1. © Cumming & Johan (2013)Valuation, Returns and Disclosure Cumming and Johan (2013 Chapter 22) 1

2. © Cumming & Johan (2013)Valuation, Returns and Disclosure Chapter Objectives Review the mechanics underlying the venture capital valuation method Present evidence on venture capital fund returns to show ways in which the discount rate or cash flows considered in valuations might be adjusted depending on the characteristics of the venture capital fund, characteristics of the entrepreneurial firm, structure of investment, market conditions, and legal conditions; and Present evidence that show how returns are disclosed to institutional investors prior to an exit event. 2

3. © Cumming & Johan (2013)Valuation, Returns and Disclosure Venture Capital Valuation Equations 3

4. © Cumming & Johan (2013)Valuation, Returns and Disclosure Example Suppose you are employed at the Soprano Venture Capital Fund, a hypothetical venture capital fund in New Jersey. Your first assignment is to value the price per share for a $10 million investment in a start-up green technology venture, and to decide on what share of the firm you should demand. You project the firm will have Net Income in Year 6 of $40 million. Similar profitable green ventures listed on stock exchanges are trading at an average Price-Earning Ratio of 15. The firm currently has 400,000 shares outstanding. Tony, your Boss, tells you that the Soprano Venture Capital Fund requires a target rate of return of 80%. What is the appropriate price per share, and how many shares do you require? 4

5. © Cumming & Johan (2013)Valuation, Returns and Disclosure Example (Continued) 5

6. © Cumming & Johan (2013)Valuation, Returns and Disclosure Example (Continued) Suppose further that you are of the opinion that three more senior staff will need to be hired by this green technology venture, and this number of top caliber recruits will probably require options amounting to 15% of this venture’s common stock outstanding. Additionally, you believe that, at the time the venture goes public, additional shares equivalent to 20% of the common stock will be sold to the public. As such, you would perform the following adjustments to your calculations: (next slide) 6

7. © Cumming & Johan (2013)Valuation, Returns and Disclosure Example (Continued) 7

8. © Cumming & Johan (2013)Valuation, Returns and Disclosure Some Lessons Valuation is an art, not a science VC Valuation technique somewhat arbitrary, particularly in the discount rate Other methods (Comparables, NPV, APV, IRR, Options Pricing) involve assumptions which might be equally problematic Here in the subsequent slides provide evidence showing valuations internationally 8

9. © Cumming & Johan (2013)Valuation, Returns and Disclosure Now: Worldwide Evidence on Returns and Disclosure Evidence from 39 countries! 9

10. © Cumming & Johan (2013)Valuation, Returns and Disclosure Motivation: Worldwide Policy Debate 2002 CALPERS disclosure lawsuit – Public pension funds must disclose venture capital and private equity returns, even on unexited investments Implications for understanding determinants of, and reporting of, returns Do we need mandated disclosure standards for VC and PE funds? Biggest issue for VC/PE markets since collapse of Internet bubble Regulation of VC and PE funds one of the biggest issues in UK Financial Times last week See also Chapter 4 10

11. © Cumming & Johan (2013)Valuation, Returns and Disclosure Research Questions 1.What are the determinants of VC and private equity returns across countries? 2.Are unexited investment values over-reported to institutional investors? 3.Are biases in reporting unexited investments related to legal conditions? 4.Relative merits of alternative approaches to stimulating VC markets 11

12. © Cumming & Johan (2013)Valuation, Returns and Disclosure New Contributions 1.First look at project-specific returns to VC and private equity across countries 2.Innovative application of econometric selection methods to measure VC returns 3.First look at biases in unexited returns and relations to fundraising 4.Policy implications: Reporting Standards needed in VC? 12

13. © Cumming & Johan (2013)Valuation, Returns and Disclosure Theory and Hypotheses Data Econometric Tests Policy Implications Theory and Hypotheses 13

14. © Cumming & Johan (2013)Valuation, Returns and Disclosure Institutional and Other Investors Venture Capital Funds Entrepreneurial Firms $ Returns $ Returns (realized vs ‘expected’) Venture Capital Cycle E.g., CALPERS California Public Pension Fund Pension Plan Members (you and I) Reporting bias of unexited returns in annual reports? Why care? Distorted asset allocations, less overall fundraising 2-7 years before exit event (IPO, Acquisition, Write-off)  This Paper  Chapter 7  CD Howe Institute, AEI Sciences Po, Brookings, PWC, EVCA, NVCA, etc. They all care a lot! 14

