Contributions to Finance and Accounting

Serena Gallo
Vincenzo Verdoliva

Private
Equity and
Venture
Capital
Theory, Evolution and Valuation
Contributions to Finance and Accounting
The book series ‘Contributions to Finance and Accounting’ features the latest
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Serena Gallo • Vincenzo Verdoliva

Private Equity and Venture

Capital
Theory, Evolution and Valuation
Serena Gallo Vincenzo Verdoliva
Department of Economics Department of Management and Quantitative
University of Campania Studies
“Luigi Vanvitelli” University of Naples “Parthenope”
Capua, Caserta, Italy Naples, Italy

ISSN 2730-6038 ISSN 2730-6046 (electronic)

Contributions to Finance and Accounting
ISBN 978-3-031-07629-9 ISBN 978-3-031-07630-5 (eBook)
https://doi.org/10.1007/978-3-031-07630-5

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Acknowledgements

We would like to thank Springer for believing in this project and for supporting us
since the beginning. Special thanks go to Rocio Torregrosa, the responsible editor
for finance. This book has also benefited from comments offered by reviewers and
colleagues. Their comments have substantially helped us to improve the quality of
this project. We alone are responsible for any remaining errors.

v
Contents

1 Theoretical Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Private Equity and Venture Capital: A Brief Summary of Their
History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2.1 The Defining Aspects of Private Equity and Venture
Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.3 How Do the Private Equity and Venture Capital Industry Work? . . . 5
1.3.1 The Private Equity Business Model . . . . . . . . . . . . . . . . . . . 6
1.3.2 Venture Capital Business Model . . . . . . . . . . . . . . . . . . . . . 9
1.4 Differences Between Private Equity and Venture Capital and
Alternative Forms of Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.5 Typologies of Private Equity Investors . . . . . . . . . . . . . . . . . . . . . . 16
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2 Start-Up, Expansion and Buy-Out Financing . . . . . . . . . . . . . . . . . . . 21
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.2 Pre-financing: Business Angels, Incubators and Crowdfunding . . . . 24
2.2.1 Business Angels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.2.2 Incubators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
2.2.3 Crowdfunding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
2.3 Early-Stage Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
2.3.1 Seed Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3.2 Start-Up Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2.3.3 Early-Growth Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2.4 Expansion Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
2.4.1 How Does Private Equity Work for Internal and External
Growth? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
2.4.2 Advantages and Disadvantages for Companies . . . . . . . . . . 41

vii
viii Contents

2.5 Replacement and Buy-Out Financing . . . . . . . . . . . . . . . . . . . . . . . 42

2.5.1 Leveraged Buy-Out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
3 A Snapshot of Private Equity and Venture Capital Industry:
Pre- and Post-crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
3.2 The Development of the Private Equity and Venture Capital
Market: Growth, Crisis and Decline During the Global Financial
Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
3.3 The Role of Private Equity and Venture Capital During
the Pre-Coronavirus Pandemic . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
3.3.1 The Role of Private Equity and Venture Capital During
the Coronavirus Pandemic: The Uncertainty of the
Future . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
3.4 Fundraising Trend in USA and Europe: A Comparison . . . . . . . . . . 56
3.5 Investment Process: Scouting, Closing and Volume . . . . . . . . . . . . 61
3.5.1 Scouting of the Target Company: The Identification
of the Best Investment Opportunity . . . . . . . . . . . . . . . . . . . 65
3.5.2 The Investment Decision and Closing . . . . . . . . . . . . . . . . . 68
3.6 Divestment: Volume and Modality of Way-out . . . . . . . . . . . . . . . . 69
3.6.1 Modality of Way-out: Trade Sale . . . . . . . . . . . . . . . . . . . . 71
3.6.2 Modality of Way-out: IPO . . . . . . . . . . . . . . . . . . . . . . . . . 72
3.6.3 Modality of Way-out: Buyback and Sale to Other Private
Equity and Venture Capital Investors . . . . . . . . . . . . . . . . . 73
3.6.4 Write-off of the Stake . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
4 Highlights of Private Equity and Venture Capital Valuation . . . . . . . . 75
4.1 Introduction to Private Equity and Venture Capital Valuation . . . . . 75
4.2 Valuation in Private Equity and Venture Capital: Techniques
and Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4.2.1 Discounted Cash Flow Valuation . . . . . . . . . . . . . . . . . . . . 78
4.2.2 Valuing Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
4.3 Weighted Average Cost of Capital (WACC) . . . . . . . . . . . . . . . . . . 86
4.4 Leverage Buy Out Valuation Models . . . . . . . . . . . . . . . . . . . . . . . 88
4.5 Case Study: A Valuation Example Using CCF and WACC . . . . . . . 89
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Chapter 1
Theoretical Background

1.1 Introduction

The first chapter of this book aims to explain the fundamentals of private equity and
venture capital. The second section provides a general definition of private equity
and venture capital, pointing out the difference between European and American
approaches to providing start-ups financial support. The third section explores the
principal characteristics of their business models and how the constitution stage of
the funds occurs typically. The fourth section explains how private equity differs
from venture capital at first and how the two forms of investments vary significantly
from the other alternative source of financing. The chapter concludes with an
overview of the leading typologies of the private equity operators in the European
and American markets.

1.2 Private Equity and Venture Capital: A Brief Summary

of Their History

As Albert Einstein said: “You have to learn the rules of the game. And then you have
to play better than anyone else”. This first paragraph explains the fundamentals to
understand “the game” covered by this book: private equity and venture capital.
First, we provide a quick reminder of the different forms of financing for those of
you who are not already familiar. Usually, one of the most significant constraints to
the development of any business entity concerns the lack of financial resources.
Good financial markets and institutions allow people to implement business ideas by
helping them get appropriate funds.
So do most of the readers know, the financial world, simplifying, can be split into
two primary sources of securities: equity (own funds) and debt (loans). Financing
with equity generates higher returns due to more significant risks. Also, this type of

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 1

S. Gallo, V. Verdoliva, Private Equity and Venture Capital, Contributions to Finance
and Accounting, https://doi.org/10.1007/978-3-031-07630-5_1
2 1 Theoretical Background

funding is called par excellence “patient capital” because it does not have a defined
payback period with a lenient repayment. Raising patient capital can be crucial for
firms since it represents the essential source of sustainable growth and development.
On the other hand, financing through debt commands a more certain return in an
ongoing coupon (i.e., interest rate), even if the remuneration is a lot less because of
the lower risks. Thereby, companies can finance growth with retained earnings and
bank loans.
However, many growing firms, such as high-technology firms, do not have
appropriate tangible assets and cash flow to get bank loans, and external equity
represents the primary source of funds [1].
Belonging to the family of equity financing, private equity and venture capital
represent innovative and alternative forms of funding through which small and
medium enterprises (SMEs) and start-ups are able to overcome the considerable
difficulties in finding financial resources through the traditional instruments. How-
ever, private equity and venture capital belong to the family of “impatient capital”
[2] because their objectives are to invest in projects with higher returns and quickly
exit the market.
Despite private equity and venture capital fundraising have been becoming
increasingly important in the financial landscape over the last decade, there is
some evidence that primal forms related to investment in the equity of companies
had already begun during the early Roman Empire. Money from family and friends
has been a relevant resource throughout the ages, whereas financing through the
selling of stocks has emerged in the modern era [3].
Indeed, in the earlier economies, intermediaries that provided equity capital on an
individual basis were known as joint-stock companies, which acted similarly to
venture capital and private equity developed in our age. Nevertheless, an early
example of a structured financial organisation similar to private equity and venture
capital was represented by British institutions during the fifteenth century when they
founded projects in order to increase and develop the trade from their colonies. The
first investments bore the features of private equity investments since wealthy
individuals were willing to launch risky projects hoping for considerable returns.
But, the true turning point in the history of private equity and venture capital took
place after the second world war,1 marking the beginning of the modern private
equity and venture capital era. In 1946, indeed, the leading two venture capital
companies were founded: American Research and Development Corporation
(ARDC) and JH Whitney & Company. However, before the second world war,
risk capital investments were made by wealthy individuals and families. These
companies had been founded to provide firms’ financial support and, at the same
time, ensure a satisfying risk-return relationship to investors. The ARDC company

1
Indeed, one of the first steps towards a well-arranged venture capital industry was occurred with
the adoption of the Small Business Investment Act in 1958 that allows to private small business
investment companies to help small and medium enterprises in the USA by providing financial and
managerial support and obtaining fiscal benefits in return for their investment.
1.2 Private Equity and Venture Capital: A Brief Summary of Their History 3

was constituted by Georges Doriot, known as the father of venture capital”, with
Ralph Flanders and Karl Compton, former president of MIT. The constitution of this
company has begun the era of institutional private equity since fundraising, for the
first time, came from sources other than wealthy families. The fundraising only from
families and friends had not been sufficient to meet the financial markets’ needs and
underpin the companies’ development.

1.2.1 The Defining Aspects of Private Equity and Venture

Capital

A brief summary of the history and origin of risk capital investments presented
above is needed to understand how this type of business has evolved since its
original inception in the 1940s.
As discussed in the first previous section, private equity and venture capital
represent alternative ways of founding economic activities.
However, when it comes to private equity and venture capital, we cannot exempt
to examine taxonomic and definitional aspects. Although one worldwide shared
definition and classification for private equity and capital does not exist, we can rely
on the literature’s broad or general definition.
The terms private equity and venture capital are often used interchangeably. They
are first cousins or more brother and sister. However, the literature defines the two
differently as they have presented more distinctive aspects as time progresses.
Indeed, private equity investment is generally considered a concept broader than
venture capital, which in turn represents its cluster or subcategory. In the early
1980s, the word “venture capital” defined the injection of capital stock or the
subscription of convertible securities into shares by specialised operators in the
medium–long term in unlisted companies with high growth potential and develop-
ment in terms of new products or services, new technologies, new markets design.
Thus, venture capital means risk equity investment by professional investors with a
holding period larger than 12 months in new unquoted firms to create value and,
consequently, generate a reward in the form of capital gain and supplemented by
dividend yield after the deal [4]. According to this definition, shareholding is meant
as temporary, minority and aimed at developing the company, increasing its value
and the likelihood of achieving a high capital gain at the time of disposal [5]. Over
time, although the underlying assumptions are still the same, some features of this
institutional investment activity into risk capital have changed, presenting diversified
aspects depending on the entrepreneurial system and the degree of market develop-
ment and offering a wider range of investment opportunities.
Concerning, instead, the private equity2 terms, it indicates all institutional invest-
ments carried out into risk capital in the medium to longer-term, aimed at enhancing

2
AIFI, venture capital e private equity, available at: www.aifi.it
4 1 Theoretical Background

the company objected of the investment, in order to achieve a greater capital gain at
the time of disposal.
The earlier definitions cannot be applied to the whole world and do not allow us to
grasp the main differences between private equity and venture capital. Over the past
few years, although terminological harmonisation has involved private equity and
venture capital investments, many definitions persist.
Therefore, according to the authors’ country of origin, where they perform
economic activity, operators’ national associations (i.e., NVCA, Invest Europe,
BVCA, AIFI, EVPA3) and central banks interpret the definitions differently. For
instance, the USA, Great Britain, and Continental Europe present different private
equity and venture capital investments approaches. First of all, the American
approach, particularly the US market, has drawn a clear line between private equity
and venture capital, which is considered a distinctive subset of private equity.
Therefore, in line with the practice more widespread in the US, institutional invest-
ment activity into risk capital is defined comprehensively as private equity activity
and divided between venture capital and buy out operations, according to the
typology of operators that sets it up [6]. The primary objective of venture capital
investments is to provide funding for new ventures in their early stage of life (early-
stage investments) or seek additional funding to support expansion and development
phases, whereby the seed and start-up stages. Instead, all other types of investments,
from expansion to leveraged buy-outs and management buy-outs, are referred to as
the private equity market. According to the NCVA,4 venture capital represents the
risk capital by professional and institutional managers who invest financial
resources, knowledge, and experience in the company. Venture capital investments
usually offer financial and managerial support to young firms with high potential
growth that cannot seek traditional bank financing. To summarise, the American
approach adopted a more restrictive definition of venture capital by excluding
buy-outs and buy-ins that, as we will see in the following sections, are included in
a more extended definition.
Instead, the approach adopted by European countries follows the most extensive
perspective to venture capital and private equity investments. According to the
European vision, private equity means equity investments in unlisted companies
on a stock market which are made to generate a high capital gain. Based on this
perspective, venture capital, thereby, represents still a separate cluster, a specify type
of private equity investment. However, according to the European definition, the two
types of investment offer funds in a different stage of the life cycle of the firms. Thus,
their difference is based on the financed firms’ life cycle. Although also in Europe is
underway a process of terminological and methodological adaptation with the US

3
According to the country’s origin exist several associations of private equity and venture capital,
such as National Venture Capital Association (NVCA); British Private Equity and Venture Capital
Association (BVCA); Associazione Italiana Private Equity e Venture Capital (AIFI); European
Venture Philanthropy Association (EVPA).
4
“What is Venture Capital?”, NVCA, www.nvca.org
1.3 How Do the Private Equity and Venture Capital Industry Work? 5

standards, even nowadays for private equity means the overall investment activity
carried out on the life cycle of the firms that have successfully undergone the initial
phase, while venture capital provides funding in start-up or early-stage companies.
Therefore, venture capital activity is part of private equity, defined as a species from
the genus [5]. Venture capital is not a different and distinctive activity compared to
private equity, but it is a specific activity involved in the private equity system, with a
strict focus on providing funding for early-stage companies.
In Great Britain, private equity and venture capital investments are considered as
two distinct segments. According to the BVCA,5 the British Association for Ven-
ture Capital and Private Equity Association, venture capital activity defines the long-
term investment into the equity of unquoted firms, allowing them to achieve
successful growth and development.
Typically, economics operators in Britain indicate for private equity solely
management buy-out and leveraged transactions, while venture capital activity
includes the other types of investment concerning the early life cycle stages of
companies and their development stage. However, in Britain, like in Europe, the
term venture capital has been frequently used interchangeably with private equity,
even though the Association has drawn a clear distinction between the two types of
equity investment. Indeed, most of the reports published in Great Britain about the
venture capital and private equity markets represent them as one single and unique
market. Furthermore, adopting this perspective could hinder econometrician analysis
and comparison of data with, for instance, the USA.
In summary, from the discussion above emerges a clear need to boost the efforts
to adopt a harmonisation process regarding venture capital and private equity
markets worldwide.

1.3 How Do the Private Equity and Venture Capital

Industry Work?

As discussed in the previous paragraph, venture capital and private equity activity
refer to the investment of risk capital of private companies by qualified financial
intermediaries. Equity investments are fundamental as satisfying a primary need: the
collection of funds allows entrepreneurs with insufficient financial resources to grow
and improve the development of their companies.
According to the economic literature and professional practice, the investment
carried out by venture capital firms must focus on promising companies with
significant growth prospects in their initial or development process [7].
In contrast, private equity defines firms’ investment into risk capital after their
initial stage. For instance, private equity funds could be constituted to acquire

5
BVCA, see for more detailed information: www.bvca.co.uk
6 1 Theoretical Background

shareholdings to solve a problem related to the generational change or to implement

a leveraged acquisition, so-called buy-out/in operations.
In general, the whole of these investments activities (both private equity and
venture capital), regardless of the firms’ life cycle phase, is defined as a subcategory
of merchant banking [8], which regards the set of financial and consulting activities
made by economic operators to support business activities. However, over the last
years, the predominance of risk capital participation activity with respect to other
services related closely to merchant banks, such as consulting, mergers and acqui-
sitions (M&A), over the last years, has generated frequently a terminological
confusion between the macro-sector and its segments.
This paragraph aims to provide an answer to the following questions:“ How do
private equity and venture capital work”? and “what are the main players”?
In the following paragraphs, we present and discuss the private equity business
model according to the EVCA, mainly adopted by economic operators in the
European market.

