Project guidance 2023 BUSI4422 Venture Capital and Private Equity (MSc) Provide an investment proposal for the project brief outlined below. “Imagine you are an executive in a venture capital (VC) or private equity (PE) firm. Identify a potential UK target investment in any market sector or size of your choice. The target can be a start-up or a management buy-out/buy-in. Prepare a report justifying why this is a potentially attractive investment for a VC or PE firm. Topics you may wish to cover include: current ownership of the venture, likelihood that the company is for sale, their unique selling proposition, market characteristics, competitive landscape, personnel and fixed capital resources, price/valuation, possible financing structure, source of potential gains, and possible exit strategy.” In completing the report: You should demonstrate good knowledge of the material and theories covered in lectures, you should demonstrate the ability to select an appropriate case and conduct a research enquiry, collecting and analysing secondary data, synthesising and reporting your evaluations in the form of an investment proposal, you should make this investment proposal as realistic as possible. It will be read not only by your module convenor, but also by some of our speakers (practitioners), ensure to include a 1 page executive summary (350 words max), report all financial information in GBP. Word limit: 2,000 words (excluding references and appendices). The word count includes the title page and the executive summary (approx. 350 words). The actual word count of the assignment must be stated by the student on the first page (cover sheet) of the assignment. The overall word count does include citations and quotations. The overall word count does not include the references or bibliography at the end of the coursework. The word count does not include figures and tables. Appendices are not included in the overall word count. The word limit may vary by a maximum of +/- 10% allowance). Students should prepare and submit their coursework assessments in the following format: Font: Verdana 11 point Spacing: 1.5 spaced Margins: Normal (2.5cm) Referencing: Harvard citation style 1 Deadline Date for Submission of Coursework You need to submit an electronic copy of your coursework to Moodle. For further details of this process see your Student Handbook (on Moodle). The deadline for the coursework submission is 3pm (BST), Thursday 4 May 2023. Additional Project Guidance This guidance is not intended to provide you with an explanation of how to do the project, how many words should be devoted to each section, or how many references there should be. There is not a template or ideal project. Your project is unique and will be considered on its own merits. Please note that this is an individual course work. Below are some issues that you might want to consider. Report structure The structure of lectures provides a useful structure to follow for your dissertation. You can also use the OUTSIDE IMPACT due diligence structure, if you think this is appropriate. It is worth noting that this is an investment report, not a business plan. Emphasis should therefore be placed on the investability of the idea/team/market, the valuation of company, the financing structure of a deal, the source of potential gains, the risk associated with the investment and the possible exit strategies. Selection of firm Please select an existing organisation. They can be at any life stage (e.g. seed, start-up, secondary-buy-out, late-stage LBO, turnaround, etc.) and from any industry. However, think about the types of firms that generally seek VC investment and also the types of firms that are appropriate targets for an LBO. Practice and academic literature can guide this. Part of this assignment is to pick an appropriate business to investigate. After a firm is selected both VC and PE firms undertake due diligence, which is a response to an adverse selection problem. Please pick a company you can collect sufficient information on to make an investment decision. On Moodle you find links to a number of resources, including the GOV Companies House, Patent office, access to relevant databases, etc. VC and PE firms will undertake some market analysis. What are the characteristics of the proposed target market in terms of size, growth rate and competitiveness? If the firm is in its early stages, does the target firm or entrepreneur have a business proposition to be successful in its market? If it’s a LBO, how well is it performing compared to the industry average or key rivals? Which metrics are you using to judge their performance and competitiveness? If it is underperforming, what can be done to change that (see value creation below)? Are there weaknesses in corporate governance determining under-performance? Valuation There are standard ways of valuing businesses and the multiples that are used. Please refer back to the Valuation lecture (week 3) by David Falzani to guide you on the VCs perspective. In the case of the LBO of a mature business, standard corporate finance techniques can be applied. Gilligan and Wright (2014) provide some insight on this. In an LBO a premium for control is sometimes paid. You might want to consider what is driving this. The VC valuation method may also be appropriate when