Course Description MBA Program

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1 Course Description MBA Program SB/ENTR A: VENTURE CAPITAL AND PRIVATE EQUITY Fall 2007 R 08:30-11:30 Room SSB W136 Catalogue # K96S01 Term: F2 Exam: D1 COURSE Kevin Talbot ADMINISTRATIVE Clara Kan DIRECTOR: ASSISTANT: OFFICE: SSB N305P OFFICE: SSB N305A OFFICE TELEPHONE: x TELEPHONE: OFFICE By appointment [email protected] HOURS: [email protected] ENTR 6910A Fall 2007 Final 1 Schulich School of Business York University ENTR 6910A Venture Capital and Private Equity Fall 2007 W136 SSB Thursdays 8:30am 11:30am Syllabus and Class Schedule Course Director: Kevin Talbot Secretary: Clara Kan Office: SSB N305P Office: SSB N305A [email protected] [email protected] Office Hours: By Appointment Phone: (416) x77960 Website: Please read this outline in its entirety as there are very specific instructions and details about which you must be aware. Ignorance of the contents of this document and procedures desribed herein will not be accepted as an excuse for not adhering to the procedures for this course. Overview

2 The 1980s and 1990s saw a tremendous boom in the private equity industry. The pool of U.S. private equity funds partnerships specializing in venture capital, leveraged buyouts, mezzanine investments, build-ups, distressed debt, and related investments has grown by over 3000% in the last fifteen years. Private equity s growth over that period has outstripped that of almost every class of financial product. Despite this growth, many questions about private equity remain unanswered, and many of its features continue to be mysterious. How do venture capital and buyout funds create value? What explains this tremendous growth in these funds? What explains the process of boom and bust: the rapid increases in fund-raising in the late 1960s, mid-1980s and late 1990s, and the precipitous declines in the 1970s, early 1990s and early 2000s? To what extent is the model developed and refined over the past several decades likely to be translated into other countries and types of investments? Lerner, J., Venture Capital and Private Equity, New York, John Wiley & Sons, 2005, p. 1 This course explores these exciting and important questions by looking at how these organizations work, why they are structured the way they are and what implications are in-store for innovation and entrepreneurship in the future. Career Focus This course is primarily geared to students interested in working in venture capital or other private equity organizations at some point in the their careers. It is also valuable for those who intend to work alongside venture capitalists as managers of firms being financed by such investors, as lenders to companies in knowledge-based industries, as investment bankers taking these companies public or as money managers investing in this asset class. It is also relevant to students interested in applying aspects of private equity investing to established organizations in both the private and public sectors. Course Outline This course focuses on the "private equity cycle beginning by considering how private equity funds are raised and structured, paying special attention to the differing perspectives and incentives of institutional investors, "gatekeepers," fund-of-fund managers, and private equity investors. Second, we will explore how investments are evaluated, structured, and overseen. We use two frameworks to understand the crucial problems that firms seeking private equity pose to investors: illiquidity and information asymmetry; and how private equity organizations address them. Finally, the course addresses the often-problematic ways in which venture capitalists harvest investments. The final module explores whether the private equity system can be duplicated in other settings. Throughout the course we will also touch on career issues with respect to private equity. Module One Fundraising We will examine and analyze the process of how private equity funds are structured and raised. These funds are often shaped by complex and arcane legal issues and the structure of such funds has a profound effect on the behaviour of venture investors and fund managers. As a result, it is as important for entrepreneurs raising capital to understand these issues as it is for partners in a fund. Module Two Investing: In the second module we will consider the interactions between private equity investors and the entrepreneurs that they finance. We will examine the process of identification, selection, due

