Private Equity and Venture Capital in the UK Melanie Perkins 17 March 2015 1.

Private Equity and Venture Capital in the UK

Melanie Perkins

17 March 2015

1

© 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

2


What is private equity?

Unquoted sharesPrivate companyPermanent/semi permanent capitalRisk capitalReturn achieved through exit proceeds

and yield

3


Venture Capital

…Is a type of private equity capital

typically provided to early stage, high

potential growth companies

4


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

5


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

6


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

7


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

8


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

9


Co Investment

Why matched funding:

Gearing up other moniesEncourages investmentCompletes investment roundsGoes furtherInvest in areas without specific expertise

10


Co Investment

Sources of matched funding:

GovernmentEU/other public bodiesCharitable organisationsFamily offices

11


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?

12


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

13


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

14


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

15


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)

16


Sourcing Deals

Marketing

ResearchFinancial AdvisersCo Investment PartnersPRWord of Mouth/Recommendation

17


The deal process

18


Choosing professional advisers

Reputation Experience Depth Location Fee structure Chemistry Comfort

19


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!

20


What would an investor want to see

in a business plan?

21


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

22


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’

23


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

24


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?

25


Due diligence

PeopleBusiness

Market Competition Customers Financial

Legal – e.g. IP, contracts, AML

26


Governance

Risk CommitteeLegal Sign OffFinance Sign offInvestment Committee

Level of approval authority Independent members? Quorum

27


Process

Offer letterSubscription AgreementMemorandum & ArticlesConditions PrecedentLegal Completion

28


Monitoring

Board representationVC or a representative?Salary?Shareholding?

Information Covenants

Review – align shareholder objectives

29


Exit

Sale

Float/IPO

Buy back

Insolvency

The preferred method and timing of exit should be discussed at the start of the deal

30


Deal Structuring

31


Risk and Reward

Big risks generate big financial returnsThe financial risk is generated by

financial engineering

32


Deal structuring

Different VCs have different preferences

No right or wrong answersWhat we are trying to achieve

maximise returnsminimise risk

33


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

34


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?

35


A structuring model

Two basic models:-‘Newco’Buyback

36


Instruments Used

Preferred Ordinary SharesPreference sharesWarrantsMezzanine DebtSecured DebtGuarantees

37


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

38


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

39


Instruments Used

RatchetsRedeemable Ordinary Shares/BuybackConvertible preference sharesConvertible loanOptions

40


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

41


Newco

Target

Deal Structuring

42


Newco

Target

Management Equity

VC Equity

VC Prefs

VC MezzDebt

Deal Structuring

43


Deal Structuring – Share Buyin

Target VC Equity

VC Prefs

New Mgt Equity

Debt

Need Revenue Reserves to do this

44


A structuring model

We are trying to achieve a satisfactory return (IRR) :-

By varying:The InputsThe Outputs

45


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

46


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%

47


Target Outputs

Yearly cash headroomIRR - VC & Mgt and MezzA financial structure that works!

48


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

49


QUESTIONS?

50


Business Angels

51


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 (?)

.

52


Business Angels – changing market

Average age reducingInvestment of City bonusesMore female angels emergingTax incentives increasingly attractiveRise of angel networksCrowdfunding

53


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?

54


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

55


Angel investment Criteria

But :Less worried about termsLess sensitive to pre money valuationPrefer straight forward deals driven by tax incentives

56


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

57


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

58


Questions ?

59

Start Ups and Early Growth Capital

Melanie Perkins

17 March 2015

60


What we will cover:

How these types of deal differTypes of funding availableStages of development of a new

businessSources of fundsAcademic spin outs

61


Start Ups

How are these types of deal different?

62


Start Ups

No track recordOften technology basedUnproven marketsBoot strappedWill require further funding later

But higher returns?

63


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

64


Important we have:

Good managementInvestor who can provide more than just

fundingPartnersProtected IPAlignment of interestsCredibility

65


How these deals are assessed:

Detailed due diligence People Market Technology Competition

Need to add value as well as money Specialist sector knowledge

66


Types of FundingWhere can companies get the money?