1.3.1 The Private Equity Business Model

A private equity firm is a type of investment firm that offers investment to private
companies, thereby not publicly listed firms on the stock exchange, with a goal to
generate fabulous returns. Typically, private equity investments focus on mature
companies in traditional industries and receive a portion of equity or ownership stake
in the exchange.
Private equity firms are interested in increasing the firm’s value during the
investment to sell the company a higher value and create a capital gain. To constitute
a private equity fund, the institutional operators raise pools of capital from several
partners. The private equity fund is closed once the fundraising goal is achieved and
money raised is invested into the target company.
The private equity business model [9] includes different economic players
actively involved within the four main phases. Figure 1.1 shows a simplified
representation of the private equity structure.
Thereby, the main actors of private equity firms are the following:
• Private equity management companies also called General partners (GPs)
• Limited partners (LPs)
• High-potential companies, also known as Investee or portfolio companies
Creating a private equity fund represents a challenging and complex process
closely affected by the legal regime of reference. Before dealing with the fundraising
process, the fund manager must identify and adopt an effective and appropriate legal
structure. Afterwards, the management team is constituted, and private equity
operators can begin fundraising for investment activity. The fundraising process is
divided into the following fundamental steps:
1.3 How Do the Private Equity and Venture Capital Industry Work? 7

Fig. 1.1 Private equity business model. Source: Authors’ elaboration based on EVCA

• The definition of strategic purposes and pre-marketing activity.

• The production and distribution of some marketing collateral.
• The meetings with potential investors and the adoption of due diligence.
• The negotiation of contractual conditions.
• The closing of funds.
Thus, private equity firms establish investment funds, afterwards the agreement
by the controlling authorities, and begin to collect capital from a pool of investors.
Typically, a high portion of financial resources came from accredited investors
supporting high-risk, high-reward companies or projects. The private equity activity
is developed through vehicles that allow investment activity. In exchange for their
investment, investors obtain a pre-negotiated stake in the investment fund, sharing
the risk associated with the private equity firms. Therefore, the relationship between
investors and private equity firms and their contribution to the fund’s risk is not the
same for all investors but depends on the type of constituted relationship or better
partnership.
The main partnerships in which the private equity actors are involved are the
following types:
1. Total Partnership. Shareholders of private equity firms. They are responsible for
managing the private equity fund and respond directly and with their assets in
performing the control of the fund.
Thus, the fund is not an autonomous legal entity since the total funds payable
for shareholders and the fund are equal. Usually, the relationship between
shareholders and the fund lasts about 10 years, until a maximum of 12 years or
more, according to the shareholder’s dispositions.
8 1 Theoretical Background

2. Limited partnership. It is possible to distinguish two main shareholders catego-

ries6: general partners and limited partners.
The separation criterion between them refers to the degree of involvement and
responsibility in raising capital management. Limited partners provide capital to
funds represented by institutional investors, such as banks, pension funds, insur-
ance companies, and individual investors (family, corporates). Their responsibil-
ity on the fund’s management and investment decisions is limited to the capital
they contribute; thereby, they have limited obligation. In contrast, the general
partners have responsibility based on their capital contribution. Still, they are also
responsible for the fundraising organisation, managing the capital raised, and
refunding the quotas to the subscribers at the expiry of the fund. However, general
partners can also respond with their personal assets. Typically, general partners of
the fund are the venture capitalist or buy-out firms [10].
Therefore, the fund managers raise capital from institutional investors and indi-
viduals with specific competencies or significant assets, which will take equity
stakes into the target company. The investors involved in the private equity firms
are also known as “qualified or sophisticated investors” because the investment is
hazardous, and they are able to understand the risk underlying it. The fundraising
process lasts for 6 months to 1 year, and the raised funds are used to buy growth
potential firms, also called portfolio/investee companies. However, most investment
funds are closed-end, which means that institutional investors cannot exit from the
funds before the ending term as they could face many constraints in doing so. It sure
represents a clear advantage in terms of financial stability to the financed
entrepreneurs.
Once the investment is made, and the target amount has been raised, the subscrip-
tion phase is closed. Afterwards, private equity firms begin to have an active role in
helping the beneficiary firms to crate the value and reach the development stage.
Indeed, as we have already argued, private equity and venture capital firms do not
provide only financial resources but also managerial and technical skills. In line with
this perspective, in this stage, private equity firms contribute to the firm’s growth by
benefiting from specialist knowledge, expertise in enhancing the company’s perfor-
mance, and creating contacts with other businesses that can help it improve its
development. Furthermore, private equity firms have refined their skills in supporting
the growth of target firms over the last decade [11]. Indeed, now many private equity
firms have adopted 100-day improvement plans. In contrast, others have created an
in-house industry to offer extra resources and help the investee firms to improve their
businesses. Private equity firms adopt all these measures to make the company worth
more at the sale stage than when the investment was made.
The holding period of investment sets on average 10 years, as the investors are
interested in long-term capital gains rather than short-term profits. Investors can

6
The separation between general partners and limited partners occur, typically, in closed-end funds.
Indeed, there is no separation between investment categories between the reserves of the venture
capital fund and fund managers.
1.3 How Do the Private Equity and Venture Capital Industry Work? 9

Fig. 1.2 Venture capital firms structure. Source: Zider (1989) “How venture capital works”

realise the return by transferring the investment to another company (trade sale),
selling the shares through a public listing or another financial buyer, depending on
market conditions and existing opportunities for disposal. At the exit stage, the
capital obtained (i.e., the fund’s initial purchase price plus any increase in value) is
returned to investors on a pro-rata based on their initial investment size. Institutional
investors hope to receive significant profit to honour the money collected by their
clients (the savers and pensioners) and compensate the capital invested for a long
time. However, when the capital raised is invested, and specific investments are
concluded with the exit, the fund managers can launch a second fund. Therefore,
attracting new investors depends on previous experience and historical performance.

1.3.2 Venture Capital Business Model

The venture capital firm’s structure is quite similar to the private equity business
model. For the sake of completeness, we also present the venture capital firm
structure.
Indeed, Fig. 1.2 shows how venture capital firms typically work and the main
actors involved in the investment activity. The leading players engaged in the venture
capital industry are [12] (1) entrepreneurs who have not the financial resources
needed to start a new business or develop an already existing economic activity;
(2) investors who are interested in receiving high returns; (3) investment bankers and
(4) venture capitalists.
Similarly to private equity firms, venture capital opens a fund to raise the money
needed to start the investment activity in the selected companies. Venture capitalists
establish with investors both limited and general partnerships. The fund typically
stays alive from 7 to 10 years. Whether the venture capital fund has invested in a
successful company, a profit is generated and distributed to investors. However,
investors in capital firms can also profit by selling some of its shares to other
investors on the secondary market.
10 1 Theoretical Background

1.4 Differences Between Private Equity and Venture

Capital and Alternative Forms of Financing

In the last section, we have presented a brief historical overview of the origins of
private equity and venture capital by underling the defining aspects according to the
different existing perspectives.
Generally speaking, the European point of view adopted by EVCA [13] (i.e.,
European Venture Capital Association) qualifies private equity as “equity capital to
enterprises not quoted on a stock market”, and venture capital as “a subset of private
equity investments made for the launch, early development or expansion of a
business”. This perspective has become the most widespread, so we have adopted
it over the following chapters.
Although we can identify venture capital activity as a subcategory of private
equity from the definition above, the following question remains lawful: What is the
difference between private equity and venture capital? The answer is not as easy as it
may seem. Before answering this question, it is crucial to discuss their main aspects.
In a nutshell, venture capital and private equity belong to the financial intermediaries
category, constituting a meeting point between providers of funds, typically
represented by institutional investors, and high-growth and high-tech companies.
Funds providers establish a limited partnership, thereby a contract between institu-
tional investors (such as banks, pension funds, life insurance companies who
become limited partners with rights as partners but trade management rights on
fund only for limited liabilities) and the fund manager, who is nominated the general
partner and takes on the responsibilities and management of the daily operations by
assuming total liability. The intermediation structure of venture capital and private
equity investments can be summarised in Fig. 1.3 for simplicity.
Academic literature [14] has provided empirical evidence on a strict relationship
between the investors and financed entrepreneurial ventures. This represents an own

Institutional investors

Debt Returns Capital

Assets

Equity Shares
Venture capital
Private Equity funds

Capital

Fig. 1.3 Venture capital and private equity intermediation structure. Source: Authors’ elaboration
based on Cumming and Joahn (2013)
1.4 Differences Between Private Equity and Venture Capital and. . . 11

feature of private equity and venture capital activity that could unlikely appear in any
other financial instruments. However, the most crucial contribution generated
through venture capital and private equity investments is related to something in
the literature known as “non-financial value-added”. As such, the financial literature
usually referred to it as the ability to add “non-financial resources” by venture capital
and private equity support. Indeed, the entrance into shareholding by institutional
investors is not limited to providing financial resources; the support consists mainly
of managerial activity, such as advisory services and full-time assistance needed for
the growth and development of the company. In addition, cooperation activity with
institutional investors generates many benefits that can improve reputation, know-
how, professional experience, competencies, knowledge, skills, and networking
with other investors and financial institutions. These soft resources may be defined
as the true benefits embedded within the capital injection by private equity and
venture capital operators. As such, they could potentially trigger the deals by helping
firm growth. Academic researches [15] have shown us that entrepreneurial firms
getting funds from private equity and venture capital investors are, on average, better
performed in terms of sales growth, employment, innovativeness and profitability.
This higher performance results from three main effects generated by funding
activity. First of all, money provisions allow financially constrained firms to seize
new investment opportunities; to obtain a lot of services, such as professionalisation,
networking, and signalling; and last, the effects generated from the screening process
adopted by venture capital and private equity firms, ensure financed firms to have
higher potential rather than those firms that get funds from other external investors.
The private equity and venture capital investment activity can be summarised in
the following points:
• Modification of shareholder structure within receiving companies that represent
the main result following the investment into the equity of companies.
• Enhancement firms’ value by generating new knowledge and providing
non-financial support (i.e., administrative, marketing, and strategic advice to
entrepreneurial firms) and.
• Established investment horizon, typically over 2–7 years.
Before discussing the difference between private equity and venture capital
instruments, we summarise their similarities. Like venture capital instruments,
private equity is a capital injection, also called long-term typology of investment,
into selected entrepreneurial ventures that are financially constrained because of their
intrinsic characteristics.
Furthermore, although private equity and venture capital present similar aspects
and as such, they can be defined as comparable providers of medium or long-term
financial resources, the two institutional funds are not identical across several
dimensions. The main classification criterion adopted in the academic literature
(Gervasoni and Sattin 2000) identifies the discriminating factor with respect to the
stage of development of entrepreneurial ventures that have obtained investments.
Figure 1.4 shows the different typologies of investors according to the firm life cycle.
Generally speaking, venture capital makes investments in earlier-stage firms (i.e.,
12 1 Theoretical Background

Fig. 1.4 Life cycle of firm and investment typology. Source: Authors’ elaboration

seed or start-up), whereas private equity refers to investments in the later stage by
encompassing both buy-outs and turnaround investments. Thus, venture capital
activity focuses on investments in the early stages of business cycle, which are
remarkably delicate and adventurous, and for this reason, they are called venture cap-
ital. In contrast, private equity investments aim to support and develop established
firms and are already well underway [5]. Depending on the stage under consider-
ation, strategic and financial needs take on different configurations so that granted
financial support assumes different denominations according to the role played in the
development path of financial intermediary [16].
Generally, it can be distinguished three types of funding based on the strategic
needs of the company, the issues to address, and the purposes to be met. In this
perspective, the financial operations can be grouped into three main typologies:
1. Early-stage financing
2. Expansion financing
3. Turnaround financing, replacement capital financing, and buy-out (BO)
The first and second categories include venture capital investment which con-
cerns the acquisitions of a minority shareholding. In contrast, the last one is linked to
private equity investment, which usually refers to the investment of majority partic-
ipation [5]. Figure 1.5 outlines financial operations into risk capital based on the
firm’s life cycle. The three typologies of economic intervention will be discussed in
detail across Chap. 2. We will be able to observe that there are overlapping and
coincident areas between private equity and venture capital solutions.
1.4 Differences Between Private Equity and Venture Capital and. . . 13

Fig. 1.5 Main categories of investment within the firms’ equity capital. Source: Elaboration based
on Gervasoni and Sattin (2020)

Furthermore, the difference between private equity and venture capital firms does
not relate to only the different firm life cycle in which they offer fundraising.
The two forms of investment, however, present other differences between them.
The principal divergences7 aspects between private equity and venture capital can
be synthesised into the following points:
• Type of Investment: Private equity firms generally focus on well-established
businesses that suffer huge losses or are not making enough profits due to internal
inefficiency. Thus, private equity investors come into the business to reorganise
their operations or improve their overall efficiency and sell it to realise a profit. In
contrast, venture capitalists come in high-growth potential firms, taking high
risks.
• Control over the Funding Business: Private equity investors usually, taking a
major stake of control over the company, whereas venture capital requires a
minority stake. Private equity funds often hold a 100% stake, giving them
complete control over the companies. In comparison, venture capital investors
have a 50% or minor stake in the companies.
• Capital Structure: Private equity firms have a mix of equity and debt in their
investment, whereas venture capital firms carry out only stock investment.
• Type of Firms: Private equity funds invest typically in traditional sectors, whereas
capital prefers tech-focused start-ups, such as biotechnology and clean-
technology firms, or other young firms which are not still established or
profitable.
• The Levels of Capital Invested: Private equity firms invest a higher amount of
money than venture capital firms.
• Exit Strategy: Private equity investors do not want to stay in business for a long
time. They would make a quick sale and realise a profit. In comparison, ven-
ture capital investors want to receive a significant capital gain, and therefore,
could stay in business until the company’s growth.

7
See Pitchbook website: https://pitchbook.com/blog/private-equity-vs-venture-capital-whats-the-
difference
14 1 Theoretical Background

Table 1.1 Types of investors (equity and debt) according to the different stages of the firm
Family and Other Business Private Banking Trade Financial
Friends partners angels equity system credit markets
Development
Start-up
Early growth
Mature age
Expansion
Crisis or
decline
Sources: Authors’ elaboration

• Degree of Risk: Venture capital represents a higher-risk investment than private

equity. Therefore, venture capital can expect that most start-ups in which they
invest could fail. Thus, venture capital firms prefer to invest in many different
firms to spread out the high risk relating to their activity. Instead, private equity
firms look for a single company since the likelihood of default in mature and
already established firms is lower.
• Management Focus: Private equity firms follow the corporate governance
approach, whereas venture capital adopts management capacity perspective.
Even though this book is focused primarily on venture capital and private equity,
it is needed to discuss also the other sources of capital for the sake of completeness.
Entrepreneurial firms can choose between different sources of financing. How-
ever, entrepreneurs can consider financing their business with both equity and debt
capital. Every type of investor can help firms to satisfy their financial needs.
Table 1.1 shows the types of investors (equity and debt) based on the different
stages of the firm. The choice of adapt source of money depends, primarily, from:
• The size of the amount required by the firm.
• The sort of financial resources the firm needs (equity or debt).
• The time horizon of investment.
Undoubtedly, firms might decide to finance their activity by reinvesting their
profit internally, which is also less costly than seeking external sources. Neverthe-
less, start-up firms with a high-growth trajectory can face many constraints in
funding their operations. Most of them do not have internal finance or suffer from
insufficient internal finance. Thereby, they must find external capital to start and
develop their business. Apart from venture capital and private equity, another
common source of capital for the earliest stage firms is represented by family, friends
and fools, also known as 3 Fs. An entrepreneur can get money from the aforemen-
tioned private individuals easier as they already know the entrepreneurs, and some-
times they have a previous relationship with them.
1.4 Differences Between Private Equity and Venture Capital and. . . 15

Besides venture capital and private equity, external financing sources include
banks, factoring firms, leasing firms, business angels, government agencies, and
public stock markets.
Bank loans represent the most famous and developed source of external debt
capital. The cost of debt is given to interest payment calculated, mainly, based on
the risk of bankruptcy in the case of nonpayment. Commercial banks usually require
significant collateral and tend to finance low-risk entrepreneurial projects to ensure that
collection of interest occurs regularly. Indeed, riskier projects that typically receive
financial support from venture capital funds do not have access to bank loans.
Another category of alternative financial sources is represented by leasing and
factor companies [17] that provide short and medium-to-long-term capital to entre-
preneurial firms. This type of investment belongs to the asset-based finance category
and relies on a different mechanism than traditional financial sources. According to
this perspective, an entrepreneur can obtain cash based on the value generated from a
specific asset during the economic activity, regardless of its creditworthiness. Leas-
ing companies, factors, and other asset lenders tend to provide credit less favourable
conditions than banking institutions. Still, entrepreneurs are forced to ask for this
type of financing to obtain the cash flows needed to pay ordinary expenses and
preserve their survival.
Business angels typically invest their wealth in financing entrepreneurs. Usually,
they do not know already the financed entrepreneurs but believe strongly in the
project and invest in it with their personal assets. Thereby, they are investors who
have their skin in the game. Business angels are defined as highly complementary to
venture capital funds. Both types of investments look for early-stage firms, even
though they stand out for different targets, motivations, scale and operating models.
However, without Business angels, venture capital could not exist and vice versa.
Indeed, Business angels need to venture capital market to provide financial resources
to target companies. In turn, venture capital can increase the deal flows when the
business angel market is well-developed.
Other sources of capital to which entrepreneurial firms can draw to support their
operations include the different types of government initiatives. These programmes
are part of public sources of capital, and they are enacted to improve access to
entrepreneurial finance. A working example of a government support initiative for
entrepreneurship is the Creative Europe Programme,8 a specific project launched by
the European Commission to sustain the culture and audiovisual sectors. The
programme aims to respond to the needs and challenges cultural and creative sectors
to face in European countries, helping them become more inclusive, digital, and
sustainable. The Fig. 1.6 shows the number of European grants issued under the
Creative Europe Programme between 2015 and 2019.
Finally, entrepreneurs can obtain financial resources through an initial public
offering (IPO), listing their firm on a stock exchange.