15. © Cumming & Johan (2013)Valuation, Returns and Disclosure 1. Advice, Monitoring & Returns Theory and Hypotheses Data Econometric Tests Policy Implications Monitoring/advice activities of VC are responsible for return of VC Main focus on VC characteristic Model with asymmetric information Advice is not contractible IRR must be sufficiently large to induce VC to undertake optimal level of advice/monitoring The more productive the VC is, the higher the optimal advice/monitoring level  the lower the price of shares for the VC  the higher the VC returns 15

16. © Cumming & Johan (2013)Valuation, Returns and Disclosure 1. Advice, Monitoring & Returns (Continued) Theory and Hypotheses Data Econometric Tests Policy Implications The higher the intensity of monitoring and advice the higher the expected IRR of the VC – Convertible securities, syndication  higher expected rate of return – Co-investment:  lower returns – Smaller portfolios (# investments) / manager  higher returns Better legal environment  more efficient advice and less information asymmetries upon exit  the higher expected returns 16

17. © Cumming & Johan (2013)Valuation, Returns and Disclosure 2. Biases in Reporting Un-Exited Investments Theory and Hypotheses Data Econometric Tests Policy Implications Valuation take place against trade-off between  Fundraising concerns (higher valuations potentially facilitate fundraising in next round)  Reputational concerns (overvaluation damages long-run reputation) Pooling equilibria may emerge (bad projects are overstated) 17

18. © Cumming & Johan (2013)Valuation, Returns and Disclosure 2. Biases in Reporting Un-Exited Investments (Continued) Theory and Hypotheses Data Econometric Tests Policy Implications Hypotheses: Expected Fundraising Benefit > Expected Reputation Cost – Inexperienced VCs: overstate – Earlier stage and high tech: overstate – Syndicated investment: less likely to overstate – Co-investment: more likely to overstate Legal environment increases costs of overstatement – Less stringent accounting rules: overstate – Sarbanes Oxley: less likely to overstate 18

19. © Cumming & Johan (2013)Valuation, Returns and Disclosure 2. Biases in Reporting Un-Exited Investments (Continued) Theory and Hypotheses Data Econometric Tests Policy Implications Formal Hypotheses Tested: H1: Unexited PE investments are less likely to be overvalued in countries that have superior accounting and legal standards. H2:Unexited PE investments are more likely to be overvalued at times of poor market conditions. H3:Inexperienced PE managers and younger funds are more likely to overvalue unexited investments. H4:Unexited earlier stage PE investments and high-tech investments are more likely to be overvalued. 19

20. © Cumming & Johan (2013)Valuation, Returns and Disclosure Theory and Hypotheses Data Econometric Tests Policy Implications Data 20

21. © Cumming & Johan (2013)Valuation, Returns and Disclosure CEPRES Dataset Theory and Hypotheses Data Econometric Tests Policy Implications 221 venture capital and private equity funds 72 venture capital and private equity firms 5117 entrepreneurial firms (3826 venture capital and 1214 private equity) 33 years (1971 – 2003) 39 countries (North and South America, Europe and Asia) Table 1 (see paper) defines the variables 21