3 diligence, valuation and term sheet negotiation from both the investor and entrepreneur s perspective. Module Three Harvesting: The third module examines the process by which private equity investors exit their investments. A fund s ability to generate attractive returns for investors is dependent upon successful and timely exits. We will look at the inherent conflict between the private equity investor s mandate and their behaviour during the exiting process, and the needs of the entrepreneur. Module Four New Models: In the final module we will review many of the key ideas developed during the course in the context of organizations with different goals from traditional private equity organizations including large corporations, government agencies, and non-profit organizations that are increasingly emulating private equity funds. In many cases, the goals of these organizations are quite different (e.g. enlightened self interest or effective commercialization). In this module we will examine the similarities and differences with a view to identifying key success factors for traditional venture organizations. In considering this material, we will investigate the internal management challenges faced by venture capital and private equity organizations, as well as their relationships with pension funds, investment managers, entrepreneurs, and investment bankers. This course is based entirely on US and International case studies that are taught at the Harvard Business School. This course is intended to complement others in entrepreneurial studies and corporate finance that students should have completed prior to enrolling in this course. Completion of all 5000-level courses is a pre-requisite without exception. Format, Grading and Assignments This course is case-based with a heavy emphasis on class discussion. You are recommended to form study teams to prepare for each case. Individual students will be asked to lead discussions and make spontaneous presentations about the cases and discussion topics. Teamwork is actively encouraged to frame and solve problems and the workload is heavy. Throughout the term, guest speakers from the world of private equity will bring context to our discussions. Participation is determined based on preparedness for and contribution to class discussions. All students are expected to participate in class discussion and should prepare to be cold-called. Students should note that the workload for this course is heavy. Class Participation (30% of overall grade) Class participation is very important in a case-based course. Class discussion is an excellent way of learning from your fellow students and, perhaps as important, learning how to make constructive and valuable comments that contribute positively. In this regard, it is impossible for you to make very insightful comments without adequate preparation including reading the assigned material, reviewing the assigned cases and preparing responses to these cases on a weekly basis. Class participation, however, is about quality of contribution not quantity. You are better off making one insightful comment in a class than either not contributing at all or trying to overpower the discussion in the hope that at least one comment is of value. Assessment of student participation is entirely subjective and based on the instructor s observations of your positive performance during class discussions. Attendance will be taken in this course; however, simply attending class without active participation will not earn a passing grade on the participation component of the overall grade. You cannot participate if you do not

4 attend; however, your participation grade is based entirely on your preparedness for and contribution to class discussion. Students are required to display their name cards and sit in the same seat for each class. Case Study Assignment (20% of overall grade) Students will complete the Case Study Assignment on an individual basis. You are required to submit up to a three-page double spaced report (plus up to two pages of supporting calculations (including spreadsheets, assumptions, etc.), if applicable) for the Adams Capital Management: March 2002 case being discussed in Week 6. The case study must be submitted by , before 5am eastern time on October 18th, to [email protected]. Please do not include a cover page but do ensure that your name and student number are included in the footer. Careful attention to spelling and grammar are suggested as this will affect your grade. Late submissions will NOT be accepted. It is strongly recommended that you form study groups to discuss, prepare and review case submissions as part of your preparation for class discussion and to learn how to write effective case study reports well in advance of this assignment. Mid-term Assignment (20% of overall grade) The mid-term assignment is an individual project consisting of a short and concise PowerPoint presentation articulating your recommendation for the Martin Smith May 2002 case assigned in Week 7. The presentation must be submitted electronically (by to [email protected] and cc to [email protected]) by 5am eastern time on the day BEFORE session 7 (which is October 31 st ). You will be graded on your submission and several students will be cold-called to present their assignments to the class. Late submissions will NOT be accepted. Final Assignment (30% of overall grade) An important component of the course is the final assignment The final assignment must be completed on an individual basis (i.e. no group work). The assignment will be distributed at the end of session 12 and is due during exam week. Specific details of the assignment, its due date and arrangements for submission will be discussed in class. Attendance at session 12, to receive your final assignment, is mandatory. Late submissions will not be accepted. Grading Scale & Calculation of Final Grades A+ 9 B+ 6 C+ 3 A 8 B 5 C 2 A- 7 B- 4 C- 1 You will be assigned a letter grade for each of the four grading components of the course. Each of these letter grades are converted into their numerical equivalent and multiplied by their representative percentages. The calculated scores for all four segments are then added together (and rounded up or down to the nearest whole number) and you are assigned the corresponding letter as your final grade for the course. Academic Honesty