8
For more information see: “https://ec.europa.eu/culture/creative-europe/about-the-creative-
europe-programme”
16 1 Theoretical Background

Fig. 1.6 Number of EU grants awarded under the Creative Europe Programme by country
(2015–2019). Source: Authors’ elaboration based on Creative Europe Programme data

Chapter 2 will present other forms of alternative finance for entrepreneurship,

such as Crowdfunding and Incubators, and discuss the figure of Business angels
investors in more detail.

1.5 Typologies of Private Equity Investors

Private equity and venture capital firms are involved in an institutional field that has
undergone a profound transformation over the last decade. Thus has had repercus-
sions both on the characteristics of the operations taken and the profile of the
investors.
According to entrepreneurial finance literature, the main typologies of private
equity and venture capital investors are identifiable in private and institutional
investors.
The private investors, also called informal investors, typically support the start-up
phase in highly innovative firms. They include the following types of investors:
• High Net Worth individuals: are private individuals who have significant finan-
cial assets. They look for private equity investment to diversify their financial
activity.
• Family office: are investment funds that aim is to manage and invest a single or
multiple family assets.
1.5 Typologies of Private Equity Investors 17

• Business angles: are defined, generally, as former business owners or managers

with high financial resources, a good network of knowledge, solid business
competencies, and a considerable wealth of experience.
• Family and friends: private individuals that known already the entrepreneur and
want to contribute financially to its implementation.
• Crowdfunding: is an alternative form of financing in which the subscriptions of
shares occur through online platforms.
Furthermore, even though private investors represent an essential source of
capital for enacting private equity and venture capital funds, the most contributors
to two forms of investments, as highlighted from entrepreneurial finance literature
[18], are institutional investors.
As firms continue to grow and develop, the needed capital will increase, and
institutional investors will compensate for the financial gap. The leading institutional
investors, also called formal investors, are:
• Financial investors: credit institutions, insurance companies, pension funds,
sovereign funds, funds of the fund, hedge funds, and other financial vehicles.
• Public investors: public entities, including local ones, operating, in particular,
geographic areas or product sectors, which provide risk capital and financial
assistance to SMEs.
• Industrial investors.
Concerning the typologies of funds to perform private equity and venture capital
activity, the most adopted and developed vehicle is the limited partnership at the
international level, both in Europe and in the USA. Related to Europe, we can
identify the following operators:
• International o pan-European fund
• National/local fund
• Investment company
• Investment and commercial banks
• Corporate venture capitalists
In the early years of the birth of private equity and venture capital firms, local
operators had primarily promoted the sector’s growth, establishing them as the
leading active operators. Only after that, international operators, such as the
pan-European fund, have begun to develop across the market, accounting for a
considerable proportion of the total market worldwide.
At the international level, most operators act through the closed investment fund
structure promoted by the fund managers. They collect capital with institutional
investors to who in turn are assigned shares of the fund to invest it in high-potential
growth firms. The closed-end fund does not grant subscribers to redeem their shares
at any time as well as it is not allowed for new subscribers to come in it whether the
fundraising was completed. Thereby, fund subscribers can redeem their shares only
at a predefined expiration. It is possible to observe a trusting relationship between
subscribers and the fund’s managers. The trust relationship between them stems
18 1 Theoretical Background

primarily from the method of remuneration, based predominantly on the mechanism

of carried interest. According to this compensation model, the fund managers retain
some proportion of the capital gain realised in the form of success fees, giving in this
way a particular entrepreneurial value to the activity performed by the closed-end
fund. However, the fund has broad decision-making autonomy on investment choice
thanks to the combination of the entrepreneurial value that characterised the fund’s
activity with the trusting relationship between managers and capital providers.
A closed-end fund can be defined as “retail” if shares of the fund are offered to all
types of savers. In contrast, it is defined as “reserved” when the subscription is
opened only to institutional investors [19]. Therefore, due to the features of closed-
end funds, the degree of liquidity is lower than open funds.
In addition, it is possible to distinguish the private equity and venture capital
operators in captive and independent. The first one, captive operators, have like the
source of capital supply, exclusively or prevalently, the parent company or other
affiliated enterprises. Thereby, they do not have recourse to the capital market to
gather financial resources. In contrast, independent operators raise capital from a
plurality of investors, leading them to subscription shares into the investment
company or closed-end fund to which they belong. Finally, in a middle position
between them, the semi-captive operators raise capital from both the capital market
and other companies belonging to the group. Originally, captive operators were
widespread in continental Europe, namely in bank-centred countries, where the
banking system has held a more predominant role rather than the capital market.
Nowadays, the most active category of operators is represented by independent
investors at a worldwide level.
According to the typology of investment, another subdivision between private
equity and venture capital market operators is possible. The early-stage operators
focus on young firms with high-growth potential; Expansion operators target firms
that want to develop on the international scenario; Buy out operators that acquire
majority shares in consolidated businesses. And finally, turnaround operators con-
centrate their investment on firms under challenging situations and want to facilitate
their restructuring needs.
It is needed to present other new forms of operators to complete the framework of
operators in the private equity and venture capital markets, such as a mezzanine fund
that provides debt financing to facilitate the implementation of buy out operations, as
well as funds of funds and the secondary funds that take direct investment into
companies in order to diversify their risks.
On this topic, the AIFI provide, yearly, an empirical investigation on the perfor-
mance of the private equity and venture capital market based on the typology of the
operator. In Table 1.2 shows the performance of the market for the typology of the
operator from its inception. As we can see from the table, the Country Fund/SGR
operators account for 77% of the Italian private equity market. In contrast, the
Pan-European PE firm focuses on minor operations, but the invested capital is
more significant than other operators.
References 19

Table 1.2 The relationship between performance of the funds and type of operators

Source: AIFI (2020)

References

1. Fenn, G. W., & Liang, N. (1998). New resources and new ideas: Private equity for small
businesses. Journal of Banking & Finance, 22(6–8), 1077–1084.
2. Gentzoglanis, A. (2022). Responsible investing with venture capital: A business case study for
sustainable finance. In Handbook of research on global aspects of sustainable finance in times
of crises (pp. 27–45). IGI Global.
3. Temin, P. (2004). Financial intermediation in the early Roman empire. The Journal of Eco-
nomic History, 64(3), 705–733.
4. Wright Robbie, M. K. (1998). Venture capital and private equity: A review and synthesis.
Journal of Business Finance & Accounting, 25(5–6), 521–570.
5. Gervasoni, A., & Sattin, F. L. (2020). Private equity e venture capital: manuale di investimento
nel capitale di rischio. Guerini next
6. Bygrave, W. D., & Timmons, J. (1992). Venture capital at the crossroads. University of Illinois
at Urbana-Champaign’s Academy for Entrepreneurial Leadership Historical Research Refer-
ence in Entrepreneurship.
7. Sahlman, W. A. (1990). The structure and governance of venture-capital organizations. Journal
of Financial Economics, 27(2), 473–521.
8. Caselli, S., & Gatti, S. (2004). Venture capital: A euro-system approach. Springer Science &
Business Media.
9. An, E. V. C. A. (2007). Guide on private equity and venture capital for entrepreneurs.
10. Metrick, A., & Yasuda, A. (2011). Venture capital and other private equity: A survey. European
Financial Management, 17(4), 619–654.
11. Europe, I. (2016). Guide to private equity and venture capital for pension funds.
12. Zider, B. (1998). How venture capital works. Harvard Business Review, 76(6), 131–139.
13. Christofidis, C., & Debande, O. (2001). Financing innovative firms through venture capital. EIB
Sector Papers.
14. Quas, A., Martí, J., & Reverte, C. (2021). What money cannot buy: A new approach to measure
venture capital ability to add non-financial resources. Small Business Economics, 57(3),
1361–1382.
15. Kortum, S., & Lerner, J. (2001). Does venture capital spur innovation?. Emerald Group
Publishing Limited.
16. Meles, A. (2013). Private equity e sviluppo dell’impresa: analisi teorica e indagini empiriche.
Private equity e sviluppo dell’impresa, 0–0.
17. Organisation for Economic Co-operation and Development. (2015). New approaches to SME
and entrepreneurship financing: Broadening the range of instruments. OECD Publishing.
18. Nielsen, K. M. (2008). Institutional investors and private equity. Review of Finance, 12(1),
185–219.
19. d’Italia, B. (2009). Il private equity in Italia-Questioni di Economia e Finanza. Occasional
papers, 41.
Chapter 2
Start-Up, Expansion and Buy-Out
Financing

2.1 Introduction

The topics on the birth and development of new ventures and the instruments
capable of supporting genesis processes have been the focus of several academic
pieces of research [1]. As one of the primary goals, any economic system should
promote new entrepreneurial activities since innovations and competitive pressure
resulting from these ventures represent significant renewal and economic develop-
ment factors.
Small business and new ventures can affect the nation’s economic health and
prosperity. Some empirical studies have pointed out that the birth of new ventures
stimulates job creation [2], accumulation and sharing of knowledge, as well as
wealth generation. New enterprises bring innovation to society throughout the
whole “journey of their creation”, from conception to birth, start-up,
pre-organisation, pre-launch, gestation, and entry into the market. However, the
interplay between people, ideas, and capital boost internal know-how, turning in
innovation.
The increasing focus on globalisation and market expansion has stimulated the
creation of a wide and different range of new firms. In addition, the technological
revolution has significantly contributed to promoting entrepreneurship. New ven-
tures creation, however, generally occurs within favourable economic environments
where it is allowed the freedom of access to the capital, labour, and technology
market, and where there are ad hoc measures to promote them. For instance, many of
the countries involved in the OCSE (Organisation for Economic Co-operation and
Development) have enacted some programmes to help develop and create small and
medium enterprises (SMEs). In contrast, countries like Japan, the UK and Germany
have adopted policy-driven programmes to sustain new ventures creation and SMEs.
Furthermore, even if some economic environments have more favourable condi-
tions for ventures creation, the achievement of complete success is not related to only
exogenous factors (i.e., surrounding environment, government, policy) but also

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 21

S. Gallo, V. Verdoliva, Private Equity and Venture Capital, Contributions to Finance
and Accounting, https://doi.org/10.1007/978-3-031-07630-5_2
22 2 Start-Up, Expansion and Buy-Out Financing

endogenous ones. In particular, entrepreneurs must exploit their idea and personal
resources to achieve success. Indeed, in a short-term point of view, to begin an
entrepreneurial activity could be relatively an easy task. Nevertheless, the enduring
permanence on the market presupposes an ongoing commitment for new ventures,
and it requires needed and specific factors. Frequently it occurs that new ventures,
although having good business ideas, are not able to achieve success or survive on
the market. Most of all, empirical studies have shown that very few start-ups are able
to survive and achieve the status of unicorn start-ups. The principal reason for the
failure include, for instance:
• An inappropriate or not enough sufficiently in-depth market analysis
• Incoherence between entrepreneurial projects and the capital endowment needed
• Bad firms’ management
• The lack of market need or firms’ experiences
• Intense competition in the market
Financial resources are one of the biggest reasons for the start-up’s failure,
representing the main critical aspects in the starting and development stages.
Although several exogenous factors can affect the firms’ growth, such as crime
and political instability, finance is surely the most variable curbing economic
growth. Investments for SMEs represent the key to successful innovation, especially
in the stage of early product development where enterprises sustain high costs in
R&D (Research and Development). Inadequacy in financial resources does not allow
young entrepreneurs to invest more in product or service development.
The increasing challenges firms face in getting financial resources can discourage
the birth of innovative new ventures, curbing new wealth, job creation, namely
economic and social development. Thus, the lack of capital represents one of the
most critical constraints to the firm’s growth. Furthermore, the size of funding needs
and their temporal manifestation can vary from sector to sector. Still, mainly
typologies of funds needed can differ according to the different stages in a
company’s life cycle, as shown in Fig. 2.1.
The types of financial resources used between the conception of the business idea
and the creation of a new firm, namely the earliest stage of the venture creation, have
been a long discussed by practitioners and academics. Indeed, the financing of
emerging firms deserves close attention for various reasons. First, new ventures
are information opaque as they have to comply with reduced disclosure requirements
compared to publicly traded companies. SMEs and new firms signal their quality
through the characteristics of the owner or founding team. Second, some forms of
financing are not available to unlist or unincorporated ventures because they cannot
access capital markets and must choose among fewer financing options. According
to the pecking order theory [4], small firms or nascent entrepreneurs use, at first,
personal capital, external debt then, and outside equity at last.
However, the lack of resources in some economic context might be considered a
chronic, almost insurmountable barrier to developing perceived opportunities. The
reasons why in some economic environments, the absence of financial resources
2.1 Introduction 23

Fig. 2.1 Main typologies of funds. Source: Lasrado [3]

could curb the growth more than in other contexts might be attributable to the
following motivations:
• The distance between centres of academic research and entrepreneurial
ecosystems.
• The lack of services and infrastructure which encourage innovation activity.
• The absence of a real market related to technologies transfer.
• The several difficulties encountered by venture capital firms in financing new
entrepreneurs in the seed stage.
However, over the last decade, the digitisation process, caused by recent progress
in information communication technology (ICT) and its heavy use, has had an
essential impact also on the financial system by determining the rise of alternative
financing instruments and FinTech companies. Thereby, new entrepreneurs and
small businesses can benefit from innovative sources of finance, such as the
Crowdfunding family, that allow better and easier access to capital needed. Thanks
to the digital revolution within the financial system, SMEs and young entrepreneurs
can contribute to employment, poverty reduction, output, and innovation in emerg-
ing and developed markets. In the following chapter, we focus on the pre-financing
stage of firms and the alternative financial instruments that they can adopt to increase
their growth and improve economic and social development.
24 2 Start-Up, Expansion and Buy-Out Financing

2.2 Pre-financing: Business Angels, Incubators

and Crowdfunding

One of the biggest issues in the new ventures creation process concerns the search
for investors who could be interested in providing the required capital in the
pre-financing stage. The “pre-seed funding” process is challenging and time-
consuming, especially for young and innovative entrepreneurs. In this phase, new
ventures need to acquire a substantial amount of capital to get their entrepreneurial
project off the ground and transform initial concepts and prototypes into a profitable
business.
However, they typically face severe financial gaps in pre-seed funding. They are
not able to raise funds from the banking system because generally, only the initial
concept of business idea is ready. Thereby, it is necessary to find early funding to
proactively engage in research and development to determine if the business idea can
become viable. In more cases, the investors in this stage are founders company,
which is a hazardous stage as the uncertainty and project’s failure are greatest.
According to academic studies on the pre-seed stage financing [5], the primary
form of capital is obtained from entrepreneurs’ personal savings, friends, family
and fools and government grants, whether the feasibility and potentiality of the
project in creating employment and wealth is validly demonstrated. Successively,
when the venture enters into a seed stage, the potential spectre of investors widens,
including business angels, incubators, accelerators and online platforms (e.g.,
Crowdfunding). Raising capital in the seed stage is crucial to sprouting and growing
new ventures and building value generation and start-up development foundations.

2.2.1 Business Angels

Business angels have been discussed wider in scholarly debates [6, 7] because
of their crucial role in financing entrepreneurs. However, despite many definitions
of business angels persist, we adopt a general definition capturing essential elements
of this phenomenon. Business angels are defined as: “a high net worth individual,
acting alone or in a formal or informal syndicate, who invests his or her own money
directly in an unquoted business in which there is no family connection and who,
after making the investment, generally takes an active involvement in the business,
for example, as an advisor or member of the board of directors” [8].
However, Business angels have a long history. They are not new players in the
financial market. Specifically, Its inception had already occurred in the thirteenth
century when investors were used to lending capital to entrepreneurial merchants,
especially in Barcelona, Valencia, Venice, or Florence. They shared with founders
the firm’s risks and rewards, which was characterised by a high uncertainty in
achieving the desired outcome. But the real turning point in its birth [9] came at
the end of the nineteenth century in Broadway when wealthy investors began to
2.2 Pre-financing: Business Angels, Incubators and Crowdfunding 25

finance the production of new musical and theatrical works. These investors took
high-risk investments and were motivated not only from financial benefits but also
from the theatre’s love and passion. Since then, business angels have become a
prominent source to finance high-risk and growth potential projects beyond
Broadway.
A business angel is a private investor, usually a physical person, who is able to
provide capital and managerial competencies to enterprises during the seed and early
stages. This type of investment is not regulated, it is not based on any regulatory
framework. Its inception, however, has been determined from the Relationship of
mutual trust and appreciation created between investor and entrepreneur. They are
also called “informal investors” and fill an essential financial gap positioning
themselves between founders, family, friends on one side, and institutional investors
(i.e., venture capital) on the other, as firms financing sources. After family and
friends, business angel investors represent the second-largest funding source for
new ventures in many countries. They play a critical role in ensuring the survival
and development of SMEs. Indeed, business angels not provide only money but also
and above all business management experiences, skills, knowledge, networking and
contacts for the firms.
Generally, business angels include such as former entrepreneurs, retired or active
managers, as well as freelancers endowed with a fair personal wealth. Thereby,
business angels are private investors who have had a successful career, usually
gaining wealth and experience during their activity work. Nevertheless, due to age
or other reasons, they cannot play longer their business and want to help new
enterprises grow and develop their business by offering their investments and
experiences.
Business angels represent a good source of “patient capital”1 since they are not
interested in a quick return on their investment but are aware that they may have to
wait to obtain some profit.
The main factor which allows us to distinguish business angel investors from
other institutional investors of high-risk capital concerns the type of assets used for
the investment. Unlike venture capital and private equity, whose financial sources
come from pension funds and banks, they invest their own wealth in newly
established ventures and take more risks than the managers of venture capital funds.
Academic studies on business angels have rapidly increased in recent years.
Concerning the profile of business angels, most of all researchers argue that they
have the same or similar demographic features:
• Gender: most of all business angels investors are male.
• Age: angels investors are from 40 to 65 years old.
• Education: they are people with a degree or other professional qualifications. In
contrast, a few angel investors have a master or doctorate.

1
For more info see European Commision at: “https://ec.europa.eu/growth/access-finance-smes/
policy-areas/business-angels_en”
26 2 Start-Up, Expansion and Buy-Out Financing

• Occupation: they come from the financial sector, machine and equipment sector,
medicine, biotechnology, etc.
• Wealth: most business angels are millionaires with a net worth of at least one
million.
• In addition, usually, business angels invest their assets in ventures near their
homes, driven by psychological motivation such as the local economic develop-
ment and the professional growth of a new entrepreneurs generation. Or, they
invest mainly in local firms because they can frequently visit and observe the
financed firms. Indeed, academic studies have shown that business angels prefer
to invest in ventures within their community or a distance of 1–2 h from their
home [9].
In most cases, business angels invest in unlisted companies by acquiring a
minority shareholding. For this reason, unlike traditional institutional investors,
business angels tend to have less control over firms and a lesser contribution to the
proper management. Generally, they invest between 5% and 15% of their own
wealth into new ventures, and thus in the case of failure, they are not meet huge
losses.
Despite many studies having sought to develop a classification of business angels,
it is challenging or almost impossible to categorise them into a single population
without any consistent difference between them. Furthermore, we adopt the main
categorisation [10] of business angels investors widely used in the financial litera-
ture. Following this classification criterion, it is possible to distinguish business
angel investors based on the investment activity and their competencies. The fol-
lowing four types of investors emerge:
Lotto Angels: This class of investors includes business angels with low managerial
and entrepreneurship experiences. They tend to invest in firms not highly ranked
in the stock market and prefer to realise lesser profits than other business angels.
Generally, they have limited “skin in the game” (i.e., involvement) in the
companies they invest in and tend to participate without any partners.
Trader Angels: Like the previous cluster of business angels, they are characterised
by limited managerial and entrepreneurship competencies. However, they prefer
to invest vast amounts of capital in companies not highly ranked in the stock
market, but their involvement in the control of firms is minimal. Since they would
like to realise high profits, they tend to frequently make investment activities, for
instance, four or five investments in 3 years.
Analyst Angels: Unlike the previous clusters of business angels, they have consid-
erable managerial and entrepreneurship experiences. They tend to invest small
amounts of capital in companies and prefer to realise the investment activity in
cooperation with other investors. In addition, they seem interested mainly in local
companies, and the holding period of investment usually lasts fewer than 3 years.
Real Angels: They are characterised by a high level of investment activity usually
tend to make over seven investments in 3 years. They have extensive managerial
and entrepreneurship experiences and tend to cooperate with other informal
investors. Unlike other clusters of business angel investors, their holding period
2.2 Pre-financing: Business Angels, Incubators and Crowdfunding 27

Fig. 2.2 Number of active business angels networks in Europe. Source: own elaboration based on
EBAN data

of investment activity is more extended. They take an active part in the companies
they invest in, becoming members of the board or advisors.
The recognised importance of business angels as an essential source of risk
capital for newly established ventures has led to the expansion of the business angels
market, playing a pivotal role in constructing an entrepreneurial climate. According
to EBAN2 an international not-for-profit organisation for business angels, seed funds
and other early-stage market players, the business angel market has experienced
increasing growth since 2012 in Europe, remaining stable enough between 2013
and 2019.
Business angel investors are the most significant players with around 8.04 billion
euros of annual investment, representing approximately 60% of the total European
early-stage investment market, followed by the venture capital industry (4.4 billion
euros) and equity crowdfunding (0.78 billion euros). Figure 2.2 shows the number of
active business angels networks in Europe between 2013 and 2019.

2.2.2 Incubators

The role of business Incubators in spurring economic development has been

recognised broadly throughout the world [11]. Although there is a lack of a clear

2
More information at: “https://www.eban.org/wp-content/uploads/2020/12/EBAN-Statistics-Com
pendium-2019.pdf”
28 2 Start-Up, Expansion and Buy-Out Financing

definition of business Incubators, there is a common consensus among academics

and practitioners about their positive effect on the economic system. Incubators
represent pivotal instruments that are able to speed up innovation and wealth
creation in developed and emerging economies.
We adopt the definition of business Incubators provided by the National Business
Incubation Association,3 the world’s largest association on business angels.
According to their explanation, a business incubator is a business support process
that helps accelerate companies’ development by providing various services.
Incubators are defined as help centre for nascent ventures and young firms,
providing them financial and managerial assistance. Thus, incubators support firms
in acquiring skills, knowledge, motivations and experiences. A business incubator
houses young enterprises by helping them develop quickly, thanks to the array of
business support resources and services such as physical infrastructures, spaces,
coaching, shared services and networking connections. Usually, young and emerg-
ing ventures do not have the entrepreneurship experience and competencies needed
to develop business plans to attract potential investors.
Thus, incubators can also offer assistance in constructing business and marketing
plans, allowing firms to obtain the necessary capital.
Business incubators, however, constitute an instrument to counter the high failure
rate of new ventures. Indeed, they represent an environment suitable for hatching
enterprises. They offer their tenant companies financial resources and primarily
several facilities, office space, management support, and knowledge. Incubators
are able to provide both managerial and technological competencies capable of
speeding up the realisation of a product or service.
Nevertheless, business incubators are capable of contributing to job creation and
wealth growth whether tenant companies are able to achieve success. For this reason,
incubators strive in limiting the failure rate of the companies involved in them.
Thereby, business incubators aim to help companies survive and grow during the
early stages. Successively to the incubation period, ventures become independent
and can self-sustain their business. The aim of incubators lies precisely in producing
successful performing firms by becoming financially viable and freestanding and
leaving the incubation programme.
The incubation activity originated in the USA around the 1960s and initially was
underdeveloped in the broader world. Nevertheless, during the industrial recession,
there has been a rapid development of incubation activity in Europe and developing
countries. Subsequently, business incubators have taken a relevant role in the
economic system of many countries, which has begun to recognise the added
value they bring to the participating companies. In particular, the added value lies
in the acceleration of the ventures creation process, as well as the improvement of the
survival and success possibility. The incubation activity occurs before the

3
NBIA constitutes the largest American association that brings together business incubators. It was
founded in 1985 which purpose is to study and collect information on the goodness and degree of
integration between business incubators and entrepreneurs.
2.2 Pre-financing: Business Angels, Incubators and Crowdfunding 29

intervening of venture capital and private equity funds, filling a step left uncovered
by them. Thereby, incubators represent the premise to attract, becoming more
desirable, venture capital and private equity industries.
Business Incubators are more similar to the structure of a laboratory or research
centre. In incubators, however, managers with high competencies in business strat-
egy, marketing, finance, accounting work. The primary goal is to verify and validate
the technical, economic and financial feasibility of the tenant firms. Whether the
business idea overcomes the initial incubation phase, the tenant firms will be
supported by incubators in the following steps.
Incubators offer to the tenant firms several services, such as:
• Leading role in the definition of the firm project.
• Access to physical resources, like spaces and infrastructure.
• Financial, legal and marketing advice, as well as the creation of an efficient
information system.
• Helping in the finding of human resources.
• Access to networks makes it possible to find individuals who may have a crucial
role in achieving the firm’s success.
• Access to financial resources, namely the required capital to sustain new ventures
creation until they will be able to generate sufficient financial resources
autonomously.
Entrepreneurs involved in the incubation programme can take advantage of
several services since they can obtain information, resources and infrastructure in
a more accessible way and in a short time [12]. Thus, tenant firms can keep up with
the market as, thanks to the incubation activity, they are able to acquire the resources
needed in a shorter time and benefit from economies of scale.
The academic literature acknowledges different typologies of incubators and
incubation models. The mission of incubators remains the same, independently
from the type and the model, namely: the reduction of time-to-market and the
achievement of the firm’s success [13].
Nevertheless, it is needed a general classification concerning the incubator’s
purpose. In particular, some incubators tend to assign more significance to the profits
generation, namely profitability offered from the incubators. From this classification
criterion emerges two macro-categories of incubators:
• No-profit oriented Incubators
• Profit-oriented Incubators
The main difference between the two macro classes of incubators lies in the major
or minor importance attributed to profit, namely to the final result of the income
statement of business incubators.
The profit-oriented incubators are private individuals whose incubation activity
has mainly been driven by profits. Thus, they have been encouraged to start
incubation activity from a purely economic perspective. They have strongly affected
from this perspective both in making decisions (i.e., the choice of potential tenant
firms within the incubation programme) and how the decisions are implemented.
30 2 Start-Up, Expansion and Buy-Out Financing

Moreover, the incubators’ profit-oriented require a fee or shareholding in return for

the services offered.
The no-profit-oriented incubators are individuals who do not set profitability as a
primary goal of the incubation activity. They favour social purposes and typically are
public operators. In most cases, this type of incubation activity is encouraged by
public entities (i.e., state or local governments, universities, researches centre), with
the purpose to implement some social policy for the development of the territorial
economy, the promotion of entrepreneurship, the restructuring or reconversion of
certain areas. Incubators no-profit include territorially close enterprises in the
programme as they are interested mainly in improving economic, technological
and employment growth.
Over the last years, University business Incubators have experienced an increas-
ing proliferation as they are able to contribute directly to the revitalisation of the
local economy and technological development. Firstly, they enhance applied
research and participate in science and technology transfer. Moreover, the output
generated by a university or research centre transforms into an industrialised product
or a new production process. This mechanism leads to patenting discovery and the
creation of new, highly innovative business ventures, such as academic spin-offs.

2.2.3 Crowdfunding

The development of online platforms has democratised access to credit for new
ventures and young enterprises. New payment solutions and digital tools have
contributed to the digitisation of transactions, leading to decreased transaction fees
and increased access to credit for unbanked firms.
Over the last decade, the proliferation of new digital platforms has brought to the
origination of a new source of financing, namely Crowdfunding. According to the
financial literature [14, 15], Crowdfunding represents an innovative form of funding
projects, companies or business ideas by collecting many small amounts of capital
from a large number of individuals through online platforms, without any traditional
intermediaries. This term means “financing of the crowd”, literally, and indicates
that the financial support to firms or projects occurs through many individuals.
Typically, it is micro-investments made in unlisted firms with high technology
content. Since the capital is provided entirely in a digital environment, crowdfunding
platforms are characterised by the absence of physical interaction, reducing costs and
transaction times. Crowdfunding allows those seeking funding to reach many
potential investors, who will receive some form of reward based on the invested
capital in return.
Although it is a phenomenon that emerged recently in correspondence to the
FinTech revolution, some early examples of Crowdfunding have arisen already in
the eighteenth century with the creation of the Irish Loan Fund, which introduced the
concept of micro-financing. Another famous example occurred in 1985 in New York
when Joseph Pulitzer published an advertisement in the Journal of New York World
2.2 Pre-financing: Business Angels, Incubators and Crowdfunding 31

to launch a campaign to raise the required funds needed to conclude the Statue of
Liberty project.
Nevertheless, the modern origins of Crowdfunding date from the development of
the internet in the late 1990s. Originally, Crowdfunding was used to raise funds only
for social purposes or charity. Over the last years, with the acceleration of innovative
technology and the adoption of social networks by many users, Crowdfunding
platforms have become one of the most popular sources of financing for entrepre-
neurs and consumers. Crowdfunding, thus, refers to different typologies of cam-
paigns, such as the support for musical groups, the sustain of arts and cultural
initiatives, and the financing of innovative start-ups.
Although Crowdfunding leads back at a unique definition, we can distinguish
different models based on the purpose of the campaign or project. According to the
financial literature [16], the main types of crowdfunding models are the following:
• Donation-Based Platforms: They represent one of the primary forms of
crowdfunding. In this model, people donate liberally to social or charitable
purposes without obtaining something in return for their financial sustain. Dona-
tion crowdfunding, typically, is adopted to the financing of artistic and musical
projects in which investors offer their support without expecting an economic
return. The required amount is usually meagre, and the duration of time collecting
is higher than other types of crowdfunding.
• Reward-Based Platforms: investors support entrepreneurial projects in several
sectors, such as arts, music, games, design and technology, in exchange for a
non-monetary reward related to the amount of money they contribute to the
campaign. Regarding the material reward offered to funders, several types have
developed. The most widespread typology offers funders a gadget, namely a tiny
material award, or the possibility to pre-order a product that has not yet been
present on the market. In addition, over the last years, the royalty-based reward
has been disseminated. It is offered to funders a financial award, such as a share of
the income related to the project, without transferring company shares.
• Lending-Based Platforms: are designed as a two-sided marketplace that enables
investors to lend to borrowers directly. This typology represents a feasible
alternative to traditional bank loans as investors lend money to consumers or
entrepreneurs in return for a specific interest rate. Its birth comes from
microcredit’s significant development and provides even modest amounts for
investments. In Peer-to-Peer platforms, the loan is made directly between people,
without any traditional intermediation. In contrast, Peer-to-Business platforms
allow lending money to entrepreneurs. However, even in this model, the capital is
not managed from a conventional intermediary.
• Equity-Based Platforms: investors become shareholders in the funded company
by purchasing a small equity stake. Thereby, the reward offered to investors is
represented by the whole of the patrimonial and administrative rights deriving
from participation in the company.
Over the last years, the Crowdfunding market has been characterised by a
significant rise. The European Crowdfunding market is underdeveloped in
32 2 Start-Up, Expansion and Buy-Out Financing

P2P/Marketplace Consumer Lending

P2P/Marketplace Business Lending

Donaon-based Crowdfunding

Equity-based Crowdfunding

Reward-based Crowdfunding

Fig. 2.3 Global volume by model (excluding China). Source: Authors’ elaboration based on data
by Cambridge Centre for Alternative Finance

comparison with China and the USA. For many years, the lack of common rules and
diverging requirements has been one of the biggest challenges faced by
crowdfunding platforms seeking to offer their services across borders. Nevertheless,
the adoption in 2020 of the Regulation on European crowdfunding service providers
for business (ECSP, 2020/1503/EU) has laid the foundations for creating a
harmonised regime for most crowdfunding platforms. Entrepreneurs can reach out
to potential investors in all European Union member states with this disposition.
According to the Cambridge Centre for Alternative Finance (CCAF),4 the alter-
native finance market in Europe has tripled between 2015 and 2018, reaching 15.3
billion euros with 632 crowdfunding platforms active in Europe. In 2020, the two
leaders of the European crowdfunding market were France and Germany, collecting
approximately 1.02 billion euros and 1.26 billion euros. Countries like Italy and
Norway also have seen significant growth. Specifically, the Italian crowdfunding
market has had massive growth, ranging from 65.6 billion euros in 2015 to 772.8
million euros in 2020. Concerning the typology of crowdfunding, P2P platforms are
the most developed at the global level (excluding China), as shown in Fig. 2.3.
Furthermore, crowdfunding platforms present differences also concern the
funding model adopted to set the fundraising goal. The main classification distin-
guishes two models [17]:
• All or Nothing: Entrepreneurs or consumers set a target goal representing the
needed capital to support their project. Based on this model, thus, a project is
considered successful or funded only if 100% of the target goal or more is reached
within the established period, usually between 30 and 60 days. Kickstarter, one of
the most famous American crowdfunding platforms, uses this model for
fundraising.

