FINS3623

Venture Capital

Lecture 4: VC Investing: Investment Selection,

Monitoring, Staging and Syndication

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Revision
 What are the main advantages of the VCLP structure over other
structures?

 Why can’t LPs fill the partnership agreement with as many

covenants as possible?

 What are the main advantages and drawbacks of corporate venture

funds?

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Lecture Outline

Focus of next 3
lectures

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 Lecture Outline
 Areas of concerns in private firm investments
 Risk
 Adverse selection/Information Asymmetry
 Moral hazard

 VC investment toolkit covered today:

 Diversification
 Conservative valuation
 Screening and due diligence
 Staging and Syndication

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Lecture Outline

Risk Information & Incentives

Market Firm Moral Hazard

Adverse Selection
(systematic) (idiosyncratic) (incentive problems)

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Risks in Private Equity Investments

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1. Market Conditions (Systematic Risk)
 Areas of systematic risk
 Uncertainty on the size of a potential market
 Uncertainty on the direction of the economy
 Uncertainty of future competition within a market
 Uncertainty with respect to future replacement technologies
 Uncertainty with respect to enforceability of contracts and
protection of copyrights
 Some firms are more sensitive to aggregate market factors than
others because of their industry and products.
 Do startup firms have higher systematic risk (beta) than established
firms?

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2. Firm Specific Risk

 This refers to the array of potential outcomes for a

company or project. The wider the dispersion of these
possible outcomes the greater the risk.

 Should VCs be concerned about firm-specific risk?

 What factors make the possible outcomes of a young

entrepreneurial firms widely dispersed?

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2. Firm Specific Risk
Entrepreneurial firm success is low probability event

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Firm-Specific Risk

• An exciting Australian Start-up “Shoes of Prey”

• https://www.youtube.com/watch?v=Lz_EmeDmUUc

• Would you invest in it?

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2. Firm Specific Risk
“Not a surprise: Investors lose millions in Shoes of Prey collapse” –SMH 13/3/2019
 Shoes of Prey was one of Australia's most high-profile startups, launched in 2009 by former
husband and wife Michael and Jodie Fox, and Mike Knapp.
 Raised $US29.5 million in total from top investors, including Blue Sky Alternative Investments, US
fund Greycroft Partners, Atlassian co-founder Mike Cannon-Brookes, Blackbird Ventures, Khosla
Ventures as well as high-end American retailer Nordstrom, which opened Shoes of Prey design
centres in some of its stores.
 “Over the last 2 years we've made very good progress with our manufacturing capability however
we've struggled to grow at the rates we'd forecast,
 "Despite all the right trends towards personalisation and our success within the customisation
niche, contrary to our market research, the mass-market fashion customer just didn't respond as
we expected,
 "We weren't able to clearly prove that these customers were willing to pay us enough at a large
enough scale to cover our fixed costs," Mr Fox said.
 As you can see, even if many good things going for Shoes of Prey, one failing aspect
(ability to scale) is enough to destroy the business

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Adjustments for RISK
• A survey paper by Gompers, Gornall, Kaplan and Strebulaev (2020) in the Journal of
Financial Economics asked 889 VCs they make various decisions.
• Most VCs rely on a required IRR or required cash-on-cash multiple as metrics to
evaluate investments
• Below is the typical IRRs and multiples required by VC investors for various deal
categories

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Adjustments for RISK

Survey results from Gompers, Gornall, Kaplan and Strebulaev (2017) “How Do Venture
Capitalists Make Decisions?”

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Adjustments for RISK

• Overall, most VC firms make decisions in a way that is not consistent with
finance theory.
• 36% of them do not adjust returns for perceived risk, and most of those
that do, treat all type of risk the same.

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2. Risk vs. Information
 In a perfect market, risk considerations are irrelevant to
the VC if they are sufficiently compensated by high
returns
 In reality, the risk-return equilibrium is subject to:
 Moral hazard:
 Entrepreneur’s tendency to take risk can deviate from the VC’s
desired level of risk taking.
 Accounting for this attitude towards risk by marking down the value of
a firm leave’s the entrepreneur with little ownership and little
incentive.
 Adverse selection:
 Entrepreneur has better information about the true extent of risk than
the VC
 Both problems are colloquially referred to in the industry as “risk”

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3. Agency Problems
 Entrepreneurs' reactions to risk falls in two extremes:
 Risk-averse entrepreneurs: with a lot of personal wealth and human
capital investment tied up in the firm, entrepreneurs may be reluctant
take risks that are consistent with an optimal firm strategy.
 the “playing-it-safe” problem – not taking enough risk

 Over-optimistic entrepreneurs: May expose VCs to too much risk -

leads to moral hazard problems (the overinvestment or asset substitution
problem).
 Taking risky negative-NPV projects (Why?)

