VENTURE CAPITAL AND THE GROWING COMPANY IBA Singapore 2007 Horacio Bernardes Neto

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1 VENTURE CAPITAL AND THE GROWING COMPANY IBA Singapore 2007 Horacio Bernardes Neto 1. INTRODUCTION Venture capital is a type of private equity capital provided by professionals who invest in financing new and rapidly growing companies at the early stage of development ( start-ups ). Venture capital can also be provided to companies during different stages of the life cycle of the business. Venture capital investments involve higher risks and have a long-term orientation, but offer the potential for above-average returns. It is an important source of capital for start-up companies. Innovative entrepreneurs tend to have intangible assets and ambitious growth plans that require large amounts of financing, which will hardly be provided through traditional alternatives. The need to offer high returns makes venture funding an expensive capital source for companies and most suitable business having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt capital. The majority of the venture capital comes from groups of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. It is the case of the venture capital funds, which are pooled investment vehicles that primarily invests third-party investors funds in enterprises that are too risky for the standard capital markets or bank loans. Venture capital firms are comprised of General Partners (also known in this case as "venture capitalists" or "VCs") who are the investment professionals which are former chief executives at firms similar to those which the partnership finances and other senior executives in technology companies, and the Limited Partners, which are the investors, such as state and private pension funds, university financial endowments, foundations and insurance companies. Venture capitalists can be generalists, investing in various industry sectors, or various geographic locations, or various stages of a company s life cycle. Alternatively, they may be specialists in one or two industry sectors, or may seek to invest in only a localized geographic area. Venture capital firms usually have strict requirements to select companies to invest in. Companies with a solid business plan, a good management team, investment and passion from the company founders, a good potential to exit the investment before the 1

2 end of their funding cycle, and target minimum returns in excess of 40% per year shall not encounter difficulties in raising venture capital. Generally, venture capital investment is made in cash in exchange for shares in the entrepreneurial company. However, far from being a passive financing alternative, venture capitalists also foster the growth of the venture companies through their involvement in the management of the company, strategic marketing and planning, providing assistance in the development of new products or services. Venture capitalists mitigate the risk of venture investing by developing a portfolio of young companies in a single venture fund. Many times they will co-invest with other professional venture capital firms (syndication). Most entrepreneurial companies seek to raise venture capital to support or stimulate economic growth. Other companies raise venture funding to establish credibility or to access resource networks which their venture capital partners have developed through years of experience. Today's global business environment is increasingly competitive requiring decisiveness, broader relationship networks, abundant financial resources, and a global presence in order to compete effectively. The venture capital relationship can often bring that exact mix of support in addition to financial funding. 2. THE LIFE CYCLE OF EQUITY INVESTMENT, FROM THE SEED AND START-UP CAPITAL TO EARLY AND LATER EXPANSION STAGES AND BEYOND Venture capital firms may provide financing for entrepreneurial companies at various stages of their business life cycle. A venture capital financing may be provided before there is a real product or company organized (so called "Seed Investing"). It also may be provided for a company which already developed a product and engaged in initial marketing activities ( Start-Up Investing ), or to a company in its first or second stages of development ("Early Stage Investing"). Also, the venture capitalist may provide needed financing to companies which already have a product or service commercially available, but need help to grow beyond a critical mass to become more successful ("Expansion Stage Financing"). Some venture capitalists focus on Later Stage Investing by providing financing to help the company grow to a critical mass to attract public financing through a stock offering (IPO). Alternatively, the venture capitalist may help the company attract a merger or acquisition with another company by providing liquidity and exit for the company s founders. 2

