Venture Capital and Private Equity __Exercise 1 Sen.

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1 summary and comments on the handouts A Note on Valuation of Venture Capital Deals from graduate school of business of Stanford University pays more attention to the venture capital valuation method, which is one of the three basic valuation method used in venture capital and private equity industry. Beside the method itself, the note also demonstrates how to determine the terminal value, the treatment of the risk and the funding requirement with multiple financing rounds. In my opinion, the essence of valuation methods is just discount the future cash flow with certain discount factor which depends on the risk, and the difficulty is how to determine the quantity and timing of the future cash flow. Technical Note: The Private Equity Industry form Kellogg School of Management of northwestern university gives the whole picture of the private equity industry, including the basic structure and process of venture capital and private equity investing. There are specific forms, tables and diagrams in the note. The details will be showed in the answers to the question number 8. Between a Rock and a Hard Place: Valuation and Distribution in Private Equity from Harvard business school lays emphasis on the valuation and distribution in the private equity industry and relations between them and the general and limited partners. I will discuss them in question number 1,4,5,6 and 7.

2 answers to the questions 2.1 There is a lock-up period of 180 days (in the US) after the IPO for a private equity LP (or anyone who holds more than 10%) of the stock to cash their share. What is the purpose of this rule? After the IPO, the private equity investors and someone who holds more than 10% of the shares do not sell their shares immediately. The reasons why they agree to a lock up period of 180 days are: First, the price of the shares price will suddenly go down after large blocks of securities sold by the insiders immediately after the IPO; Second,

the lock-up period is intended to demonstrate to the market the strong confidence that these investors have in the business; Thirdly, the lock-up period is to protect individuals and small invertors who can not get all the market and company information from the price down. 2.2 One of the grandfathers of venture capital and private equity maintained, You can only value a private portfolio twicewhen you first invest and when you exit. Does interim valuation matter in private equity? Interim valuation is important in private equity. There are several reasons accounting for this. Consider the variability in valuation of the public securities, firms might revisit portfolio valuation monthly, quarterly, semi-annually, or only when the company endured a material adverse change or closed a new financing. The LPs who have lots of money in venture wanted clarity, consistency, and conservatism to ensure that they were allocating their asset correctly. Assets invested in venture firm were far less liquid and less transparent. Yet the effects of over-allocation to that sector could be profound. Some foundations, required by law to distribute a certain percentage of their net asset value every year, could find themselves either over- or under-distributed if valuations were inaccurate. Other investors, such as endowments and pension funds, relied upon the valuations of their PE portfolios, to determine their contributions to operating budgets. And write-down also imposed costs on the fund managers themselves. Many reported to oversight committee and feared the impact of a large PE write-down on their returns and reputations. On the personal level, many fund managers had their compensation or bonus tied to their results, or even to the paper value of the portfolios. Based on the above arguments, the interim valuation really matter in private equity. 2.3 Consider a $100 million venture capital fund that has invested in 10 deals at $10 million each. The first two deals have early liquidation events and yield $50 million each, or a total of $100 million. The venture firm has a typical sharing rule of 80/20 on a deal-by-deal basis. The $100 million would be split as follows: $20 million cost to the LPs (two deals at $10 million each), the remainder to GP. Now consider that the valuation of the remaining portfolio sinks. As happened after the bubble burst, so

that the eight companies left are liquidated for 50% of cost. What does Claw back mean in this case? Make an after Claw back payoff evaluation in this case. A Claw back obligation represents the general partners promise that, over the life of the fund, the managers will not receive a greater share of the funds distributions than they bargained for. Generally, this means that the general partner may not keep distributions representing more than a specified percentage (e.g., 20%) of the funds cumulative profits, if any. When triggered, the Claw back will require that the general partner return to the funds limited partners an amount equal to what is determined to be "excess" distributions. In our case, after the liquidations of the first investments, the $20 million of invested capital was returned directly to the LPs. Of the $80 million in the capital gains, 80% went into the LPs and 16 million (20%) to the GPs. Now consider that the valuation of the remaining portfolio sinks, the GPs would have over-distributed to themselves at the expense of the LPs. Here, if the ultimate value realized from the remaining holdings of the portfolio was only $40 million (liquidated for 50% of cost), the GPs would have over-distributed $8 million, that is 20 %*( 80-0.8*80), so the GPs has to return $8 million to the LPs. 2.4 Now consider a venture capital firm that has a real estate sharing rule. That is, the LPs would first receive all the money they had invested in the fundin this case, the full $ 100 million. Which one is a better sharing rule? Over-distribution of funds and resulting issues around claw back were problems of both valuation and distribution. The valuations could have changed for many reasons, even if the company were valued correctly all along, claw back liabilities could occur because the distribution mechanism, one solution to solve this problem is the real estate sharing rule, which return 100% of capital to the LPs before distributing any carried interest. However, premature exits and risk aversion will happen when making investment choices. So in my opinion, the real estate sharing rule is better in this case we discussed. 2.5 What are the benefits of stock distributions from funds to LPs? Stock distributions from funds to LPs have three advantages:

Firstly, SEC rules restricted the size of sales by corporate affiliates (officers, directors and holders of 10% of the firms equity).The venture investors always qualified as affiliates! And selling a large number of stocks will take quite a long time. So distribute the shares to LPs who are not affiliates and can sell the shares without limit, the PE investor could quickly dispose of a large holdings.

