venture capital

Yale School of Management MGT 635 Introduction 1_______________________________________________________________________

Introduction, Goals and Course Outline

[email protected]

O David Cromwell worked at JPMorgan & Co. for 30 years in a variety of job positions in New York and London. He retired early in 1995 and began teaching at Yale in 1996.

O During his years at JPMorgan, Cromwell had difficulty in holding down any given job. The Bank reassigned him to a new department almost every time he was just getting the hang of his current job. During 1966-1995, his job assignments included:

Year Location Department Job Function1966 New York Credit Department Financial Statement Analysis1

1967 New York Credit Department Credit Investigations1968 New York Credit Department Corporate Credit Analysis1969 New York Securities Research Industry Securities Analyst – Chemicals1970 New York Corporate Research Credit Analyst -- Airlines & Aerospace1971 London Financial Analysis Vice President & Unit Head -- London1973 London Project Finance VP Banker – Energy & Mining Projects1974 London UK Banking Dept. VP & Unit Head – Corporate Banking1978 New York Financial Analysis Senior Vice President -- Dept. Head1981 New York Mergers & Acquisitions Senior Vice President -- Dept. Head1983 New York Corporate Banking Group Executive – UK & Industries USA1985 New York Training & Adult Ed. SVP & Head of Corporate Training1986 New York Banking Division Morgan Senior Credit Officer1987 New York Investment Banking Managing Director, Head of Research1989 New York JPMorgan Capital President & CEO – Private Investments

O During his six years as head of JPMorgan Capital, that entity invested over $750 million in 75 companies, mainly in the USA but also in Europe, Latin America and Asia. Investments included venture capital, buyouts, turnaround situations and privatizations. Investments sold showed total gains of about $2 billion -- a return on investment (IRR) of about 32% per annum.

O When Cromwell arrived in late 1989, Morgan Capital reported a modest pretax profit of about $17 million. Its 1994 reported pretax profit was $625 million, about one third of JPMorgan’s total earnings for that year. During 1989-95, the investment portfolio grew from 50 companies worth $500 million to about 85 companies worth $3 billion. (Today, JPMorgan Partners is one of the largest private equity investors: portfolio = $30 billion.)

O In addition to teaching, David Cromwell remains active in the field of private equity as a private investor, an advisor to local startup companies and on the Board of Directors of several local venture companies.

1 War Story. Bethlehem Steel: Statement Spreading and learning to “round off the small change.”_______________________________________________________________________

Spring 2008


Course Goals

o Private equity investing is an apprenticeship business. One learns best by doing.

o Successful investors require a wide variety of skills and knowledge:

Ability to understand a business Knowledge of financial markets Industry and country knowledge Financial statement knowledge Knowledge of information sources Ability to do financial modeling Effective research skills Knowledge of capital structure Ability to work with insufficient data Knowledge of legal concepts Ability to focus on the key issues Ability to work under pressure Drawing appropriate conclusions Negotiating and selling skills Communication & presentation skills Teamwork skills, facilitation Interpersonal and people skills Leadership and flexibility Ability to organize self and others Ability just to say, “No.” Creativity and flexible thinking Sense of humor

o This course aims to provide students a chance to develop these skills and knowledge. Course Outline (See Attached Schedule Summary)

The course contains both lectures and cases. Proper textbooks on the topic do not exist. 2

Actual private deals (that involved the professor) form the basis for all the cases.

The first third of the course contains most of the Lectures. Lectures attempt to provide students with enough basic principles and techniques so that they can work on the cases.

o Attached is a list of 27 Lectures topics.

o The professor covers 15 lectures over the first five weeks of the course. Familiarity with this material enables students -- working together as teams -- to tackle complex “deals”.

o Copies of the Lecture Notes are available in packets from the Distribution Center. The first packet is there now; the second packet will be available in about two weeks’ time. The Notes will enable students to spend most of their time listening to the lectures, rather than writing down what the professor says.

The professor strongly recommends reading the Lecture Notesafter each lecture, rather than before.

o Students should buy a 3-hole binder for Lecture Notes and bring the notes to class.3

2 If you find a proper textbook, please let me know.3 Probably because of the total lack of sentences with verbs in the passive voice, a number of former students have said that they have continued to refer to the Lecture Notes long after graduation from SOM. _______________________________________________________________________

Spring 2008


Lecture Notes -- Content Summary 4

Part 1 1) Private Equity Jargon: EBITDA, pari-passu, P/E Ratio, Rule 144, vorpal blade

2) Private Equity Basics: Description, history, economics, players, risk concepts

3) Screening Deal Flow: Finding new opportunities, quick kills, the pursuit, criteria

