Structure LP Shareholder % GP Shareholder % Annual Management Fee Carried Interest Hurdle Rate

98% 2% 2% 20% 8%

Buy-Back Option Characteristics Buy-Back Percentage Buy-Back Option Duration Buy-Back Required Return

Table 5.2: VC Fund Inputs, Part 2 - Scenario 1 VC Investment Return Characteristics w/o buy-back option with buy-back option Assumption Set Benchmark Benchmark IRR Homeruns 20% 20% IRR WalkingWounded 5% 5% IRR Living Dead 0% 0% IRR Write-Offs N/A N/A

Table 5.3: VC Fund Inputs, Part 3 - Scenario 1 VC Fund Class % w/o buy-back option with buy-back option Assumption Set Benchmark Benchmark % Homeruns 20% 20% % WalkingWounded 30% 30% % Living Dead 30% 30% % Write-Offs 20% 20%

50% 3 Years 20%

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CHAPTER 5. RESULTS AND DISCUSSION

5.1.3

The Outputs

The outputs of the model are also given in three parts. The first part (see table 5.4 and fig 5.1) consists out of the expected exit values and returns (gross & net) of the VC fund. As a reminder, the gross returns refer to the fund as a whole while the net returns refer to the amount received by the LPs. Table 5.4: VC Fund Gross and Net Returns, Outputs Part 1 - Scenario 1 VC Fund Returns

Gross Exit Value Gross IRR Gross CoC multiple

w/o buy-back option with buy-back option 101.35 Million EUR 82.69 Million EUR 7.32% 5.16% 2.03 1.65

Net Exit Value 89.32 Million EUR Net IRR 6.19% Net CoC multiple 1.82 Carried Interest to GP 0 Million EUR Management Fee to GP 10 Million EUR

71.04 Million EUR 3.78% 1.45 0 Million EUR 10 Million EUR

The second part of the outputs contains the liquidity details of the VC fund (see table 5.5). Because of the buy-back option, it is expected that the investor will receive some of its invested money back earlier, which it can reinvest or return to the LPs. In this financial model, it is assumed that the amount returned is reinvested at the IRR of the VC fund without using the buy-back option which is 7.32%. Table 5.5: Liquidity VC Fund Gross, Outputs Part 2 - Scenario 1 Liquidity VC Fund

Total Amount Invested Amount Returned after 3 Years Amount Returned after 8 Years

w/o buy-back option with buy-back option 50 Million EUR 50 Million EUR 0 Million EUR 8.64 Million EUR 101.35 Million EUR 82.69 Million EUR

The third part of the outputs contains an overview of some other important mea-

5.1. SCENARIO 1

49

Figure 5.1: Gross Expected Value of the VC Fund over the Fund’s Lifetime Scenario 1

sures which are needed to be able to clearly interpret the results. These are the assumption sets used, the characteristics of the buy-back option and a clear answer on if the option was exercised or not.

Table 5.6: Other VC Fund Outputs, Outputs Part 1 - Scenario 1 Other Outputs w/o buy-back option with buy-back option VC Investment Return Char. Benchmark Benchmark VC Fund Class % Benchmark Benchmark Buy-Back Option Percentage N/A 50% Buy-Back Option Duration N/A 3 Years Buy-Back Required Return N/A 20% Homeruns: Option Exercised? N/A Yes