5 Please familiarize yourself with the University s policies with respect to Academic Honesty (see Academic Policies and Regulations in the Graduate Student Handbook). These policies will be strictly enforced by the instructor. The Course Director reserves the right to make changes to this course outline at any time and for any reason. Course Materials Required Texts: Hardymon, Felda, Leamon, Ann and Lerner, Josh, Venture Capital and Private Equity A Casebook Third Edition, 2005, John Wiley & Sons Inc. Strongly Recommended Reading: Ellet, William, The Case Study Handbook, 2007, Harvard Business School Press. Recommended Reading: Gompers, Paul A. and Lerner, Josh, The Venture Capital Cycle, 2001, MIT Press. Gompers, Paul A. and Lerner, Josh, The Money of Invention, 2001, Harvard Business School Press. Gupta, Udayan, Done Deals: Venture Capitalists Tell Their Stories, 2000, Harvard Business School Press. Wilson, John W., The New Venturers Inside the High-Stakes World of Venture Capital, 1985, Addison-Wesley Publishing Company. (Note: This book is out of print and may be difficult to locate.) Fenn, George, Liang, Nellie, and Prowse, Steven, The Private Equity Industry: An Overview, (Financial Markets, Institutions and Instruments Series, Volume 6, Number 4), Boston, Blackwell Publishers, (An older version was published as The Economics of the Private Equity Industry, Washington: Federal Reserve Board, 1995, and is available on-line). Course Outline Please Note: There will be no session on September 6 th. The first meeting of the class will be September 20 th. You are required to complete the cases and readings assigned for Session 2 prior to the first meeting of the class. Week Topic & Case Advance Preparation Students wishing to do advance reading for this course are recommended to review the following prior to the first session. Reading The Private Equity Industry: An Overview (see Recommended List above) The Money of Invention

6 Course Introduction 1 There will be no class held on September 6th Module One Fundraising 2 An Introduction to the Private Equity Industry Case: Martin Smith - January 2002 An MBA candidate faces a choice between positions in different private equity organizations. To make the best career choice, the student must consider a large number of features of these funds. The opportunities appear to differ significantly and fully assessing the extent of these differences is challenging. Chapters 1-4 Private Equity Today and Tomorrow (Casebook pp. 1-9) Introduction to Module 1 - The Private Equity Cycle: Fundraising (Casebook pp ) Objectives and Perspectives of Institutional Investors Case: Yale University Investments Office - July 2003 A large university endowment has relied on private equity to achieve very attractive returns over the past 17 years. The fund manager must decide whether to continue to invest heavily in private equity in light of current market conditions, and if so which sub-segments of private equity and which types of funds to select. 3 The Structure and Role of Compensation Schemes Case: Acme Investment Trust: January 2001 Note on Private Equity Partnership Agreements (Casebook pp ) A pension fund must decide whether to invest in a new private equity fund organized by Hicks, Muse, Tate and Furst (HMTF). The proposed terms of the new fund include a personal guarantee from the general partners of a 20% return over 5 years on the $200 million already invested in 13 Internet transactions. The pension fund officials must assess the reasons behind and implications of this offer. 4 Intermediation in Private Equity Case: Grove Street Advisors

7 Clint Harris, the managing partner and cofounder of Grove Street Advisors, a provider of individually tailored private equity investment programs for large institutions, has been pleasantly surprised by the success of his organization over its five-year life. By offering a unique combination of private equity experience and knowledge of the needs of public pension funds, the group now has over $3 billion under management. Along with one of the largest pension funds in the world (California Public Employees Retirement Systems, or CalPERS), his firm s client list includes a major European pension manager and a mid-sized state organization. Looking forward, though, he and his partners must decide how they can grow in a market that is becoming increasingly competitive. 5 Challenges of Fund Raising Case: Gold Hill Venture Lending Note on Private Equity Fundraising Process (Casebook pp ) Dave Fischer, one of the founding partners of Gold Hill Venture Lending, a new venture debt fund, is trying to raise $200 million to get the operation off the ground. Gold Hill is a spin-off from Silicon Valley Bank (SVB), the world s largest technology lender, and the founders plan to work closely with the parent, sharing deal flow, back office support, and the contacts and background information developed during SVB s 20 year history in providing banking services to venture-backed companies. Yet the fund-raising has proceeded less smoothly than anticipated. Fischer and his partners have to consider whether to continue to try to raise the full amount or to raise a smaller fund, prove the model, and then return to the market with a more substantial track record. Module Two Investing 6 Investment and Monitoring Strategies Case: Adams Capital Management March 2002 Introduction to Module 2 - The Private Equity Cycle: Investing (Casebook pp ) Adams Capital Management (ACM), an earlystage venture capital investment firm, has developed a strict set of guidelines to use in assessing and managing its portfolio companies. On the basis of this system, which emphasizes NOTE: Case Study Assignment Due before 5am today. Please see instructions for submission above.

