6 VC PE Investment Process

7/24/2019 6 VC PE Investment Process

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Entrepreneurial Finance

Module 6

Venture Capital and Private Equity:

The investment process

Chair of Entrepreneurial Finance

Prof. Dr. Reiner Braun

Entrepreneurial Finance Summer Term 2015


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Updated Schedule


Financingyoung

companies

VentureCapital &

Private Equity

VentureValuation


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Financing relationships of a VC/PE firm

Investingsmart money(Equity & Help)

Return oninvestment

Money(Fundraising)

Successparticipation

Investors

PE / VC firm

Portfolio company

Refinancing

relat ionship

Financing

relat ionship

Source: Based on Schefczyk (2006)



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The investment process

Investors

Portfolio Companies

Investor Relations

InvestmentExit

InvestmentDevelopment

InvestmentStructuring

InvestmentDue

Diligence

InvestmentOrigination

Fundraising

Distribution

of Returns

Source: Fingerle, C. (2004): Smart Money - the Influence of Venture Capitalists on Portfolio Companies



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6.2 Investment Development

6.3 Investment Exit

Agenda

6.1 Investment Process



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Content of the Structuring Phase

Legally non-binding term-sheet: actual financial & legal terms related to a transaction

These terms are finally included in various legal documents such as

the shareholders agreement,

the articles of association,

the bylaws of the management team and supervisory board and

the employment contracts of the management team.

VC/PE firm Portfolio Company

about contractual agreements

financial instruments

additional investor rights

Negotiations



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Equity

Financial Instruments (1/3)

Shareholders share the same level of risk and return Additional rights can be given by shareholders agreement

Additional investor rights directly linked to ownership of stock

Usually issued as convertible preferred stock

Common stock

Preferred stock



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Debt


has a lower priority than a senior loan in case of a

liquidation of the asset or company

enjoys higher priority than other loans or equity stock incase of a liquidation of the asset or companySenior debt

Subordinated debt



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Mezzanine


Silent partner participates in profit and losses(maximally with amount of investment)

German tax law differentiates between:

typical silent partnership

atypical silent partnership (rather comparable to anequity investor)

according to the degree of entrepreneurial risk, return

and participation rights attributed to the silent partner

Allows lender to exchange debt for common shares at apreset conversion ratioConvertible debt

Silent Partnerships



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Financing an MBO/LBO Transaction

Financing requirements for a buyout consist of

Purchase price (company value) Net financial debt to be taken over Necessary investments Transaction costs

Financing secured by various capital forms

Equity Debt (A, B, C Senior, Junior)

Hybrid financing instruments (Mezzanine)

Source: Deloitte



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But

1)All exi

Where is the M of the Management Buy Out?



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Whats expected from the management?

Equity investment of 1 times annual salary

Negotiable Depends on institution Envy factor

Considerable upside reward for success

Total commitment to the project


A d


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And now

The L of the Leveraged Buyout!


Wh t b k l ki f ?


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Strong positive cash flow

Equity contribution of 30% to 40%

Repayment of Senior A typically within 7 years

First charge over assets as security

Financial and other covenants

Interest coverage of 2.5 to 3 times

Leverage of 3.5 up to 8 x EBITDA

Cash cover of at least 1

What are bankers looking for?

Source: Deloitte


Additional Investor Rights Overview


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Additional Investor Rights - Overview

AdditionalInvestor Rights

2. Control Rights

1. Information Rights

5. Cash Flow Rights

6. Preemptive Rights 3. Management Covenants

7. Disinvestment Rights

4. Milestone Agreements


1 Information Rights


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Information Rights

1. Information Rights

Many rights already defined by statutory regulation (e.g. 51a GmbHG for

GmbHs, 131 AktG for AGs) Ability to react on happenings within the company

VC/PEs define a catalogue of information (financial statements, budgets, non-financial information regarding company development)

Information provision in regular intervals, usually monthly

define the extent to which the VC/PEs have access toinformation of the portfolio company

Reduce post-contractual information asymmtries


2 Control Rights (1/3) Voting Rights


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Voting Rights

2. Control Rights (1/3) - Voting Rights

Usually VC/PE firms hold a certain class of preferred stock and ask for aclass voting right:

Only holders of this type of preferred stock are allowed to vote on changesregarding the status of their class of stock without other investors having theright to intervene

measure the percentage of votes that shareholders have toeffect corporate decisions.