50

5.1.4

CHAPTER 5. RESULTS AND DISCUSSION

Discussion of Results - Scenario 1

From the results of the first scenario, one can conclude that providing a buy-back option to the entrepreneur has a negative impact on the returns of the VC fund, assuming that there is no change in the underlying performance of the investments and that the option can be exercised. Working with a VC fund of 50 million EUR with a gross IRR of 7.32%, the expected exit value would be 101.35 million EUR (excluding the option) compared to 82.69 million EUR (buy-back option included). The buy-back option has capped the returns on the best performing investments which is of course not desirable. This potential downside of the proposal has been mentioned during one of the interviews with a Belgian VC fund, specialized in life sciences. This scenario confirms the potential concerns of that VC. In addition, the hurdle rate of 8% has not been reached in this scenario for both cases, meaning that the GPs would not receive any carried interest. However, the benefits of using the buy-back option in this scenario would be that the investor would have received a share of its investments back faster, improving the liquidity of the fund. More specific, in the case of a fund of 50 million EUR, the investor would have received 8.64 million EUR back after 3 years on an investment of 10 miilion EUR and still have 50% of its original share percentage. Though this can be seen as a benefit, according to another interview with a different VC investor, most LPs are less concerned about the illiquidity of a VC fund, but more about the final returns. Then again, it might be an interesting way for LPs to quickly identify good GPs. When more investments are able to exercise the buyback option, it can also show the capability of the GP’s value adding capabilities.

5.2. SCENARIO 2

5.2 5.2.1

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Scenario 2 Scenario Description

In the second scenario, the VC fund will also have given a buy-back option to the entrepreneur during the first investment round. However, this time the assumption is made that the underlying performance of the investments will improve. More specific, because of the extra incentive of the buy-back option to grow faster, the assumption is made that there will be more successful companies within the portfolio of the VC fund. In addition, the buy-back option allows the investor to negotiate for a lower pre-money valuation which in turn could have a positive effect on the IRR of these investments. It is also important to note that it is still assumed that the entrepreneur would be able to find the resources to exercise the option.

5.2.2

Inputs

Compared to the first scenario, only the investment return characteristics and class percentages change. These changes are indicated in bold in tables 5.8 and 5.9. Table 5.7: VC Fund Inputs, Part 1 - Scenario 2 VC Fund Characteristics VC Fund Size Vintage Year Industry Focus Stage Focus Geographic Focus Number of Investments Life Time VC Fund Investment Horizon Years before 1st Investment

50 Million EUR 2014 Fintech Seed/Early Europe 10 10 Years 8 Years 2 Years

VC Compensation Structure LP Shareholder % GP Shareholder % Annual Management Fee Carried Interest Hurdle Rate

98% 2% 2% 20% 8%

Buy-Back Option Characteristics Buy-Back Percentage Buy-Back Option Duration Buy-Back Required Return

50% 3 Years 20%

52

CHAPTER 5. RESULTS AND DISCUSSION Table 5.8: VC Fund Inputs, Part 2 - Scenario 2 VC Investment Return Characteristics w/o buy-back option with buy-back option Assumption Set Benchmark InvRet ++ IRR Homeruns 20% 25% IRR WalkingWounded 5% 7.5% IRR Living Dead 0% 0% IRR Write-Offs N/A N/A Table 5.9: VC Fund Inputs, Part 3 - Scenario 2 VC Fund Class %

Assumption Set % Homeruns % WalkingWounded % Living Dead % Write-Offs

5.2.3

w/o buy-back option with buy-back option Benchmark InvCla ++ 20% 25% 30% 35% 30% 25% 20% 15%

Outputs

The outputs of the second scenario can be found in tables 5.10, 5.11 and 5.12. An overview of the expected value of the VC fund over the fund’s lifetime can be found in figure 5.2.

5.2.4

Discussion of Results - Scenario 2

In the second scenario, the improved performance of the investments has a significant positive effect on the returns of the VC fund. The expected exit value with the buy-back option is now 122,15 million EUR compared to 101.35 million EUR when not using the buy-back option. In addition, the investor would have already received 10.80 million EUR back after 3 years. Of course, the magnitude of these effects are based on the assumptions about the performance of the investments. There might be some concerns that these assumptions are not realistic. However, this scenario was created to illustrate the potential positive effect the buy-back

5.2. SCENARIO 2

53

Figure 5.2: Gross Expected Value of the VC Fund over the Fund’s Lifetime Scenario 2

Table 5.10: VC Fund Gross and Net Returns, Outputs Part 1 - Scenario 2 VC Fund Returns