3 Moreover, there are also venture capital firms which provide Buyout Financing, a capital to enable an acquisition of a product line, a company s division or a whole company, or Turnaround Financing for companies in financial distress (not earning their cost of capital). Some venture capital firms provide financing for public held companies, a type of investment often called Private Investment in Public Equity (PIPE Deals). The venture capital firms subscribe shares issued by the company, which are acquired with a slight discount in relation to their stock market price. It provides the companies with quick access to capital at a reasonable transaction cost. On the other hand, investors find these investments attractive because they buy shares with a discount in relation to the stock market price, and because it provides an opportunity to acquire a considerable position without having to chase a rising stock price caused by their own purchases. The venture capital investment is neither a short term nor a liquid alternative of investment. An early stage investment may take 7 to 10 years to mature, while a later stage investment may only take a few years, depending on the limited partners appetite for liquidity. Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of extensions in case of private companies still seeking liquidity. The investing cycle for most funds is generally 3 to 5 years, after which the focus is managing and making follow-on investments in an existing portfolio. The Limited Partners have a fixed commitment to the fund that is "called down" by the VCs over time as the fund makes its investments. There can be substantial penalties for a Limited Partner that fails to comply with a given capital call. Venture capital funds are most interested in ventures with exceptionally high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required timeframe, which is achieved through the reduction of agency costs and information asymmetry between the company and the potential buyer. Information asymmetry occurs when one party to a transaction has more or better information than the other party. Agency costs are the costs incurred by an organization that is associated with problems such as divergent management-shareholder objectives and information asymmetry. In this context, the total duration of a venture capital investment shall depend on several factors, such as (i) the quality of the entrepreneurial firm; (ii) the stage of the company's development at the time of initial investment; (iii) the nature of the firm's assets (e.g., high-technology); (iv) the structure of the investment, among others. 3

4 Higher quality entrepreneurial companies have greater growth potential and are less risky. Venture capitalists also certify the quality of the firms in which they invest through their involvement and assistance in the management of the company (including finding suitable legal and accounting advisors, securing distribution networks and reliable suppliers, and making strategic decisions), which ultimately causes the reduction of the cost of information asymmetry between the venture capitalist and the company. The stage of development of the firm will influence investment duration. The earlier the stage of development, the longer the investment duration it shall take more time to venture capitalist to make the investment mature. Moreover, the agency costs associated with investing in early stage firms are more pronounced. The nature of the firm's assets will also influence investment duration. Specifically in high technology industries, for instance, information asymmetry is higher than other industries. For that reason, high-technology investments shall be longer than other investments. Longer investment duration enables the venture capitalist to minimize the pronounced agency costs between high-technology entrepreneurial companies and potential buyers, maximizing the value of the company upon exit. In respect of investment structure, the venture capital investment may be staged or syndicated. Staging involves periodic capital flows to the entrepreneurial venture, rather than a lump-sum amount of financing at the outset, contingent upon on-going satisfaction of performance reviews. It allows closer monitoring, which causes the reduction of information asymmetry. Syndication involves more than one venture capital firm investing in an entrepreneurial venture. It facilitates risk avoidance through risk sharing, enables better and more informed investment decisions, and mitigates the hold-up problem inherent to a single supplier of capital. The greater the number of investors, the better the signal to the potential buyers that there exists less informational asymmetry associated with investing in the venture. Therefore, staged or syndicated investments may reduce the investment duration. The agency costs associated with information asymmetry between entrepreneurs and any potential buyer will be lower the longer the venture capitalist maintains a relationship with the entrepreneurial firm. A more established entrepreneurial firm will have a more efficient organizational structure, distribution channels and a better developed relationship with legal and accountant advisors. By the time of the exit of the venture capitalist, the entrepreneurial firm shall be sufficiently mature so that the venture capitalist may not create significant additional 4

5 value to the company. Once this stage is achieved, the entrepreneurial firm may have access to other funding sources. 3. THE ROLE OF BUSINESS ANGELS, VENTURE CAPITAL FUNDS AND OTHER INVESTORS IN GROWING COMPANIES Business angels (or Angel investors) are wealthy individuals who provide seed or startup financing to entrepreneurial firms usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors are organizing themselves into angel networks or angel groups to share research and pool their investment capital. They play an important role in the venture capital industry by filling a financing gap existing between entrepreneurs and venture capital firms. Most entrepreneurs who do not have a well structured business plan, or cannot meet with the strict requirements of any venture capital firm to apply for financing, may seek funding from angel investors, who may be more willing to invest in highly speculative opportunities, or may have a prior relationship with the entrepreneur. Many venture capital firms will only seriously evaluate an investment in a start-up otherwise unknown to them if the company can prove at least some of its claims about the technology and/or market potential for its product or services. To achieve this, or even just to avoid the dilutive effects of receiving funding before such claims are proven, many start-ups seek to self-finance until they reach a point where they can credibly approach outside capital providers such as VCs or angels. This practice is named "bootstrapping". Business angels are increasingly occupying the space left behind by venture capitalists. They are making more and larger investments into early-stage businesses, and coalescing into networks based upon geography or sector. There is a great potential for angel investors to serve as the patient, experienced, and expert source of money required by many early-stage businesses, although it is unlikely that they will be able to fulfill all of the companies finance requirements. 4. GOVERNMENT AND OTHER PUBLIC REGULATORY INTERVENTION IN VENTURE CAPITAL, INCLUDING PUBLICLY- BACKED INVESTMENT SCHEMES The governments seek to encourage additional funding to strategically important areas that are presently unattractive to private sector investors and they also need 5

