B.Com.(Hons), M.A., J.D., Ph.D., CFA Venture Capital and Private Equity Contracting: An International Perspective Douglas Cumming B.Com.(Hons), M.A., J.D., Ph.D., CFA York University Schulich School of Business Sofia Johan LL.B., LL.M., Ph.D. Tilburg Law and Economics Centre (TILEC) 1

Materials Textbook: Web: Cumming, D.J., and S.A. Johan, 2013. Venture Capital and Private Equity Contracting: An International Perspective, 2nd Edition, Elsevier Science Academic Press. Web: http://booksite.elsevier.com/9780124095373/ 2

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Venture Capital and Private Equity Definitions Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Chapter 1 Objectives Introduction Venture Capital and Private Equity Definitions Issues addressed in course and textbook 4

Sources of Funds for Entrepreneurial Firms Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Sources of funds What do VC/PE Managers Do? Possible Misconceptions? Sources of Funds for Entrepreneurial Firms There are various sources of funds Characteristics of other sources are very briefly provided on the next slide Our focus in this course is on Venture Capital (VC) and Private Equity (PE) 5

Table 1.1. Greatly Oversimplified Typical Characteristics of Funds Providers Source Investment Motivation Focus of Attention Cash Typically Available Source of Funds Biggest Drawbacks Biggest Advantages Security Required Subject to Market Conditions? Internal Operations Reinvestment Execution Unlimited Earnings Slow Non-Dilutive None Some Founders Ambition Varies $100,000 Savings Personal Risk Little Friends and Family Relationships Support $250,000 Easy Sell Private ‘Angel’ Investors The Entrepreneur $500,000 to $1.5M Previous Successes Varying Commitment Brings Credibility Considerable Venture Capital Funds Business Plan, Team, Market, Trajectory Contracts, Liquidity Event, Valuation $1M to $20M Limited Partners, Institutions Time Consuming, Expensive Brings Help, Credibility Contractual Terms and Conditions Greatly Private Equity Funds Mezzanine, Buyout, Turnaround $20M to $500M Commercial Banks (& Venture Banks) Risk versus Return Two Repayment Sources 80% of A/R, 50% of inv. Deposits Regulatory Agencies Advice, Clean, Straight-forward, Businesslike A/R, Inventory, IP Bridge Funds Low Risk $500K to $5M Warrants Speed (5 days to get a loan) All Assets Including IP Leasing Companies Liquidation Values 80% of value Company Treasury Costly Cheaper than Equity Factors (buy your A/R) Collections 80% of A/R ~5% over Prime Asset Lenders Balance Sheet 80% of A/R, 60% of inv. Expensive Personal Guarantee Partner Companies What You Can Do For Them Synergies May Preclude Other Opportunities 2-Way Economics, Low Pricing Pressure Government Agencies Mandates Regulations, Warrants Taxes Paperwork, Oversight Inexpensive, No Recourse Little or None Investment Bankers at IPO Fees Stock Market Public Costs, Underpricing, Public Disclosure Advice, Public Exposure Escrow, Lock-in Extreme 6

Figure 1.1. Venture Capital Financial Intermediation Investors Returns Capital Venture Capitalist Equity, Debt, Warrants, etc. Capital Entrepreneurial Firm 7

What Do Venture Capitalists (VCs) Do? Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Sources of funds What do VC/PE Managers Do? Possible Misconceptions? What Do Venture Capitalists (VCs) Do? Due Diligence Screening 1 to 2 deals out of >1000 Value-added Monitoring, Networks, Expertise Legal, Financial, Accounting, Suppliers, Buyers, Boards of Directors, Human Resources, Strategic, Marketing, other 8

Possible Misconceptions (?!) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Sources of funds What do VC/PE Managers Do? Possible Misconceptions? Possible Misconceptions (?!) “Vulture” capital: significant ownership and control rights Insufficient funds Sell bad investee firms public in initial public offerings (IPOs) 9

Venture Capital and Private Equity Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data Venture Capital and Private Equity Some Definitions 10

P R O F I T S TIME Figure 1.2 VCs, Acquisitions/Mergers SEO Strategic Alliances, etc. SEO Angels, FFF P R O F I T S Early Stage Later Stage Seed Capital (Could include VC) Public Market IPO Mezzanine 3rd 2nd Break Even 1st Valley of Death TIME 11