Gross Exit Value Gross IRR Gross CoC multiple

w/o buy-back option with buy-back option 101.35 Million EUR 122.15 Million EUR 7.32% 9.34% 2.03 2.44

Net Exit Value 89.32 Million EUR Net IRR 6.19% Net CoC multiple 1.82 Carried Interest to GP 0 Million EUR Management Fee to GP 10 Million EUR

95.57 Million EUR 6.91% 1.95 14.14 Million EUR 10 Million EUR

54

CHAPTER 5. RESULTS AND DISCUSSION Table 5.11: Liquidity VC Fund Gross, Outputs Part 2 - Scenario 2 Liquidity VC Fund

Total Amount Invested Amount Returned after 3 Years Amount Returned after 8 Years

w/o buy-back option with buy-back option 50 Million EUR 50 Million EUR 0 Million EUR 10.80 Million EUR 101.35 Million EUR 122.15 Million EUR

Table 5.12: Other VC Fund Outputs, Outputs Part 3 - Scenario 2 Other Outputs w/o buy-back option with buy-back option VC Investment Return Char. Benchmark InvRet++ VC Fund Class % Benchmark InvCla++ Buy-Back Option Percentage N/A 50% Buy-Back Option Duration N/A 3 Years Buy-Back Required Return N/A 20% Homeruns: Option Exercised? N/A Yes option might have on the performance of the investments. The magnitude of these potential improvements on the investment’s performance is of course hard to predict. A more realistic scenario in which the performance would improve a little bit, the buy-back option would still be not advisable to use as an investor. The IRR of the “Homeruns” and the “Walking Wounded” would both need to increase significantly to even-out the capping effect of the buy-back option.

5.3. SCENARIO 3

5.3 5.3.1

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Scenario 3 Scenario Description

The third scenario is quite similar to the second one, however the assumption now is that the entrepreneur does not exercise the buy-back option. Either he does not find the resources or was not able to do so in time. Still, the positive effects on the performance of the investments are assumed. The changed inputs and outputs are again highlighted in bold.

5.3.2

Inputs

In this scenario, the required return on the buy-back option is set high enough at 50% so that it is assumed that even the “Homeruns” will not be able to exercise the buy-back option. This allows to look for the potential effect of the extra incentive to grow as fast as possible (higher success rates) and negotiating a lower pre-money valuation (improved IRR) without the capping effect on the exit value of the option being exercised. Table 5.13: VC Fund Inputs, Part 1 - Scenario 3 VC Fund Characteristics VC Fund Size Vintage Year Industry Focus Stage Focus Geographic Focus Number of Investments Life Time VC Fund Investment Horizon Years before 1st Investment

50 Million EUR 2014 Fintech Seed/Early Europe 10 10 Years 8 Years 2 Years

VC Compensation Structure LP Shareholder % GP Shareholder % Annual Management Fee Carried Interest Hurdle Rate

98% 2% 2% 20% 8%

Buy-Back Option Characteristics Buy-Back Percentage Buy-Back Option Duration Buy-Back Required Return

50% 3 Years 50%

56

CHAPTER 5. RESULTS AND DISCUSSION Table 5.14: VC Fund Inputs, Part 2 - Scenario 3 VC Investment Return Characteristics w/o buy-back option with buy-back option Assumption Set Benchmark InvRet ++ IRR Homeruns 20% 25% IRR WalkingWounded 5% 7.5% IRR Living Dead 0% 0% IRR Write-Offs N/A N/A Table 5.15: VC Fund Inputs, Part 3 - Scenario 3 VC Fund Class % w/o buy-back option with buy-back option Assumption Set Benchmark InvCla ++ % Homeruns 20% 25% % WalkingWounded 30% 35% % Living Dead 30% 25% % Write-Offs 20% 15%

5.3.3

Outputs

The outputs of the third scenario are given in tables 5.16, 5.17 and 5.18. An overview of the expected exit value in relation to the fund’s lifetime is given in figure 5.3.