6 simultaneously to attract experienced venture capitalists to manage the funds which they support. The primary role for governments in developing a functioning venture capital market is considered by its practitioners and scholars to be restricted to the creation and maintenance of conductive fiscal and legal environments for venture capital financing. Many public programs have recognized the possible adverse effects of government involvement in markets, mainly in concern of new venture investment, because this would carry a material risk of market disruption through the potential misallocation of capital and the consequent crowding out of private investors. However, government s direct intervention in the supply of venture capital has frequently been defended in market failure arguments. According to this logic, public involvement is a contingent response to private shortcomings. It is only considered necessary in those specific conditions where the capital markets either refrain from investing or provide insufficient finance for the available opportunities. Thus, the programs of government intervention shall be seen as a temporary correction. Public/private hybrid investment activity is typically directed towards areas where private markets are believed to be under-developed or where difficult investment activity, e.g. early-stage equity finance in technology ventures, has been increasingly abandoned by private investors in favor of more lucrative, and less uncertain, later-stage market opportunities. These public backed schemes may vary according to the needs of the domestic economy. However, there are basically three different kinds of structures: (i) structure based on the different timing of public and private investments, which can create a great leverage and benefit for the private investor; (ii) incentive structures based on capping public investor s profits and providing the public investment as a subordinated loan (a loan that ranks below other loans with regard to claims on assets or earnings, in case of default riskier than unsubordinated debt); (iii) incentive structure that provides a down-side guarantee against the failure of investments - such structure focus on minimizing the costs of adverse selection (i.e. bad investments) to the investors, which provides only very modest possibilities for altering that distribution of rewards. 5. DEVELOPMENT OF EXIT STRATEGIES FOR ENTREPRENEURS AND VENTURE CAPITALISTS A venture capitalist may exit an investment through an initial public offering (IPO), a merger or a sale to a potential buyer, secondary market sale, buyback, liquidation of assets (in case of failure). The choice of the strategy depends on the market conditions and industry trends since the venture capitalist s target is to achieve maximum return. 6

7 The initial public offering is the most glamorous and visible type of exit for a venture investment. It usually offers more opportunities for valorization of the venture company. Mergers and acquisitions represent the most common type of successful exit for venture investments. In the case of a merger or acquisition, the venture firm will receive stock or cash from the acquiring company and the venture investor will distribute the proceeds from the sale to its limited partners. Secondary market sales are also an alternative when venture capital firms transfer the venture capital fund s ownership to another venture capital firm. The company may also be required to buy back a venture capital firm's stock at cost plus a certain premium. Often a venture capital firm will put a redemption clause (sometimes referred to as a "buy-back clause") in the investment terms which allows them to exit their investment in the company in the event that an IPO or acquisition does not happen within a designated time period or does not happen at all. The venture capitalist may also partially exit the business, which may indicate the quality of the entrepreneurial company and cause the mitigation of informational asymmetry between the entrepreneurial company and any potential buyer. 6. KEY TERMS AND PROCESSES FOR SEED AND VENTURE CAPITAL INVESTMENT Before effectively invest in an entrepreneurial company, the venture capitalist perform several studies in order to confirm the economic viability of the business and to ensure maximum returns upon exit of the business. This pre-investment phase comprises the elaboration of a business plan, so as to determine company s operational activities and businesses, market conditions, company s strategies and elaborate financial projections. It also comprises a due diligence process in order to verify company s assets and obligations (including contingent obligations) in order to enable the venture capital firm to identify the company s status. The primary objectives of the due diligence process are to (i) understand how management approaches problems, issues and decisions; (ii) confirm management's representations and the investor's own perceptions regarding the company's technology and market opportunities; (iii) identify key vulnerabilities and risks so that the risk/reward outlook can be quantified; (iv) gain an intimate understanding of the company and its market so that as a partner, the venture capitalist is prepared to counsel management to anticipate and manage change. 7