analysing earlier stage companies. Capital Structure There are two issues to consider here: (i) structuring a deal in a particular way is partly a necessity of financing the deal (although the maximum debt in the capital structure is determined by the amount of cash available to service the debt) (ii) structuring the deal 2 to create financial incentives for both the VC/PE firm and the management. Academic literature provides guidance on how debt and equity attenuate the agency problem. Also be mindful of assessing both the business and financial risks when structuring the deal. For instance higher risk (business risk) early stage businesses tend to be structured more conservatively debt wise (financial risk). LBOs tend to have a lower business risk and therefore can cope with a higher degree of financial risk through higher levels of debt. Lectures 4 and the Hoots case presented by David Achtzehn might be particularly helpful here. You may also recommend contractual tools (e.g. tag/drag along rights, ratchets, etc.) to help structure a fair deal and manage the risks. Value creation Firm value is increased when a firm is more profitable. Simply, profit = total revenue minus total cost, so profit will increase if the portfolio firm generates additional revenue streams or costs can be cut. Higher gross margins can also improve profitability for a given cost base. A key driver of value creation are the financial incentives created by VC and PE deals. In particular, the theory in the academic literature suggests that equity creates entrepreneurial incentives and debt disciplines use of cash flows, preventing managers from wasting cash. In early-stage VC deals an explanation of how the firm will penetrate a market and create profit is required. Equity provides managers with incentives and VCs with the incentives to be active investors. In the LBO of a listed company, restructuring the firm, refocusing on core business and the firm and management focusing at what they are good at could be considered. The sale of assets might be used to pay down debt. Remember, financial incentives are driving behaviour. Equity provides managers with financial incentives and PE firms with incentives to be active investors. Consider the roles played by VCs and PE firms – are they providing more than finance? Will you offer strategic guidance to support value creation? Exits A key feature of the VC and PE business model is exit. It is how the investors liquidate the value that has been created and realise their investments. Consider the pros and cons for different types of exit for the portfolio firm in your project and recommend the most appropriate option in your case (e.g. tradesale – can you identify potential buyers for the business x years down the road?). Frequently Asked Questions Should I choose a real life example? Yes. You must use a real life example of a UK company. The aim of the report is to make it as realistic as possible. Can I use real accounting/financial information? Yes. If you are considering an LBO (MBO or MBI) you might want to choose a larger firm where accounting/financial information are easily available from their websites, Bloomberg, or Datastream. Sometimes it is possible to get information on subsidiaries, so this opens up the possibility of a project examining the LBO of a whole firm or the LBO of a division/subsidiary. Articles of respectable news outlets are another good source for financial information, as well as reports from the CompaniesHouse.gov.uk If you cannot access all financial information (e.g. future revenue growth) you will have to make sensible and realistic estimations. Support your forecasts with appropriate research (e.g. by comparing them to relevant competitors and market growth rates). 3 Do I need to include full financial statements in my report? No. We expect you to synthesising and digest all information/financials and report your analysis, evaluations and recommendations. It is your responsibility to filter through the large amounts of information available and make a judgment call. Please make sure all financial data in presented in GBP. Are tables included in the word count? Yes. It may be useful to organise text in a table if that helps to clarify your points. This might include calculations of financial scenarios, such as those relating to deal structure, IRR, and enterprise values. It may also include a SWOT or attributes of competitors. We advise that a limited number of financial scenarios are required when used. Last year some reports had a large number of scenarios. There is no need for more than three scenarios, for example: ‘low, medium, high’, or ‘good, neutral, bad’, or ‘recession, stable, growth’. It would just involve a bit of care in selecting scenarios for illustration. 4 Marking Rubric for MSc Venture Capital and Private Equity Coursework 2023 Investment The investment opportunity (attractiveness/ appropriateness of target company for a VC/PE) is articulated clearly. A convincing and realistic value adding strategy is presented. Structure Structure (e.g. OUTSIDE IMPACT) and Comprehensiveness 0-29 Poor, irrelevant or unconvincing investment opportunity and value adding strategy. 30-39 Inadequate relevance or unconvincing investment opportunity and value adding strategy. 40-49 Limited investment opportunity and/or unrealistic value adding strategy. 50-59 Adequate, reasonable investment opportunity and realistic value adding strategy. 60-69 Good, convincing and relevant investment opportunity and realistic value adding strategy. 70-79 Thorough, clear and convincing investment opportunity and realistic value adding strategy. 80-100 Outstanding, logical and convincing investment opportunity and realistic value adding strategy. Poorly structured and incomplete piece of work with a lack of connecting key elements. Inadequate structure to the work showing inadequate connection and insufficient detail of key elements. Limited structure to the work with limited attempt to cover and connect key elements. Reasonably structured piece of work with reasonable attempt to cover and connect key elements. Good structure to the work showing good cover of and connection between key elements. Well-structured piece of work effectively covering and connecting key elements. Cogently structured piece of work effectively covering and connecting key elements. Missing or incomplete analysis and evaluation. Inadequate analysis and evaluation. Limited analysis and evaluation. Adequate analysis of core elements. However, descriptive at times, lacking depth and original evaluations. Good analysis of core elements. Some depth and originality in evaluations demonstrated. Very good analysis of core elements, demonstrating depth and originality in evaluations. Excellent analysis of core elements, demonstrating outstanding depth and originality in evaluations. Relevant subheadings might include: exec. sum., mgt. team, market analysis (growth), USP, competitor analysis, SWOT, valuation, deal structure, summary financials, exit route, VC returns, sensitivity/risk analysis, 100 day plan. Analysis The subheadings mentioned above are analysed and evaluated comprehensively. 5 Continued… Financial Understanding of the financial requirements e.g. valuation, deal structure, summary financials, exit route, VC returns, sensitivity/risk analysis Coherence Coherence, clarity and focus. Referencing Background Research and Citations All work must use Harvard Style referencing. 0-29 Poor, irrelevant or unconvincing acumen of the financial requirements demonstrated. 30-39 Inadequate relevance or unconvincing acumen of the financial requirements demonstrated. 40-49 Limited acumen of the financial requirements demonstrated. Complies with specification of written work. 60-69 Good, convincing and relevant acumen of the financial requirements demonstrated. Financial analysis and forecasts are largely sensible and realistic, with minor mistakes in the calculations. Writing is coherent, demonstrating good clarity and conciseness, and is easy to follow. 70-79 Thorough, clear and convincing acumen of the financial requirements demonstrated. Financial analysis and forecasts are sensible and realistic. Writing is insightful, demonstrating thorough clarity and conciseness throughout. 80-100 Outstanding, logical and convincing acumen of the financial requirements demonstrated. Financial analysis and forecasts are very sensible and factually backed up. Writing is incoherent, demonstrating poor clarity and focus. Writing is incoherent at times, demonstrating inadequate clarity or creating confusion as to the point being made. Writing is incoherent at times, demonstrating limited clarity or creating some confusion as the point being made. Writing is coherent, demonstrating adequate clarity and conciseness, and is relatively easy to follow. Largely anecdotal, with poor or no citations or referencing is poor or absent. Largely anecdotal, with inadequate citations to support claims, or there is inadequate referencing. Limited use of citations of relevant academic and nonacademic sources to support claims; limited referencing. Adequate use of citations of relevant academic and nonacademic sources to support claims, with adequate referencing. Good use of citations of relevant academic and nonacademic sources to clearly support claims, with good referencing. Thorough use of citations of relevant academic and nonacademic sources throughout work to clearly support claims; well referenced. Writing is insightful, demonstrating outstanding clarity and conciseness throughout; development of ideas is easy to follow. Outstanding use of citations of relevant academic and nonacademic sources throughout work to clearly support claims; well referenced. Poorly formatted with poor or no evidence of proof reading, numerous errors or not edited to expected word count. Inadequately formatting with some errors, inadequate evidence of proof reading, numerous errors or not edited to expected word count. Limited formatting with errors, limited evidence of proof reading or not edited to expected word count. Adequately formatted with few errors, evidence of proof reading and within expected word count. Good formatting with very few errors, good evidence of proof reading and within expected word count. Well-formatted work, with very few errors showing thorough proof reading, edited to expected word count. Well-formatted work, free from errors showing extensive proof reading, edited to expected word count. Depth, relevance, quality of sources, etc. Comply 50-59 Financial assumptions are adequate but may include some mistakes in calculations. 