Family/AngelsGrants/Government/UniversitiesInternal Positive CashflowDebtEquity

67



Types of Money:Public Sources

GrantsGovernment

Seedcorn FundsNESTABusiness Angel co investment fund

UniversitiesSeedcorn Funds

69


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

70


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

71


Alternative sources of funding

R&D PartnerDistributorsPartnering e.g. merge with better

capitalised company

72


Stages of DevelopmentOf a New Business

73


Stages of Development of a New Business

SeedStart UpEarly GrowthExpansion Maturity

74


Stages of Development (But first…)

IdeaDevelopment of ideaProof of conceptPrototypeMarket testing/Proof of marketLaunch

75


Types of company

Lifestyle

High Growth

Depends on objectives of shareholders

76


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

77



Money

Time

High Growth

Lifestyle


- 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

78



Money

Time

High Growth

Lifestyle


- 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

79


Risk Assessment

Risk*

Time

Risk


- 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

80


Sources of Funds

Risk

Time

FoundersFounders

Venture CapitalistsVenture Capitalists


Friends andFamily

Friends andFamily

AngelsAngels

BanksBanks

Acquisitions &Equity Markets


81


Sources of Funds

Risk

Time

FoundersFounders


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

82


Sources of Funds

Risk

Time

FoundersFounders


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

83


Sources of Funds

Risk

Time

FoundersFounders


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

84


Sources of Funds

Risk

Time

FoundersFounders


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


85


Sources of Funds

Risk

Time

FoundersFounders



Friends andFamily

Friends andFamily

AngelsAngels

BanksBanks



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

86


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

87


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

88


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?

89


Levels of Support

LowSmall department and team

Funded with public money

Networking with university departments

Limited IPR

90


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

91


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

92


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

93


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

94


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

95


Questions

96

Portfolio Management

Melanie Perkins

17 March 2015

97


Objective:

Maximise Institutional Return

Income

Capital Gain

98


Key Areas:

Your rights under the Investment Agreement

Relationship with management

Board representation

Relationship with other investors

Financial Information

Company strategy

Shareholder objectives

99


Institutional Rights:

Shareholder Protections

Right to appoint NXC/NXD

Drag along/Tag along

Right to Financial & other Information

Restriction on borrowings

Restriction on emoluments

100


Drag & Tag

Assuming a 100% acquisition:

PE 95% Mgt/Other 5% - PE can DRAG management

PE 15% Mgt/Other 85% - PE can TAG along

101


Management Incentives:

Salary and emoluments (employment contract)

Sweet equity

Ratchets + ve & - ve

Options

Exit bonus

102



Board MeetingStrategy MeetingAd hoc meeting/Liaison MeetingAGM

103


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

104


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

105


If all is going well:

Focus on shareholder strategy

Maximise profit

Prepare for exit

106


Methods of Valuation

Cost

Earnings

Net asset value

Market value

Full provision

(BVCA Guidelines)

107


Potential Pitfalls

Failure to achieve plan

Inability to service & repay debt

People issues

Political issues

Shareholder issues

‘Act of God’

108


Failure to achieve plan

What levers do you have to effect change ?

109


Cash Issues

Relationship with debt providers

Friend or foe ?

110


What interests the bank?

Security Cover available Income Cover available Overall level of gearing Overall yield

Will/How can we get our money back?

111


Options:

Change/strengthen management

Need to keep all interests aligned

Provide further funding/raise new capital

Restructure balance sheet

BOGOF

Increase or decrease risk ?

112


Beware:

Solvency issues

Directors’ responsibilities

Directors’ contracts

Bank’s agenda

Is the business worth rescuing ?

113


Rescue Funding:

Equity with preferred rights

Convertible loan

Reward for risk

114


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

115


Exit

Trade sale

Flotation

Management buyout

Company buyback

116


Need to align:

Shareholder objectives

Management objectives

117


Trade Sale

Market price

Company has greater resources going forward

Management may not be required

“Friendly’’ buyer

Consideration cash / paper / deferred / earn out

118


Flotation

Access to capital

In the public eye

Management stay on

Harder to exit

Costly

Dependent on stock market conditions

119


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

120


Company Buyback

Need sufficient revenue reserves

Need to raise capital (again)

Other shareholders increase pro rata

NEA

121


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 !

122


Any questions ?

123


Case Study

“Softin”

124


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?

125


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?

126


Softin

Outcome

127



Questions?

128



Thank You !

129

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Private Equity and Venture Capital in the UK Melanie Perkins 17 March 2015 1.

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