8 Should the venture capital firm have interest to continue negotiations and to invest in the company, the parties may execute a Term Sheet which may outline the key financial and other terms of a proposed venture capital investment. Such Term Sheets are usually not meant to be legally binding and may also contain some conditions to be met before the investment is completed. It also shall serve as basis for the drafting of the investment documents and, therefore, the more detailed the Term Sheet, the fewer issues to be agreed upon during the drafting process. The Term Sheet may include the following terms: (i) the type of shares to be subscribed by the venture capital firm; (ii) the valuation of the company, obtained in accordance with the due diligence process; (iii) reinvestment of dividends; (iv) liquidation preferences; (v) redemption clause (which entitles the venture capitalist to exit the investment in the company in the event that an IPO or acquisition does not happen within a designated time period or authorizes the founders to buy back its own shares from the investor); (vi) preemption rights on new shares issue; (vii) right of first refusal, co-sale and tag along rights; (viii) drag along rights; (ix) consent rights (veto power); (x) voting rights; (xi) participation in the board of directors; (xii) information rights; (xiii) exit events; (xiv) confidentiality; (xv) intelectual property assignment; (xvi) noncompete rights; (xvii) exclusivity for the venture capital firm; (xviii) Liquidation preferences (the amount payable to the venture capitalist upon a sale of the company in priority to any payments made to the entrepreneurs); (xix) participation rights (right to participate along with entrepreneurs in the sale proceeds remaining after the payout of the liquidation preferences, usually capped at a multiple of the purchase price of the shares subscribed by the venture capitalist); (xx) management cave outs (provisions whereby a certain amount or percentage of future sale proceeds will be set aside for management and other designated employees, and are structured so that any liquidation preferences of the preferred stock are subject to these initial carve outs. It ensures the retention of the management members and main employees in case of sale of the venture company). Generally, the main documents required for an investment round in venture capital financing are a Subscription Agreement, a Shareholders' Agreement and an Articles of Association or Bylaws. The Subscription Agreement will usually contain details of the investment round, including number and class of shares subscribed for, payment terms and representations and warranties about the condition of the company. The Shareholders' or Agreement will usually contain investor protections, including veto powers, rights to board representation, drag-along provision, put and call options, as well as non-compete restrictions. Finally, the Articles of Association/Bylaws will include the rights attaching to the various classes of shares, the procedures for the issue and transfer of shares, the holding of shareholder and board meetings, quorums, veto powers for specific decisions and attributions of the management of the company (Board of Directors and/or Executive board). 8

9 7. THE ROLE OF LEGAL ADVISERS Besides financial provision, venture capital can also include managerial and technical expertise, providing business advice, access to networks, commercial development and legal support. In fact, the pre-investment phase involves the employment of accountants, lawyers and industry specialists. Investing in early-stage business, for example, frequently entails higher risk because they often have unproven business models, less experienced management and fewer tangible assets. In this context legal advisers must act independently, acting as technical consultants and conducting the due diligence processes, which shall involve rigorous analysis, multiple meetings and interviews with management, at both the investor's and company's offices. Simultaneously with the due diligence process, the venture capitalist and management will negotiate terms of the investment. Legal advisors may actively work on the drafting the term sheets and the investment agreements (Subscription agreements, Articles of Associations/Bylaws and Shareholders Agreement). Also, the incorporation of venture capital funds requires the participation of legal advisors. Legal advisors may also actively contribute for the preparation of the entrepreneurial company for the capital markets. The modifications in the company s management structure, the creation of stock option programs and the adoption of corporate governance standards shall be implemented under the supervision of a legal advisor. 8. VENTURE CAPITAL IN BRAZIL Brazilian private equity and venture capital markets are growing. According to a research performed by the Fundação Getulio Vargas Private Equity and Venture Capital Study Center (GVcepe) and Endeavor Institute, the amount of capital committed for the private equity (PE) and venture capital (VC) funds has raised from US$ 5.6 billion in 2004 to US$ 16.7 billion in In comparison with the United States 2007 PE and VC markets, which amounted to US$ 400 billion, the Brazilian market is still modest, but with a very promising growth capacity. This increase may be attributed to the current global liquidity and the improvement of Brazilian economic scenario. 9

