private equity and venture capital in the uk melanie perkins 17 march 2015 1
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Private Equity and Venture Capital in the UK
Melanie Perkins
17 March 2015
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© Melanie Perkins 2015
What we will cover:
• The private equity market
• The deal process
• The business plan
• Business angels
• Deal structure
• High Tec start ups/Early Stage Deals
• How investments are managed
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What is private equity?
Unquoted sharesPrivate companyPermanent/semi permanent capitalRisk capitalReturn achieved through exit proceeds
and yield
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Venture Capital
…Is a type of private equity capital
typically provided to early stage, high
potential growth companies
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Why Private Equity?
Private Equity gives higher returns, but at higher risk
Stability possible due to Private Equity’s long term outlook and ability to adapt to changing market conditions
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Current Issues for the Industry
Banks unwilling to lendDifficulty in raising new fundsAdditional government support availablePricing starting to increase againAnother Tech bubble?Good opportunities Rescue finance
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Some deal terms
What is Private Equity used for:
Start-up
Growth Capital – working capital, acquisitions
MBO – Management Buy Out – the existing management of the company buy the companyMBI – Management Buy In – incoming management buy the
companyBIMBO – combination Buy out and Buy in - strengthen the teamLBO – Leveraged Buyout – can be any of the aboveIBO – Institutional Buy Out – a PE company buys the company and then puts in the management of its choiceP to P – Public to Private (i.e. de-listing)Buy and Build – the PE company makes an investment in order to buy more companies in that sector and put them together to make something big and profitable
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Sources of private equity funding
Private equity firms
VCTs EIS SEIS Funds
Government
Pension funds/Insurance companies
Corporate investors
Private individuals – ‘Angels’
Other – e.g. Academic, Family Trusts/Offices
Either direct or via ‘Funds of Funds’
BVCA
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Targeting the most promising funds
More experienced managers perform better
No. of previous funds raised is significantly associated with performance
Past success predicts future success
Investing in earlier rounds is a good thing
Investing in ICT generated the highest historical returns
Funds £50M - £250M performed better (neither too small or too big)
Nesta Research
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Co Investment
Why matched funding:
Gearing up other moniesEncourages investmentCompletes investment roundsGoes furtherInvest in areas without specific expertise
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Co Investment
Sources of matched funding:
GovernmentEU/other public bodiesCharitable organisationsFamily offices
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The ideal private equity deal gives a high return (cash-to-cash and IRR) for a low risk
Given the huge amounts of money in the industry, the ideal private equity deal is very big!
Can we make money on this?
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Understanding private equity deals
Price/Buy the company at value / under-value Price will be based on DCF, comparative multiples (EBIT or EBITDA), recent
PE deals, surplus asset availability and the level of competition
Finance as much as possible by debt - gearing
Incentivise the management by giving them more equity than their cash investment merits
Grow the business / make it more efficient
Sell it at a profit
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What interests private equity companies? – Pointers to Success
Good management Growth prospects (in bottom line) Cash generation – strong and predictable USP/Barriers to entry
e.g. brand names / strong market position Deal price Not hostile Transaction angle - e.g. a ‘buy and build’, or an individual to bring into the
business Readily separable assets A clear exit strategy
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Deal terms will include…
A structure to give an acceptable IRR Memorandum & articles Shareholders’ agreement / Investment Agreement
Details of the investment and the terms attached to each of the securities – e.g. votes, vetoes, covenants, rights on exit, conversion terms …
Drag along and tag along rights Pre-emption rights Board representation rights
Fees Representations and warranties Service contracts Banking agreements
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How they make their money
By selling out at a higher P/E
By selling parts of the business separately
By improving the business at an operational level
By using gearing to create equity value (and to create focus on the need for cashflow so that debt can be paid down quickly)
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Sourcing Deals
Marketing
ResearchFinancial AdvisersCo Investment PartnersPRWord of Mouth/Recommendation
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The deal process
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Choosing professional advisers
Reputation Experience Depth Location Fee structure Chemistry Comfort
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The venture capital process
Prepare business plan Approach venture capitalist with plan Initial evaluation by VC Initial meetings and enquiries Heads of Terms Due diligence Final negotiations and completion Monitoring Exit
It will take longer than you think!
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What would an investor want to see
in a business plan?
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The business plan
Executive Summary History and background to the deal Market/Competition People Financial history Financial projections Plans for growth Exit Strategy Assumptions behind projections/Sensitivity SWOT
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Preparing the plan - who does what?