22. © Cumming & Johan (2013)Valuation, Returns and Disclosure 22

23. © Cumming & Johan (2013)Valuation, Returns and Disclosure 23

24. © Cumming & Johan (2013)Valuation, Returns and Disclosure Table 22.3. Summary Statistics Unrealized / Partially realizedFully Realized Difference Tests Portfolio Firm Investments # FirmsAverage IRRMedian IRR # FirmsAverage IRRMedian IRRMeansMedians Part AAll Funds 1All Funds in the Data261963.230241968.6716.990.22p <= 0.00*** Part BMarket and Legal Factors 2Legality Index > 20187460.012.16163147.2319.26-0.87p <= 0.00*** 3Legality Index < 2074571.30788113.0414.210.54p <= 0.00*** 4Disclosure Level Index > 0.75165455.381.66143843.6819.24-0.81p <= 0.00 *** 5Disclosure Level Index < 0.7596776.650981105.3114.570.47p <= 0.00 *** 6Earnings Aggressiveness Index > -0.38376527.433.1764685.518.391.03p <= 0.00*** 7Earnings Aggressiveness Index < -0.383185477.920177362.5416.22-0.54p <= 0.00*** 8MSCI Return > 3.5%61176.889.32190858.0720.21-1.14p <= 0.00*** 9MSCI Return < 3.5%200859.070511108.24-10.990.64p <= 0.00*** Part CFund Characteristics 10Fund Number in the PE Firm > 3160369.37078188.721.510.34p <= 0.00*** 11Fund Number in the PE Firm < 3101853.5510.3163859.1120.270.29p <= 0.00*** 12Age of Specific PE Fund > 1795 days123054.159.23223357.4818.730.19p <= 0.00*** 13Age of Specific PE Fund < 1795 days139171.250186202.96-91.740.67p <= 0.00*** 14 Portfolio Size (# Portfolio firms) / # General Partners > 20103559.58098821.2912.34-2.52**p <= 0.00*** 15 Portfolio Size (# Portfolio firms) / # General Partners < 20158665.611.71431101.3822.070.87p <= 0.00*** 24

25. © Cumming & Johan (2013)Valuation, Returns and Disclosure Table 22.3. Summary Statistics (Continued) Unrealized / Partially realizedFully Realized Difference Tests Portfolio Firm Investments # FirmsAverage IRRMedian IRR # FirmsAverage IRRMedian IRRMeansMedians Part DPortfolio Firm Characteristics 16Seed Stage1468.88071520.37-2.921.01p <= 0.097* 17Start-up Stage56126.7218.973448.58-11.45-1.65*p <= 0.127 18Early Stage67039.550424-1.52-29.14-2.93***p <= 0.00*** 19Expansion Stage24036.4022628.9114.54-0.56p <= 0.00*** 20Unknown Seed, Early or Expansion Stage83891.85.09111971.6920-0.36p <= 0.00*** 21Late Stage16855.770116121.225.341.5p <= 0.00*** 22Industry Market / Book > 51448101.95081680.276.08-0.55p <= 0.00*** 23Industry Market / Book < 5117315.427.92160362.7620.282.01**p <= 0.00*** Part EInvestment Characteristics 24Syndicated Investment72968.110449151.2715.881.01p <= 0.00*** 25Initial Amount Invested > US $2,500,000131034.625.04104075.5825.221.09p <= 0.00*** 26Initial Amount Invested < US $2,500,000131191.80137963.468.6-0.75p <= 0.00*** Part F 27UK30522.046.2530440.8124.11.36p <= 0.00*** 28U.S.127360.890.19116243.6213.84-0.95p <= 0.00*** 29All English Legal Origin169954.251.16149342.7617.49-0.8p <= 0.00*** 30France22617.943.82259149.5312.350.88p <= 0.00*** 31All French Legal Origin31819.13.82312127.312.760.95p <= 0.00*** 32Germany126142.740109105.3115.39-0.35p <= 0.04** 33Switzerland1911.483.841260.5135.511.48p <= 0.21 34All German Legal Origin20689.97013483.6410.95-0.08p <= 0.00*** 35Sweden277.7302744.9921.441.41p <= 0.11 36All Scandinavian Legal Origin5414.13.274950.8419.291.33p <= 0.02** 25

26. © Cumming & Johan (2013)Valuation, Returns and Disclosure “Realized Returns Econometrics” Theory and Hypotheses Data Econometric Tests Policy Implications Multi-step Heckman correction to measure the returns to VC and private equity investment Heckman selection corrections for 1.Unexited / Exited Investments 2.Partial / Full Exits Statistical problems associated with OLS on a subsample of fully realized IRRs 26

27. © Cumming & Johan (2013)Valuation, Returns and Disclosure 3-Step Heckman Correction Theory and Hypotheses Data Econometric Tests Policy Implications 1.Probit: Exit / No Exit 2.Selection Corrected Probit: Full / Partial Exit, accounting for the selection effects associated with an actual exit (step 1) 3.Heckman Linear Regression IRR, accounting for both steps # 1 and 2 27