“Venture Capital” vs “Private Equity” (1/3) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data “Venture Capital” vs “Private Equity” (1/3) Seed Financing provided to research, assess and develop an initial concept before a business has reached the start-up phase. Start-up Financing provided to companies firms for product development and initial marketing. Companies Firms may be in the process of being set up or may have been in business for a short time, but have not sold their product commercially. Other Early Stage Financing to companies firms that have completed the product development stage and require further funds to initiate commercial manufacturing and sales. They will not yet be generating a profit. Expansion Financing provided for the growth and expansion of a company firm which is breaking even or trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital. 12

“Venture Capital” vs “Private Equity” (2/3) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data “Venture Capital” vs “Private Equity” (2/3) Bridge Financing Financing made available to a company firm in the period of transition from being privately owned to being publicly quoted. Secondary Purchase / Replacement Capital Purchase of existing shares in a company firm from another private equity investment organization or from another shareholder or shareholders. Rescue / Turnaround Financing made available to an existing business firm which has experienced trading difficulties (firm is not earning its cost of capital (WACC)), with a view to re-establishing prosperity. Refinancing Bank Debt To reduce a company’s firm’s level of gearing. Management Buyout Financing provided to enable current operating management and investors to acquire an existing product line or business. Management Buyin Financing provided to enable a manager or group of managers from outside the company firm to buy-in to the company firm with the support of private equity investors. 13

“Venture Capital” vs “Private Equity” (3/3) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data “Venture Capital” vs “Private Equity” (3/3) Venture Purchase of Quoted Shares Purchase of quoted shares with the purpose of delisting the firm. Other Purchase of Quoted Shares Purchase of shares on a public stock market. In practice, sometimes broader categories of definitions are used. For example, Start-up: sometimes used in practice to refers to Start-up, and Other Early Stage Expansion: sometimes used in practice to refers to Expansion, Bridge Financing, Rescue/Turnaround Replacement Capital: sometimes used in practice to refers to Secondary Purchase/Replacement Capital, Refinancing Bank Debt Buyouts: sometimes used in practice to refers to Management Buyout, Management Buyin, Venture Purchase of Quoted Shares. 14

Size of VC and PE Markets? Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data Size of VC and PE Markets? VC is a small but important sector of the economy Connected to: IPO markets (stock markets) Legality: shareholder protection, bankruptcy law, tax Government programs Armour and Cumming (2006 Oxford Economic Papers) 15

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Figure 1.5. Comparison of VC Amounts by total PE versus GDP and Population This figure shows the differences across countries in terms of amounts of early stage VC / total PE, early stage VC / GDP and early stage VC / population. Amounts are scaled as indicated to enable direct comparisons and show how country rankings for VC amounts change depending on the benchmark used to compare countries. Data are averaged by country for the period 1989-2011. 17

Figure 1.6. Comparison of the Number of VC Investments by total PE versus GDP and Population in Europe This figure shows the differences across countries in terms of numbers of early stage VC investment / total PE, early stage VC / GDP and early stage VC / population. Amounts are scaled as indicated to enable direct comparisons and show how country rankings for VC amounts change depending on the benchmark used to compare countries. Data are averaged by country for the period 1989-2011. 18

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data VC Data U.S.: http://www.ventureeconomics.com, http://www.vfinance.com, http://www.v1.com The PricewaterhouseCoopers MoneyTreeTM Survey: http://www.pwcmoneytree.com/ Canada: http://www.cvca.ca, http://www.canadavc.com Europe: http://www.evca.com Australia: http://www.abs.gov.au/Ausstats/abs@.nsf/0/bffef2819df68ca2ca256b6b007ab94e?OpenDocument Private data sources Data and empirical methods summarized in Cumming and Johan (2013, Chapter 3) 19

Geographic concentration Specialized focus Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data VC Industry in US Over 1000 funds Geographic concentration Specialized focus Over $US 100 billion capital under management Predominantly Private Limited Partnership VC Funds 20

Figure 1.7.a Capital Overhang for Venture Capital Funds Raised by US Investors Source: Pitchbook 21

Figure 1.7.b. Capital Overhang for Private Equity Funds Raised by US Investors Source: Pitchbook 22

Figure 1.8.a. Average Venture Capital Return Multiples by Vintage Year Source: Pitchbook 23

Figure 1.8.b. Average Private Equity Return Multiples by Vintage Year Source: Pitchbook 24