Entrepreneur Explanation of the
concept Words Assumptions for
financials
Adviser Structure of plan Financial models Review for
completeness and acceptability
Prepare a Summary plan too – a ‘taster’
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Preparing the plan - who’ll read it?
VCs spend about 10 – 15 minutes on initial screening of proposals. Angels spend about 9 minutes.
VCs, angels and bankers all look for different things in business plans Debt is looking at risk; equity considers growth Bankers place a lot more emphasis on the financials VCs emphasise financials and market issues about equally; the entrepreneur
and the strategy are also very important Angels also emphasise financials and markets, but focus more on the
entrepreneur than do VCs Angels also emphasise investor fit/chemistry
Bankers and VCs tend to be more consistent in their views than do angels
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Initial evaluation by venture capitalist
Does it fit investment criteria?
You can check this on BVCA.co.uk Amount Stage Industry Geographical area
Does it seem commercially feasible? Is it interesting? How much other work do we have on?
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Due diligence
PeopleBusiness
Market Competition Customers Financial
Legal – e.g. IP, contracts, AML
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Governance
Risk CommitteeLegal Sign OffFinance Sign offInvestment Committee
Level of approval authority Independent members? Quorum
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Process
Offer letterSubscription AgreementMemorandum & ArticlesConditions PrecedentLegal Completion
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Monitoring
Board representationVC or a representative?Salary?Shareholding?
Information Covenants
Review – align shareholder objectives
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Exit
Sale
Float/IPO
Buy back
Insolvency
The preferred method and timing of exit should be discussed at the start of the deal
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Deal Structuring
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Risk and Reward
Big risks generate big financial returnsThe financial risk is generated by
financial engineering
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Deal structuring
Different VCs have different preferences
No right or wrong answersWhat we are trying to achieve
maximise returnsminimise risk
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Buy-outs vs Technology Investments
High growth
Cash negative
High risk
High return
Low growth
Cash positive
Low risk
Low return
Buy Outs
Technology
To maximise returns (IRR) on buy-outs we need to introduce gearing
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But ….. Gearing does increase the risk
Be prudent - every business should have a financial structure it can service
Good structuring can improve returns but will not make a bad company a good investment
Higher fixed costs due to servicing debt Allow for some contingency funding Will the bank be supportive?
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A structuring model
Two basic models:-‘Newco’Buyback
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Instruments Used
Preferred Ordinary SharesPreference sharesWarrantsMezzanine DebtSecured DebtGuarantees
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Instruments Used
Fixed & redeemable elements are split:
VC fixed equity matched to management fixed equity
e.g.. if… Mgt Ords £1m 20%
then… VC Ords £4m 80%
Balance is subordinated loan/preference shares
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Envy Ratio
‘The ratio of management’s capitalisation to PE’s capitalisation (all risk money)’
e.g. Mgt invest £50k for 25% equity, Cap = £200k
But PE invests £600k for 75% (say £150k for equity + £450k prefs) Cap = £800k
Envy Ratio is 200: 800
i.e 1 : 4
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Instruments Used
RatchetsRedeemable Ordinary Shares/BuybackConvertible preference sharesConvertible loanOptions
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Instruments Used
Debt terms - market conditions/risk profile Repayment over 6-8 years 2% over base rate Secured creditor
Mezzanine terms Bridge between debt & equity Year 8-9 bullet repayment 3 to 4% over base rate + warrant (to encourage repayment) Returns c. 15-20% Used to enhance equity returns where cashflow is good
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Newco
Target
Deal Structuring
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Newco
Target
Management Equity
VC Equity
VC Prefs
VC MezzDebt
Deal Structuring
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Deal Structuring – Share Buyin
Target VC Equity
VC Prefs
New Mgt Equity
Debt
Need Revenue Reserves to do this
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A structuring model
We are trying to achieve a satisfactory return (IRR) :-
By varying:The InputsThe Outputs
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IRR Inputs – The Variables
Price Working capital/ overdraft
facility Fees Debt (£ + Int rate + repayment
+ warrant Vendor loan note/rollover (£ +
Int rate + repayment) Mezzanine loan - VC
(£ + Int rate + repayment Equity - mgt (£ + %)
Equity - VC (£ + % + dividends) EBIT Depreciation/capex/other cash
items Working capital movements Tax rate Trading Projections Exit year & multiple
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IRR Inputs
Exit assumptions - Timing & P/E applied Classic IRR measurement 3 & 5 yrs. Actual timing specific to deal /
market/shareholders Usually multiple in = multiple out (unless
business bought “cheaply”) Target returns: 25-35%
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Target Outputs
Yearly cash headroomIRR - VC & Mgt and MezzA financial structure that works!