28. © Cumming & Johan (2013)Valuation, Returns and Disclosure Table 22.4. Regression Analysis on the Determinants of Realized Returns Predicted Sign for Realized Returns Model 1Model 2 OLS on Subsample of Fully Realized IRRs 1st Step Heckman Regression: Bivariate Probit Model 2nd Step Heckman Regression (Realized IRRs) Step 1a: Determinants of Exit Step 1b: Determinants of Full Exit, conditioned on step 1a regarding an actual exit Dependent Variable = Log(1+IRR) Dependent Variable=1 if Exit Dependent Variable=1 if Full Exit Dependent Variable = Log(1+IRR) Coefficientt-statisticCoefficientt-statisticCoefficientt-statisticCoefficientt-statistic Constant-5.48-1.5-0.26-2.08**-4.17-2.3**-15.88-3.4*** Duration of PE Investment (in Days) 0.000714.4***0.00022.4** Market and Legal Factors Log (Legality Index)+3.913.6*** 1.272.0**3.302.4** Log (Committed Capital Overall Market at Inv Date) --0.82-6.8*** 0.894.5*** Log (MSCI Return)+1.091.4 1.453.0*** Log (Risk Free Rate)?-10.23-2.5** -20.66-4.1*** Fund Characteristics Log (Fund Number in the PE Firm)+0.060.6 -0.04-0.4 Log (Portfolio Size (# Portfolio firms) / General Partner) --0.30-2.1** -0.33-2.4** Portfolio Firm Characteristics Seed Stage?-0.55-1.1 0.120.5-0.55-1.4 Start-up Stage?0.070.1 0.372.3**-0.16-0.3 Early Stage?-1.34-4.6*** 0.230.9-1.25-5.2*** Expansion Stage?0.060.2 -0.08-0.40.020.1 Late Stage?1.002.0** 0.110.40.85**2.2** MBO/MBI?-0.36-2.0** -0.45-3.6***-0.21-0.7 LBO?-0.32-0.6 -0.51-1.50.220.3 Publicly Listed Firm?2.323.0*** 2.472.6*** Turnaround?-0.03-0.1 -0.52-2.0**0.510.5 Secondary Trade?-1.83-0.9 0.460.8-1.96-1.5 Log (Industry Market / Book)+0.120.6 -0.11-1.1-0.01-0.1 Industry Dummy Variables?YesNoYes Country Dummy Variables?YesNoYes Year of Exit Dummy Variables?YesNoYes 28

29. © Cumming & Johan (2013)Valuation, Returns and Disclosure Table 22.4. Regression Analysis on the Determinants of Realized Returns (Continued) Predicted Sign for Realized Returns Model 1Model 2 OLS on Subsample of Fully Realized IRRs 1st Step Heckman Regression: Bivariate Probit Model 2nd Step Heckman Regression (Realized IRRs) Step 1a: Determinants of Exit Step 1b: Determinants of Full Exit, conditioned on step 1a regarding an actual exit Dependent Variable = Log(1+IRR) Dependent Variable=1 if Exit Dependent Variable=1 if Full Exit Dependent Variable = Log(1+IRR) Coefficientt-statisticCoefficientt-statisticCoefficientt-statisticCoefficientt-statistic Investment Characteristics Syndicated Investment+0.422.06** -0.40-2.7***0.552.3** Co-Investment--0.11-0.52 -0.20-0.9 Convertible Security with Actual Periodic Cash Flows +2.5615.64*** 2.2213.3*** Lead Investment?0.341.37 0.361.6 PE Board Seat(s)+-0.54-1.67* -0.78-2.9*** Standard Deviation of Cash Flows to Entrepreneur ?0.001.67* 0.000.9 Log (Amount Invested)?0.020.43 0.040.8 Heckman Lambda A- -1.99-3.0*** Heckman Lambda B- -6.40-10.4*** Model Diagnostics Number of Observations181943061819 Adjusted R 2 0.28 0.32 F Statistic17.27*** 19.99*** 29

30. © Cumming & Johan (2013)Valuation, Returns and Disclosure Unexited Reported IRRs (2000 – 2003) versus Predicted IRRs Theory and Hypotheses Data Econometric Tests Policy Implications Contrast reported unexited IRRs (as reported to the institutional investors) with predicted IRRs for unexited investments Log(1+IRR Reported)-Log(1+IRR Expected) = Log((1+Reported IRR)/(1+Predicted IRR) = 143% Regression evidence: quite remarkably(!) consistent with the proposition that more informational asymmetry is associated with more ‘lying’! Table 4: full sample Table 5 (see paper): same results with European-only subsample 30