4) Evaluation of Business Plans: Investment plays, unique strategies, secrets & lies

5) Macro Economic and Industry Analysis: Countries, industries, niches, competitors

6) Teamwork: Organization, techniques, “Do’s” and “Don’ts”, performance evaluation

7) Financial Statement Analysis and Ratios: Definitions, key ratios, foolish traditions

8) Financial Plans: Projection models, key elements, sensitivity, standard format

9) Timing the Market: (Just say, “No.”) Investors’ folly, big egos, indexing, discipline

10) Equity Valuation: Simple math, VC jargon, IRR, tools, comparable companies

Part 2

11) Custom Financial Models: Assumptions, traps, startups, getting rich and famous

12) Deal Structure: Management incentives, instruments, governance, exit alternatives

13) Writing Style for Business Proposals: Goals, standard outline, reading ease index

14) Oral Presentations: Presentation tactics, handouts, slide shows and oral deliveries

15) Evaluation of Management: Judgment art, difficulties, soft research, private eyes

16) Leveraged Buyouts: Buyout concepts, capital structure issues, credit risk analysis

17) Negotiations: Positions, interests, getting to “Yes,” emotion, those darn gremlins

18) Term Sheets: Investment proposals, outline of key provisions, standard examples

19) Investment Memos: Purpose, standard format, list of “pro” and “con” reasons

20) International Investing: Regions, regulations, language, culture, country & FX risks

21) Follow-On Investments: Good money after bad, down & dirty, a little poker math

22) Legal Documentation: Key issues, boilerplate, lawyers, the taxman, boring samples

23) Monitoring; Exits: Board reps, IPO, selling out, block sales, going bust gracefully

24) Common Obstacles: Insufficient research, valuation gaps and common death traps

25) Portfolio Management: Diversify, timing, rule of 20, discipline, portfolio accounting

26) Raising a Private Equity Fund: Types, finding investors, track record, key terms

27) Career Opportunities: In venture capital and the private equity investment industry

4 Copyright © by David Cromwell. Revised January 2008._______________________________________________________________________

Spring 2008


Key Features of the Course

o The professor hands out cases as we go. Major cases are rather complex and require the use of multifarious skills. Cases require knowledge and techniques students have learned in other SOM courses (or before coming to SOM.) Most of the opportunity to learn comes from working on the cases, outside of class hours.

o The cases all contain financial projection models. Via email, students will receive copies of the models in Microsoft Excel format.

_______________________________________________________________________

o Investing in the equity securities of private companies typically requires many steps:

Screen deal flow by reading Private Placement Memos from deal sponsors. Do “macro research” on economics, industry, sectors, niches and competition. Prepare and analyze financial statement projections, usually a custom model. Do equity valuation work and compare the results to similar public companies. Reach conclusions, make written and oral presentations. Negotiate the price and other terms & conditions of a deal, sign legal documents.

o Except for negotiations, the first case takes each of the above steps, one step at a time. Students work in teams to learn the basics.

o All the other cases require combination of all the steps. Students work in larger teams.

o Major cases include early stage venture capital, leveraged buyouts and turnarounds.

o The last two cases are international, cross-border investment deals. The final case is extremely complex. It requires creativity, flexible thinking and a sense of humor.

o Effective teamwork is critical for the cases. Teams of 5-6 students play roles, compete or join forces with each other -- to attempt to “do the deal”. Teams share the heavy workload. One luckless team plays the difficult role of Management, trying to raise capital. The professor rotates the teams for each case, so that people will work with a completely different team each time, and with many members of the class. Rotation also allows the professor to balance the teams with respect to skill levels.

o After each case, students receive feedback on perceived performance of both teams and individuals. Feedback includes (a) things done well and (b) things students could improve for the next time. This is how apprenticeship learning works. ☺

o The instructor will attempt to explain the key business learning points of each case. These include a variety of general business principles beyond just equity investing. There is a lot of feedback in this class.

_______________________________________________________________________

Spring 2008


Logistics and Other Features

o This course requires a very heavy time commitment. In addition to class time, students should allow up to 15 hour's time per week.

o Workload during the first week of the course is relatively moderate. Thereafter, the work tends to expand to fill all the available time, as major deals get underway.

o Prerequisites – Financial Accounting, Valuation / Corporate Finance and Options

o Some working knowledge of financial statement analysis is useful, but not required. Most cases require the manipulation of detailed, company financial projections. “Doing the model” is not that difficult, but does require lots of practice. In addition to class lectures, optional training workshops on “How to do research at SOM” are available.

o There is no textbook reading.

o Performance on five major cases is 92% of the course grade, with 8% of the grade linked to a minor case and feedback tasks. There are no tests. No exams.

Task Points Major Teamwork Cases PointsScreening Deal Flow 3 Cinemex S.A. 14FSSNE 12 Porco S.A. 22HigherOne, Inc. 22Luck Industries, Inc. 22 Team Reviews (5 of Them) 5

Subtotal 59 Subtotal 41

o For the five major teamwork cases, the instructor awards half of the points based on the perceived performance of each team as a whole. One’s personal contribution to his/her team’s effort -- as perceived by other members of your team -- is the other 50%.

o After each case, all team members will complete a short “Team Review” report. This review evaluates the quality and quantity of effort contributed by each team member. Students make 3 brief comments about each of their teammate’s greatest strengths and 3 remarks about areas needing improvement for the next time. The professor keeps the sources of these student comments strictly confidential. The professor edits this input for detailed feedback to each person, after each case.

o Judging skills, strengths and weaknesses of people is a business skill that is vital for a successful investor. If you cannot (or will not) judge performance of people, then this course is not for you.

_______________________________________________________________________

Spring 2008


Logistics and Other Features (Continued)

o People who do not to do their share of the team’s workload also are in the wrong class. “Free Riders” -- who coast along on the work of others -- get slammed by their colleagues and by the professor. Insufficient effort hurts your colleagues and limits your learning experience. “Slackers” end up at the very bottom of the class, or worse. The professor does give grades of “less than proficient” to slackers and free riders.

o Quiet People -- who almost never say a word in meetings -- tend to do rather poorly. The major cases involve active discussion and debate. Talking to your colleagues is important in making a useful contribution to solving the task. If you feel you cannot or will not speak up, ever, no matter what -- then you should give this class a miss.

o The professor does not permit Audit of this class, since it does not work. Much too much of the “learn by doing” is off-line, outside of class, in team meetings and in long negotiating sessions with other teams.

o Waiting List. If you are on a waiting list to get into the course, come to class and do the homework -- until your status finally is clear. Those who turn up for class and do the work -- will receive priority when openings occur. We will keep an attendance list. (There is too much content at the front end of the course to easily “catch up”, later on.)

o The class size limit is 36 mostly second-year students. The course will work with less than 36 people, but not with more. This large class size restricts active in-class discussions. As part compensation, there are active off-line team discussions, plus the professor has a tendency to inject side comments and feedback wherever possible.

o We will set up a free Hotmail account for each student -- plus use free Microsoft Messenger and Microsoft Netmeeting software. This will allow students to chat with the professor and each other online, and to share and edit documents online.

o There will be workshops for (1) How to do research -- Library, Lexis/Nexis, Bloomberg and the Internet and, if requested, on (2) How to run the Simplex model.

o The professor always is looking for ways to make this class better. There will be a custom survey and an official end-course survey to collect your ideas and suggestions.

Registrar General’s Warning: This course carries a heavy workload and requires a large commitment of time. This VC Class may threaten all of your spare time and can cause serious damage to your social life.

_______________________________________________________________________

Spring 2008


1. Wednesday JANUARY 23, 2008

Lectures: Introduction, Course Goals and Outline (See Handout) (Logistics, Heavy Workload and Other Requirements)

2. Private Equity Basics (Start, Part 1)

Assignment: Read: Lecture Note 1: “Private Equity Jargon”For Next Class

2. Monday JANUARY 28, 2008

Lectures: 2. Private Equity Basics (Continued, Part 2)3. Screening Deal flow

Assignment: Screening Deal Flow (E-mail answers before 8 AM Wednesday)

For Next Class Training: Macro Research (Several Dates: Optional)

3. Wednesday JANUARY 30, 2008

Lectures: 4. Business Plans

5. Macro Research / Industry Analysis (Information Sources)

Discussion: Screening Deal Flow

Assignment: Read Case: “Fire Security Systems of New England, Inc.”

4. Monday FEBRUARY 4, 2008

Lecture: 6. Teamwork, Hints, Team Reviews

Assignment: FSSNE 1: Continue Macro Research For Next Class

5. Wednesday FEBRUARY 6, 2008

Lectures: 7. Financial Statement Analysis8. Financial Plans & Financial Models

Assignment: FSSNE 2: Model -- Build High, Low and Base CasesFor Next Class

_______________________________________________________________________

Spring 2008



Lectures: 9. Timing the Market (Just say, “No”)

10. Equity Valuation Techniques

Assignment FSSNE 3: Do Equity Valuation For Next Class


Lecture: 11. Custom Financial Models

Discussion: FSSNE Case Review

Complete FSSNE Team Reviews (In class)

