xxv About the Author Stefano Caselli is a Full Professor of Banking and Finance at Bocconi University where he is Director of the Masters of International Management for CEMS. He is the Head of Executive Education Custom Programs, Banks and Financial Institutions Division at SDA Bocconi School of Management. He specializes in corporate fi nance with specifi c attention to private equity and venture capital, SMEs and family fi rm fi nancing, and corporate banking. He is the author of several books and publica- tions on these topics and serves as a strategic consultant to many fi nancial institu- tions and corporations. This page intentionally left blank PART 1 General Framework This page intentionally left blank 3 The fundamentals of private equity and venture capital 1 This chapter presents the fundamentals of private equity and venture capital. The fi rst section covers private equity and venture capital, underlining impor- tant differences between American and European approaches to funding start- ups and the typical characteristics of the business. The second section explains how private equity fi nance is different from corporate fi nance, emphasizing the distinguishing elements. The third section analyzes private equity and venture capital from the entrepreneur’s perspective, while the last section discusses the views of all types of potential investors. 1.1 DEFINITION OF PRIVATE EQUITY AND VENTURE CAPITAL There is evidence that investing in the equity of companies started during the Roman Empire. However, the fi rst suggestion of a whole structured organization that funded fi rms to improve and make their development easier was found dur- ing the fi fteenth century, when British institutions launched projects dedicated to the increase and expansion of trade to and from their colonies. Modern private equity and venture capital have been around since the 1940s when it started to be useful and essential for fi nancial markets and a fi rm’s development. Financing fi rms by private equity and venture capital has become increasingly more important, both strategically and fi nancially. Because this type of business has been around so long, together with dif- ferences between fi rms and fi nancial markets, one worldwide defi nition and classi fi cation for private equity and/or venture capital does not exist. However, CHAPTER Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 2010 by Elsevier, Inc. All rights reserved. 4 it is clear that a broad defi nition does exist: private equity is not public equity because it includes the investments realized from the stock market. In the third part of this book, various defi nitions are formulated based on the operation, the stage of the fi rm’s life cycle, the operator’s approach, and the type of support. Institutionally , private equity is the provision of capital and management expertise given to companies to create value and, consequently, generate big capital gains after the deal. Usually, the holding period of these investments is defi ned as medium or long. This defi nition, even if very broad, cannot be applied to the real world, because operators ’ national associations (i.e., NVCA, EVCA, BVCA, AIFI), or central banks interpret the defi nition according to the countries in which they operate. For this reason, many defi nitions still exist. According to the American version, venture capital is a cluster of private equity dedicated to fi nance new ventures. Therefore, venture capitalists fund fi rms during their initial phases or look for sources to expand and develop the activity of the fi rm, whereas private equity operators fund fi rms at the end of their fi rst/fast growth process. The European defi nition proposes that private equity and venture capital are two separate clusters based on the life cycle of the fi rm. Venture capitalists provide the funding for start-up businesses and early stage companies, whereas private equity operators are involved in deals with older fi rms. Different from the American defi nition, the European defi nition does not consider the expan- sion phase (the phase after the beginning and the start-up) as a part of venture capital, but more of an autonomous subcategory. Although there are differences in defi nition, private equity and venture capi- tal create a strict relationship between the investor and the entrepreneur. This is a unique characteristic not found in any other fi nancial institution. This is attrib- uted to the typical characteristics of private equity and venture capital fi nancing schemes: Modifi cation of shareholder composition Knowledge and non-fi nancial support Predefi ned time horizon of the investment Private equity and venture capital investment are used to invest in equity; for this reason, operators specializing in these kinds of deals may decide on the fi rm’s strategy and day-by-day management. This participation, or the admission of a new subject among the original shareholders, generates a metamorphosis in the decision process. Additionally, a modifi cation in the stability and symmetry of the organization and its consequences among original shareholders may be noted. CHAPTER 1 The fundamentals of private equity and venture capital 5 The operation of private equity and venture capital is not limited to simple money provision; the fi nancial support comes from managerial activity consist- ing of a series of advisory services and full-time assistance for fi rm development. For young fi rms or a new business idea, cooperation with fi nanciers is very important, because reputation, know-how, networking, relationships, compe- tencies, and skills are the non-fi nancial resources provided by private equity and venture capital operators. Although diffi cult to measure, these resources are the real reason for the deal and important for fi rm growth. Private equity and venture capital agreements always defi ne length and exit conditions for fi nancial institutions. Even though funding institutions are active shareholders and engaged in company management, they are not interested in taking total control or transforming their temporary participation into long-term involvement. Venture capitalists and private equity operators, sooner or later, sell their position; this is the most important reason for defi n- ing this type of investment as “ fi nancial ” and not “ industrial. ” The presence of a predefi ned time horizon for the investment makes private equity and ven- ture capital useful for fi rms wanting quick development, managerial