31. © Cumming & Johan (2013)Valuation, Returns and Disclosure Table 22.5. Determinants of the Difference Between Unrealized IRRs Disclosed to Institutional Investors and Predicted IRRs Model 3Model 4 Unrealized Log(1+IRR) - Fitted Values from Predicted Log (1+IRR) in Model 1 of Table 3 Unrealized Log(1+IRR) - Fitted Values from Predicted Log (1+IRR) in Model 2 of Table 3 Coefficientt-statisticCoefficientt-statistic Constant6.4212.7***4.613.9*** Market and Legal Factors Disclosure IndexH1 (-)-0.45-4.8***-0.39-2.2** Earnings Aggressiveness IndexH1 (+)42.6114.4***44.987.8*** Sarbanes Oxley-0.31-5.9***-1.65-16.3*** Log (MSCI Return)H2 (-)-1.46-8.3***-4.00-10.5*** Log (Risk Free Rate)30.1214.5***-31.18-7.6*** Fund Characteristics Log (Age of PE Fund within the PE Firm)H3 (-)-0.36-6.4***-1.72-11.3*** Log (Portfolio Size (# Portfolio firms) / General Partner)0.349.6***0.7311.0*** Portfolio Firm Characteristics Seed StageH4 (+)0.100.75-0.62-3.2*** Start-up StageH4 (+)0.171.400.542.1** Early StageH4 (+)1.2420.5***1.059.6*** Expansion StageH4 (-)-0.12-1.56-0.45-2.9*** Late StageH4 (-)-0.97-8.9***-0.95-5.5*** MBO/MBIH4 (-)0.262.4**-0.42-1.8* LBOH4 (-)0.421.54-0.38-0.7 Publicly Listed FirmH4 (-)-1.79-10.5***-1.63-9.3*** Log (Industry Market / Book)-0.11-2.0**-0.03-0.3 Disclosure Year Dummy VariablesYes Industry Dummy Variables?Yes Country Dummy Variables?Yes Investment Characteristics Syndicated Investment-0.34-5.8***-0.63-6.3*** Co-Investment0.081.460.050.6 Convertible Security with Actual Periodic Cash Flows-2.62-21.5***-3.06-9.6*** Lead Investment-0.18-2.8***0.040.3 PE Board Seat(s)0.597.2***0.715.2*** Standard Deviation of Cash Flows to Entrepreneur-.276867D-04-0.10.001.5 Log (Amount Invested)-0.04-2.4**0.020.6 Model Diagnostics Number of Observations1294 Adjusted R 2 0.740.65 F Statistic99.80***74.91*** 31

32. © Cumming & Johan (2013)Valuation, Returns and Disclosure Theory and Hypotheses Data Econometric Tests Policy Implications Subsample of 80 observations (investee firms) from 11 countries for which both the realized and unrealized reported IRR are known (Canada, Finland, France, Germany, Israel, Norway, Spain, Sweden, the Netherlands, the UK, and the US) The correlation between out-of-sample average realized IRRs and our predicted IRRs is 0.45 AverageMedian Duration Report  Exit2.6 years Unrealized reported IRR219.71%2.56% Subsequently Realized Reported IRR 98.46%8.70% Predicted IRR (Based on Table IV Model) 15.22%7.75% Unexited Reported IRRs (2000 – 2003) versus Actual IRRs 32

33. © Cumming & Johan (2013)Valuation, Returns and Disclosure Table 22.7. Determinants of the Difference between Reported Unrealized IRRs Disclosed to Institutional Investors and Subsequently Realized IRRs Hypothesis # (Predicted Sign) Model 11Model 12Model 13Model 14 Dependent Variable: Unrealized Reported Log(1+IRR) - Fitted Values from Predicted Log (1+IRR) in Model 1 of Table 3 Unrealized Reported Log(1+IRR) - Subsequently Realized Log (1+IRR) Coefficientt-statisticCoefficientt-statisticCoefficientt-statisticCoefficientt-statistic Constant10.894.8***19.262.4**7.730.917.302.784*** Market and Legal Factors Disclosure IndexH1 (-)-8.06-7.1***-16.50-2.9*** Earnings Aggressiveness Index H1 (+)20.591.1489.703.9***387.382.5**375.452.5** Log (MSCI Return Reporting Time) H2 (-)-1.74-1.8* Log (MSCI Return Reporting Time) - Log (MSCI Return Exit Time) -2.26-0.5-1.93-0.4-0.17-0.05 Duration from Reporting to Realization 0.361.0 Fund Characteristics Log (Age of PE Fund within the PE Firm) H3 (-)-0.38-1.50.090.90.050.04 Log (Portfolio Size (# Portfolio firms) / General Partner) 0.401.8*1.931.01.060.6 Portfolio Firm Characteristics Log (Industry Market / Book) 0.763.5***0.01 -0.19-0.20.050.04 Industry Dummy Variables? Yes Country Dummy Variables? Yes 33