 Appropriate structuring of the relationship between VC and

entrepreneurs overcomes these problems

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4. Adverse Selection
 Distinct from uncertainty, as uncertainty is where time will reveal the
true state, whereas adverse selection is where one party knows
the true state and hides it from others.

 In venture capital funding, high information asymmetry is driven by

the extent of intangible assets:
 Human capital provided by the entrepreneur

 Unique technologies and trade secrets

 Equipment is often specialised and specific to the firm’s needs

 Overall, the firm’s source of value is hard to verify and its assets has
low quantifiable liquidation value.

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Elephant Man Lawsuit
 German biotech company TeGenero
developed TN1412 to treat leukaemia
and multiple sclerosis
 First human testing resulted in multiple
severe side effects (see picture)
 The company was aware of this
possible side effects
 Funded by HBM BioVentures and Bear
Stearns
 Tried to settle by paying each victim
$10,000 USD.
 Was only insured up to $4 million
USD
 TeGenero went bankrupt

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Example – Shoes of Prey

'Not a surprise': Investors lose millions in Shoes of Prey collapse – SMH 13/3/2019

 Shoes of Prey's assets mainly comprised intellectual property such as its customer lists.
 Blue Sky and Greycroft Partners declined to comment but a well-placed source said it
was not a good outcome for Blue Sky's investors and they were unlikely to recover any
capital.

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Applying the theory …
 Which of the following concerns is related to agency
problems, and which is more related to adverse selection?
 The entrepreneur proposes an aggressive marketing strategy
 The does not want to provide the source code of the beta candidate
 The entrepreneur is a scientist and wants to patent the drug under
his name
 The entrepreneur has no or little cash investment in the business
 The entrepreneur forecasts a high uptake rate for the product
 The company proposes to invest in a distant foreign country
 The CFO is reputed to be a brilliant business strategist but had
worked in a company involved in accounting frauds
 The entrepreneur is known to also be negotiating with interested
buyers of the technology
 The entrepreneur insists upon an “inner-circle” management team

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How Do VCs Select Investments?

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VC Investment Decision Making
 Screening/Deal Sourcing
 (Strategy identification and Qualitative analysis)

 Due Diligence/ Deal Evaluation

 (Preliminary quantitative analysis, questionnaires, making inquiries, seeking
expert opinions)

 Valuation and Risk Analysis

 (Detailed quantitative analysis)

 Deal Closing
 (Bargaining, Contracting, and Funding )

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Overview of VC Investment Toolset
 In making investments venture capitalists use several mechanisms
to mitigate the conflicts and issues that arise from the 4 areas of
concerns discussed earlier.
 These are:
 Conservative valuation and diversification
 Systematic screening and due diligence procedures
 The staging of investments
 The syndication of investments
 Monitoring, advice and contract enforcement (next week)
 Control of voting rights and the board (next week)
 Financing instruments (next week)
 Performance incentives and exit incentives (next week)

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Conservative Valuation & Diversification
 The idea: only a few companies in a VC portfolio need to deliver
returns to make up for losses in the others
 As long as the VC can price investee companies really cheaply,
overall portfolio return can compensate for the risk
 VC therefore relies a lot on sensitivity analysis
 Valuation of an investee firm should be below the AVERAGE-case
scenario
 Discount normally applies when comparing investee firms to similar
listed firms

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 VC Quotes
 For the rest of the lecture, I will use quotes taken from interviews of seasoned
Silicon Valley VCs to illustrate the theoretical concepts
(source: Roberts and Barley (2004), How venture capitalists evaluate potential venture opportunities, HBS Cases)

 The interviewees:
 Russell Siegelman, Kleiner Perkins Caulfield Byers
 Sonja Hoel, Menlo Ventures
 Fred Wang, Trinity Ventures
 Robert Simon, Alta Partners

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VC Quotes
 All the quotes to follow are from interviews of seasoned Silicon Valley VCs to
illustrate the theoretical concepts
(source: Roberts and Barley (2004), How venture capitalists evaluate potential venture opportunities, HBS
Cases

 Risk and return

 “We need to make good venture multiples, say 5 to 10 times”.
 “We lay out our investment hypothesis. We typically list 3 or 4 key risks we want
to mitigate with the money going in”