8 investing in applied business-oriented technology that exploits fundamental market changes, the partners raised $700 million in three funds between 1997 and By 2002, however, the venture environment had changed substantially and ACM s partners must reexamine both their markets of interest and their strategy. 7 Evaluating Investment Opportunities Case: Martin Smith - May 2002 Martin Smith has just started his career as an associate with Newport Partners, a prestigious East Coast leveraged buyout (LBO) firm. His first assignment is to assess three possible investments, based on their PowerPoint presentations, and report to the partners meeting. Each company has different strengths and weaknesses, and Martin must try to evaluate them in the context of his firm s own assets and constraints. 8 Deal Structure, Negotiation, Due Diligence, and Valuation Techniques Case: Brazos Partners: the CoMark LBO NOTE: Mid-term Assignment Due before 5am October 31 st. Please see instructions for submission above. Note on Valuation in Private Equity Settings (Casebook pp ) The partners of a new mid-market buyout fund are working on a buyout of a closely held modular building company. Although originally structured as a stock deal, they have realized that an asset deal would be preferable from their point of view and are trying to determine what benefits it might hold for the sellers, whose continuing involvement in the company is essential for success. This case describes the process of the deal s due diligence, the structuring of a leveraged buyout, and the state of the buyout industry in the early 21 st century. 9 Introduction to Venture Capital Term Sheets Case: TBD (will be handed out in class) Note on Private Equity Securities (Casebook pp )

9 10 Term Sheet Simulation Case: The Endeca Negotiation Steve Papa, CEO of Endeca Technologies is trying to decide between two term sheets for his company s C round. Although the company s product is installed at some well-known customers, the fund-raising has coincided with the NASDAQ downdraft of Both term sheets value the company at far less than the pre-money at which Papa had started the process. One comes from the insiders; the other offers a slightly higher price per share but will change a board that has worked well thus far. In addition, the insiders have requested full-ratchet anti-dilution protection on the B round shares, a change from the weighted-average protection in the contract. How did this happen and which term sheet should Papa accept? NOTE: Case study will be handed out in Session 9 (we are not using the version in the case book). Module Three Exiting 11 Exiting the Investment Case: Apax Partners and Xerium S.A. Apax Partners, a global private equity firm, is considering the best approach to exiting one of its buyout investments: Xerium SA, a maker of inputs to the paper industry. While the company is doing well and has paid off its acquisition- Introduction to Module 3 - The Private Equity Cycle: Exiting (Casebook pp ) Note on the Initial Public Offering Process (Casebook pp )

10 related debt ahead of schedule, a sale either to another private equity house or to an industry acquirer is proving difficult, and the company is not well suited for an initial public offering (IPO). The Apax partner involved must investigate the possibility of doing a recapitalization, and how that will affect the firm s efforts at raising a new fund, returns to the fund out of which Apax purchased the company, and the company s future performance. Between a Rock and Hard Place: Valuation and Distribution in Private Equity (Casebook pp ) Module Four New Models 12 Corporate Venture Capital Case: In-Q-Tel Gilman Louie, CEO of In-Q-Tel, the investment arm of the Central Intelligence Agency (CIA) must recommend whether or not to expand the number of government agencies his group will serve. This case presents the history and structure of the unusual effort and explores the public sector s attempts to stimulate private sector innovation for its own use. Introduction to Module 4 - The Private Equity Cycle: New Frontiers (Casebook pp ) Note on Corporate Venture Capital (Casebook pp ) Note on Private Equity in Developing Countries (Casebook pp ) Final Assignment Handedout (Due Exam Week) Course At-a-Glance Week Date Sept 6 Sept 20 Sept 27 Oct 4 Oct 11 Oct 18 Oct 25 Module Fundraising Investing Topic Case NO CLASS An Introduction to the Private Equity Industry Objectives and Perspectives of Institutional Investors Martin Smith January 2002 Yale University Investments Office July 2003 The Structure and Role of Compensation Schemes Acme Investment Trust - January 2001 Intermediation in Private Equity Grove Street Advisors Challenges of Fundraising Gold Hill Venture Lending Investment and Monitoring Strategies Adams Capital Management: March 2002 Reading Private Note on Note on Intro to READING WEEK