10 The increase of private equity and venture capital investment in Brazil is reflected on the capital markets. 28 out of 72 initial public offerings (IPO) which took place in the São Paulo Stock Exchange (BOVESPA) from 2004 until the second quarter of 2006 were carried out by companies which received private equity and venture capital funding. Some of the Brazilian internationally recognized companies received venture capital funding, such as Natura (cosmetics), GOL (aviation), ALL (logistics), CPFL (energy), Dasa (Medicin and esthetics), Submarino (department store), UOL (internet), Lupatech (industrial valves and metals), Gafisa (real state) and Totvs (software). Independent organizations (i.e. not related to banks or industrial sectors) are the majority in the Brazilian private equity and venture capital markets, summing up to 70% of the existing players. Governmental organizations account for 8.5% of the market through BNDESPar (investment arm of BNDES Brazilian Development Bank) and Financiadora de Estudos e Projetos (Finep). The Ministry of Science and Technology also stimulates the entrepreneurial innovation through several programs, among then, the INOVAR Project. It aims to promote the development of small and medium size technology based business through the creation of mechanisms for financing, especially venture capital. Since 2003, the Brazilian Securities and Exchange Commission (CVM) is setting out the regulatory framework for the private equity and venture capital markets CVM Normative Ruling No. 391/03 promoted the creation of venture capital funds, which leads to more transparency between the investor and the fund management and the establishment of firm fund governance rules and alternative dispute resolution mechanisms such as arbitration. CVM Normative Ruling No. 391 provides for the formation, operation and management of venture capital investment funds. Firstly, in order to operate, those funds must be registered before CVM. Only qualified investors (which, pursuant to CVM Normative Ruling No. 409, are financial institutions, insurance companies, individuals or entities with financing investments in excess of R$ 300,000.00, investment funds for qualified investors, among others) are authorized to invest in such funds, with a minimum subscription amount of R$ 100, Closely-held companies (companhias fechadas) which receive financing from such funds shall adopt corporate governance standards, such as: (i) prohibition to issue founders shares (partes beneficiárias); (ii) 1-year mandate for all Board of Director s members; (iii) adoption of arbitration to settle corporate-related conflicts; (iv) annual auditing of company s financial statements by an independent accounting firm; (v) publicity in respect of agreements with related parties, shareholders agreement and stock option programs. 10

11 The Brazilian PE and VC firms present very strict requirements for investing in entrepreneurial companies. Approximately 1 or 2 out of 300 investment proposals presented to the venture capital firms per year are elected to receive capital funding. Despite of the expressive market growth recently experienced, there are still few PE and VC funds in Brazil. Also, the PE and VC investing is not a widespread alternative of investment. Those factors may justify the unexpressive number of selected projects. However, this scenario is expected to change with the increase of venture capital funds playing in this market. The UBS investment bank estimates the existence of US$ 100 trillion floating worldwide, out of which US$ 600 billion shall be directed to PE and VC investments all over the world. Brazil is expected to receive an inflow of US$ 2 to 3 billion for investment. Moreover, specialists contend that investment opportunities in China and India are performing beyond investors expectations, which may cause the emersion of a new investment round aiming at new investment alternatives. The popularization of the PE and VC as an investment alternative, more professional entrepreneurs and a new generation of entrepreneurs concerned about corporate governance rules shall certainly contribute for the growth of the Brazilian market and for the improvement of Brazilian economy. 11

12 Venture Capital and the Growing Company Chris Ashworth, Head of European M&A at O Melveny & Myers LLP, London

13 O Melveny & Myers attorneys 13 offices 3 continents 23 languages 2

14 Business angels Who are they? Angels not cherubs Not a Dragons Den Why do they do this? Count your fingers! 3

15 Typical angels Business background Motivation financial and the challenge Role following investment What do they provide to the company? The exit 4

16 UK experience Invest in groups why? How many out there? Typical size of investment Percentage of equity The gap between the investor and the company s perception of value Time period to effect investment Get a good business plan 5

17 Examples Mix Pix - a computer games company Twenty One Net net surfing on a train Padlife modular design 6

18 The venture industry The BVCA a major player The story of growth Investment stage buy out -v- expansion -vstart up The investment professional sector and advisers The importance of exits AIM 7

19 Role of Government The importance of the tax regime The professional associations The universities and R&D establishments The business angel community The Government regional and targeted funds 8