Table 1.4. Thomson Financials' Private Equity Performance Index (PEPI) Investment Horizon Performance through 09/30/2006 (expressed in %) Fund Type 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr Early/Seed VC 2.9 5.5 -5.4 38.3 20.5 Balanced VC 10.7 12.8 1.8 16.8 14.6 Later Stage VC 27.8 10.5 2.7 9.4 13.9 All Venture 10.8 -1.0 16.5 Small Buyouts 11.3 5.0 6.0 25.2 Medium Buyouts 37.2 12.3 6.1 10.9 15.3 Large Buyouts 23.1 16.4 8.3 12.4 Mega Buyouts 23.4 16.2 10.1 8.9 11.6 All Buyouts 23.6 15.6 9.2 8.8 13.2 Mezzanine -8.1 4.7 5.9 8.4 All Private Equity 19.0 11.2 14 NASDAQ 7.8 8.7 7.1 11.4 S & P 500 9.7 9.9 5.2 7.5 25

Figure 1.9. Venture Capital Horizon IRR by Fund Size Source: Pitchbook 26

Figure 1.10. IRR Quartiles by Fund Size for Mature Venture Capital Funds Source: Pitchbook 27

Figure 1.11. Median 1-Year Rolling Horizon IRR by Fund Type Source: Pitchbook 28

Figure 1.12. Horizon IRR – Private Equity, Venture Capital and Public Index Source: Pitchbook 29

30 Figure 4.13. US Buyout Returns by Vintage Year Median, Upper and Lower Quartiles as of December 2006 Source: Kaplan (2007), Venture Economics -10.00% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Lower 1/4 Median Upper 1/4 30

Figure 1.14. US versus Non-US Venture Capital Investment by Fund Vintage Year Source: Thompson SDC. 31

Figure 1.15. US versus Non-US Venture Capital IPO Exits by Fund Vintage Year Source: Thompson SDC 32

Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data VC Industry in Canada The estimated size of Canada’s VC/PE) market: $76 billion at the end of 2013 Buyout:$53.2 bil.; Mezzanine: $7.6 bil.; VC: $14.9 bil. Private indp. Funds: 59% of total funds; $44.6 billion, Institutional captive funds accounted for $20 billion Corporate captives $2.3 billion. Retail funds were $7.6 billion and Government owned and -directed $1.8 billion. 33

Venture Capital in Australia Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data Venture Capital in Australia Table 1: Amount of Funds Raised by Fiscal Year, Australia (in A$ Millions) Year Venture Capital Private Equity TOTAL FY2001 325.50 585.20 910.70 FY2002 55.60 780.40 836.00 FY2003 161.70 521.70 683.40 FY2004 155.30 863.20 1,018.50 FY2005 84.30 2,094.60 2,178.90 FY2006 184.70 3,933.60 4,118.30 FY2007 435.60 4,951.90 5,387.50 FY2008 343.60 5,581.70 5,925.30 FY2013 298.92 1,412.31 1,711.23 FY2010 168.28 1,456.07 1,624.35 34

Venture Capital in Europe Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Definitions Size Countries/ Data Venture Capital in Europe Fundraising by European private equity houses reached €16bn in 2013, 80% below the €81bn raised in 2008 35

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Main Issues addressed in this Course Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Main Issues addressed in this Course [Not a comprehensive list] 37

I. Why Do VCs Exist? Why not simply borrow from banks? Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? I. Why Do VCs Exist? Why not simply borrow from banks? What does this imply about any theory / evidence in venture capital? Review agency theory in detail because it is paramount to all issues addressed in this course Cumming and Johan (2013 Chapter 2) 38

II. What Matters in Running a Fund? (1/6) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (1/6) What do institutional investors care about? Return expectations, Reporting, Liquidity How does this affect fundraising? How does this affect specialized fund mandates, such as socially responsible funds? Cumming and Johan (2013, Chapter 4) 39

II. What Matters in Running a Fund? (2/6) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (2/6) What terms with institutional investors? Limited partnership agreements Restrictive covenants Limited liability What clauses to use and when to use them Cumming and Johan (2013, Chapter 5) 40

II. What Matters in Running a Fund? (3/6) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (3/6) How to structure compensation? Fixed fees Carried interest Cash versus share distributions Clawbacks Cumming and Johan (2013, Chapter 6) 41

II. What Matters in Running a Fund? (4/6) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (4/6) Style Drift Why and when should institutional investors care? Why and when does it matter to fund managers? Cumming and Johan (2013, Chapter 7) 42

II. What Matters in Running a Fund? (5/6) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (5/6) Listed private equity (LPE) What are the differences between LPE and limited partnerships? Who invests in LPE, and when and why? Cumming and Johan (2013, Chapter 8) 43

II. What Matters in Running a Fund? (6/6) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? II. What Matters in Running a Fund? (6/6) What role for government? Existence of capital gaps? Economic sources of capital gaps Legal sources of capital gaps Direct government investment programs Legislation Evidence from US, UK, Continental Europe, Israel, Australia, Canada Cumming and Johan (2013, Chapter 9) 44

III. Financial Contracting with Entrepreneurs (1/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? III. Financial Contracting with Entrepreneurs (1/4) Investment process Due diligence Stage of development and industry Location Staging Fund flows and valuations Syndication Portfolio size / manager Board seats Contracts Innovative activity Investment duration Cumming and Johan (2013, Chapter 10) 45

III. Financial Contracting with Entrepreneurs (2/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? III. Financial Contracting with Entrepreneurs (2/4) What structure of investment? Security design Warrants Common equity Preferred equity Convertible preferred equity Convertible debt Debt Other veto and control rights Cumming and Johan (2013, Chapter 11) 46

III. Financial Contracting with Entrepreneurs (3/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? III. Financial Contracting with Entrepreneurs (3/4) Specific veto, control and cash flow rights Definitions and terms Role of preplanned exits Cumming and Johan (2013 Chapter 12) 47

III. Financial Contracting with Entrepreneurs (4/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? III. Financial Contracting with Entrepreneurs (4/4) International differences in contracts, due diligence, board seats, syndication, co-investment Role of legal systems Cumming and Johan (2013, Chapter 13) 48

IV. Investor Value-Added (1/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? IV. Investor Value-Added (1/4) VC and PE Value-Added Jobs Total Factor Productivity Patents Locusts? Cumming and Johan (2013 Chapter 14) 49

IV. Investor Value-Added (2/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? IV. Investor Value-Added (2/4) Do contracts ensure effort? Advice Monitoring Conflicts When more pronounced Role for contracts in facilitating effort and mitigating problems Cumming and Johan (2013 Chapter 15) 50

IV. Investor Value-Added (3/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? IV. Investor Value-Added (3/4) Where to invest? Distance between investor and investee in the US Inter- versus intra-provincial in Canada Implications of proximity and local bias Cumming and Johan (2013 Chapter 16) 51

IV. Investor Value-Added (4/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? IV. Investor Value-Added (4/4) How many investments? Portfolio size/manager Trade-off: Diversification Diffusion in effort Cumming and Johan (2013 Chapter 17) 52

IV. Investor Value-Added (4/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? IV. Investor Value-Added (4/4) Fund size Scale economies versus limited attention Cumming and Johan (2013 Chapter 18) 53

V. How to Successfully Divest? (1/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? V. How to Successfully Divest? (1/4) Overview of divestment process Exit vehicle IPO, Acquisition, Secondary sale, Buyback, Write-off Issues with IPOs IPO short-term underpricing, long-term overpricing Impact of venture capital backing Cumming and Johan (2013 Chapter 19) 54

V. How to Successfully Divest? (2/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? V. How to Successfully Divest? (2/4) Investment Duration How long to invest Economic conditions versus fund and investee characteristics Cumming and Johan (2013 Chapter 20) 55

V. How to Successfully Divest? (3/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? V. How to Successfully Divest? (3/4) Which exit vehicle? Market conditions Legal conditions Fund characteristics Investee firm characteristics Allocation of control rights Cumming and Johan (2013 Chapters 21) 56

V. How to Successfully Divest? (4/4) Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Why do VCs exist? What matters when running a fund? Financial contracting with entrepreneurs Investor Value-Added How to Successfully Divest? V. How to Successfully Divest? (4/4) Returns, Valuation and Disclosure Mechanics of valuation What enhances returns? How to make adjustments with valuations based on return expectations? How to disclose valuations of unexited investments to institutional investors? Cumming and Johan (2013 Chapter 22) 57

VC/PE unique form of financing Idiosyncratic risk matters Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary Summary VC/PE unique form of financing Idiosyncratic risk matters Contracts matter Fund structures: relations with limited partners Public policy and design of statutes Relations between investors and entrepreneurs Exits, Returns, Valuations, Disclosure 58