change, fi nancial stability, etc. 1.2 MAIN DIFFERENCES BETWEEN CORPORATE FINANCE AND ENTREPRENEURIAL FINANCE What is the difference between corporate fi nance and private equity fi nance (or entrepreneurial fi nance)? This is a very interesting question and the answer is not as easy as it may seem. The question can be answered in two different ways: institutionally and environmentally (see Figure 1.1 ). Corporate fi nance, which is the most traditional way to fund fi rms, is more standardized, less fl exible, and focused on debt. Expected returns are lower and linked to the costs that fi nancial institutions incur while collecting money from savers. The reference point for the valuation (i.e., costs, feasibility, etc.) is the whole company, independent of funded sources. Another interesting point is the fi nancial institution’s unwillingness to participate in the fi rm’s decision framework. Private equity fi nance is very fl exible and the expected returns are higher (non-fi nancial resources must be paid) than corporate fi nance. It is characterized by a medium to long time horizon, higher options available for the fi nancial insti- tution’s exit strategy, and by its high profi le in the decision process. The focus of private equity fi nance is the potential growth path of a company. 1.2 Main differences between corporate fi nance and entrepreneurial fi nance 6 CHAPTER 1 The fundamentals of private equity and venture capital The institutional approach, even though it is able to distinguish between cor- porate and entrepreneurial fi nance, does not consider the environment companies face when they contemplate private equity as a fi nancing option. The environmen- tal approach does consider the environment and the situation faced by entrepre- neurs during the fi nancial selection process. Some aspects of the environmental approach are the same as the institutional approach, whereas some aspects better explain the consequences of entrepreneurial fi nance. The elements in the following list distinguish private equity fi nance from cor- porate fi nance using the environmental approach. Interdependence between investment and fi nancing decision Managerial involvement of outside investors Information problem and contract design Value to entrepreneur Legal and fi scal ad hoc rules Corporate finance Private equity finance Participation Focus on debt Focus on equity Reference point for the valuation The whole company Potential growth Collateral Usually real estate No guarantees or agreement between company and financier Target return Spread over the financial costs of funds collections High or very high, consisting of capital gain realized at exit moment Exit Repayment Different options: Time horizon Variable From medium to long, 5/7 years Financial institution participation NO For the whole length of the deal Flexibility Usually low Very high - IPO - Buy back - Trade sale - Write-off FIGURE 1.1 Corporate fi nance versus private equity fi nance. 7 With the institutional approach, private equity fi nancing does not fund the whole company. In this scheme of fi nancial and non-fi nancial support, a specifi c project the entrepreneur needs to fi nance is targeted. Because of this, a strong and effective interdependence between the fi rm’s investment and fi nancing must exist and must continue during the entire length of the deal. Private equity operators and venture capitalists provide fi nancial and non- fi nancial sources. This generates the involvement of third parties (external investors) in the decision process and/or company management. It must be emphasized that only in private equity fi nance is there a decisive participation in the fi rm’s administration. The third issue seen in the environmental approach is that private equity operators support fi rms on risky projects. This increases conventional informa- tion problems occurring in all fi rm fi nancing schemes. These problems lead to a lack of standardized agreements, so a special settlement is signed for every funded project. The strong interdependence among companies and fi nancial institutions gen- erates problems in wealth and value distribution too. As private equity fi nan- ciers became shareholders, a strong co-participation between the entrepreneur’s desires and the fi nancial institution’s purposes exists. Private equity fi nanciers support fi rms with their skills, competencies, know-how, etc. Because this cre- ates value for funded fi rms, the investor allows the entrepreneur to take value from the funded idea. In most cases, without private equity or venture capital- ists, fi rms would not be able to develop projects. The special legal and fi scal framework for the investor and/or vehicle used to realize the deal is the last factor that sets private equity fi nance apart from venture capital. It will be shown throughout the following chapters that the pri- vate equity industry, because it simultaneously acts as entrepreneur/shareholder and fi nancier, needs special treatment regarding taxes and legal frameworks to develop and carry out investments. In the private equity business, relationships between entrepreneur, share- holders, and external investors are intertwined. In large deals within large cor- porations there is a clear convergence between the entrepreneur (and many times, his family) and the shareholders. This modifi es the traditional perspec- tive of corporate fi nance in which shareholders and managers are two separate blocks with different goals and tasks. This is particularly true for venture capital. The smaller the fi rm or the earlier the life cycle, the more likely the entrepreneur is the shareholder and the manager. This makes it easier for the deal to be realized, developed, and carried out. 1.2 Main differences between corporate fi nance and entrepreneurial fi nance 8 CHAPTER 1 The fundamentals of private equity and venture capital 1.3 THE MAP OF EQUITY INVESTMENT: AN ENTREPRENEUR’S PERSPECTIVE Development of the private equity and venture capital industry starts when the entrepreneur realizes he needs to be funded by external investors to support the expansion or the transformation of his fi rm. Therefore, equity investment pro- vides a fi rm’s specifi c fi nancial needs or the fi nances to create a fi rm. Firms need funding during sales development, which occurs during different stages for each fi rm. The drivers that measure the fi rm’s need for funding are investment, profi tability, cash fl ow, and sales growth. These four variables are strictly