6 Structuring Deals Hoots Case Prof David Falzani, MBE email@example.com 22nd February 2023 Last week we covered valuations: We did a worked example together of the VC method, and discussed the relative merits of Aidcraft and Plantland. This week, we’re focusing on a really interesting case to explain how to Structure Deals. It puts you in the position of being the venture capitalist. You are going to structure a deal in order to meet your design objectives in terms of rewards for the different parties. So please start by reading the Hoots case. Schedule & Moodle 2 BVCA Report on Investment Activity 2017 Hoots is an MBO. £22.23bn overall Myth that VC is mostly investing in start-ups -> most money is in Buyouts (MBO/MBI/LBO) -> why is the governance structure of a buyout so popular? Agency theory – align mgt and shareholders interest and incentive (legal control over mgt through ratchets) Leveraged (debt larger than equity) – why -> cheaper, debt replayed first, tax shield, currently low interest rates Debt focuses mgt -> improve profitability, better use of money, cut cost, less waste Example – Boots (11bn/9 bn debt – e.g. loan/bond/mezzanine/etc.) vs ToysRUs UK stock exchange 3000 down to 2000 companies 3 Deal Structuring • Key issue for VC/PE is to maximize the return for the amount they invest • Do NOT start with equity stakes – the end point! • MBO’s: Optimize/maximize the amount that can be borrowed • Cost lower than for equity • “Levers up” the return on equity VC wants return for investments (at least 35%, in this case 40%, last week biotech example was 50%) Focus on exit, end point and calculate back Max debt, why (cheaper), tax shield (deduct debt before tax), amplify return on equity Deal Structuring • Focus on initial deal structure that meets the VC/PE’s minimum IRR requirement on most likely assumptions • This may not be the final deal structure but provides basis for negotiation • Can vary assumptions to see what happens to the structure and equity stakes So, focus on a deal structure that meets your minimum Internal Rate of Return requirements, based on the most likely assumptions. What does that mean? The most likely assumptions here is the business plan forecast. You have a forecast going out over 4 years so you can use that to work on your deal. You can ask what is the structure I require? What is my minimum IRR requirement, it is 40% per year. What will that look like after 4 years, and how do I work backwards to find a deal structure that delivers this? In the real world, this case information is pre due diligence, so we only have a summary level of information. Therefore the deal structure we produce will probably not be the final deal, but be the basis for negotiation with the management team. And perhaps most usefully, once we have an initial deal structure we can change some of the assumptions and see how that changes the valuation – if things go better or worse than expected, how does that change the rewards to the VC and rewards to the management? It’s worth noting that, normally, when we design a deal we want to align our interests (the investor interests) with those of the management team. We want the management team to feel that they can do well. If the management team do well we do well. If the management team do extra well, and the outcome is better than expected, then they should be extra rewarded. However, if things don’t go as well as planned, then we, as the VC, require some form of insurance – perhaps getting more money back than the management team. So, we like the management team’s interests to be aligned with our own plus we like some ‘insurance’. Once we have a structure, we can do ‘what if?’ analysis to see how outcomes change with different scenarios. Deal Structuring Steps – Group Work, 10 Mins 1. Establish funding requirement 2. Establish debt capacity 3. Deduct debt from overall requirement to establish requirement from management and VC/PE firm 4. Assume (estimate) exit valuation 5. Deduct outstanding debt from exit value if any 6. Calculate minimum value required on exit by VC/PE 7. Deduce maximum balance available to management on exit 8. Deduce equity split between management and VC/PE (maximizing the amount the VC/PE invests in preference shares or loan stock) These are the suggested steps to structure this deal. So, I hope you had a go at this before our Learning Engagement session today… 1 to 7 are fairly straight forward. Please also try step 8. We will work through these together on Wednesday. 1.The first step is to establish the funding requirement – all of the information you require is in the case. 2.Establish the debt capacity – how much debt can the business support? How much debt will the bank lend the business? 3.Think about the exit valuation and the role of the debt. Normally we deduct the debt from the exit valuation before apportioning the remains to equity shareholders. 