4
Cambridge Centre for Alternative Finance is a research centre at the University of Cambridge
Judge Business school. The purpose of centre is to study alternative finance, such as financial
channels and instruments emerging outside the traditional financial system.
2.3 Early-Stage Financing 33

• Take it All: Entrepreneurs or consumers keep the amount raised even if the set
goal is not achieved. Indiegogo, the second-largest crowdfunding platform after
Kickstarter, offers the possibility to entrepreneurial firms of keeping the entire
pledged amount even if the stated capital raising goal is not reached.
Crowdfunding platforms can choose to adopt different business models. The
academic literature recognises the existence of four typologies of business models,
as presented below:
• The Client Segregated Account: the platform matches borrowers and lenders
without an intermediary. This model creates a segregated account that constitutes
a separate patrimony. The capital collected from lenders and gets to borrowers is
separated from the platform’s balance sheet and included in a legally segregated
client account. The platform has no claim over those funds, even in the case of the
platform’s collapse.
• The Notary Model: the loan is generated thanks to the relationship between
crowdfunding platforms and banks. Firstly, the crowdfunding platform deals
with cross borrowers and lenders, like a traditional broker. Lenders make bids
on the loans they want in their portfolios. However, the loan is originated by a
bank. The platform issues a note to the lender in proportion to their loan
contribution. The notary model is adopted mainly in the USA.
• The Guaranteed Return Model: the platform generates the loan based on the
borrower’s risk and features. This business model allows lenders to invest in
loans by the online platform, setting a rate of return on the investment guaranteed
by the intermediary platform itself.
• The Balance Sheet Models: the platform retains generated loans in its balance
sheet. After creating a loan, the platform sells them to institutional investors or
other lenders. The platform collects money from investors and gets them to
borrowers.
However, the absence of any risk management model in all business models
discussed above may lead to several concerns in the financial market.

2.3 Early-Stage Financing

The early-stage financing relates to all financial interventions whose aim is to

support new venture creation, whether still in the embryonic stages or the earliest
stage of its inception. Therefore, early-stage financing indicates the activity that can
be defined as venture capital, in a narrow sense. Early-stage investing regards the
financing of the first three stages of a firms development. Furthermore, early-stage
financing can be divided into three distinct funding types:
1. Seed financing: Capital provided to help an entrepreneur launch a new business.
2. Start-up financing: Money used by a company to develop and market the product.
3. Early-growth financing: Money provided is used to establish and boost sales.
34 2 Start-Up, Expansion and Buy-Out Financing

The funding types presented above will be discussed separately in the following
paragraphs. It is more evident than ever that new ventures have to face many needs
during these stages, not only capital requirements. However, institutional investors
can help start-ups define the business idea or the entrepreneurial spirit that seems to
be a crucial need. The bearers of a new entrepreneurial idea have to receive support
in terms of entrepreneurial capability as sometimes they do not have prior experi-
ences. Usually, this type of investment is carried out to implement a highly innova-
tive entrepreneurial project. On the demand side, entrepreneurs ask for this
intervention to develop an invention, improve an existing product/process, or launch
a new product or service on the market. On the provider’s side, instead, the
investment has to generate returns that discount the high randomness of likely
achievable results, the low liquidity related to instruments subscribed, and the low
information flow, both qualitative and quantitative, concerning the existence of
information asymmetries in the financial markets.
Firstly, in order to identify the whole peculiar features of this typology of
investment, it is needed to analyse some particularities of the new ventures creation
process. The key steps that new ventures must achieve can be enclosed in the
following points:
• Seize the opportunity
• Refine and the business idea
• Create mechanisms to protect against imitations
• Build a motivated and highly professional working team
• Finding financial resources
• Realise enterprise start-up
• Launch the product or service on the market
However, institutional investors into risk capital should play an essential role in
all activities presented above. Indeed, before marketing a new product or service and
the first successful results are achieved, there is a need to implement market research
or other activities requiring vast and costly investments.
The creator of a business idea, firstly, needs a contribution in terms of entrepre-
neurial competency, as well as business and management skills. Thus, entrepreneurs
should find financial resources and present a business plan to one or more institu-
tional investors. Typically, entrepreneurs contribute mainly with the idea and
knowledge of the business, and their involvement in terms of capital may be
relatively limited. In contrast, the venture capitalist contributes a significant amount
of money. As a part of the business creation process, innovation represents a
fundamental element. Starting a new business initiative may result from the desire
to make a new product or service marketable or redesign of product and service
through an innovative mechanism and the will to give life to a new organisation as an
emanation of an already existing and established one reality (i.e., spin-off). Whether
starting a new business means the emergence of a new business entity on the market,
investors’ contributions may be higher in terms of managerial and strategic support
than the financial one.
2.3 Early-Stage Financing 35

Another essential element relates to the distinction between the launch of tradi-
tional products or services and those with high technological content. The need for
highly specialised knowledge and the rapid obsolescence of products and processes
in the technical sectors make this typology of investment highly risky. Indeed, the
early-stage operations concerning technological products or services are
characterised by a high failure rate. However, due to the increased risk underling
in this category of investment and the great difficulty deriving from the disinvest-
ment process, investors tend to acquire majority shareholdings. As a matter of fact, in
early-stage financing, investors such as private equity or better venture capital are
more than mere suppliers of risk capital. They work hard to increase the growth of
the financed company not only by providing financial resources but by acting as a
real shareholder of the company.

2.3.1 Seed Financing

Seed financing is fundamental to ensure the growth and development of a new

venture. Generally, we talk about seed financing when the money provision occurs
in the experimentation stage of products or venture creation.
This type of financing is also called first round or initial financing. During this
phase, entrepreneurs do not have a complete output, and they are unable to sell it on
the market and gather revenue. Seed financing aims to convert R&D projects into a
successful business company in which financial institutions play an essential role.
However, entrepreneurs require financial resources to check the technical validity of
the product/service and implement a company structure that is able to produce and
promote it. The business plan has not yet been drawn up in such cases, and high
technical and managerial competencies are needed. Because of the uncertainty
surrounding the outcome and timing of the project, it is challenging to obtain
financial support through traditional instruments, such as banking institutions, and
thus venture capital funds fill a fundamental gap. Indeed, the risk-return relationship
is difficult to determine due to the high risk of the project, and expected returns are
hardly affected by the uncertainty of R&D results. Also, the risk and uncertainty of
the desired results derive from the possibility that once the output is being com-
pleted, it may not have a market or an appetibility into the market. This may be the
case of biotech and high-tech products that sometimes have a market but not
marketability due to their complexity and huge costs.
At this stage of the life cycle of the company, equity financing is more adopted
than alternative debt capital due to the requirements of collateral that entrepreneurs
cannot give. However, seed financing could be divided into other two phases:
pre-seed and seed capital finance. Generally, Pre-seed finance, also called proof of
concept, is provided by public sources and is used for basic research activity; in
contrast, seed capital is applied to complete the output.
In seed financing, investors play an active role. In specific, they perform the
following tasks:
36 2 Start-Up, Expansion and Buy-Out Financing

• Provide some support in the research activities

• Move the business idea into a patent
• Product the processes
• Create the team of the company
• Make the business plan, other analysis and validation of the business idea
Public authorities mainly provide the funding due to the high risks and have a role
of leadership in seed financing related to the allocation of public funding. However,
private investors deal with providing the expertise for efficient management.

2.3.2 Start-Up Financing

Seed financing aims to transform R&D activities into a business idea. The following
step is to convert the business idea into an operating company, namely the start-up
financing stage. In a start-up stage, entrepreneurs do not yet know the commercially
valuable of the product or service. Compared with seed financing, the firm exists
although being still at an early stage of activity. The experimental stage is overcome,
and the product prototype has been developed and validated. When in a start-up
stage, the engineering and patenting phases are generally completed. The company
exists formerly, the management is constituted and has already started product
testing and market research. For this, the financing raised is used to support the
development of productive activity and launch the projects. In specific, the financial
resources collected are helpful to buy equipment, infrastructures, inventory and
everything needed to transform the business idea into an operating company.
Although the seed stage is riskier than start-up financing for the investors, even
the start-up operations are very sensitive. The uncertainty concerns that the market
may not turn a business idea into a successful company. Thereby, even if the
investors may consider the business idea as worthwhile, they may earn high returns,
but at the same time, they could bear considerable losses in the case of projects
default.
In addition, investors’ profiles concerning their competencies and experiences
may be different based on the stage financed. In seed financing, investors should
have more experience in technological and engineering fields to implement R&D
activities efficiently. While during start-up financing, the validation of the prototype
is completed, and financiers should support the company in making a business plan
and defining the value strategy. Thereby, private equity investors and venture
capitalists are mainly included in the firm’s management and, sometimes, are the
most significant shareholders.
2.3 Early-Stage Financing 37

Risk-return profile Management involvement

Capita raised is used to finance Very limited.

Seed financing
research activities. Risk is very high,
and the return is very difficult to
calculate.
Capita raised is used to finance a Very strong. It is related to the
Start-up financing
company. Risk is very high, and the support in making the business plan.
return could be estimated.
Capita raised is used to finance the Very strong. It is related to all
Early-growth financing
first stages of a native firm. Risk is needed activities to support the
very high, and the return can be management activities.
estimated.

Fig. 2.4 Summary prospectus. Source: Authors’ elaboration

2.3.3 Early-Growth Financing

During early-stage financing, a new venture moves from the start-up to the real
business life cycle. The purpose of early-stage financing is to build a steady
organisation.
Unlike previous phases, in early-stage financing, the problems resulting from the
conception, design, experimentation and the start of productive activity have been
overcome. The funding collected is used to finance a modestly developed business in
which sales begin to grow. The little developed company has needed financial
resources to boost its growth and development. However, equity financing repre-
sents a more appropriate form of financing for different reasons, mainly because debt
capital is more costly and entrepreneurs do not have the proper collateral. Investors
consider that financing begins with this stage.
At this stage, the risk-remuneration profile of investors is very similar to the
previous phases. The underlying risk is very high as there is more uncertainty related
to the company’s future development. Usually, there may be potential financial
interventions in this phase by operators who do not have previous investment
experience, namely financiers new to the market or the sector.
The expected returns, calculated as expected IRR, are very high due to the
uncertainty about sales and future development. In this phase, investors help the
company revise and strengthen the previous business plan. In addition, they may
give strong support in activities like mentoring and advisory. Investors could verify
the basic assumptions of the business plan, strategic decisions, as well as marketing
and financial advice. The typology of investors mainly involved includes private
equity operators or venture capitalists, and usually, they have a large number of
shares (Fig. 2.4).
38 2 Start-Up, Expansion and Buy-Out Financing

2.4 Expansion Financing

After achieving a limited level of development, a company enters into the expansion
stage. The second macro-category of financial interventions undertaken by institu-
tional investors into the risk capital concerns all the complex issues a firm has to face
linked to its development stage. The overall financial interventions performed by
institutional investors in this phase are called operations of expansion capital.
An entrepreneurial activity that has reached a certain level of maturity may
choose to pursue the development phase by increasing or diversifying production
capacity, acquiring other businesses, or integrating other business activities.
In the case of increasing or diversifying production capacity, institutional inves-
tors’ contribution in the risk capital will be predominantly financial. In contrast, in
the case in which the development of a firm will be achieved through the acquisition
of other businesses, institutional investors will trigger an international network to
identify the ideal partner. In the last case, the advisor activity by institutional
investors becomes extremely valuable.
The expansion financing regards all cases where an entrepreneurial activity has
already achieved a certain degree of development. The interventions of institutional
investors are linked to the development of products or services or to medium and
long-term growth strategies.
Investors consider this type of investment particularly attractive because they
firmly believe in the potential growth of the company’s value. This type of invest-
ment is beneficial for medium-sized companies that can increase their value thanks
to capital injection.
Expansion financing represents a more complex investment for the investors than
early-stage financing (i.e., seed, start-up and early-growth financing). The complex-
ity of operation lies in the negotiation phase. An investor has to negotiate with a high
number of stakeholders that, typically, have conflicting interests. In addition, also the
preliminary analysis is more complex. Being an already established and developed
firm, investors must analyse its entire history from its inception. The preparatory
phase of the investment consists of applying rigorous due diligence without
neglecting any aspect. Every element regarding business, legal and organisations
should be considered in the investment analysis. Thus, investors should perform an
economic valuation of the whole balance sheet and a financial assessment regarding
the entire company.
Thereby, Expansion financing is helpful for firms that have experienced a fast
growth of their business and want to expand their activity, seizing the market
opportunity. At this stage, firms aim to consolidate their market position.
Even if the company has been growing, it has needed financial resources (i.e.,
Equity or Debt) to sustain its development and inventories since the company may
not profit at this stage. In specific, funds may be used to achieve a significant
expansion of the business, increase sales volume, and achieve profitability.
Concerning the investor risk-return profile, in expansion financing, the risk-
taking by investors is moderate, but it is strongly dependent on the sector of the
2.4 Expansion Financing 39

company. However, the funding collected is used to increase sales growth or

improve projects with newer technology. Thereby the uncertainty of possible results
is lower compared with the previous stages of the phase. Since the risk underlying
these operations is lower than the other stage financing, also the return will be lower.
During this stage, the role of financial institutions is fundamental. They could be
delegated in developing growth plans. Sometimes, they may perform mentoring and
advisory regarding the choice of rights strategic decisions.
Nevertheless, at this point, the company needs to diversify its financial portfolio,
and thereby the shares held by private equity and venture capital firms are very low.
Another reason regards the nature of the operation. Indeed, expansion financing
deals do not require technological and industrial skills, so a high number of investors
could finance these projects.
From the company standpoint, the expansion stage is financed mainly through
private equity, representing a valid alternative to corporate lending. Indeed, the risk
profile is high in both since there is high uncertainty about future results and a large
amount of capital invested, even if the financing through private equity allows firms
to enjoy the direct involvement of investors in the management of the company.
Thereby, the company can benefit from private equity investors’ managerial skills
and technical competencies.
In this second part of the life cycle, private equity operators represent the more
appropriate financiers than venture capitalists, who prefer taking investment in the
first part of the company life cycle.
However, private equity deals made in the expansion stage can be clustered in
four macro-categories, namely:
• Sustain the costs related to manufacturing and marketing tools
• Improve or rebuild the facilities needed to perform business activities
• Finance Mergers and Acquisition (M&A)
• Cover the working capital needs.
During expansion financing, the company’s growth stage can be split into two
subcategories: development (i.e., second-stage financing) and consolidation (i.e.,
third-stage financing).
In the second-stage financing, private equity investors help in accelerating the
company’s growth and development. The commercial validation of the product or
service of the target company has occurred in the previous stage. Therefore, inves-
tors can commit all their forces to increase the production and selling of the
company. The target company’s growth has improved, even if it has yet medium
or small dimensions. However, in this stage, the financial resources needed for the
company are lesser than the previous stage as the company has already positioned on
the market.
In the second-stage financing, private equity investors support the target company
in consolidating its development. During expansion financing, the company has
overcome the initial growth phase, and it is ready to consolidate and enlarge its
market share. Generally, financiers invest large amounts of money in order to
maintain the company’s market pòsition and provide the sustain in designing new
40 2 Start-Up, Expansion and Buy-Out Financing

plans of growth. The types of development can include the launch of a new product,
business diversification, or the acquisition of new firms or only business units.
Generally, a company needs financial resources and managerial and networking
skills during this stage. For this reason, the use of institutional investors like private
equity operators can provide several benefits to the target company in terms of
financial support and mainly managerial needs.