linked together, and should be evaluated from a long-term perspective. These four variables/drivers represent the stage the fi rm is in, which helps fi nan- ciers defi ne their strategy. Analyzing the four drivers, typical stages of the fi rm used to classify fi nancial needs can be identifi ed. There are six different stages: 1. Development 2. Start up 3. Early growth 4. Rapid growth 5. Mature age 6. Crisis and/or decline These stages impact the four drivers — investment, profi tability, cash fl ow, and sales growth — used when analyzing fi nancial needs and equity capital demand of a fi rm as seen in Figure 1.2 . During the fi rst stage, the entrepreneur has to cope with development, the length of which depends on the business features and the entrepreneur’s com- mitment. The objective is to defi ne the most convenient structure for the project’s progress. In this phase, sales do not exist and profi tability and cash fl ow are negative due to the presence of compulsory investments such as the completion of informa- tion memorandum, costs for legal and fi scal advisory, engineering development, etc. The start-up stage consists of company creation and launch of fi rm activity. During this period, sales start, but the trend is not solid enough to support costs incurred by sizeable and substantial investments related to the acquisition of pro- ductive factors. Consequently, cash fl ows and profi tability are strongly negative. The next stage, early growth, occurs just after start up. Investments have been made and the fi rm’s current needs are related to inventory, rather than working cap- ital; the revenues realized by the company are increasing. There is a rise in profi t- ability and cash fl ow, even though they remain negative. However, the whole trend is positive and stable and the negative value is slowly becoming greater than zero. [...]... of venture capital and buyout investments is very different The main sectors financed in the venture capital businesses were life sciences, computer and consumer electronics, and communications representing 47,9% of all venture capital investments and 58% of the deals The main sectors financed in buyout businesses were business and industrial products and services and consumer goods and retail, representing... greater the risk, and the greater the need for equity and the risk-taking profile of the investor If firm-developing phases and types of investors are considered simultaneously, the different risk–return profiles like the ideal or potential size of investors create an interesting scheme of equity capital investment availability Figure 1.4 illustrates the potential role of private equity and venture capital... sales are increasing but the growth trend is negative and cash flow and profitability are positive and increasing After the rapid growth stage, there is a period of maturity and firms enter the mature age phase The sales growth tends to zero while profitability and cash flows level off During this phase, investments are not just related to inventory and/ or working capital but the replacement of ineffective... France (15,1%), Germany (13,5%), the Netherlands (7,3%), and Spain (5,4%) The figures regarding buyouts and venture capital investments show: Total amount of buyouts realized equals €56,8 billion (78,8% of the total) and venture capital deals amounted to €12,3 billion Small buyouts realized were 6,7% of the total number of deals, with a total value of €5,5 billion and an average deal size of €4,1 million... Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 20xx by Elsevier, Inc All rights reserved 2010 15 16 CHAPTER 2 Clusters of investment within private equity Early stage financing (early growth) Expansion financing (rapid growth) Replacement financing (mature age) Vulture financing (crisis and/ or decline) A very close relationship exists between each stage and financial need For example,... patent and production process, build the company team, and manage any sudden death risk The most important elements financiers provide are the business plan preparation, analysis, and validation (see Figure 2.1) Because of the high risks, both public and private investors offer seed financing There is no clear distinction between them, but the private sector provides the expertise required for efficient and. .. expected IRR, and high risks with possible delays in or the default of the project During seed financing, financiers are expected to be experienced in technical and engineering fields In start-up financing, because the R&D stage has already been completed, financiers are expected to support the business plan, have an in-depth understanding of its nature and its assumptions, value the management team, and define... sector or the market The expected IRR and the linked risk are high, because investments are already made and there is no certainty about sales development In this phase financial institutions are asked to revise and strengthen the business plan Private equity operators or venture capitalists are very involved in management and own a large numbers of shares Realized and required activities range from assistance... development and its financial needs The firm-based approach, on the other hand, is a relatively new method of analysis It evolved because of competition and great difficulty matching a firm’s needs with the activities of the private equity investor According to the traditional approach, the stages of equity investment are Seed financing (development) Start-up financing (start up) Private Equity and Venture... last of the six stages is the crisis or decline phase During this period, sales, profitability, and cash flow fall and the firm is unable to decide what investments should be completed to overturn the decline These stages create a demand for financial resources measured by the net cash flow produced by the firm Demand for financial resources is satisfied by different players with different tools ranging from . market. 1. 5 .1 Investment activity during 2007 Considering the investment analysis: The number of investments has decreased by 21, 8% with 8, 411 deals executed in 2007 (10 ,760 deals in 2006);. activity were business and industrial products ( 10 ,3 billion, 14 %), the consumer goods and retail (€9,5 billion, 12 ,9%), and communications (€9 billion ,12 ,2%). 13 Focusing our attention. divested were 18 ,7% of the total (€5 billion). French fi rms divested were 15 % of the total (€4 billion). 15 Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright