How the Venture Capital Industry Works (End)

本系列文章主要是对曼海姆商学院(Business school of university of Mannheim)Advanced Entrepreneurship 课程的一个总结,所以大部分内容都来自于 Professor Dr. Michael Woywode 的课件。其中也有部分内容是自己做的补充。由于翻译比较麻烦,直接用的英文。


Where does “all the money” come from? (fundraising, investments?)


The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.


VCs versus Banks

This intermediation function sounds very similar to what a bank does

  • evaluating potential investments
  • monitoring function

How is VC different from banking?

  • high uncertainty, no proven business or revenue
  • little to no collateral
  • VCs take equity instead of making loans
  • VCs take active role in management of portfolio company


VC Fund Structure (how are returns distributed?)

  • Venture capital is the intermediary that matches investable money with ideas
  • Organized as Limited Partnership funds
  • The VC firm professionals are the General Partners (GPs)
    • select portfolio of companies to invest in
    • manage day-to-day operations of the partnership
  • The investors are the Limited Partners (LPs)
    • provide capital
    • have limited liability
    • restricted from involvement in day-to-day operations

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.


LP Agreement and GP Compensation(how are returns distributed?)

LP Agreement

LP agreement is “term sheet” of the fund, typical terms :

  • Compensation and allocation of profits (“waterfall”)
    • hurdle return and subsequent catch-up
    • timing of payout
  • Life and liquidation of fund
    • typically ten years with three possible one-year extensions
    • draw-down schedule and investment period
  • Negative covenants / limitations
    • exposure to any single investment
    • co-investments with earlier deals
    • recycling of capital
    • restrictions on fund raising, key man restrictions
    • restrictions on GPs selling their partnership interests

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

VC Compensation: Standard Arrangement

Management fee:

  • annual payment of 2% (1.5-2.5%) of committed capital (paid quarterly)
  • sometimes calculations change from using committed capital to invested capital after investment period ends

Carried interest or “carry”: typically 20% (20-30%) of profits

Limited partners (LPs) get:

  • Preferred return of committed capital
  • Then, 80% (1-carried interest) of profits

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.


Why do we see this type of compensation structure?

Incentives and agency problems?

Agency Issues

Fund structure, compensation and covenants are designed to limit agency problems (“moral hazard”).

  • the GP (“agent”) is supposed to act on behalf of the LP (“principal”)
  • BUT: incentives may not (always) be aligned

Limited fund life and no-recycling of funds promotes transparency

  • there is no feasible mark-to-market of net asset value (NAV) in the interim
  • carried interest provides incentives to GPs to maximize return to LPs

Examples of how covenants help align incentives:

  • limiting fund life – force accountability

  • limiting GP co-investment in particular deals to prevent excessive attention to one or a few deals

  • restricting the sale of partnership interests by GPs keeps alive incentives to monitor

  • restrictions on GP fundraising and outside activities to limit distractions

Besides covenants: Reputation matters!

  • not a one-shot game, much of lifetime GP compensation is derived from future funds

Dynamics of VC Fund

Initially

  • GPs raise capital for new fund from LPs。“Committed capital” is not paid up front。

Investment period (3-5 years):

  • fund buys companies
  • GPs make investment decisions and manage companies
  • required capital for investments is “drawn down” (or “called”) from LPs
  • LPs must honor their capital commitments
  • very little ability to withdraw or renege on commitment

When there is an exit?

  • when a company is sold, the proceeds are “distributed” back to the LPs according to the waterfall
  • mostly, GPs cannot recycle capital

End of life (10 years):

  • fund liquidates and all assets are distributed to LPs.
  • LPs’ prefer distributions in cash
  • sometimes, shares distributed to LPs
  • fund life can sometimes be extended at the option of the GP, for up to 3 years

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.


Four Facts about Venture Capital

  1. Extremely skewed returns

    • a small number of firms account for all of the excess return versus the public equity markets
  2. Extreme persistence

    • the return on one venture fund is predictive of the return on the next fund of the same firm
  3. Highly dependent on IPO market

  4. Only invested successfully in a narrow band of the spectrum of technological innovation

    • ICT
    • Biotech
    • Cleantech

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

The picture is from the sildes of Lecturer Andrew Isaak and Professor Dr. Michael Woywode, Business school of university of Mannheim.

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