2.4.1 How Does Private Equity Work for Internal

and External Growth?

As discussed in the previous paragraph, expansion financing regards the funding of

the growth process of the target company. However, the strategy of a company’s
growth can be managed in two different ways: internal or external. Usually, at this
stage, the stake in the game held by private equity operators is lower than the
previous stage of the company life cycle.
Companies in the expansion stage generally choose to finance two types of
growth: internal or external.
If firms choose to pursue internal growth, private equity operators subscribe a
minority stake of the target company, and their investments regard mainly:
• Improve the production capacity by constituting new production plants and
acquiring new facilities.
• Increase or consolidate the company’s domestic market position or
internationalisation strategy to capture a new profitable group of customers.
• Adoption of aggressive marketing and commercial strategies, in the case that the
company is involved in a highly competitive sector.
• Exit through the listing on the market or a trade sale of the financed company.
In the internal growth deals, the company grows by enlarging its organic and
investing in new assets or enhancing the working capital. In this case, the role of
private equity investors is very simple and consists of giving money to the target
company, which in turn is used to buy new fixed assets or enhance its working
capital. On the one hand, the private equity investors could compete with banks and
other institutions in this deal. Still, on the other hand, they could support the target
company in helping them receive additional money from banks. However, because
the internal growth may be pursued without any specific competencies, for instance,
a strong network is not needed to support the development, there could be many
investors offering this investment. So, it seems to be less rewarding compared to
other ones.
The target company could also choose to pursue external growth. In this event,
private equity operators realise their investment by acquiring a target company. The
decision to implement external growth may be derived from:
2.4 Expansion Financing 41

• Potential growth opportunity that may be exploited by unifying different firms

involved in highly fragmented sector.
• Real opportunity related to the acquisitions of undiscovered products or
technologies.
However, in the external growth deals, the company wants to buy another firm to
increase sales volume through the realisation of an M&A. In this case, the role of
private equity investors is more complicated.
Private equity investors are not the provider of money, but they become an
advisor and consultants of the company. For this reason, this deal is more appropri-
ate and attractive for professional investors who have the needed competencies to
improve the efficiency of operative processes.

2.4.2 Advantages and Disadvantages for Companies

The company growth financed through private equity operators can generate several
advantages and disadvantages.
Firstly, the key advantages can be summarised in the following points:
• Private equity investors can help the target company in the M&A activity,
selecting the optimal firms to acquire.
• Private equity investors, through their money injection, provide the needed funds
to the target company.
• The involvement of private equity investors within the company allows its
shareholders to increase the returns from their investments.
• The realisation of IPO (initial public offering) in an efficient way by creating
higher returns for investors.
• Private equity operators provide advisory support to the target company by
helping it in entering into new markets or industries, sharing their management
competencies and business know-how.
• Private equity can help the target company increase its reputation on the market.
Indeed, since private equity supports high-growth potential firms, their involve-
ment represents a clear signal of the goodness of business.
However, private equity investments can affect the target company negatively.
Some disadvantages can include:
• The transformation of company culture. The new partner can pressure the target
company and managers to pursue the ongoing development to obtain high profits.
• Private equity investors can have considerable control of the activities performed
by the original shareholders and managers.
• Many conflicts can result concerning the exit strategies. However, the timing of
exit may deviate from the plan of original shareholders and management of the
target company.
42 2 Start-Up, Expansion and Buy-Out Financing

• A high level of value generated from the target company will transfer from
original to new shareholders, namely private equity investors.
• Completing a transaction with private equity firms can be complex and time-
consuming.
• Finally, Investors can decide not to conclude the transaction with private equity
due to many bureaucratic delays.

2.5 Replacement and Buy-Out Financing

After the growth stage, the company becomes more steady and enters the maturity
phase. At this point, the profitability and cash flows grow steadily. Notwithstanding,
the role of private equity can be still essential. Although during the previous stage
(i.e., early financing and expansion financing), the primary need was to increase and
improve sales volumes and dimensions of the company, a company at a mature age
has different types of problems. Specifically, in this period, the main issues arise
from the governance or corporate finance decisions. The financing collected in a
mature company is used to implement strategic choices concerning governance,
status, corporate finance decisions, sustaining the strategic and acquisition process.
These types of investments could be realised in the following ways:
• Through the listing of the company on the stock market
• Replacement of original shareholders
• A new system of corporate governance
The series of interventions carried out in a mature company is called replacement
financing. Generally, the financial support by private equity for firms during this
stage does not regard the increase of sales growth and the realisation of new
investments. Still, it consists of finding the right solutions to spin-off projects,
shareholder replacement, equity restructuring, IPOs, buy-in or buy-out operations,
etc. (Fig. 2.5).
Because the financing raised has not to boost sales growth or investment, the risk-
taking by private equity investors is moderate. Indeed, the company’s business
models are booming, and the risk depends mainly on the entire market risk. Private
equity operators shift from mere financers to effective company consultants in this
phase. For this reason, investors should have qualified and deep knowledge, as well
as sophisticated expertise in managing corporate governance issues and financial
deals.
However, in the financial market, the needs and expectations of consumers
change quickly. Thereby, companies are forced to change and adapt their strategic
decisions and organisational structures to survive and save their market position.
Sometimes, companies have to fight hard to avoid erosion of their competitive
advantage and generate revenues that exceed the cost of assets.
A company involved in a replacement financing programme has overcome the
embryonic stage and stays itself into a mature and often a stagnating phase.
2.5 Replacement and Buy-Out Financing 43

Mature age

Replacement
Expansion financing

Expansion
Early-growth financing

Start-up Early-growth
financing
Seed Crisis or decline
Start-up
Seed financing financing
Vulture financing

Fig. 2.5 The types of financing based on the company life cycle. Source: Authors’eleboration

Sometimes, a company faces many difficulties to move it through this stage linked to
the management structure. On the other side, investors have to know that most of all
energy will be spent solving concerns related to management activity. After solving
these managerial problems, modifying competitive strategy will drive the company
to success, exiting stagnating phase.
At this point of the company life cycle, the deals performed by investors can be
grouped in:
• PIPE (private investment in public equity)
• Corporate governance deals or turnaround
• LBO (leveraged buy-out)
PIPE represents a private equity investment made in a public company, namely a
company listed in the stock exchange. The PIPE investors invest in the company’s
equity and acquire a degree of ownership. The deal’s goal is to purchase a minority
stake in the company and then sell it to other potential investors.
In contrast, Corporate governance deals or turnaround deals occur when the
company wants to communicate a new vision of the business activity. However,
the change of management is not an easy task. Firstly, the executives have to
convince key stakeholders that the replacement of leadership is crucial for the
firm’s recovery. In addition, usually, a company can incur a risk of bankruptcy,
and the sense of urgency of the process should be communicated to obtain the
support of the overall employees of the company.
Concerning the last deals, namely, in the leveraged buy-out is the private equity
firms that want to invest in the target company and not vice-versa.
Because the three typologies of deals have similar features, they are typically
clustered as operations belonging to replacement financing. Indeed, the three typol-
ogies of investment generate the same effect on the target company, namely the
change of ownership structure. After one of these financial interventions, one or
many original shareholders will be replaced by transforming the governance struc-
ture within the target company.
44 2 Start-Up, Expansion and Buy-Out Financing

Thereby, buy-out operations are characterised by the simultaneous change in the

existing shareholder structure usually acquired by the private equity operators. For
this reason, replacement and buy-out financing, namely the third category of finan-
cial interventions in the risk capital of the company, differ substantially from
expansion financing and early-stage operations. In these types of procedures, private
equity investors play the role of major shareholders.
In summary, the family of buy-out operations represents acquisitions of compa-
nies performed by private equity firms. Buy-outs represent the financing of buys of
businesses by management teams. In this process, therefore, the company’s man-
agement, which may be the existing or new explicitly assembled for the realisation
of buy-out operations, acquires a target company from the current owners. The
company’s management uses to conclude the process both equity capital from
private equity providers and debt capital from financial institutions.
Buy-out operations involve the following typologies:
• Management buy-outs (MBOs), namely the already existing management team
purchases the company it handles.
• Management buy-ins (MBIs) in which a management team is being assembled to
carry out the acquisition.
• Buy-in/management buy-outs (BIMBOs), which represents a hybrid model that
brings together an existing management team with an external management team.
• Institutional buy-outs (IBOs), where a private equity fund sets up a company to
acquire a business and gives management a small stake either at the time of the
buy-out or after its completion.
However, frequently the buy-out operations are confused with leveraged buy-out
operations. Furthermore, the two terms refer to different operations, and their
features will be argued in the following paragraph.

2.5.1 Leveraged Buy-Out

An operation of the buy-out consists of a structured financial investment to achieve

the transfer of ownership from the old shareholders to the new entrepreneurs,
realised thanks to the economic and technical support of a financial intermediary,
typically a private equity firm. The buy-out operation is generally accomplished
through merger, acquisition or division of control participation.
In a leveraged buy-out (LBO), the deal leads to the change of the existing
shareholder composition, and it is made by using not only equity financing but
also debt capital. Usually, in this particular buy-out case, a company is purchased by
a specialised investment firm using a small portion of equity capital and a more
significant amount of debt financing. However, the debt is gathered through the
subscription of a pool of banks and other financial intermediaries. Generally, in
LBO, the financing is structured with 90% debt and 10% equity capital. The
academic literature [18] tends to define the leveraged buy-out operation as a
2.5 Replacement and Buy-Out Financing 45

Fig. 2.6 The typical phase of leveraged buy-out operations. Source: Authors’ elaboration

particular case of M&A activity. The purchased firm after the deal usually has a
higher debt ratio.
In a typical leveraged buy-out operation, the private equity fund buys majority
control of the target company, which stays in a maturity phase. In this arrangement,
the presence of venture capital is very unusual since, as we have understood in the
other section of this book, it prefers to focus the investment activity on young and
emerging firms by acquiring a minority control.
LBOs present a particular structure. To carry out the LBO operation, it is
necessary to create a new company, usually called NewCo, to raise the required
debt capital to acquire the assets or shares of the target company. After completing
the acquisition, NewCo is merged with the acquired company. It can be accom-
plished by means of a forward merger where NewCo incorporates the target com-
pany or a reverse merger where the target company incorporates NewCo. The
decision regarding adopting a forward merger or reverse merger depends mainly
on financial conditions and fiscal terms. Generally, the investors of the NewCo are
bankers or other purchasers, and the promise to pay the debt is secured by the use of
particular collateral, i.e. assets owned by the target company or its ability to generate
valuable cash flows.As a result of a buy-out operation, two types of events occur. On
the one hand, the LBO leads to a change of ownership, like in any purchase
transaction. On the other hand, it occurs a complete restructuring of the liabilities
of the divested company. In a highly simplified way, the typical functioning of LBO
operation [19] can be represented in the following Fig. 2.6.
Thus, the holding company or NewCo is constituted in the first phase. The
managers of the target company or new managers from other companies contribute
a certain amount as equity capital, supported by institutional investors. In the second
phase, one or more financial companies provide financing to the NewCo for an
amount covering the purchase price of the target company’s shares. Usually,
the funding is unsecured as supplied to a company without an operative structure.
In the third phase, thanks to the obtained financing, the NewCo will be able to
acquire the shares of the target company by paying the agreed amount to the original
46 2 Start-Up, Expansion and Buy-Out Financing

shareholders. In the last phase, namely the fourth one, once the acquisition of the
target company is completed, the NewCo will have among its assets the shares of the
target company and merges with the target company itself. The main result of the
operation lies in the restructuring of the structure of liabilities in the target company,
namely an increase in its indebtedness.

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Chapter 3
A Snapshot of Private Equity and Venture
Capital Industry: Pre- and Post-crisis

3.1 Introduction

This chapter analyses the development of the private equity and venture capital
industry before, during and after the global financial crisis in 2007. So, the first
section discusses the fast growth of this market before the crisis. In the following
paragraphs, after showing the reasons that drove the market’s decline during the
crisis, the market analysis of this topic is presented, providing a comparison between
the USA and European private equity and venture capital markets. The last two
sections analyse the investment and divestment process and the main phases.
The years leading up to the outbreak of the financial crisis marked what can be
described as a golden age for private equity. However, in the period pre the global
financial crisis of 2007, the so-called subprime crisis, the private equity and venture
capital industry reached the highest peaks in the funds raised, both in invested and
disinvested capital. The reasons for this remarkable development were different, but
mainly they can be summarised as follows:
The proliferation of substantial many attractive target companies able to generate
higher returns on investment than listed companies.
The low-interest rates on debt had encouraged many companies in borrowing
considerable amounts.
The considerable liquidity at disposal is because of the significant capital coming
from Asia and the diversification requirements of managers.
Regulatory changes that have involved especially European pension funds have
been granted greater openness to alternative investments.
However, the golden story of the private equity and venture capital industry has
been heavily disrupted following the rise of the global financial crisis in 2008/2009,
when the financial market suffered a setback due to the trouble of the subprime
market. The crisis of confidence and trust resulting from financial market turbulence
had led to two significant consequences. On the one hand, investors became more
unwilling to invest in risky investment projects or companies. And on the other hand,

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 47

S. Gallo, V. Verdoliva, Private Equity and Venture Capital, Contributions to Finance
and Accounting, https://doi.org/10.1007/978-3-031-07630-5_3
48 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

most banks were less willing to provide funds to the private equity and venture
capital industry. Therefore, the private equity industry no longer had the liquidity to
carry out its multi-billion-dollar leveraged buyouts.
The venture capital industry could not invest in high-risk and innovative compa-
nies. Consequently, the number and the dimension of private equity and venture
capital deals and buyouts declined sharply. However, the changes resulting from the
financial crisis in this market did not interest only the total number of acquisitions
and the amount of money invested. But, the empirical evidence suggests that the
investment strategies of private equity and venture capital industry are very different
today rather than in the pre-crisis period.