2 Control Rights (2/3) - Veto Rights


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Annual budget

2. Control Rights (2/3) - Veto Rights

Appointment ofdirectors

Taking onadditional debt

Contracts ofother majorrelated party

Alteration ofcompany statues

Capital increase

Creation ofsubsidiaries

Issue of chargesover the companys

asset

Contracts with

othershareholders

Introduction ofcorporate pension

schemes

Changes in

the shareholderstructure

Managementcontracts

Financ ial aspec ts

Merger withor acquisition of

companies

Sale of a businessdivision

Investm ent and respect iv ely

d is investment aspects

Organizational asp ects Contracts of mater ial

inf luence


2 Control Rights (3/3) - Board Rights - Definition


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Board Rights

2. Control Rights (3/3) - Board Rights - Definition

Board rights define membership in the supervisory board.

Exemplary responsibilities:

Hiring, evaluating and firing senior management

Advising senior management on general corporate strategies anddecisions and ratifies them


3. Management Covenants (1/2)


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Define correct behaviorof the companys management.

For example, management promises to maintain adequate insurance to pay corporate debts and taxes in accordance with

normal terms

If a founder leaves the firm, he cannot work in the sameprofession for a couple of years and geographical location

Affirmative covenants

Non-compete clauses




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Founders will forfeit granted shares or options

if they leave the employment of the company before vestingperiods expire (t ime vest ing )or

if certain milestones are not met (perform ance vest ing ).

The company is required to make representations andwarranties on:

its good standing,

the ownership of its technology and other assets,

full disclosure of all material information needed to makean informed investment decision,

Representations &warranties

Vesting


4. Milestone Agreements - Overview


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Milestones

g

Contracts may specify measures to be taken contingent on certainpredefined events - these so-called milestones define importantsteps in the development of the company.

Financial nature Technical nature Conclusion of contracts

e.g.

Reaching certain salesand profitability numbers

Registration for an IPO

e.g.

Completion of design

Pilot production

Introduction of a secondproduct

e.g.

Acquisition of key customer

Conclusion of licensing

R&D contracts


4. Milestone Agreements Most Relevant Milestone Agreements (1/2)


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g g ( )

VC/PE firm pays certain amount on top of the price itinitially paid for its stake if the company manages to achieve

pre-specified, mostly financial criteria within a time period.

Ratchet-down agreement:

transfer of shares from management to VC, if management

fails to meet a performance target within a specified time

Ratchet-up agreement:

transfer of shares from VC to management, if management

timely meets a performance target

Earn-out

Ratches


4. Milestone Agreements Most Relevant Milestone Agreements (2/2)


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Moral hazard

Staging

g g ( )

capital needs are met through several financing rounds

additional financing only if pre-specified milestones are achieved if company fails to reach its milestones, the VC/PE firm is typically released from its

contractual obligation to provide further finance.

Threat that VC/PE firm may stop financing creates incentives for theentrepreneur to exert high effort and avoid high risks.

Adverse Selection

Staging lowers amount of capital at risk

resolve uncertainty about companys characteristics next stage financing with less information asymmetries

Hold-upBy keeping the initial financing rounds as small as possible thepotential payoff of a hold-up strategy is reduced drastically.


5. Cash Flow Rights Liquidation Preference Definition


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Liquidation Preference

Liquidation preferences specify the amount and the orderin which holdersof different classes of securities get paid in the event the company is sold or

liquidated.


5. Cash Flow Rights Liquidation Preference Implementation


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Additional elements Participating preferred stock

Preferred dividends are of somespecified percent that will be accrued onthe preferred stock and paid before anydividend can be paid to holders ofcommon stock.

Cumulative preferred dividends nothave to be paid out during normalbusiness operations but accumulate andare added to the liquidation claim of theVC/PE firm.