34. © Cumming & Johan (2013)Valuation, Returns and Disclosure Table 22.7. Determinants of the Difference between Reported Unrealized IRRs Disclosed to Institutional Investors and Subsequently Realized IRRs (Continued) Hypothesis # (Predicted Sign) Model 11Model 12Model 13Model 14 Dependent Variable: Unrealized Reported Log(1+IRR) - Fitted Values from Predicted Log (1+IRR) in Model 1 of Table 3 Unrealized Reported Log(1+IRR) - Subsequently Realized Log (1+IRR) Coefficientt-statisticCoefficientt-statisticCoefficientt-statisticCoefficientt-statistic Investment Characteristics Syndicated Investment-0.67-2.58**0.810.60.660.5 Convertible Security with Actual Periodic Cash Flows -2.88-12.2***-3.42-3.4***-3.22-3.3***-3.13-3.4*** Standard Deviation of Cash Flows to Entrepreneur 0.101.8*-0.04-0.3 Log (Amount Invested)0.020.20.350.80.371.1 Model Diagnostics Number of Observations80 Adjusted R 2 0.800.130.1310.159 F Statistic19.28***1.71*1.74*2.35** 34

35. © Cumming & Johan (2013)Valuation, Returns and Disclosure Overstatement of Unexited IRRs and Fundraising Theory and Hypotheses Data Econometric Tests Policy Implications Not possible to assess causality but there is evidence of positive correlations between overstatement of unexited reported IRRs and fundraising 35

36. © Cumming & Johan (2013)Valuation, Returns and Disclosure Correlations: Overstatement of Unexited IRRs and Fundraising Theory and Hypotheses Data Econometric Tests Policy Implications Actual Difference (Reported - Predicted IRR) Fitted Value From Difference Regression Actual Difference1.000.23 Fitted Values from Difference Regression 0.231.00 Fund Size0.180.27 VC Firm Age0.240.39 Capital Under Management0.210.33 Capital Under Management to Date of Fundraising 0.260.37 36

37. © Cumming & Johan (2013)Valuation, Returns and Disclosure Theory and Hypotheses Data Econometric Tests Policy Implications Graphical Illustration of these Results (2 plots in next 2 slides) Cumming and Walz 2013 Journal of International Business Studies 37

38. © Cumming & Johan (2013)Valuation, Returns and Disclosure Better Legal Conditions are Associated with Higher Fully Realized IRRs 38

39. © Cumming & Johan (2013)Valuation, Returns and Disclosure Worse Legal Conditions are Associated with Higher Reported Unrealized (Unexited) Returns 39

40. © Cumming & Johan (2013)Valuation, Returns and Disclosure Theory and Hypotheses Data Econometric Tests Policy Implications 40

41. © Cumming & Johan (2013)Valuation, Returns and Disclosure Measuring VC Returns Theory and Hypotheses Data Econometric Tests Policy Implications Heckman selection effects are crucial  Misspecification of model without selection effects  Multidimensional selection effects are a useful new component introduced in this paper VC value-added is crucial  E.g., portfolio size / manager  Enables us to explain up to 36% of the variation in returns Legality is crucial for cross-country differences 41

42. © Cumming & Johan (2013)Valuation, Returns and Disclosure Unexited IRRs Reported to Institutional Investors Theory and Hypotheses Data Econometric Tests Policy Implications Findings are quite consistent with the proposition that more informational asymmetry is associated with more ‘lying’!  for smaller ENTs, tech companies, higher earnings aggressiveness index, lower disclosure index Positive correlation between fundraising and lying 42