3.2 The Development of the Private Equity and Venture

Capital Market: Growth, Crisis and Decline During
the Global Financial Crisis

The private equity and venture capital market have experienced enormous trans-
formations in the last decade [1]. The first setback occurred due to the collapse of the
high-tech bubble. Some years after this event, the private equity and venture capital
market have undergone a recovery phase with an incredible increase in fundraising
and deal size. In this period, private equity and venture capital also started to play an
important role in countries where their investment activities were relatively scarce in
the past. The expansion of their activity contributed to the signed a new market
record in 2007/2008. Even if, immediately after, the market had to deal with a further
massive financial sector turbulence following the financial crisis. Therefore, the
financial crisis of 2007 has impacted the extent to which the capacity to raise new
funds, obtain debt funding for leveraging operations, and withdraw from existing
investments, mainly through stock markets. In comparison to the highest level
reached in 2007/2008, fundraising and investment activity is lowest, average trans-
action sizes have become somewhat correspondingly lower, the use of leverage has
diminished, the private equity and venture capital activity have moved slightly
towards turnaround/distressed and secondary business.
The private equity and venture capital market are assessed by using different
measurements. This market’s most comprehensive combined measures are
represented by the following indicators: fundraising, investment, and disinvestment
activity.
All three of these measurements exhibit the same general trend over 2002–2012,
namely rapid growth after the high-tech bubble, the decline of their activity follow-
ing the financial crisis and subsequent recovery to date.
Fundraising measures the total amount of new fund commitments in a given year.
Between 2002 and 2012, years before, during and after the Global Financial Crisis,
the EVCA, namely the European Private Equity and Venture Capital Association,
revealed that the Fundraising by European private equity funds increased from
3.2 The Development of the Private Equity and Venture Capital Market: Growth,. . . 49

Fig. 3.1 PE fundraising, investment and divestment in Europe, 2002–2012. Source: EVCA (www.
evca.eu)

20 billion per year, at the early part of the period, to a high level of approximately
80 billion in both 2007 and 2008. In 2009 during the financial crisis, fundraising
dropped and was about 20 billion, reaching the level of the initial period (e.g.,
2002–2003). The recovery phase occurred between 2011 and 2012, when the
fundraising was about 40 billion. The history of growth, decline and recovery of
private equity is shown in Fig. 3.1.
Concerning Investment, EVCA refers to investment activity undertaken directly
by private equity funds in the target companies during the year in review. Before the
financial crisis, namely in 2002, investment activity in Europe by private equity
funds increased from around 30 billion to a maximum of 70 billion euros in 2006 and
2007. Investment activity during the financial crisis dropped to about 25 billion in
2009, and after that started the recovery phase in which the volume of activity
reached about 45 billion.
Regarding Disinvestment, EVCA indicates to ita s the value of sales of target
companies. As for the other measurement previously analysed, disinvestment activ-
ity increased before the financial crisis reaching about 10 billion in 2002 and about
30 billion in 2006. During the financial crisis, disinvestment activity fell back to
10 billion before recovering to somewhat to about 30 billion in 2011. Table 3.1
shows the private equity activity of European countries before, during, and imme-
diately after the financial crisis of 2008.
As shown in Table 3.1, the UK in the period in review seems to be in a dominant
position rather than the other countries. France represents the second most important
country concerning fundraising activity. It is worth noting that although Sweden is
50 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

Table 3.1 Private equity activity across European countries

2007 2008 2009 2010 2011

Amounts in € Amount % Amount % Amount % Amount % Amount %
million
Country
Austria 675 0.8 247 0.3 286 1.6 208 1.0 249 0.6
Baltic coun- 63 0.1 8 0.0 0 0.0 86 0.4 0 0.0
tries
Belgium 195 0.2 708 0.9 355 2.0 732 3.3 232 0.6
Bulgaria 13 0.0 28 0.0 0 0.0 0 0.0 0 0.0
Czech Republic 1 0.0 2 0.0 48 0.3 10 0.0 8 0.0
Denmark 773 1.0 278 0.3 289 1.6 284 1.3 761 1.9
Finland 1,188 1.5 881 1.1 315 1.8 335 1.5 419 1.1
France 6,853 8.6 8,776 11.0 2,216 12.5 4,465 20.4 6,054 15.2
Germany 4,641 5.8 2,508 3.1 1,071 6.0 1,222 5.6 3,115 7.8
Greece 370 0.5 44 0.1 200 1.1 0 0.0 0 0.0
Hungary 0 0.0 100 0.1 35 0.2 110 0.5 0 0.0
Ireland 327 0.4 155 0.2 124 0.7 94 0.4 10 0.0
Italy 1,785 2.2 1,513 1.9 2,311 13.0 702 3.2 841 2.1
Luxembourg 657 0.8 244 0.3 213 1.2 508 2.3 92 0.2
Netherlands 3,198 4.0 1,907 2.4 1,046 5.9 1,247 5.7 2,197 5.5
Norway 1,057 1.3 1,766 2.2 17 0.1 490 2.2 1,378 3.5
Other CEE* 43 0.1 103 0.1 43 0.2 18 0.1 248 0.6
Poland 815 1.0 760 1.0 135 0.8 115 0.5 443 1.1
Portugal 509 0.6 15 0.0 1,001 5.6 142 0.6 502 1.3
Romania 0 0.0 0 0.0 0 0.0 94 0.4 0 0.0
Spain 3,746 4.7 2,253 2.8 691 3.9 478 2.2 402 1.0
Sweden 4,588 5.7 6,786 8.5 827 4.7 803 3.7 5,624 14.1
Switzerland 1,865 2.3 3,327 4.2 907 5.1 695 3.2 737 1.9
Ukraine 258 0.3 259 0.3 0 0.0 35 0.2 0 0.0
United King- 46,251 57.9 47,231 59.1 5,635 31.7 9,039 41.3 16,471 41.4
dom
European 79,872 100.0 79,899 100.0 17,765 100.0 21,910 100.0 39,783 100.0
total

Source: EVCA (www.evca.eu)

relatively small, it is in third place over the period, accounting for between 4 and
14% of total European fundraising. Following Germany and the Netherlands.
Figures 3.2 and 3.3 report the development of the private equity and venture
capital market from the Global Financial crisis to the most recent years.
However, before the beginning of the COVID-19 crisis, the European private
equity and venture capital ecosystem had started to exhibit a significant recovery. In
addition, the optimistic sentiment among principal players in the financial market is
being restored. Therefore, recently, the private equity and venture capital industry
must tackle a new crisis, namely the COVID-19 Pandemic, which will be at the
centre of the debate in the following paragraph. Against this backdrop, the reaction
to past macroeconomic turmoils can serve as a helpful benchmark through which we
can evaluate the potential adverse effects of the COVID-19 Pandemic on the private
equity and venture capital market.
3.3 The Role of Private Equity and Venture Capital During the Pre-Coronavirus. . . 51

Funds raised Investments Divestments

120
bn EUR

100
80
60
40
20
0
19 7
98
99
00
01
02
03
04
05
06

20 7
08
09
10
11
12
13
14
15
16

20 7
18
19
9

1
19

19
20
20
20
20
20
20
20
20

20
20
20
20
20
20
20
20
20

20
Fig. 3.2 European private equity market. Source: European Investment Funds (2020)

Fig. 3.3 European venture capital market. Source: European Investment Funds (2020)

3.3 The Role of Private Equity and Venture Capital During

the Pre-Coronavirus Pandemic

In the previous paragraph, we have discussed private equity and venture capital
activity in terms of fundraising, investment and disinvestment. In particular, we have
seen that economic shocks, such as the Global Financial Crisis, can negatively affect
private equity and venture capital activity. Indeed, during and after the Global
Financial Crisis, the private equity and venture capital fundraising in Europe suf-
fered a 74% and 55% drop, respectively [2].
However, the historical fluctuations resulting from the Global Financial Crisis
demonstrated that the private equity and venture capital ecosystem is sensitive to the
macroeconomic environment.
However, during the wake of the COVID-19 Pandemic, although the determining
factors are different from the Global Financial crisis, the investment activity by
private equity and venture capital still suffered a setback.
In the first two quarters of 2020, following the beginning of the COVID-19 crisis,
the European and global economies have suffered a great shock. Firstly, the shock
resulted from the stopping of a mix of supply-such as restrictions at work, businesses
and school closures- and demand factors, such as a decrease in demand for goods
52 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

and services and a reduction in investments. After that, the crisis, like a domino
effect, spilled over to other segments of the economy and has been further exacer-
bated by financial markets and global trade linkage. Therefore, the COVID-19 crisis
differs from the Global financial crisis in which the shock was inherent in an
imbalance in the financial system. In this case, thus, the financial system has been
affected by the COVID-19 crisis due to the spillover effects.
In addition, the mitigation measures adopted to tackle the Pandemic have harmed
particularly those economic sectors1 where social interactions are fundamental to the
business’s survival. The general sentiment among businesses has fallen to an all-time
low. Concerns about a significant knock to business activity have contributed to
affirming a sense of deep risk aversion, leading to a repricing of equities, commod-
ities, bonds, and currencies. There will still be high degrees of volatility in the
foreseeable future due to the uncertainties regarding the needed time to contain the
spread of the virus and to restore all economic activities fully.
The negative effects derived from the COVID-19 crisis have also hit the private
equity and venture capital industries. Indeed, private equity and venture capital
activities represent a fundamental element of the European entrepreneurial ecosys-
tem by contributing to valuable growth, jobs and innovation. In some European
countries, like Italy and Spain, there are primarily young and innovative SMEs.
Therefore, the strong presence of the private equity and venture capital markets is
crucial in boosting entrepreneurship creation and supporting their survival.
However, the adverse effects of the COVID-19 crisis on private equity and venture
capital activities can harm most young and innovative start-ups across European
countries.
SMEs may be unable to access financing whether they cannot obtain private
equity and venture capital funds due to possible restrictions of their funding activ-
ities. Indeed, the environment of uncertainty in the first quarters of 2020 has affected
the private equity and venture capital industries. Most reports show that investment
activity in the first wake of COVID-19 has suffered a drop. As discussed in the
previous paragraph, fundraising for both private equity and venture capital funds
suffered a substantial decline in the wake of the Global Financial crisis but then a
significant recovery. The market analysis in the first quarters of 2020 reports a
decline for both private equity and venture capital industries. Indeed, the number
of funds decreased by 32%, and the amount raised fell by 29%, compared to the last
quarter of 2019. Table 3.2 summarises the fundraising activity for private equity and
venture capital during the three principal financial turmoil, namely the Dotcom era,
the Global Financial crisis, and the Pre-COVID-19 Pandemic.

1
https://www.eif.org/news_centre/publications/eif_working_paper_2020_64.pdf
3.3 The Role of Private Equity and Venture Capital During the Pre-Coronavirus. . . 53

Table 3.2 Fundraising during previous financial crises

Source: Arundale and Mason, 2020

3.3.1 The Role of Private Equity and Venture Capital During

the Coronavirus Pandemic: The Uncertainty
of the Future

Between 2018 and 2019, the private equity and venture capital market experienced a
flourishing recovery. Thus, in the pre-Coronavirus Pandemic, the private equity and
venture capital market were in their full flowering, and a significant amount of
money was raised.
Nevertheless, due to the outbreak and the COVID-19 and social distancing
measures, the economic activity has suffered a sudden and unpredictable stop.
Consequently, significant changes have impacted income and financial resources
distributed across families, firms, and sectors. Indeed, the uncertainty induced by the
Pandemic and the global economic recession has generated, as a primary effect, a
reduction in available resources for many firms and sectors [3] since the stock market
has been particularly affected by it.
Even though 2020 was a challenging year for people, firms and countries across
Europe and the entire world, the European private equity and venture capital
ecosystem have accrued skills and competencies in the past decade that can contrib-
ute to strengthing its resilience during financial turmoils. Indeed, European venture
capital and private equity funds could not avoid the adverse impacts of COVID-19
54 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

Number of daily VC deals (bi-weekly moving average)

50

11 March
40

30

2020

20

2018-19

10
Jan Feb March April May June July

Fig. 3.4 Number of venture capital investments. Source: European Investments Funds (2021)

but reacted with more strength. Furthermore, the advent of the Global Pandemic has
been helpful to assess the resilience of the European private equity and venture
capital ecosystem. The potential decline of the private equity and venture capital
market may generate adverse consequences in the financial market, especially for
small and highly innovative firms in which the support of alternative financial
instruments is vital for their survival.
According to European Investments Funds (EIF) investigation, the European
private equity and venture capital industries in the wake of the COVID-19 recession
have demonstrated remarkable resilience. However, this does not mean that the
ecosystem of private equity and venture capital will face a smooth road across future
years. Indeed, for example, the structural problems related to the exit and scaleup
markets have been further intensified by the COVID-19 recession. However, after
March 2020, a month after the advent of the Pandemic, the venture capital market
started to decline, especially in the number of investments that was because of the
marked decrease in the likelihood of active venture capital firms. Nevertheless, they
fell significantly below the historical average in some weeks, experiencing a drop of
about 13.6% in the number of new deals. The empirical evidence also reveals that the
number of firms taking a VC investment declined considerably in the second quarter
of 2020. Also, the exit rates decreased by 43% due to the increase in the market
uncertainty. What is said is shown in Figs. 3.4 and 3.5, respectively.
Concerning the invested volume by the European venture capital firms, the
volume of investments seems to be similar to the previous 2 years, namely 2018
and 2019. Therefore, the European private equity and venture capital ecosystem
have demonstrated its resilience in the middle of 2020. Indeed, the total volumes did
3.3 The Role of Private Equity and Venture Capital During the Pre-Coronavirus. . . 55

Number of investing firms per day (bi-weekly moving average)

40

11 March
30

2020
20

2018-19
10
Jan Feb March April May June July

2020 2018-2019 average 95% confidence interval

Fig. 3.5 Number of venture capital investment firms. Source: European Investments Funds (2021)

Total daily VC volumes (EUR M, bi-weekly moving average)

50
11 March

40

30
2020

20

2018-19
10

0
Jan Feb March April May June July

Fig. 3.6 Venture capital investment in terms of volumes. Source: European Investments Funds
(2021)

not undergo a decline compared to the previous 2 years. Figure 3.6 shows the
investments trend until July 2020.
Also, concerning investment activity, according to Invest Europe in 2020, more
than 5000 companies have been granted venture capital financing, including a
56 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

significant number of SMEs and innovative start-ups. Related to sectors, information

and communication technologies (ICT) represented 50% of all venture capital
investments, followed by biotechnology and healthcare (23%) and consumer
goods and services (10%).2
Despite a modest decline in venture capital fundraising activity in Europe during
the Pandemic in 2020, the general trend seems to be positive since the investment
activity has been increasing and several innovative unicorns have risen.
Some empirical studies [4] have examined whether the outbreak induced by the
COVID-19 Pandemic has determined a different allocation of financial resources, for
example, in other sectors countries, by venture capital funds around the globe.
Indeed, the number of early-stage deals decreased by 38% when the majority of
the countries had already experienced a confirmed case of COVID-19. In contrast,
late-stage deals seem to be stable and unaffected by the outbreak. In line with these
observations, the decline in the venture capital market is more marked for invest-
ments with higher uncertainty, i.e., investments in companies in the seed stage,
industries more severely affected by the COVID-19 crisis, international investments
and non-syndicated investments.
The outbreak of COVID-19 has also hit the private equity market that has to face
more challenges and difficulties than in the past years. Indeed, some empirical
evidence has shown that the access to international markets by private equity firms
has been more challenging, especially in emerging markets. However, the COVID-
19 has also impacted private equity funds’ business models by increasing the internal
and external risks. Table 3.3 summarises the risk factors within the private equity
business model, which have been amplified following the advent of the Pandemic.
In summary, most market analyses have shown that the private equity market has
been partially affected by the COVID-19 pandemic, demonstrating its strength and
resilience towards economic and financial turmoils. Indeed, given the continuing
uncertainties about COVID-19 and consumer spending, some private equity firms
have adopted a wait-and-see approach to their new investments. Still, there is a risk
of missing a valuable investment opportunity with this approach.

