1. 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

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

3. 3

4. 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

5. 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

6. 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

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

8. 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

9. 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

10. 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

11. 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

12. “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

13. “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

14. “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

15. 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

16. 16

17. 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 17

18. 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 18

19. Introduction Venture Capital & Private Equity Main Issues Addressed in this course Summary
Definitions Size Countries/ Data
VC Data
U.S.:
The PricewaterhouseCoopers MoneyTreeTM Survey:
Canada:
Europe:
Australia:
Private data sources
Data and empirical methods summarized in Cumming and Johan (2013, Chapter 3) 19

20. 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

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

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

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

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

25. 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

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

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

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

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

30. 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

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

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

33. 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

34. 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

35. 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

36. 36

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. 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

49. 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

50. 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

51. 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

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)
How many investments?
Portfolio size/manager
Trade-off:
Diversification
Diffusion in effort
Cumming and Johan (2013 Chapter 17) 52

53. 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

54. 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

55. 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

56. 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

57. 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

58. 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