The venture capitalist

first receives the par value of thepreferred stock (plus the accumulateddividend, if present) and then

participates in the remaining

payments with the common stock asif he had converted.

Liquidation preference - Basic structure

VC/PE firm receives its initial investment back

before other investors receive any payments


5. Cash Flow Rights Dividend Preference Example Participating Preferred Stock


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Common Stock

VC/PE firm investment inconvertible 2m EUR (50% of common stock)

Trade sale after 5 years 5m EUR (100%)

Cumulative dividend (10%) 0 EUR

Repayment of investment 0 EUR

Pro rata repayment ofremaining assets

2.5m EUR

Total repayment to VC/PE firm 2.5m EUR

Total repayment to VC/PE firmas % of trade sale

50%

Participating preferred stockwith cumulative dividend

1m EUR

2m EUR

1m EUR

4m EUR

80%


5. Cash Flow Rights Antidilution Protection


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Share dilution/percentage baseddilution provisions

Capital increases, stock dividends andstock splits

Keep the percentage of the venturecapitalists shareholding constant

Preemptive right

Price dilution/price based dilution provisions

Sales of shares at lower valuations indownrounds

Adjust the price per share paid bythe VC to a lower level

Full ratchet and weighted averageratchet

Trigger

Intent ion

Design

Antidilution rights

protect the shareholdings of the VC/PE firmagainst share and price dilution


5. Cash Flow Rights Antidilution Protection


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Full ratchet Weighted average ratchet

The venture capitalists average cost per

share will then equal the lower price pershare given to the new investor

The venture capitalists average cost per

share will then equal the average priceper share given to all investors

The lower the valuation in the next financing round, the higher thedilutive costs of raising additional capital

old sharesconversion price

original investmentFree shares -=

Conversion Price = New price

old sharesconversion price

original investmentFree shares -=

outstanding shares+

Conversion Price =

old price x

new investmentold price

outstanding shares + new shares

If the venture sells shares at a lower price,the venture capitalist receives

additional shares for free


5. Cash Flow Rights Example for Full-Rachet Dilution Protection


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ConversionPrice of

Preferredshares

First RoundCommon SharesSeries A Preferred Shares $1.00

7,5002,500

7,5002,500

75.00%25.00%

SharesIssued(000s)

CommonShares AfterConversion

Percent ofCompanyOwned

Capitalization No Dilution Protection

Second RoundCommon SharesSeries A Preferred SharesSeries B Preferred Shares

$1.00$0.50

7,5002,5002,000

7,5002,5002,000

62.50%20.83%16.67%

Second Round Capitalization Full Ratchet Dilution Protection

Common SharesSeries A Preferred SharesSeries B Preferred Shares

$0.50$0.50

7,5002,5002,000

7,5005,0002,000

51.72%34.48%13.79%


5. Cash Flow Rights Example for Weighted Average Anti-Dilution Protection


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ConversionPrice of

Preferredshares

First RoundCommon SharesSeries A Preferred Shares

$1.007,5002,500

7,5002,500

75.00%25.00%

SharesIssued(000s)

CommonShares AfterConversion

Percent ofCompanyOwned

Capitalization No Dilution Protection

Second RoundCommon SharesSeries A Preferred SharesSeries B Preferred Shares

$1.00$0.50

7,5002,5002,000

7,5002,5002,000

62.50%20.83%16.67%

Second Round Capitalization Weighted Average Dilution Protection

Common SharesSeries A Preferred SharesSeries B Preferred Shares

$0.917$0.50

7,5002,5002,000

7,5002,7272,000

61.34%22.30%16.36%


6. Preemptive Rights


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Requires the portfolio companys management to offer the stock for

sale to the venture capitalist at the same price and terms negotiatedwith a third party.

Limits the liquidity of shares of the management

Goals of the venture capitalist

Option to increase its stake in the company

Possibility to control the composition of the shareholder group

Right of FirstRefusal

Management must merely define the minimum price and terms it willaccept for the sale of stock to third parties. The venture capitalistthen has the option to purchase the stock at these minimum termsfor a designated period of time.

From the perspective of the venture capitalist, less attractive as itdoes not control the shareholder structure as effectively as the rightof first refusal.

Right of FirstOffer


7. Disinvestment Rights (1/2)


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Right of the VC/PE firm to participate in any sale of stock by themanagement (usually on a pro rata basis)

Protection against a sell-out by the companys management

Requires the management to sell their shares to a third party if

the VC/PE firm sells his shares Ensures that the management is not capable of upsetting

an exit possibility by not participating in a trade sale

Tag-along right

Drag-along right


7. Disinvestment Rights (2/2)


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Entitles the VC/PE firm to sell the stock to the company

The company is required to repay the initial investment plusa minimum interest rate to the VC/PE firm

Exercisable at the will of the VC/PE firm but usually onlyafter a certain event has occurred

Entitle VC/PE firms to require their portfolio company to registerits shares for sale to the public.

Mechanism to exit: help the VC/PE firm to realize anexit where the management still hesitates to undertake anIPO.

Registration rights

Redemption right


Financing an MBO / LBO Transaction


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Management is seeking to execute an MBO

Vendor is prepared to accept a price of EUR 20 mil

Business turns over EUR 30 mil and achieves a profit after tax of EUR 2 mil

Business has no existing debt or cash

Management believes that the company will be able to make profits aftertax of EUR 4 mil in five years time when the company will have cash of

EUR 16 mil and in total will be worth EUR 56 mil

They have told the potential investors that they

are able to invest EUR 250.000

want to own 40 % of the company

Company Data

Example for deal structuring of a MBO

The effect of various types of finance on the eventual return to the investor




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MBO Company Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Earnings before interest and tax 2.0 2.4 4.02.8 3.2

0.0 0.0 0.00.0 0.0 0.0

3.6

Interest

0.0 0.0 0.0 0.0 0.0 0.0Tax

Earnings after interest and tax 2.0 2.4 4.02.8 3.2 3.6

0.0 2.4 5.2 8.4 12.0 16.0Cash Balance

Value of the Company(10 times earnings before interest and tax) 20.0 40.0

Plus cash

Cost of acquisition

Proceeds available on exit

20.0

0.0

0.0

56.0




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Investors accept terms and invest EUR 19.75 mil in return for 60% of thecompany

In five years time they will receive back 60% of EUR 56 mil = EUR 33.6 mil

IRR = 11% per annum

Management then converts EUR 250.000 into EUR 22.4 mil

Example for deal structuring of an MBO: OPTION A

The effect of various types of finance on the eventually return to the investor

Option A Cash(in mil) %

IRR(in %) Proceeds

Investors ordinary equity 19.750 60 11.2 33.600

0.250 40 145.7 22.400Managements ordinary equity

20.000 100 56.000Total Option A




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Investors do not accept terms and pay the same price as the managementfor the ordinary shares otherwise the risk that management makes profiton the investment and investors make substantial losses, is too high

(e.g. if company was worth only EUR 30 mil after five years, thenmanagement would receive 12 mil for a profit of EUR 11.25 mil, whileinvestors would receive 18 mil for a loss of EUR 1.75 mil)

Hence, if management pays EUR 250.000 for 40% of common shares, theinvestors should pay EUR 375.000 for 60% making a total of common stockof EUR 625.000. The investors could then invest the remaining EUR 19.375mil in preferred shares, which must be redeemed at the time of the sale ofthe company

When company is sold for EUR 56 mil, investors would receive back EUR19.375 plus 60% of EUR 56 mil less EUR 19.375, which is in total EUR41.35 mil management would receive EUR 14.65 mil

Now investors would have a return of 16%, which is still too low

Example for deal structuring of a MBO: OPTION B



Financing an MBO / LBO Transaction: OPTION B


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Option B Cash(in mil) %

IRR(in %) Proceeds

Investors preference shares 19.375 19.375

0.375 60 21.975

Managements ordinary equity 0.250 40 14.650

20.000 100 56.000Total Option B

Investors ordinary equity

19.750 41.350Investors total 15.9

125.7



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Another possibility is to introduce debt to the transaction

With pre-tax profits of EUR 3 mil by year 2, the company could afford to payinterest in around EUR 10 mil of debt and still covers the interest aroundthree times (profit is three times interest rate)