5.3.4

Discussion of Results - Scenario 3

From the results of the third scenario, providing a buy-back option to the entrepreneur is interesting when the underlying performance of the investments improve and if the option is not exercised at all. The model shows a significant increase in the expected exit value, which of course is based on the assumptions of the improved performance of the investments (164.98 vs. 101.35 million EUR). The magnitude of this performance improvement is probably not that realistic, however it illustrates the positive effect that the buy-back option might have.

5.3. SCENARIO 3

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Table 5.16: VC Fund Gross and Net Returns, Outputs Part 1 - Scenario 3 VC Fund Returns

Gross Exit Value Gross IRR Gross CoC multiple

w/o buy-back option with buy-back option 101.35 Million EUR 164.98 Million EUR 7.32% 12.68% 2.03 3.30

Net Exit Value 89.32 Million EUR Net IRR 6.19% Net CoC multiple 1.82 Carried Interest to GP 0 Million EUR Management Fee to GP 10 Million EUR

129.15 Million EUR 10.18% 2.64 22.56 Million EUR 10 Million EUR

Figure 5.3: Gross Expected Value of the VC Fund over the Fund’s Lifetime Scenario 3

58

CHAPTER 5. RESULTS AND DISCUSSION Table 5.17: Liquidity VC Fund Gross, Outputs Part 2 - Scenario 3 Liquidity VC Fund

Total Amount Invested Amount Returned after 3 Years Amount Returned after 8 Years

w/o buy-back option with buy-back option 50 Million EUR 50 Million EUR 0 Million EUR 0 EUR 101.35 Million EUR 164.98 Million EUR

Table 5.18: Other VC Fund Outputs, Outputs Part 3 - Scenario 3 Other Outputs w/o buy-back option with buy-back option VC Investment Return Char. Benchmark InvRet ++ VC Fund Class % Benchmark InvCla ++ Buy-Back Option Percentage N/A 50% Buy-Back Option Duration N/A 3 Years Buy-Back Required Return N/A 50% Homeruns: Option Exercised? N/A No

5.4

Sensitivity Analysis

Next to looking at the three distinct scenarios, it is also interesting to look at the effect on the expected performance if the buy-back option parameters are changed. A sensitivity analysis was made by changing (i) the required rate of return to exercise the buy-back option and (ii) the percentage of shares which can be bought back. An overview of this analysis can be found in figure 5.4. Some conclusions can be made from changing these variables. First, it seems beneficial for the investor to provide a buy-back option to the entrepreneur in order to have an extra incentive for the entrepreneur to grow the company and allowing for a lower negotiated pre-money valuation (positive impact on IRR). On the other hand, is would be in the best interest of the investor that the entrepreneur does not exercise the buy-back option. As a result, it would be best for the VC to give a buy-back option to the entrepreneur but with a required rate of return that is just too high so that it is unlikely that it will be exercised. This translates

5.4. SENSITIVITY ANALYSIS

59

into an optimal solution in our model of a required rate of return of 35% and a buy-back percentage of 50%. This solution would provide the largest incentive for the entrepreneur, though it is very unlikely that he would be able to exercise the option. It also allows a higher bargaining power for the investor to negotiate a low pre-money valuation. An alternative could be to give the entrepreneur a buy-back option but only on a very limited amount of the investor’s shares (e.g. 10%). This limits the risk of the best investments capping the upside potential of the returns. In other words, if the option would be exercised, the best solution would be a buy-back percentage of 10% at a required rate of return of 30%. However, it seems unlikely that an entrepreneur would have a large incentive to only be able to buy-back a very small amount of shares at a high cost.

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Figure 5.4: Sensitivity Analysis

Chapter 6 Conclusions & Recommendations 6.1

Conclusion

From the results, conclusions can be made from two perspectives, that of the investor and that of the entrepreneur.

6.1.1

The Investor’s Perspective

From the results, it seems that the a buy-back option can be an interesting clause to use, given that a certain set of conditions are met. Providing a buy-back option would allow the investor to negotiate a lower pre-money valuation which would have a positive effect on the IRR of the VC fund, provided that the exit values of the investments would be the same. In addition, it would be expected that the investments have an extra incentive to grow as fast as possible, likely increasing the success rates of the portfolio companies. In turn, this has also a positive effect on the expected exit value, and thus the return of the VC fund. However, if the 10-20% very successful portfolio companies, the “Homeruns” (W. Bygrave & A. Zacharakis, 2014), would actually exercise the option; it would cap the upside of the VC fund’s best investments. This would have a large negative effect on the VC fund’s return, as most of their returns are made on these few investments, which is of course not desirable. The overall conclusion for the VC investor is that providing the buy-back option is interesting, assuming the extra growth incentives and negotiating a lower pre-money valuation; but only when the best-performing 61

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CHAPTER 6. CONCLUSIONS & RECOMMENDATIONS

companies would not be able to exercise the option. Limiting the expiration date of the option in which it can be exercised, or increasing the required rate of return, can be therefore interesting. It would decrease the likelihood of the option being exercised.

6.1.2

The Entrepreneur’s Perspective

From the perspective of the entrepreneur, receiving a buy-back option on a percentage of the shares the investor is buying seems like a good deal. However, it allows for the investor to have more bargaining power in negotiating a lower premoney valuation of the company and possibly giving up more shares than initially desired. In addition, the entrepreneur would have to be able to find the resources to exercise the option, even if it is successful enough. It seems unlikely that other investors would buy existing shares of a young company so that the entrepreneur could exercise the buy-back option. The money would not increase the value of the company as it is used to buy existing shares. Investors would most likely want to see their invested capital put to use in order to grow the business, hence adding value. However, assuming that the few successful companies which actually perform very well would be able to exercise the option, it would be interesting as it works as an anti-dilution mechanism for the entrepreneur. The overall conclusion for the entrepreneur would be that the buy-back option is not interesting as it would be unlikely to be able to exercise the option as provided in the research proposal. For the few 10-20% successful companies it would be interesting, only if they are able to exercise the option.

6.2

Limitations of the Study

Several limitations of this study should be addressed. The first limitation is the reliability of the assumptions the model is based upon. In turn, most of the assumptions are based upon academic research and industry reports. In addition, several assumptions were made to simplify the model, inherent to be able to use a top-down approach. A main concern in VC research is the survivorship and reporting bias in databases (W. Bygrave & A. Zacharakis, 2014). Many academic

6.3. SUGGESTIONS FOR FURTHER RESEARCH

63

researchers use IPO’s as an indicator to base their conclusions on. As the PE and VC industry are private industries, there is no obligation to report results, which makes it more likely that more positive than negative results are reported. Therefore, the assumptions can be also be biased to being too optimistic. If more reliable data is available from the VC industry, it could be used to improve the reliability of the financial mode. A second limitation is that several VC fund characteristics would have an impact on the expected return of a VC fund. Previous work has shown that VC funds out of the U.S. perform better than those in Europe (Kaplan, 2005; EVCA, 2013). In addition, also later-stage focused VC funds seems to perform better than early-stage focused VC funds (EVCA, 2013; Spieringers, 2011). Including these difference might improve the accuracy of the expected exit values and returns, and thus the conclusion made from this model.

6.3

Suggestions for Further Research

The financial model is still prone for several improvements. A review on the made assumptions would be welcome in order to make the model more realistic. To be more specific, the performance of the investments made by the VC fund are broad assumptions. Including a bottom-up analysis could verify the results and conclusions made. In addition, incorporating more factors into the model could make it more realistic which in turn can provide more reliable results. Including a flexible expiration date of the buy-back option could also show some interesting additional results. Itdeally, it would be a nice experiment if a VC fund would try to work with a buy-back option for half of its investments and without for the other half. This way, a comparison can be made in the differences of the underlying performance. The results from this research could provide valuable insights which in turn can be used to update the assumptions of this financial model.

64

CHAPTER 6. CONCLUSIONS & RECOMMENDATIONS

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List of Figures 2.1 2.2 2.3 2.4

Expert Ratings of the Belgian Entrepreneurial Ecosystem, Source: GEM Report 2015/2016 . . . . . . . . . . . . . . . . . . . . . . . Venture Capital Fund Structure, Source: Smith et al. (2011) . . . Venture Capital Investment Process, Source: Smith et al. (2011) . Five-year rolling IRRs for Europe and the US . . . . . . . . . . .

4.1 4.2

High-level Structure of the Financial Model . . . . . . . . . . . . . 35 Overview of the VC model . . . . . . . . . . . . . . . . . . . . . . . 38

5.1

Gross Expected Value of Scenario 1 . . . . . . . . Gross Expected Value of Scenario 2 . . . . . . . . Gross Expected Value of Scenario 3 . . . . . . . . Sensitivity Analysis . . .

5.2 5.3 5.4

the VC Fund . . . . . . . . the VC Fund . . . . . . . . the VC Fund . . . . . . . . . . . . . . . .

over the . . . . . over the . . . . . over the . . . . . . . . . .

Fund’s . . . . Fund’s . . . . Fund’s . . . . . . . .

Lifetime . . . . . . Lifetime . . . . . . Lifetime . . . . . . . . . . . .

. 7 . 14 . 17 . 23

. 49 . 53 . 57 . 60

C.1 The Engine: Without Buy-Back Option . . . . . . . . . . . . . . . . 80 C.2 The Engine: With Buy-Back Option . . . . . . . . . . . . . . . . . 81 D.1 D.2 D.3 D.4 D.5

Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Value Ranges - Inputs . . . . . . . . . . . . . . . . . . . . . . . Value Ranges - Inputs . . . . . . . . . . . . . . . . . . . . . . . Input-Output Relationships, If influence = “Yes”, if not = “No” Overview User-Interface of the Financial Model in Excel . . . .

71

. . . . .

. . . . .

84 85 86 87 88

72

LIST OF FIGURES

List of Tables 4.1

Fixed Assumption - Benchmark Investment Classes Weights . . . . 39

4.2

Fixed Assumption - Benchmark Investment Class Returns . . . . . 39

4.3

Investment Class Weights - Assumption Sets . . . . . . . . . . . . . 41

4.4

Assumption Sets - Investment Class Returns . . . . . . . . . . . . . 41

4.5

VC Fund Characteristics - Input Variables . . . . . . . . . . . . . . 42

4.6

VC Fund Compensation Structure - Input Variables . . . . . . . . . 43

4.7

Buy-Back Option Characteristics - Input Variables . . . . . . . . . 43

5.1

VC Fund Inputs, Part 1 - Scenario 1 . . . . . . . . . . . . . . . . . 47

5.2

VC Fund Inputs, Part 2 - Scenario 1 . . . . . . . . . . . . . . . . . 47

5.3

VC Fund Inputs, Part 3 - Scenario 1 . . . . . . . . . . . . . . . . . 47

5.4

VC Fund Gross and Net Returns, Outputs Part 1 - Scenario 1 . . . 48

5.5

Liquidity VC Fund Gross, Outputs Part 2 - Scenario 1 . . . . . . . 48

5.6

Other VC Fund Outputs, Outputs Part 1 - Scenario 1 . . . . . . . . 49

5.7

VC Fund Inputs, Part 1 - Scenario 2 . . . . . . . . . . . . . . . . . 51

5.8

VC Fund Inputs, Part 2 - Scenario 2 . . . . . . . . . . . . . . . . . 52

5.9

VC Fund Inputs, Part 3 - Scenario 2 . . . . . . . . . . . . . . . . . 52

5.10 VC Fund Gross and Net Returns, Outputs Part 1 - Scenario 2 . . . 53 5.11 Liquidity VC Fund Gross, Outputs Part 2 - Scenario 2 . . . . . . . 54 5.12 Other VC Fund Outputs, Outputs Part 3 - Scenario 2 . . . . . . . . 54 5.13 VC Fund Inputs, Part 1 - Scenario 3 . . . . . . . . . . . . . . . . . 55 5.14 VC Fund Inputs, Part 2 - Scenario 3 . . . . . . . . . . . . . . . . . 56 5.15 VC Fund Inputs, Part 3 - Scenario 3 . . . . . . . . . . . . . . . . . 56 5.16 VC Fund Gross and Net Returns, Outputs Part 1 - Scenario 3 . . . 57 5.17 Liquidity VC Fund Gross, Outputs Part 2 - Scenario 3 . . . . . . . 58 73