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In Summary…….
Need to: Balance risk / reward expectations Juggle repayment profiles / levels of gearing Use debt instruments Stepped interest profiles Equity ratchets
To get the required IRR
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QUESTIONS?
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Business Angels
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Business Angels
90% of them are men. 75% are over 50 years old. 84% have start up experience. 79% have started one or more businesses themselves. 55% are syndicate founders of at least one SME. 75% had made their wealth from existing businesses.
Only 29% of angel investments make money (?)
.
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Business Angels – changing market
Average age reducingInvestment of City bonusesMore female angels emergingTax incentives increasingly attractiveRise of angel networksCrowdfunding
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Business angels
Reasons for investing Financial return Tax incentives - EIS Job Fun Social Other
Amounts invested Average angel investment is about £75,000 – but there are a lot more
looking to invest £10,000 than there are £100,000
Virgin angels Are they serious?
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Angels’ investment criteria
Good balance of risks and rewards Impressions of management
including the business plan Understand the business/sector Size of investment Projected margins and return on investment
Sales potential Niche markets
Synergies with own skills Asset backing Location Exit strategy
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Angel investment Criteria
But :Less worried about termsLess sensitive to pre money valuationPrefer straight forward deals driven by tax incentives
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Do I want an angel?
Advantages Fewer prejudices May invest in earlier stage
businesses Quicker decisions Flexible May be cheaper Longer term view Hands on experience and
advice
Disadvantages Second round funding
and less chance of syndication
Meddlesome Less investment
experience than VC firms
Less prestigious than VC Buying a job? Midas complex
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How do I find an angel?
Friends and family Local referrers Networks
European Business Angels Network (Eban.org)
BBAA.co.ukSpecialist networks
Internet search Crowdfunding platform
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Questions ?
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Start Ups and Early Growth Capital
Melanie Perkins
17 March 2015
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What we will cover:
How these types of deal differTypes of funding availableStages of development of a new
businessSources of fundsAcademic spin outs
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Start Ups
How are these types of deal different?
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Start Ups
No track recordOften technology basedUnproven marketsBoot strappedWill require further funding later
But higher returns?
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Buy-outs vs Start Ups
High growth
Cash negative
High risk
High return
Low growth
Cash positive
Low risk
Low return
Buy Outs
Start Ups
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Important we have:
Good managementInvestor who can provide more than just
fundingPartnersProtected IPAlignment of interestsCredibility
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How these deals are assessed:
Detailed due diligence People Market Technology Competition
Need to add value as well as money Specialist sector knowledge
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Types of FundingWhere can companies get the money?
Family/AngelsGrants/Government/UniversitiesInternal Positive CashflowDebtEquity
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Types of Money:Public Sources
GrantsGovernment
Seedcorn FundsNESTABusiness Angel co investment fund
UniversitiesSeedcorn Funds
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Types of Money: Debt
Early stage companies generally have difficulty borrowing money.
Few assets/collateral No history of earnings No record of credit Guarantor required
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Types of Money: Equity
Selling a piece of the company.
Doesn’t “cost” anything upfrontPartner relationshipHigh cost if successfulMust convince others of valueBuild support network “Force” your commitment
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Alternative sources of funding
R&D PartnerDistributorsPartnering e.g. merge with better
capitalised company
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Stages of DevelopmentOf a New Business
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Stages of Development of a New Business
SeedStart UpEarly GrowthExpansion Maturity
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Stages of Development (But first…)
IdeaDevelopment of ideaProof of conceptPrototypeMarket testing/Proof of marketLaunch
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Types of company
Lifestyle
High Growth
Depends on objectives of shareholders
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Stages of Development
Money
Time
High Growth
Lifestyle
Seed Startup Early Growth Expansion Maturity
-You have a new business-Business plan is solid-Patents, if any, may be in process-Product demo or prototype has traction – interested clients/investors-Maybe some initial sales-Key management, in place or on sidelines
-You have a new business-Business plan is solid-Patents, if any, may be in process-Product demo or prototype has traction – interested clients/investors-Maybe some initial sales-Key management, in place or on sidelines
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Stages of Development
Money
Time
High Growth
Lifestyle
Seed Startup Early Growth Expansion Maturity
- Success in marketplace- Hiring sales and marketing- Hiring operations- Office space/warehouse/manufacturing- Equipment purchases
- Success in marketplace- Hiring sales and marketing- Hiring operations- Office space/warehouse/manufacturing- Equipment purchases
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Stages of Development
Money
Time
High Growth
Lifestyle
Seed Startup Early Growth Expansion Maturity
- Growing quickly- More hiring- Transition from initial admin/operations to full scale
-Move offices to accommodate hires-New production facilities/hardware-Invest in marketing-Invest in product development
- Competition takes notice- Fire-fighting, keeping the wheels on
- Growing quickly- More hiring- Transition from initial admin/operations to full scale
-Move offices to accommodate hires-New production facilities/hardware-Invest in marketing-Invest in product development
- Competition takes notice- Fire-fighting, keeping the wheels on
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Risk Assessment
Risk*
Time
Risk
Seed Startup Early Growth Expansion Maturity
- 80% of startups fail- Less than 5% become high growth
- 80% of startups fail- Less than 5% become high growth
* Level of investment risk assumed by investor
* Level of investment risk assumed by investor
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Sources of Funds
Risk
Time
FoundersFounders
Venture CapitalistsVenture Capitalists
Seed Startup Early Growth Expansion Maturity
Friends andFamily
Friends andFamily
AngelsAngels
BanksBanks
Acquisitions &Equity Markets
Acquisitions &Equity Markets
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Sources of Funds
Risk
Time
FoundersFounders
Seed Startup Early Growth Expansion Maturity
Founders:
Highest riskTypically invest up to £100KUse their own savingsAsk friends to join themOffer a piece of company as incentive – outlined in Operating AgreementWork without salary (may defer on books)Provide space (garage/basement)Ask for favors (legal advice, accounting)Should all be highly active
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Sources of Funds
Risk
Time
FoundersFounders
Seed Startup Early Growth Expansion Maturity
Friends and Family
High riskFund most new businessesTypically invest up to £200kCan be quick moneyPersonal relationship riskPart of networking for your businessFormal Private Placement MemoHave consistent agreements drawn and approved by a lawyerKeep recordsGenerally passive investorsValuation
Friends andFamily
Friends andFamily
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Sources of Funds
Risk
Time
FoundersFounders
Seed Startup Early Growth Expansion Maturity
Friends andFamily
Friends andFamily
AngelsAngels
Angels
Moderate to high riskTypically invest £50K to £1MPerform due diligenceGroups may work as a syndicateCan help with next round of funding1/3 of deals at the seed stageMay take seat on board
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Sources of Funds
Risk
Time
FoundersFounders
Seed Startup Early Growth Expansion Maturity
Friends andFamily
Friends andFamily
AngelsAngels
VCs
Moderate riskTypically invest £1M to £5MPerform due diligenceCan help with next round of funding6% of deals at the seed or startup stageGenerally lead a roundWill take seat on board
Venture CapitalistsVenture Capitalists
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Sources of Funds
Risk
Time
FoundersFounders
Venture CapitalistsVenture Capitalists
Seed Startup Early Growth Expansion Maturity
Friends andFamily
Friends andFamily
AngelsAngels
BanksBanks
Acquisitions &Equity Markets
Acquisitions &Equity Markets
BanksMore likely to loan when cash flow is good and assets on the books
Borrow on receivables and other assets
Acquisitions/Equity:IPOs are rareAcquisitions are much more common
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Funding Stages
Multiple steps in raising funds – roundsFunds advanced against achievement of
milestonesLarger sums raised at each stepNew investors at Series AGrowing valuationOwners get diluted
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Common Issues
Worry about dilution
Raising too little
Insufficient cash for marketing
Unrealistic milestones and technical slippages
Too slow to execute or adapt
Over optimistic sales forecasts
Naïve exit expectations
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Academic Spin-out Companies
International increase in commercialisation of university inventions and knowledge
A source of income for universitiesDoes a spin-out have to create wealth?How can universities organise for spin
out wealth creation?
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Levels of Support
LowSmall department and team
Funded with public money
Networking with university departments
Limited IPR
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Levels Of Support
Supportive A financially independent, commercial organisation Spin out service employs specialists in IP,legal etc Public/private equity funds to finance development Networking with local industry, specialised advisers
and VC community University owns IPR Business plan required Incubation space and specialised support are
offered, at market prices Equity in spin out company is taken
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Levels of Support
Incubator Highly capitalised and leading edge companies An independent R&D organisation Internal research space and infrastructure provided
(for free?) Spin out service employs specialist advisers Revenues generated by contract research and
licenses Spin out service manages IPR service internally
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What can go wrong!