Lender will ask for a covenant that interest is always covered more thantwice

IRR would turn to over 25%, as investors would only have to pay EUR9.375 mil instead of EUR 19.375 mil

Example for deal structuring of a MBO: OPTION D



Financing an MBO / LBO Transaction: OPTION D


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Option D Cash(in mil) %

IRR(in %) Proceeds

Investors preference shares 9.375 15.090

0.375 60 14.883

Managements ordinary equity 0.250 40 9.922

20.000 100 56.000Total Option B

Investors ordinary equity

9.750 29.973Investors total 25.2

108.8

With 10% cumul. dividend

10.000 16.105Bank debt (10% cum. Interest)


Contingent Structure of Venture Capital/Private Equity Contracts


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Financial and controlrights of entrepreneur

Company performance

VC/PE firm relinquishesseveral financial and control

rights

VC/PE firm obtains extensivefinancial and control rights


Effects of Typical Venture Capital/Private Equity Contractual Agreements


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Applicable Not applicable

Reduce risk of

Effects

Contractual rights

managerial

opportunism

Disinvestment rights

competitive

opportunism

unfavorable

decision taking

exit

obstruction

Preemptive rights

Cash flow rights

Milestone agreements

Managementcovenants

Control rights

Information rights


Literature


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Kaplan, S. / Strmberg, P. (2003): Financial contracting theory meets the real world: an empiricalanalysis of venture capital contracts, in: Review of Economic Studies, 70 (2), pp. 281-315.

Sahlman, W. (1990): The structure and governance of venture-capital organizations, in: Journal ofFinancial Economics, 27, pp. 473-521.


Agenda


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6.3 Investment Exit



Roles of the VC/PE firm in the Investment Development Phase


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Monitor

Protecting the valueof the investment

Coach

Enhancing the valueof the investment


Approaches towards the Coaching Functions of the VC/PE investors


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VC/PE firms do notinterfere with thedecisions of themanagement of aportfolio company andfollow a laissez-fairepolicy

VC/PE firms are activelyinfluencing themanagement of theportfolio company

Involvement of the VC/PE firm

Hands-offapproach

Hands-onapproach


Investment Development


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FOCUS on VC


Certification as Indirect Activity of Venture Capitalists


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Venture capital-backed companies benefit from the reputation of their venture capital firms

Transmission ofvaluable signals about a portfolio company to third parties:

Customers

Suppliers

Investors

Personnel and management

Investment banks

Accountants

Reduction of asymmetric information and transaction barriers

certification


Resource Provision Table of Venture Capitalists


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Social resources

Resource categories

Technological resources

Financial resources

Managerial resources

Personnel resources

Physical resources

Organizational resources

Reputational resources

Resource provision by venturecapital firms

(

/ )

Some resources provided No resources provided

Source: Fingerle,C. (2004): Smart Capital the Influence of Venture Capitalists on High Potential Companies.


Stages and Value Adding Activities


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Financial engineering

Extent of activity

Early stage Later stage

Hands-on coaching


Performance and Extent of Involvement


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Potential write-off Living dead On-track High-flyer


Performance and Extent of Involvement Contrary Opinions


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(need for oversight argument)Extent of venture capitalists involvement depending

on performance

high low

Extent of venture capitalists involvement depending on

performance (prospect theory argument)low high

Living dead On-trackPotential write-off High-flyer


Prospect Theory


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Assumptions The value function

Value is defined in terms ofgains and losses and evaluatedto a reference point (deviations)

Value function has a differentshape for gains and losses

Value function is concave forgains

Value function is convex andsteeper in the area of losses

Utility gainof venture capitalist

Value increaseof portfolio company

Reference point

Utility lossof venture capitalist

Value decrease

Utility loss

Utility gain


Investment Development


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FOCUS on PE


Different Categorization for Value Drivers in PE Transactions (1/4)


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Operative support /restructuring

Strategic orientation

Reduction of agencycosts

Mentoring

Financial arbitrage


Financial value drivers

Operative and strategic

value driver Corporate governance

Source: Own diagram based on Berg/Gottschalg (2005)