 Valuation
 “Last year we did 2 investments that were 2nd round financing. In both cases, they
were in revenue and starting to ramp. We’re willing to pay a higher value for that.
They should be of lower risk: the dogs were starting to eat the dog food. It was a
question of how quickly they’d eat and how well the company would scale from an
execution standpoint. In those cases if we made five times our money we’d
probably be happy, but we’d also expect the success rate to26 be much higher.”
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Deal Sourcing & Screening
 Networks and Referrals are critical to deal sourcing
 31% of deals a sourced from networks and a further 20% from referrals
 28% are pro-actively sourced

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Proactive Sourcing Approaches
 Top-down approach
 Analyzing industries/markets, identifying opportunities/strategies and
approaching firms
 Often used by late-stage, buyout and generic funds
 Bottom-up approach
 Inviting proposals or sourcing deals through referrals from network
connections.
 Screen and evaluate every team and market opportunity on its merits,
and on how it aligns with the funds focus and expertise.
 Often used by early-stage funds and funds with very deep technological
focus.

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To Fund or not to Fund

The screening process often leads to outright rejection of funding

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Quotes on Screening
 Let’s have a look at a few quotes from VCs in an interview about VC
investment selection strategies
 Screening strategies
 “Market potential needs to be at least $500 mil and the company needs
to achieve at least 25% market share”.
 “Markets trump people and trump technology”
 “It’s a sector (market) bet… a rising market lifts all companies in the
sector”
 “how proprietary and difficult the solution to the problem is”
 “we look for a strong technical founder and a sales oriented
entrepreneur…”
 “if we have a founder who is in it for the lifestyle or who is unwilling to
upgrade the team, we have a conversation…”
 “we get a little concerned when the entrepreneur comes in and says I’m
in this to flip it…”

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Due Diligence
 Definition:
 Process of ensuring information disclosed by entrepreneur is correct
 Process of identifying all relevant risks and reducing information
asymmetries before making an investment
 Process starts from the screening process
 Both qualitative and quantitative
 Mainly acts to confirm VC investment instincts:
 But revelation of “show-stoppers” will mean a rejection of funding

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Due Diligence
 Some typical due-diligence work:
 Verifying information with experts’ opinions
 Check regulatory backgrounds
 Background and credit checks
 Questionnaires to entrepreneurs:
 Identifying their attitude towards risk
 Verifying information with previous rounds’ investors:
 Especially important for early-stage companies funded by non-
professional investors
 New-round financing often leads to dilution and hence, conflicts
 Price paid, amount invested and other terms and conditions
 Proper documentation (lodged with regulators?)
 Whether rescission offer to repurchase earlier-rounds securities is
necessary?

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 Quotes
 Due diligence issues
 “From a due diligence standpoint, we always have at least two general
partners who are sponsors of the company”.
 “The product wasn’t thrown together, but it wasn’t a full enterprise-class-ready
product because they didn’t have the resources. Specifically, we did a
technology drill down with the team to look at the architecture and the
processes. I introduced the Clarus team to the person who runs the telecom
network at JP Morgan Chase; he’s implementing the VoIP there. I asked him to
take a look at the product and give me feedback about big holes”
 Keith had to clean up the management team. We did all our reference calls
on the management team, background checks, and criminal tests. That is
one thing we never want to get burned on. Funding a felon is a bad bet”
 We also spent a lot of time on the financial model. The key question is how
much they raise… Also, it was a situation where it had been a very scrappy
team that hadn’t been taking full salaries. So all kinds of things could have
emerged – oh, this person loaned the company $100,000, or we didn’t pay
this bill. We find liabilities crop up when the company has been living hand-to-
mouth

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• From Gompers, Gornall, Kaplan and Strebulaev (2020) in the Journal of
Financial Economics

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 Staging of Investments
 What is staging? Two different meanings of the term
 Funding rounds: Financing in discrete stages (or rounds) over time, Seed,
Series A, Series B…etc…
 New funding amount and shares issued
 New valuation and terms
 New investors
 At a new round, the firm has to convince the VC market again that it’s worth
investing in
 At each round, the investors have clear expectation that more funding
rounds (additional investments) will be required of them until they can exit
from the firm
 Tranches: releasing committed funding of a given round in tranches
conditional upon achievements of milestones
 Terms and valuation unchanged
 The firm has to demonstrate that it’s meeting the terms of the current funding
round.
 Investors can in theory walk away by not releasing the next tranche
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Benefits of Staging to VC
 Matching liquidity/fund flows:
 VC funds themselves receive funding from LPs also in stages
 Staging helps VC funds maintain high IRRs
 Reducing adverse selection
 As information only reveals over time, VC funds can limit potential losses
from bad decisions by having more time to collect information.
 Staging creates opportunities to set clear, agreed, and measurable
performance targets (milestones)
 Allows the entrepreneur to avoid excessive dilution (more on this later)
 Reducing agency problem
 Staging creates opportunities to monitor the progress of the firm and
renegotiate terms and contracts
 VC funds can maintain the option to abandon financing
 At each stage, the value of investment in previous stages must be viewed as ‘sunk costs’
 Failure to do so leads to the problem of “throwing good money after bad’

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Staging Strategies
 How do you observe the intensity of staging and how it varies across
start-ups? Key variables in staging strategies
 Duration between funding rounds, size of round, number of rounds.
 These variables are a function of the tradeoff between agency
problem vs. monitoring costs (See reading).
 Agency risks can arise when an entrepreneurs' actions are hard to observe and
difficult to verify and so the founder can wastefully use the VCs capital.
 However it is not realistic for a VC to continuously stage their capital i.e. every
dollar spent needs to be authorized by VC, as this is costly to do.
 The staging size and frequency will seek to balance these factors.
 Key firm characteristics in deciding staging strategies:
 Firm development stages (e.g., pre-revenue, expansion, etc.)
 Potential for over expansion
 Cost of bankruptcy: Asset tangibility and specificity
 Difficulty of continuous monitoring activities

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Benefits of Staging

 Suzy SmartyBoots has a great idea for a new company that requires
$3.75million to see it through to fruition

 Victor VentureGuy is willing to invest in her new venture, at a pre-money

valuation of $1million (the value of the firm nett of the VC money,
conditional upon receiving VC funding)

 Suppose Victor unconditionally commits all the capital to Suzy’s venture at

the beginning.

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 Benefits of Staging

 Smarty Software’s ownership would be

Raising capital all at once

Smarty Suzy's Victor's

Software Equity Equity
Value (pre-investment) 1,000,000 100%
Investment - Round 1 3,750,000 79%
Value (post-investment) 4,750,000 21% 79%

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Benefits of Staging
 Victor’s partner’s warn him of the dangers of this unconditional commitment
and convince him to stage the capital based on milestones.

 Victor decides to provide only $250,000 in the first round.

 He also agrees to consider providing further (say $500,000) in about 18

months, if Suzy can successfully pass a key milestone, which in this case
is to prove the key concepts behind her startup’s technology.

 After 18 months, Suzy is successful in proving her startup’s technology

does indeed work and has successfully sold the technology to 4 large
customers

 Victor’s fund has committed all of its dry powder to other investments, but
now bring in a syndicate partner who is happy to invest a further $500,000.
Because the business has progressed (and is attracting attention from other
VCs) the new investor (Investor 2) offers to invest at 2x the valuation of the
firm in the first round.

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Benefits of Staging
 The evolution of Smarty Software’s ownership across the two
rounds would be:

Raising capital in stages according to milestones

Smarty Suzy's Victor's VC Investor 2

Software Equity Equity Equity
Value (pre-investment) 1,000,000 100%
Investment - Round 1 250,000 20%
Value (post-investment) 1,250,000 80% 20%

Meet milestone 1. Value increases by: 2

Value (pre-investment) 2,500,000 80% 20%
Investment - Round 2 500,000 17%
Value (post-investment) 3,000,000 67% 17% 17%

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 Benefits of Staging
 A year later the product has become the premium technology in its sector
so and the value of the firm has doubled again.

 Suzy now requires $3million to scale up her business.

 Another new VC which (Investor 3) agrees to provide the $3m, as both

previous investors have run now run out of capital.

Smarty Suzy's Victor's Investor 2 Investor 3

Software Equity Equity Equity Equity
Meet milestone 2. Value increases by: 2
Value (pre-investment) 6,000,000 67% 17% 17%
Investment - Round 3 3,000,000 33%
Value (post-investment) 9,000,000 44% 11.1% 11.1% 33%

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Benefits of Staging
 Overall, the capital raised with and without staging is identical at $3.75m.

 However, with staging Suzy has been able to keep 44% of the ownership
versus only 21% without.

 The key driver of this benefit is Suzy’s ability to create value (by reducing
risk/uncertainty and information asymmetry)

 Only time can reveal the truth

 While more effort may have been required to raise capital three times, in
reality it is actually much easier to raise capital once you have passed
important milestones.