Secondly, tax motivations provide an incentive for the GPs to distribute shares. There will be immediate capital-gains taxes for both the LPs and the GPs when the GPs sold the shares and distribute cash. And the investor might have different preferences regarding the timing of selling the shares. Further, the GPs wish to postpone paying personal taxes by selling their shares later.

Thirdly, in order to not let the share price go down by selling stocks to generate cash, the PE investors always want to distribute shares. GPs worry about the share price go down which had gone public because of the outside fund tractors and most LPs computed returns based on the closing price of the distributed stock on the day of distribution. If a firm waited to sell the shares and return cash, the funds return would be based on the dollars realized from the sale, which might not be less than the market value at the time of the stocks distribution. The distribution price might not be the actual price received when the LPs sold their shares. 2.6 What are the benefits of cash distribution from funds to LPs? The benefit of cash distribution is the distribution of shares is definitely a heavy burden for the administration of LPs, particularly in terms of record-keeping and tax calculations. The second one is it is really a trouble to management the stocks for the LPs because of the fluctuation of the stock price. They do not know what to do and when to sell the shares. 2.7 Exhibit 6 in Between a Rock and a Hard Place Valuation and distribution in private equity suggests that there appears to be a substantial run-up prior to the distribution, followed by a drop at the time of the security transfer, and a gradual

downward drift thereafter. There are at least three explanations for this, can you think of any? From the exhibit 6, we can see a substantial run-up prior to the distribution, followed by a drop at the time of the security transfer, and a gradual downward drift thereafter. First reason to explain a substantial run-up prior to the distribution is the PE investors will seek the best stock price to announce the distribution because LPs computed returns based on the closing price of the distributed stock on the day of distribution.

Second reason for the a drop at the time of the security transfer when the distribution really happen, there will be a big increase in the stock supply in the market, which drives the share prices down sharply. Some of the private equity companies know about this and therefore try to sell their shares immediately after the transfer.

And the last reason for a gradual downward drift thereafter is that after the LPs receive the shares, they always want to seek the relatively high price during the stock price fluctuation, they do not sell all the stock at one time, the sophisticated LPs would be inclined to sell some stock gradually when it was not worth the trouble to manage. So the stock price fell steadily after distribution. 2.8 Provide a basic understanding of the structure and process of the venture capital and private equity industry. The private equity industry and its firms are an important source of capital for a variety of business. Venture capital is a subset of Private Equity and pays more attention to the young, rapidly growing companies with potential to develop into significant economic contribution. We can see the structure and process clearly of the venture capital and private equity industry though the following diagram.

Legal structure Organization and Formation Staffing Compensation

Fundraising

Deal Flow Business plan review Management

Investment Analysis

Valuation Subjective Factors Final Decision A letter of intent, term sheet, Investment agreement and so on

Structuring the Deal

Multiple Rounds of Funding

Portfolio Management

Interim valuation

IPO Exit Strategies Strategic Investor MBO Capitalization

2.9 Summarize the basic valuation method used in venture capital and private equity industry. There are three basic valuation method used in venture capital and private equity industry. They are discounted cash flow method, comparables and venture capital method. At the first place, it is the discounted cash flow method. Discounted cash flow method uses future cash flow projections and discounts them to get the present value of the target. Accurately forecasting cash flows is difficult in venture investment because of timing and uncertain of the cash flow.

PV=DCF=CFN / (1+R) N PV: present value DCF: discount cash flow CFN: cash flow at time n R: discount factor

Secondly, comparables method analysis involves identifying companies with similar valuation characteristics and using this information to approximate the valuation of a potential investment. The key in this method is that to find the comparable company, the venture capitalists examine private and public companies. Once the comparable company is found, one common technique is to examine the relationship between the valuation and common accounting metrics. This method also called multiples valuation. The most common multiples are net income, EBIT, EBITDA. Unfortunately, this method only provides a rough estimate.

The last method is Venture capital method, which was discussed specifically in the first handout A Note on Valuation of Venture Capital Deals from graduate school of business of Stanford University. The venture capital method values a potential

investment by forecasting the future value of an investment at exit and then discounting that value to the present using a certain discount rate. V=terminal value t=time to exit I=amount of investment r=discount return used by investors x=number of exiting shares Step 1: to find Post-money valuation POST: POST=V/ (1+r) t Step 2: to find Pre-money valuation PRE: PRE=POST-I Step 3: the required ownership fraction F for the investor: F=I/POST Step 4: Number of shares y the investors required to achieving their desired ownership fraction: y=x*(F/ (1-F)) Step 5: to calculate the price p of each share: P=I/y There are two methods to deal with the uncertain of the expected values in the future. First one is to recognize the fact that the discount rate incorporates a risk of failure component. The second is to allow for a variety of scenarios with different possibilities to happen to generate a less biased estimate of expected value in the future.