General conditions




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Source: Own diagramme based on Berg/Gottschalg (2005)

Operative support / restructuring through

Cost reduction, efficient management and

increase of margins (outsourcing, cost control,overhead reduction)

Optimizing capital employment(working capital management and reduction)

Improving personnel and decision makingprocesses (increasing productivity and

competence) Contribution of managerial resources

Strategic orientation through

Reorientation of markets and products(price policy, improving customer service,distribution channels, redefining target groups)

Focus on core competences

Operative support /restructuring

Strategic orientation

Operative and strategicvalue driver




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Reduction of monitoring costs through

interest alignment (share ownership,

performance-related compensation) Strict monitoring (reports and boards) and

disciplining effect of debt (preventing empirebuilding)

Mentoring support by private-equity investors

through:

Contribution of industry know-how andmanagement expertise

Contribution of social and industry networks

Reduction of agencycosts

Mentoring

Corporate Governance




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Financial arbitrage: no value creation(buy-low and sell-high; leveraging company pricechanges due to changes in market prices,identification and correction of mispricing)

Financial engineering: no value creation but valueshift (often on the account of creditors)

Above average proportion of debt

Tax deductibility Leverage effect

Reduction of agency cost of free cash flow

Financial arbitrage


Financial value drivers


Value transfer hypothesis

Conflict in Theory: Value Transfer versus Value Creation


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Basic hypothesis: no creation of new value within a buyout transaction

- just a value transfer in favor of the private equity companies.

Consequently, there must be stakeholders that are negatively affected by the

transaction, e.g.

Employees: value transfer due to personnel cost reduction BUT no

empirical confirmation

State: tax saving of portfolio company due to high leverage, yet post-

buyout tax payments could be higher and all related buyout parties have to

be considered

Debt providers: due to increased leverage, worse creditworthiness and

increased default risk, yet covenants buffer the risk (change-of-control-

clause)

Diverging opinions within scientific empirical research

Value transfer hypothesis

Source: Lowenstein (1985) and other studies


Value creation hypothesis

Conflict in Theory: Value Transfer versus Value Creation


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Value creation hypothesis

Basic hypothesis: there is a creation of new value within a buyout transaction

Value creations emerge due to improvements within the portfolio company

Among others due to reduction of agency costs, disciplining function of debt

and better monitoring systems (see also slides before)

Or due to increase in entrepreneurial flexibility and reduction of bureaucracy

Majority of empirical studies confirms that buyout transaction are subject

of significant value increases due to an increase in profitability and

productivity

Scientific studies confirm the value creation hypothesis, nonetheless, in

most cases value increases are caused by a mixture of value transfer and valuecreation

Source: Meier et. Al. (2006), Wright et. Al. (1996) and others.


Evaluation of Value Creation A Practical Approach

Operational effects


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Source: Achleitner et al. (2010)

Value creation EBITDA growth Free cash flow (FCF)effect

Multiple effect

EBITDA at entrycompared to EBITDA atexit.

EBITDA serves as abasis for valuing acompany (assumingunchanged EBITDAmultiples).

Cash flows that are beinggenerated on a companylevel over the holdingperiod.

Amongst others, free cashflow is used for payingdown debt or for payingdividends.

This illustrates the de-leverage effect, not theleverage effect.

EBITDA multiplesrepresent the enterprisevalue as a multiple ofEBITDA.

Change in EBITDAmultiples between entryand exit impacts theenterprise value.

Increase in equity valuefrom a GPs point of view.

EBITDA effect can be

further split into sales

effect and EBITDA

margin effect.


Evaluation of Value Creation ExampleSales Effect

( Sales) x Margin @ Exitx EV/EBITDA @ Exit


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Entry 4 years Exit

Sales (m) 100.0 150.0

EBITDA Margin (%) 10% 15%

EBITDA (m) 10.0 22.5

EV/EBITDA (x) 10.0 12.0

Enterprise Value (m) 100.0 270.0

Net Debt 70.0 5

Equity 30.0 265.0

EBITDA Effect

( EBITDA) x EV/EBITDA @ Exit

Margin Effect

( Margin) x Sales @ Entry

x EV/EBITDA @ Exit

+

=

Multiple Effect

( Multiple) x EBITDA @ Entry

FCF (De-leveraging) Effect

( Net Debt)

Total Value Creation = Equity

Money Multiple = Equity @ Entry / Equity @ Exit

Entrepreneurial Finance Summer Term 2015 Page 64

Literature


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Berg, A. / Gottschalg, O.F. (2005): Understanding Value Generation in Buyouts, in: Journal of

Restructuring Finance, 2 (1), pp. 9-37.

Dotzler, F. (2001): What do venture capitalists really do, and where do they learn to do it?, in:Journal of Private Equity, 5 (1), pp. 6-12.

Easterwood, J. / Seth, A./ Singer, R. (1989): The impact of leveraged buyouts on strategicdirection, in: California Management Review, 32 (1), pp. 30-43.

Lowenstein, L. (1985): Management Buyouts, in: Columbia Law Review, 85 (4), pp. 730-784.

MacMillan, I. / Kulow, D. / Khoylian, R. (1988): Venture capitalists' involvement in theirinvestments: extent and performance, in: Journal of Business Venturing, 4, pp. 27-47.

Meier, D. / Hiddemann, T. / Brettel, M. (2006): Wertsteigerung bei Buyouts in der Post Investment-Phase - Der Beitrag von Private Equity-Firmen zum operativen Erfolg ihrer Portfoliounternehmen imeuropischen Vergleich, in: Zeitschrift fr Betriebswirtschaft, 76 (10), pp. 1035-1066.

Wright, M. / Wilson, N. / Robbie, K. (1996): The longer term performance ofmanagement buy-outs, in: Journal of Entrepreneurial and Small BusinessFinance, 5 (3), pp. 312-334.


Agenda


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6.3 Investment Exit



Exit Possibilities (1/2)


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Liquidation

Buyback

IPO

Trade Sale

Secondary Sale

Pros/cons according to perspective

Dependent on

Capital market situation

Overall economic conditions

IPO window forsector/industry

Comparable M&A activity andnumber of potential buyers

Source: EVCA (2002)


Exit Possibilities (2/2)


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Investee company is bankrupt and the VC/PE firm has to

write off the complete investment.Liquidation

Repurchase of the VC/PE firms stake by the entrepreneurs.Buy Back

Initial Public Offering is the first sale of stocks by a privately

held company to the public. Issued stocks are then tradedon the stock market.

Sale of the VC/PE firm's stake to another financial investor.Secondary Sale

Purchase of the investee company by another corporation.

IPO

Trade Sale


VC/PE Firms Role in the Exit Process


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Decision on exit route

Advice helping the company to grow in line with exit decision

Validation of expected price

Selection of key advisers


Success Factors in an IPO


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Speed, co-ordination, and timeliness

IPO team working together to raise the companys public profileand awareness of the impending flotation

Generation of a perception of scarcity amongst potentialinvestors

Positive market view of the companys future

Favorable exogenous factors

Source: EVCA (2002), Entrepreneurship Education Course, Modul 8, Exit: IPOs and Trade Sales, p. 9.


Evaluation of a Public Sale


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Advantages Disadvantages

Limited to High Flyers

Strong dependence on stock

exchange conditions/IPO

window

No full investment reduction

possible

Higher costs and time

expenditure

Higher exit proceeds

Lower potential for conflicts

Higher reputation

Possible triggering of a takeover

Flexible investment reduction Participation in future value creation

of the portfolio company

Source: Paffenholz, G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.114


Benefits and Downsides of Public Quotation for the Company


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Access to a potentially unlimited sourceof capital

Currency for acquisitions(the companys own stock)

Better reputation - impact on

relationships with all key businessconstituents(employees, customers, suppliers)

Financial rewards for the companysfounders and stock option beneficiaries

Benefits

Cost/inconvenience of uncertain andlengthy IPO process

Ongoing reporting obligations of a publiccompany

Hard to satisfy short/medium-term

market expectations withoutcompromising the companys long-termprospects

Exposure to systemic market risks,which can affect a companys stockirrespective of its own performance

Unsolicited take-over offers

Downsides

Source: EVCA (2002)


Definition Lock-up


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Lock-up

Agreement between underwriters and existing shareholders notallowing the existing shareholder to sell any shares for a certain

specified period of time.