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Benefits of Staging
 But what about Victor Venture Guy? Is staging better for him?
 He would have had 77% of the business vs. only 11.1% now
 However in reality staging also has benefits for Victor
 The investment has far more risk and information problems in round 1 than in round 3.
So the 77% ownership would be needed to compensate for that.
 Suzie’s low ownership (23%) could create incentive problems and the amount of free cash in the
business could cause a loss of discipline.
 This means that Victor may have ended up holding 77% of a failure. He is much better off holding
11.1% of a success.
 Note that Victor could have also funded the third and fourth round and ended up with 56%, but
now he benefits from network connections with new VCs who might return the favour in the future.

 Using staging, Victor has manufactured a valuable abandonment

“option”.
 This is like a put option on a stock giving you the ability to cut your losses. Such options
are expensive to buy on risky assets.
 The value of this abandonment option also needs to be incorporated when comparing
returns from staged to non-staged investments.

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Further Examples of Staging
 Staging can also allow a VC to reprice their investment at different
stages to make continuation viable.
 E.g. Federal Express
 $12,250,000 September 1973 $204.17 / share
 $6,400,000 March 1974 $7.34 per share
 $3,800,000 September 1974 $0.63 per share
 Firm went public in 1978 at $6 per share
 Apple Computer – Example of a smoothly staged investment .
 $518,000 January 1978 $0.09 / share
 $704,000 September 1978 $0.28 / share
 $2,331,000 December 1980 $0.97 / share
 Apple went public on December 12, 1980 at $22.00 per share.
 The stock has split four times since the IPO so on a split-adjusted basis the IPO share
price was $0.39.
 40 years later (2020) Apple is at around $280.00. About 18% compound annual return!

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Quotes
 Staging strategies
 “After we’ve funded, we track our milestones around product, first
beta customer, first revenue customer”.
 “We do try to make each round of financing have enough cushion
for the company to make a major milestone…We don’t overfund
the first round, and we don’t underfund because in this
environment it takes between 3 and 6 months to fund-raise. We
rarely fund a company for less than a year because they are out
fund-raising again in six months, perhaps without too much to
show for it. We’re usually looking for an 18-month window”
 “We try not to do tranched investments… the danger with
tranches is it’s very hard not to do that next tranche of capital.
There are always reasons something didn’t work. We find
ourselves in board meetings saying you’re right you’re right, let’s
throw in the next tranche

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Syndication
 What is syndication?
 More than 1 investor in an entrepreneurial firm
 Syndication can arise in 1 funding round or over multiple rounds

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Reasons for Syndication
 Some well-established reasons:
 Risk sharing among VCs
 A lot is riding on a VC fund’s performance record, e.g. getting “tarred with the bottom-
quartile brush” and signals of low skill that can be inferred from strong performance
persistence in the industry.
 Such high risks facing VCs should encourage them to diversify and to try not to let their
performance diverge too far away form peers (after all a bottom-quartile ranking is a
relative performance measure).
 VC’s can do this by syndicating and investing in as many deals as possible.

 Sharing of monitoring task among VCs

 Dominance/Control of the Board and the firm’s ownership
 Sharing of expertise
 Improved valuation
 by reducing information asymmetry
 or by collusion

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Reasons for Syndication
 Sah and Stiglitz (1986)
 VCs make better decisions about whether to invest.
 When many VC firms agree that an investment is worthwhile, the chances of
success increase.
 Prediction: syndicated investments perform better

 Admati and Pfleiderer (1994) provide a reason for why later-round financings
must be syndicated:
 After funding a start-up for several rounds, its capital needs grow and it is
necessary to bring in new investors.
 A venture capitalist who has been involved in the firm's daily operations for many
years (an “inside” venture capitalist) may exploit this informational advantage, and
overstating the proper price of the firm in the next financing round.
 Knowing this, new “outside” VCs may be unwilling to invest. The only way to avoid
this opportunistic behaviour is if the “inside” venture capitalist maintains a constant
share of the firm's equity in the new financing round
 This is a credible signal that the round is correctly priced.
Reasons for Syndication
 Lerner (1994)
 Venture Capitalist may try to window dress their record by participating in late
round deals in high profile portfolio firms (e.g. Facebook, Uber, AirBnB).
 This strategy allows them to represent themselves in marketing documents as
investors in these firms.
 This can allow VCs to overstate or misrepresent their performance to potential
new investors.
 VCs may collude with each other in such a practice (“you scratch my back and I’ll
scratch yours”)
 It predicts that VCs will syndicate with other VCs who they believe will most likely
be able to let them syndicate on a successful deal in the future.

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