Assignment: Read Case: “HigherOne, Inc.” (New 6-Person Teams)For Next Class


Lecture: 12. Deal Structure

Breakout: HigherOne: Organize Team Logistics (In Class)

Assignment: HigherOne: Start Research, Do Financial ModelFor Next Class


Lectures: 13. Writing Style for Business Proposals

14. Oral Presentations

Breakout: HigherOne: Team Discussions (In Class)

Assignment: HigherOne: Team Discussions / Make Decisions For Next Class


Lecture: 15. Evaluation of Management

Assignment: HigherOne: Prepare Presentation for Investors For Next Class

_______________________________________________________________________

Spring 2008


11. Wednesday FEBRUARY 27, 2008 Time: 10:00 AM-12:30 PM

Discussion: Presentations to Investors Extended Class Time

HigherOne

Special: Best Presentation Contest (Class Vote)

Complete HigherOne Team Reviews (In Class)

Assignment: Read Case: “Luck Industries” (New Teams)

12. Monday MARCH 3, 2008

Lecture: 16. Leveraged Buyouts

Assignment: Luck: Team Discussions -- LogisticsFor Next Class

13. Wednesday MARCH 5, 2008

Discussion: HigherOne: Case Review

Breakout: Luck: Team Discussions (In Class)

Assignment: None For Next Class

Midterm Exams & Spring Break: No Classes until March 24

14. Monday MARCH 24, 2008

Lectures: 17. Negotiations

18. Terms Sheets

Breakout: Negotiate Deal (In Class)

Assignment: Luck: Team Discussions, Negotiate DealFor Next Class Optional Reading: “JPM Term Sheet Alternatives”

15. Wednesday MARCH 26, 2008

Lecture: 19. Investment Memos

Breakout: Negotiate Deal (In Class)

Assignment: Luck: Prepare Presentation For Investment CommitteeFor Next Class

_______________________________________________________________________

Spring 2008


_______________________________________________________________________

Spring 2008


16. Monday March 31, 2008 Time: 10:00 AM-12:30 PM Extended Class: 6 Sections

Discussion: Investment Committee Meetings Luck Industries

Assignment: Luck: Negotiate Final Deal Deadline: 8 PM Tues. NightFor Next Class

17. Wednesday APRIL 2, 2008

Discussion: Luck: Final Deal Description vs. Actual Results

Complete Luck Team Reviews (In Class)

Assignment: Read Case: “Cinemex” (New Teams)For Next Class

18. Monday APRIL 7, 2008

Lecture: 20. International Investing

Discussion: Luck: Case Review

Assignment: Cinemex: Team DiscussionsFor Next Class


Lecture: 21. Follow-On Investments (Poker Math)

Assignment: Cinemex: Prepare Presentation For Investment CommitteeFor Next Class

20. Monday APRIL 14, 2008 Time: 10:00 AM-12:30 PM Extended Class: 6 Sections

Discussion: Investment Committee Meetings Cinemex

Assignment: Cinemex: Negotiate Final Deal Deadline: 8 PM TuesdayFor Next Class


Discussion: Cinemex: Final Deal Description vs. Actual DealComplete Cinemex Team Reviews (In Class)

Assignment: Read Case: “PorcoComasas S.A.” (New Teams)

_______________________________________________________________________

Spring 2008


For Next Class

_______________________________________________________________________

Spring 2008



Lectures: 22. Legal Documentation

23. Monitoring Portfolio Companies, Exits

Discussion: Cinemex: Team Performance & Case Review

Assignment: Porco: Team Discussions For Next Class


Lecture: 24. Common Obstacles

25. Portfolio Management

Special: Try to Solve Legal Language Puzzle (In Class)

Assignment: Porco: Negotiate For Next Class (Search for the vorpal blade)


Lectures: 26. Raising a Private Equity Fund

27. Career Opportunities in Private Equity

Assignment: Porco: Prepare Presentation For Investment CommitteeFor Next Class (Watch Out For Gremlins)

25. Wednesday APRIL 30, 2008 Time: 10:00 AM-12:30 PM Extended Class: 6 Sections

Discussion: Investment Committee Meetings PorcoComasas S.A.

Assignment: Porco: Negotiate Final Deal Deadline: 7 PM Sun.For Next Class (Cash in Solar Credits, Locate Wine Bar)

26. Monday May 5, 2008

Discussion: Porco: Final Deal Description; Case ReviewComplete Porco Team Reviews (In Class)

Special: Official Course Evaluation

_______________________________________________________________________

Spring 2008


Final Exam Week NO EXAM ☺

_______________________________________________________________________

Spring 2008

venture capital

Economy & Finance