4.Do the exit valuation. You have the criteria in the case. Think about which year to apply it to. 5.Ask yourself, is there any debt at the point of exit? Is there any bank debt left? You have hints in the case as to whether there is or not. 6.Calculate the minimum value required on exit by yourself, the VC. You should know how much money you are going to put in, how much money the management team will put in, what is the minimum value you require upon exit in order to achieve your portfolio aims and your IRR? 7.Deduce how much will the management team get back on exit. If we’ve done the previous steps correctly, we’ll know if there’s any debt to pay back, we’ll know how much the VC gets back, the remainder must be what the management team get. 8.The final step is to structure the deal. So, how do we split the deal between management and the VC. Is there also a VC loan element in order to achieve all of the objectives we have highlighted here, and if so, how much? Deal Structuring Steps Group Work, 10 Minutes These are the suggested steps to structure this deal. So, I hope you had a go at this before our Learning Engagement session today… 1 to 7 are fairly straight forward. Please also try step 8. We will work through these together on Wednesday. 1.The first step is to establish the funding requirement – all of the information you require is in the case. 2.Establish the debt capacity – how much debt can the business support? How much debt will the bank lend the business? 3.Think about the exit valuation and the role of the debt. Normally we deduct the debt from the exit valuation before apportioning the remains to equity shareholders. 4.Do the exit valuation. You have the criteria in the case. Think about which year to apply it to. 5.Ask yourself, is there any debt at the point of exit? Is there any bank debt left? You have hints in the case as to whether there is or not. 6.Calculate the minimum value required on exit by yourself, the VC. You should know how much money you are going to put in, how much money the management team will put in, what is the minimum value you require upon exit in order to achieve your portfolio aims and your IRR? 7.Deduce how much will the management team get back on exit. If we’ve done the previous steps correctly, we’ll know if there’s any debt to pay back, we’ll know how much the VC gets back, the remainder must be what the management team get. 8.The final step is to structure the deal. So, how do we split the deal between management and the VC. Is there also a VC loan element in order to achieve all of the objectives we have highlighted here, and if so, how much? 18/19 Feb 2019 MSc Hoots – 1 Funding requirement 1 Funding requirement £m Purchase price 2.5 Fees & costs 0.1 TOTAL 2.6 “We’d like to make a bid for a management buy-out – if you’ll lend us the money.” In addition the bank provides an overdraft facility of £300,000 Fees and costs: DD by external parties, changes to the article of association, changes to the shareholder agreement, covernance, guarantees Cant use the overdraft – that’s for working capital 18/19 Feb 2019 MSc Hoots – 2 Debt Capacity Debt capacity Maximum interest payments the bank willing to accept is £200,000 At 10% interest rate, 200,000 / 0.1 = £2m or 4 * £500,000 = £2m Why not 2m + 300k overdraft – remember the money in the box This includes the interest/principle Working in nominal values (so no need for discount, time value of money) 18/19 Feb 2019 MSc Hoots – 3 Requirement from Management and VC £m Total Requirement 2.6 Less Senior Debt (2.0) Requirement £0.6 from: Management 0.1 Venture capital 0.5 £0.6 Anyone work it out? 18/19 Feb 2019 MSc Hoots – 4 Assume exit valuation 2023 Forecast PAT x pe = £650,000 x 6 = £3.9m Exit year 4 – PAT 18/19 Feb 2019 MSc Hoots – 5 Deduct debt (if any) £m Exit Valuation 3.9 Less Senior Debt Nil Management & VC Value £3.9 All debt has been repaid prior to exit 18/19 Feb 2019 MSc Hoots – 6 Calculate MINIMUM VC return requirement Future value of £0.5m at 40% pa over 4 years = £1.92m. £500k * (1+0.40) 4 = £500k * 3.84 = £1.92m x1.4 £0.5m x1.4 x1.4 x1.4 £1.92m 18/19 Feb 2019 MSc Hoots – 7 Deduce balance available to management £m Value net of debt 3.9 Less Required minimum VC return 1.92 Available to management 1.98 How much did management put in? Exit £3.9m Man. V.C. 1.98m 1.92m 50.8% 49.2% Deal Structuring Steps 1. Establish funding requirement 2. Establish debt capacity 3. Deduct debt from overall requirement to establish requirement from management and VC/PE firm 4. Assume (estimate) exit valuation 5. Deduct outstanding debt from exit value if any 6. Calculate minimum value required on exit by VC/PE 7. Deduce maximum balance available to management on exit 8. Deduce equity split between management and VC/PE (maximizing the amount the VC/PE invests in preference shares or loan stock) 18/19 Feb 2019 MSc Hoots – Deduce equity split giving the optimum structure for the VC Investments excl. bank debt £0.6m Exit £3.9m 16.7% Man. 0.1m V.C. 0.5m 83.3% Man. V.C. 1.98m 1.92m 50.8% 49.2% 18/19 Feb 2019 MSc Hoots – 8a Deduce equity split giving the optimum structure for the VC Exit £3.9m Man. V.C. 1.98m 1.92m 50.8% Scenario 1: Straight Ordinaries in Proportion to Investment Amount Management’s £0.1m = 16.7% of equity x £3.9m = £0.65m £1.92m 49.2% Scenario 2: 60: 40 split in favour of management plus a VC loan element Management’s 60% = £0.1m of ordinaries For VC, 40% = 40/60 x £0.1m = £0.067m of ordinaries Therefore, balance of VC investment = 0.5m – 0.067m = 0.433m loan/prefs Total required for VC = £1.92m Therefore, 1.92m – 0.433m = 1.49m from ordinaries But £3.9m – £0.433m = £3.467m Total return for VC = (3.467 x0.4) + 0.433 = 1.388 + 0.433 = £1.82m
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