Definition Grandstanding


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Grandstanding

Young venture capital firms take their portfolio companies public

earlier than established venture capital firms in order to built up

reputation and successfully raise capital for new funds.

Source: Gompers, P. (1996): Grandstanding in the venture capital industry, in: Journal of Financial Economics, 42 (1), S. 133-156, p. 133


Trade Sale

Sale of the portfolio company to


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p p y

As the buyer has a strategic interest in the firm, usually all shares of the company have to besold, i.e. the entrepreneurs have to sell their shares alongside the other financial investors.

conflicts of

interest

Competitor horizontal integration Supplier/customer vertical integration

Probably prefers a complete sale Might have a strong interest to resist

a trade sale

AcquirerCurrent

managementteam


Phases of a Trade Sale


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Identificationand selection ofpossible buyers

Initial contact

Distribution of

informationmemorandum

Contribution ofletter of intent

Due diligenceby potentialbuyers

Start ofnegotiations

Form ofcontract andcontact closing

Source: Paffenholz,G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.122.

InternalProcessing

Agreement onexit strategy

Analysis ofcompany

If necessary

restructuringmeasures

Preparation of adata room

Identification ofBuyers

Valuation/Negotiations


Success Factors in a Trade Sale


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A leak may trigger adverse reactionsfrom employees, customers or suppliers

Such reactions may spook the

purchaser into seeking to renegotiate orabandoning the deal

Other potential buyers have lower

interest in targets widely known to be upfor sale

If sale does not take place, desire to sellmay be seen as indication for vendorslack of confidence in the businessfuture, negative spiral

Secrecy

If potential purchaser sense that otherparties may be interested, this will help to

create a sense of urgency

maximize the price

ensure that acquirers remain honest

(i.e. do not continually try to renegotiate)

Competition

Source: EVCA (2002)



Evaluation of a Trade Sale


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High potential for conflicts

Limited number of potential

buyers

Obligation to accepted non-cash

or payment by installments Obligation to grant guaranties

Higher exit proceeds, but also

possibility to exit in case of a

moderate development

Immediate and complete exit

possible

Easier, quicker and cheaper

transaction (compared to an IPO)

Source: Paffenholz,G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.120


Influence of Exit Strategy on Growth Strategy


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Company needs to be well-rounded and

capable of thriving as an independent

entity

Build an IPO-ready mentality

Main requirements are

quarterly budgets and forecasts accounting standards for publiccompanies

disclosure standards for publiccompanies

public relations conference tour

IPO

Company does not have to be a

complete firm and may lack entire

functions

Purchaser may only be interested in one

function

At least one aspect of the companyshould be directed to achieve the

best in class

Trade Sale

Source: EVCA (2002)


Mini Quiz


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?Would you as investor prefer a trade sale or an IPO as exit route?



Evaluation of a Secondary Purchase


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g g

Low potential for high returns

Reservation of potential buyers

Small number of market

participants

Possibility to exit even if portfolio

company is still immature

Low potential of conflicts

Simple and quick transaction

Rarely problems to identify relevantpotential buyers

Source: Paffenholz,G. (2004): Exitmanagement Desinvestition von Beteilgungsgesellschaften, p.124


Recommendation Readings


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Brian Burrough and John Heylar (1990): Babarians at the Gate: The fall of RJR Nabisco.

Sebastian Mallaby (2010): More Money than God: Hedge Funds and the Making of a New Elite.

Daniel Schfer (2006): Die Wahrheit ber die Heuschrecken. Wie Finanzinvestoren die Deutschland AG umbauen.

Paul Jowett and Francoise Jowett (2011): Private Equity: The German Experience.

Stephan Eilers, Nils Koffka, and Markus Mackensen (2012): Private Equity: Unternehmenskauf, Finanzierung,

Restrukturierung, Exitstrategien.

Eli Talmor and Florin Vasvari (2011): International Private Equity.


6 VC PE Investment Process

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