11 Equity Today and Tomorrow pp. 1-9 Intro to Module 1 Fundraising pp Private Equity Partnership Agreements pp Private Module 2 Equity Investing Fundraising pp Process pp Week Date Nov 1 Nov 8 Nov 15 Nov 22 Nov 29 Dec 6 Dec 13 Topic Case Reading Evaluating Investment Opportunities Martin Smith: May 2002 Mid-Term Assignment Due Deal Structure, Negotiation, Diligence and Valuation Techniques Brazos Partners: the CoMark LBO Note on Valuation in Private Equity Settings pp Investing Exiting New Models Introduction to Term Sheets TBD Note on Private Equity Securities pp Term Sheet Simulation The Endeca Negotiation (handed out Nov 16 th ) Exiting the Corporate Investment Venture Capital Apax Partners and Xerium S.A. Intro to Module 3 Exiting pp Note on Initial Public Offering Process pp Between a Rock and a Hard Place: Valuation and Distribution in Private Equity pp In-Q-Tel Final Assignment Handed-out Intro to Module 4 New Frontiers pp Note on Corporate Venture Capital pp Note on Private Equity in Developing Countries pp Final Assignment Due Case Study Questions for Class Discussion and Case Reports The following are suggested study questions for the cases covered in this course. These questions may be used as a framework for class discussion, but this is not meant to be an exhaustive list and, in class, we may deviate from the framework. Analysis of cases is left to your discretion and there is no requirement that you restrict yourself to these questions. You should feel free to address any other issues that seem relevant. You are required to prepare all cases for purposes of class discussion. Martin Smith January 2002

12 What job should Martin Smith take? Yale University Investments Office July 2003 Why is Yale investing in private equity? What is Yale s private equity investment strategy? How is the private equity industry changing and what are the implications for Yale s strategy? Acme Investment Trust January 2001 What differentiates HMTF from other private equity groups? Why are the incentives offered to private equity investors so similar? What are the financial implications of HMTF s offer? Should Acme invest? Grove Street Advisors How does Grove Street Advisors propose to create value for its investors? Are their arguments plausible? Why are venture capitalists interested in having GSA as a potential investor? How should GSA address the strategic choices that it is currently facing? Gold Hill Venture Lending Why would a CEO of an entrepreneurial firm and her board take venture debt? What does it offer that other financing sources don t? Why are Fischer and his colleagues raising a separate fund, rather than to operate within Silicon Valley Bank? Are investor concerns with respect to conflict of interest legitimate? Has Gold Hill taken adequate steps to address these concerns? Evaluate the terms Gold Hill has proposed. Are these reasonable or problematic? What are the financial and non-financial implications of a decision to raise a smaller fund? How can Gold Hill mitigate the challenges faced by first-time funds? Adams Capital Management March 2002 Adams espouses a market-first analysis of opportunity by looking for discontinuities. Is this substantive or window-dressing? Analyze Structured Navigation. Is this a valid measurement of progress in early stage investing? How should ACM shift its strategy? Martin Smith May 2002 Please review the case and the three PowerPoint presentations. As you read over the materials, consider how Martin should structure his presentation at the partners meeting. Among the issues you may wish to consider are: Which company should he recommend? Which uncertainties should he highlight?

13 Are there valuation issues that he should highlight? What organizational issues are likely to influence the partners decision? Please choose one deal on Martin s behalf and prepare a short and concise PowerPoint presentation (no more than 3 slides) that he should use when presenting to the general partners. You should give serious consideration to the context in which this recommendation is being made. For this assignment, you ARE Martin. Brazos Partners: the CoMark LBO What is Brazos investment strategy? Does it seem well suited for its position as a first-time fund? How do you assess the merits of the GTI transaction? How has the current recessionary climate affected Brazos investment strategy, in both favourable and unfavourable ways? Is CoMark an attractive investment? What are your major concerns with the proposed deal? How attractive is the purchase price? Apax Partners and Xerium S.A. What are the difficulties associated with exiting private equity investments? Xerium might in many respects be seen as an ideal LBO: a solid firm that has generated lots of cash, paid down its debt ahead of schedule, and so forth. Why is it, then, that Apax is having so many problems selling the firm? Or has the LBO world s expectations changed? What are the issues associated with the recapitalization of Xerium? How will the firm s capital structure change after the deal? How are the various parties likely to view the transaction? What should Apax do sell Xerium, recapitalize the firm, or wait? In-Q-Tel What were the key design choices made when structuring in-q-tel? Are these choices still valid? If you were a CEO of a private company that has a choice of several traditional venture sources and the In-Q-Tel fund, would you be inclined to accept money from the fund? What are the major concerns that you would have? As a traditional financially oriented venture capitalist, would you co-invest with the fund? Does it make sense to expand In-Q-Tel to include other intelligence agencies? What about other government agencies? How significantly could proliferation of the In-Q-Tel model by other agencies affect return on technology? What about impact to In-Q-Tel s financial returns? Last revised: 07/30/2007