Insufficient cash resourcesSales and profits take longer to come
throughIP cannot be protectedTechnology overtakenConcept not provedApprovals (e.g. FDA) refusedEntrepreneurs not managers
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Things Not To Do
Wait until the last minute to raise money
Get more money than you need
Hire names rather than competencies
Spend money extravagantly
Be secretive about your problems and worries
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Things To Do
Have contingency plans Fail quickly, fail small, try again Focus on revenues, margins – this will make
raising money easier and valuations better Minimise your burn rate Don’t be a big business too soon Focus on the size of the cake and not the size of
your piece Build a strong relationship with your investors Get excited, be confident and think big but
recognise your own limitations
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Questions
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Portfolio Management
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17 March 2015
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Objective:
Maximise Institutional Return
Income
Capital Gain
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Key Areas:
Your rights under the Investment Agreement
Relationship with management
Board representation
Relationship with other investors
Financial Information
Company strategy
Shareholder objectives
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Institutional Rights:
Shareholder Protections
Right to appoint NXC/NXD
Drag along/Tag along
Right to Financial & other Information
Restriction on borrowings
Restriction on emoluments
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Drag & Tag
Assuming a 100% acquisition:
PE 95% Mgt/Other 5% - PE can DRAG management
PE 15% Mgt/Other 85% - PE can TAG along
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Management Incentives:
Salary and emoluments (employment contract)
Sweet equity
Ratchets + ve & - ve
Options
Exit bonus
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Portfolio Management
Board MeetingStrategy MeetingAd hoc meeting/Liaison MeetingAGM
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Liaison Meeting Agenda
Update of progress v budget
v 3 year plan – milestones?
Cash position
Market / competition
People issues – succession planning?
Shareholder relationships
Any other issues
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Buy-outs vs. Technology Investments
High growth
Cash negative
High risk
High return
Exit?
Low growth
Cash Generative
Low risk
Low return
Exit strategy
Buy Outs
Technology
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If all is going well:
Focus on shareholder strategy
Maximise profit
Prepare for exit
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Methods of Valuation
Cost
Earnings
Net asset value
Market value
Full provision
(BVCA Guidelines)
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Potential Pitfalls
Failure to achieve plan
Inability to service & repay debt
People issues
Political issues
Shareholder issues
‘Act of God’
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Failure to achieve plan
What levers do you have to effect change ?
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Cash Issues
Relationship with debt providers
Friend or foe ?
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What interests the bank?
Security Cover available Income Cover available Overall level of gearing Overall yield
Will/How can we get our money back?
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Options:
Change/strengthen management
Need to keep all interests aligned
Provide further funding/raise new capital
Restructure balance sheet
BOGOF
Increase or decrease risk ?
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Beware:
Solvency issues
Directors’ responsibilities
Directors’ contracts
Bank’s agenda
Is the business worth rescuing ?
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Rescue Funding:
Equity with preferred rights
Convertible loan
Reward for risk
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Waterfall
Sale for £1,000,000
Less: Secured Debt (300,000)
Less :Mezz. Debt (200,000)
Available for shareholders: £500,000
Less: Preference Shares (400,000)
Less Pref. Ordinary Shares (200,000)
Surplus for Ordinary Shareholders Nil
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Exit
Trade sale
Flotation
Management buyout
Company buyback
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Need to align:
Shareholder objectives
Management objectives
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Trade Sale
Market price
Company has greater resources going forward
Management may not be required
“Friendly’’ buyer
Consideration cash / paper / deferred / earn out
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Flotation
Access to capital
In the public eye
Management stay on
Harder to exit
Costly
Dependent on stock market conditions
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Management Buyout
Continuity of business and management;
Need to raise capital (again);
No warranties or indemnities;
100% ownership
Opportunity to bring in new management shareholders
NEA
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Company Buyback
Need sufficient revenue reserves
Need to raise capital (again)
Other shareholders increase pro rata
NEA
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Potential Issues
Need to keep interests aligned
Management contracts
Incentives to management – keep them on side
Warranties & indemnities
Tax Issues
Is it market price ?
Keep business performing !
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Any questions ?
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Case Study
“Softin”
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Softin - Issues
1. Should they consider going through an IPO?
2. What do you think of Smittenwith’s proposals?
3. What do you consider are the main issues?
4. What advice would you give Paul?
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Softin – To date
Start up which has been successful Good profits and strong cash flow No institutional involvement Board structure right What about the future? What do the shareholders want?
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Softin
Outcome
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Portfolio Management
Questions?
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Portfolio Management
Thank You !
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