74

LIST OF TABLES 5.18 Other VC Fund Outputs, Outputs Part 3 - Scenario 3 . . . . . . . . 58

Appendix A List of Abbreviations • BA = Business Angel • CoC = Cash-on-Cash Multiple • EVCA = European Venture Capital Association • EU = European Union • GEM = Global Entrepreneurship Model • GP = General Partner • IPO = Initial Public Offering • IRR = Internal Rate of Return • LLP = Limited Liability Partnership • LP = Limited Partner • M&A = Mergers & Acquisitions • NES = National Expert Survey • NVCA = National Venture Capital Association • PE = Private Equity 75

76

APPENDIX A. LIST OF ABBREVIATIONS • SEC = U.S. Securities and Exchange Commission • U.S.A. = United States of America • VC = Venture Capital / Venture Capitalist

Appendix B Important Terminology • Homeruns - These are the investments that will be responsible for the large majority of the VC fund’s returns. In a portfolio of ten investments, typically two (or 20%) are big successes that produce excellent financial returns. Source: W. Bygrave & A. Zacharakis, 2014 • Walking Wounded - These are the investments that are not successful enough to be harvested but are probably worth another round of venture capital to try to get them into harvestable condition. Typically three out of ten (or 30%) will generate some returns at the end of the funds. Source: W. Bygrave & A. Zacharakis, 2014 • Living Dead - 30% meaning that they may be viable companies but have no prospect of growing big enough to produce a satisfactory return on the venture capital invested in them. Source: W. Bygrave & A. Zacharakis, 2014 • Write-offs - These are the investments that will be outright failures in which the VC loses all its invested money. Typically two out of ten (or 20%) of the investments will have to be written off. Source: W. Bygrave & A. Zacharakis, 2014

77

78

APPENDIX B. IMPORTANT TERMINOLOGY

Appendix C The Engine C.1

The Engine: Without Buy-Back Option

An overview of the engine without the buy-back option can be found in figure C.1.

C.2

The Engine: With Buy-Back Option

An overview of the engine without the buy-back option can be found in figure C.2.

79

Figure C.1: The Engine: Without Buy-Back Option

80 APPENDIX C. THE ENGINE

Figure C.2: The Engine: With Buy-Back Option

C.2. THE ENGINE: WITH BUY-BACK OPTION 81

82

APPENDIX C. THE ENGINE

Appendix D Figures and Tables D.1

Terminology

The terminology of the factors used in the model can be found in figure D.1.

D.2

Assumption Sets - User-entered & Fixed

To have an overview of the fixed and possible user-enterd assumptions, look at figure D.2.

D.3

Value Ranges - Inputs

The value ranges which can be put into the model can be found in figure D.3.

D.4

Input-Output Relationships

To see which inputs have an impact on which outputs, look at figure D.4.

D.5

Overview of the User-Interface

In figure D.5, an overview can be found of what the user-interface looks like in the financial model made with Microsoft Excel. 83

84

APPENDIX D. FIGURES AND TABLES

Figure D.1: Terminology

85

Figure D.2: Value Ranges - Inputs

D.5. OVERVIEW OF THE USER-INTERFACE

86

APPENDIX D. FIGURES AND TABLES

Figure D.3: Value Ranges - Inputs

D.5. OVERVIEW OF THE USER-INTERFACE

87

Figure D.4: Input-Output Relationships, If influence = “Yes”, if not = “No”

Figure D.5: Overview User-Interface of the Financial Model in Excel

88 APPENDIX D. FIGURES AND TABLES