3.4 Fundraising Trend in USA and Europe: A Comparison

In this paragraph, we discuss the development of private equity and venture capital
in Europe and the USA. We try to answer a leading question: What is the difference
between private equity and venture capital market in Europe and the USA? Where is
the market most developed?
The European private equity and venture capital ecosystem have grown and
developed quickly over the last decade. Between 2010 and 2020, European venture

2
For more info see: “https://www.ey.com/en_lu/private-equity/european-venture-capital-s-resil
ience-through-a-global-pandemic”
3.4 Fundraising Trend in USA and Europe: A Comparison 57

Table 3.3 Elements of the private equity business model impacted by COVID-19

Source: International Finance Corporation (IFC) analysis, 2020

capital fundraising has achieved a new record, principally thanks to Limited Partners
(LPs) and General Partners (GPs) around the European continent finally shook off
the long-term issues raised by the COVID-19. Furthermore, the European venture
capital ecosystem seems far from the US venture capital market regarding
fundraising. Indeed, the US venture capital ecosystem raised $73.6 billion in 2020.
However, the European venture capital ecosystem has shown impressive growth
over the last years, achieving a growth rate of about 1.5 times that US fundraising
58 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

Current situation

100% 60%

50% 50%
Percentage of respondents

26%
80% 44%
40%

Net balance
59%
45% 58% 30%
60%
20%
40%
40% 14%
10%
24%
34% 28% 0%
32%
20%
31% -8% -10%
9% 14%
0% -20%
2020 Feb 2020 Mar 2020 Oct 2021

Bad/Very bad Average Good/Very good Net balance

Fig. 3.7 Fundraising European Environment. Source: EIF PE MM Survey (2021)

reached over the same period. Figure 3.7 draws the European fundraising environ-
ment between 2020 and 2021. An optimistic vision regarding the market has
replaced the pessimistic sentiment due to the COVID-19 pandemic.
Regarding the geographic distribution of the private equity market across
European countries, it seems to be very much concentrated in the top-three countries.
Indeed, over 2020, Germany, Italy and France took a leading position in the market.
Fund managers expect these three countries to continue to be the most promising
private equity investment. Figure 3.8 shows the percentage of countries respondents
believe will be promising in the coming years. Table 3.4, instead, contains the main
motivations related to the development of the private equity market in these
countries.
Instead, the European venture capital ecosystem is concentrated in three coun-
tries, namely Germany, the UK and France, as shown in Fig. 3.9. Surprendently,
Italy, which is in the top-three countries for the private equity market, occupies the
last positions. This suggests that investors in Italy are traditional more averse to
risky, and venture capital investment represents a riskier activity than private equity
(Table 3.5).
At the level of the metropolitan area, London is the most popular city for VC
locations in Europe, representing 25% of the number of firms. Paris represents
another 12% of VCs, with Amsterdam and Berlin accounting for slightly more
than 5%.
Furthermore, the United States is where the private equity and venture capital
industries are born. Nowadays, most fundraising and investment activity still takes
place in it. The gap between Europe and the United States is still significant,
although it has narrowed in recent years. According to European Investments
funds (EIF), the factors that can explain the gap can be enclosed in the
following ones:
3.4 Fundraising Trend in USA and Europe: A Comparison 59

6%

3%

4%
Top 6
11%
Germany
17% 14% Italy
7% 31% France
5%
UK

8% Spain
3%
7% Poland
19%

22%

9%
16%

Fig. 3.8 Promising European Countries for the private equity market. Source: EIF PE MM Survey
(2021)

Table 3.4 Promising European Countries: Motivations

Source: EIF PE MM Survey (2021)

• Smaller European VC industry

• Shorter track record of the European VC industry
• Underdeveloped IPO market
• Underdeveloped entrepreneurial ecosystem centred around scale-ups
60 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

60%

50%
48%
50%

38%
Percentage of respondents

35%
40%
27%
27%

30%
16%

20%

14%
14%
14%
13%

13%
13%

11%

10%

9%
8%

8%
7%
8%

7%

7%

7%
6%

6%
6%

6%
10%

6%
6%
5%

3%
3%
3%
3%

3%
3%
2%

2%
0%
en
ce

Sw n
y

om

nd

nd

Po d

Es l
a

ia

ey

ay

ia

nd
s

ga
an

ar
ai
nd

an

ni

Ita

am

ch
iu
an

ed

rk

w
la

la

la
Sp

rtu

to
gd

m
m

lg
rla

nl

or

ze
er

Po

Tu

Ire
Fr

om

en
Be
er

Fi
n

N
he

itz

C
Ki
G

D
R
Sw
et
d

N
te
ni
U

Autumn 2020 2021

Fig. 3.9 Promising European Countries for the venture capital market. Source: EIF PE MM Survey
(2021)

Table 3.5 Promising European Countries: Motivations

Source: EIF PE MM Survey (2021)

• Lower average fund sizes due to insufficient funding from large institutional
investors
• Fewer large late-stage VC funds in Europe
• Limited awareness about the importance of scale-ups in Europe
• Insufficient follow-on financing options leading companies to sell earlier
• The underdeveloped market for venture debt
• Lack of cross-over funds
3.5 Investment Process: Scouting, Closing and Volume 61

Fig. 3.10 Most important factors in explaining the gap between Europe and the USA. Source: EIF
PE MM Survey (2021)

Most important factors inexplaining the gap with the US

Underdeveloped IPO market 61%
Smaller European VC industry / Shorter track record 50%
Lower average fund sizes 46%
Fewer large late-stage VC funds in Europe 45%
Insufficient follow-on financing options leading to sell earlier 35%
entrepreneurial ecosystem not centred around scale-ups 27%
Lack of cross-over funds 26%
Limited awareness about the importance of scale-ups 20%
Underdeveloped market for venture debt 12%
Other/s 9%
0% 10% 20% 30% 40% 50% 60% 70%
Percentage of respondents

Fig. 3.11 Most important factors in explaining the gap between Europe and the USA. Source: EIF
PE MM Survey (2021)

The following Fig. 3.10 represents the motivations related to the gap between
Europe and the USA, with the respective percentage representing their order of
importance, in the private equity market.
Instead, Fig. 3.11 represents the most crucial factors in explaining the gap
between Europe and the USA for the venture capital market. In this case, the most
critical factor is the underdeveloped IPO market in Europe compared to the USA.

3.5 Investment Process: Scouting, Closing and Volume

The investment process for private equity and venture capital firms aims to create
and add value to their portfolio firms and then, subsequently, exit to the investment
in the predictable future. One of the fundamental prerequisites for valuable invest-
ment decisions is to reduce the information asymmetry between the target company
and investors [5].
Thriving venture capital and private equity deals is no easy task. These invest-
ment processes consist of several stages where the number of challenges to be faced
may be significant [6]. First of all, venture capitalists sometimes have to instruct
young entrepreneurs who may not have clear venture capital or private equity
financing. They may confuse it with other fundraising types, so young and still
62 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

Fig. 3.12 The private equity investment process. Source: EVCA (2007)

unskilled entrepreneurs should be educated about venture capital and private equity
industries. Secondly, entrepreneurs may be unable to interact with venture capital
and private equity funders. For instance, they may not have any informal document,
such as the business plans and financial forecasts, to describe their business activity
or idea to potential funders. They may be unprepared to receive venture capital
support. And thirdly, the same venture capital and private equity investment process
may be challenging to structure, especially in the case of an entrepreneur obtaining
for the first time venture capital sustain.
Investing activity represents the core of private equity and venture capital firms.
During this activity, private equity and venture capital funds are involved in several
challenges, such as:
• Operate within specified time limits.
• Acquire the needed share of the target company to control its activity and monitor
the resulting risks.
• More focus on returns on investment in terms of capital gain and goodwill.
However, the investors’ remuneration consists of dividends or compensation
for consulting activity in the ownership period.
• Provide certain types of services.
The investing phase presents two crucial and delicate stages: decision-making
and deal-making.
Decision-making involves valuing and selecting better opportunities and com-
bining them with the appropriate target company. The assessment of the target
company is a core competence of private equity and venture capital fund. This
activity regards the implementation of strategic analysis, such as market, business
and competitors analysis, business planning, financial forecasting, human resources,
as well as the evaluation of the target company and its management team.
Deal-making includes all activities of negotiation of contracts through which
private equity and venture capital firms can participate within the target company.
The negotiation process involves, for example, the calculation of shares to acquire or
the corporate governance regulation.
The European Venture Capital Association (EVCA) has drawn the private equity
investment process, underling the actions that private equity firms must perform in
every step (Fig. 3.12).
The investment process involves five stages: evaluation, negotiation, due dili-
gence, final negotiation and monitoring. For each step, private equity firms must
adopt one or more corresponding actions.
3.5 Investment Process: Scouting, Closing and Volume 63

During the evaluation stage, the private equity firm reviews the business plan and
validates the forecast analysis of the target company. Usually, in the first stage of the
investment process, private equity firms assess the target company in terms of
business growth potential, the return of equity for the investors, or the investee’s
capabilities in creating valuable cash flows in the foreseeable future.
In the Initial negotiation stage, the private equity firms are involved in evaluating
the potential investment by identifying the means of financing, such as debt and/or
equity sources.
After that, the private equity firms must adopt due diligence. In this phase, they
are usually helped by external consultants, such as lawyers, tax consultants, accoun-
tants, etc., who will assist the private equity firms in analysing all the relevant aspects
of the potential investment.
The last stages are the final negotiation, in which the investment decision process
is concluded, and the monitoring activity, in which the private equity firms are
actively involved in the acquired company.
Although the investment process seems to follow a standard model, it is an
interactive process in which the activities involved in a given step may overlap. In
addition, as a result of additional information acquired in subsequent phases, aspects
addressed in the previous stages may be redefined several times.
The investment process can be summarised based on the following stages:
• Deal origination
• Screening
• Evaluation
• Deal structuring
• Post-investment activities
According to the academic literature on the topic, the mechanism of venture
capital and private equity deals are more complex. Therefore, a comprehensive view
of the venture capital investment process should be considered. Against this back-
ground, the following models are presented and compared across them in order to
capture the real essence of the investment process (Fig. 3.13).
Although the stages of the investment process may differ according to the type of
investment undertaken, according to the relevant literature, we can identify six basic
steps that the venture capital or private equity fund takes when launching a new
investment. They are the followings:
• The identification of the target company: detecting the valuable opportunity
represents a challenger task, especially for some countries like Italy, where the
alternative financing instruments are still not well known from the arena of SMEs
and young enterprises. In the USA and UK, generally, entrepreneurs or managers
have a deep knowledge of these instruments. Therefore, they present their project
directly to institutional investors, which must be financially sustained. In coun-
tries where entrepreneurs have embryonic expertise of private equity and venture
capital, institutional investors must commit their efforts to identify the target
company in advance, collect some information, and establish an effective
64 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

1st Model 2nd Model Klonowski

Deal generation Origination Deal generation

Screening VC-firm specific screen Initial screening

Due diligence phase I

Generic screen
and internal feedback

Evaluation First phase evaluation

Second phase Pre-approval

Structuring evaluation completions

Duediligence phase II
Closing
and internal approvals

Deal completion

Post-investment
Monitoring
activities

Exit

Fig. 3.13 The models of the venture capital investment process. Source: Klonowski, D. (2010)

network of contacts with managers, banks, research centres, associations, and

others ones. This activity requires a lot of resources.
• Evaluation of the entrepreneurial profile and the managerial team: after identify-
ing investment opportunities, institutional investors must evaluate the entrepre-
neurial’s reliability, competencies, experiences and reputation, as well as the
effectiveness of the business formula for which financial support has been
requested.
• Evaluation of the target firm: the identification and assessment of the target firm’s
potentialities. The investment decision by institutional investors is affected not
only by the growth potential of the target firm but also by other factors, such as
the analysis of the current market, the study of the competitors, as well as the
possibility of the participation disinvestment.
• The negotiation and price setting: the negotiation phase is very delicate, and it
also involves the payment methods, such as share capital increase, the acquisi-
tions of shares by old shareholders and so forth.
3.5 Investment Process: Scouting, Closing and Volume 65

• The monitoring of the investment: once participation is taken, the institutional

investors participate within the target company by monitoring company perfor-
mance, collecting relevant information in order to act promptly in the case of
some concerns about its profitability.
• Disinvestment process: it represents the most critical phase since the institutional
investors’ profit or loss is particularly affected by the disinvestment result.
Obviously, the investors’ purpose is to generate a higher return from the disin-
vestment process. The investment activity can be outlined in three macro-categories:
scouting, orchestrating, and closing the deal. The following sections describe in
detail the three macro-categories.

3.5.1 Scouting of the Target Company: The Identification

of the Best Investment Opportunity

The first step of the investment process involves the whole universe of activities
related to scouting and exploring the best target company to which institutional
investors must devote their financial sustain.
Scouting can be referred to as the process of identifying firms performed by
venture capital and private equity funds. Typically, a venture capital fund is self-
scouting and searches for start-ups that meet its investment goal. Scouting activity,
especially in the case of early-stage start-ups, is a critical process in beginning
business deals as investments and/or partnerships. According to the innovation
model [7], the scouting phase involves all activities which generate, discover,
develop and visualise opportunities. The following conceptual framework in
Fig. 3.14 provides a detailed example of scouting activity.
The scouting conceptual framework is shown above and consists of seven fields
organised in three hierarchical levels.
The execution level regards the core operational level of a start-up scouting agent.
For instance, this level involves desk research, events, networks and (social media)
marketing, namely the universe of activities that help to identify the appropriate
information and the needed networks and partners to realise the deal.
The management level consists in adopting professional scouting managers and
using additional outsourced scouting services.
The ambassador level represents the most sophisticated level of the scouting
process. The ambassadors are different from other scouting in the network. Gener-
ally, in addition to their scouting skills, they have a specific solid knowledge of the
sector they serve, which aids the scouting manager in their decision-making process.
The identification process of the investment opportunities represents a critical
phase. It is the most important activity to develop the investments in risk capital by
venture capital and private equity funds. The selection process, especially in Europe,
is extremely strict, and thereby the investment’s purpose is sometimes hard to
achieve.
66 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

Fig. 3.14 The models of scouting intensity

scouting activity of Early-
stage start-ups. Source:
Heinz et al. [8] ambassadorial network ambassador level

external scouting services

management level
scouting management

desk
networks
research

execution level

(social)
(media) events
marketing

The modalities by which the professional investors tend to structure the deal flow
are affected primarily by the following three types of factors:
• The features of operators.
• The geographical area where the investment is undertaken.
• The typologies of deals.
Characteristics of operators, like image, reputation and experience in the market
where they perform their economic activities, can affect the ability significantly in
generating a systematic flow of investment opportunities. In this regard, the tradi-
tional marketing channels, such as journals, magazines, publications, conferences,
and trade associations, can help in making the market aware of this. For instance,
most venture capital and private equity operators in Europe extensively use such
promotion and dissemination tools.
Therefore, in the structuration of mechanism able to maximise the deal flow,
another critical aspect is represented by the peculiarities of the geographical market
where most venture capital and private equity operators want to perform their
investments. Indeed, in the USA, most private equity operations are managed
through professional intermediaries like mergers and acquisitions companies that
support entrepreneurs in arranging business plans. They also help assess the target
company and manage the sales process through tender-based mechanisms. Instead,
in Italy and other markets that are still underdeveloped concerning venture capital
and private equity funds, only if the operation is relevant in terms of volume is
managed through specialised professional operators. Indeed, in the case of small
3.5 Investment Process: Scouting, Closing and Volume 67

operations of venture capital and private equity, entrepreneurs tend to rely on trusted
professionals who have, sometimes, lack specialisation in the mergers and acquisi-
tion sectors. In this case, the deal negotiation occurs, typically, directly with the
potential sellers, and sometimes entrepreneurs do not make any business plans.
Thus, in this type of market, the marketing activity must be focused strictly on
entrepreneurs. Word of mouth between entrepreneurs represents a critical value in
this context, as well as meetings, conferences or the implementation of networks
with local banks that have had already previous relationships with entrepreneurs.
A third and important factor to consider in the structuration of an adequate
mechanism for identifying investment opportunities regards the typologies of finan-
cial initiatives that venture capital and private equity operators intend to carry out.
Indeed, identifying the best potential target company may be more challenging based
on the sectors in which it performs its business. Whether the investment is addressed
versus companies operating in the technology sectors, like telecommunications or
biotechnology, the marketing process should be more focused on the specific
characteristics of industries. Additionally, the marketing initiatives should also be
oriented in the places where these investments opportunities are generated, such as
universities, research centres, researcher associations, experts in the field, specialised
consultants as well.
Therefore, in the case of the aim of investment regarding the participation
acquisition within already developed and big companies (i.e., expansion financing,
management buy out or leveraged buy out), the mechanisms through which it is
possible to identify better investments opportunities are better are logically very
different. For example, in the USA, in past years, some banks have tended to offer
financial rewards to university or business schools students who could identify
profitable listed companies to acquire through the mechanism of the leveraged buy
out. However, the concerns related to deal flow generation can become particularly
hard to resolve. Sometimes, institutional investors could not have the specific
competencies to deal with all its issues. Therefore, it can be helpful to ask the help
and assistance from specialised consultants or scouting professional managers with
sophisticated skills in market analysis and marketing strategies, as discussed in the
first part of this paragraph. Nevertheless, it is needed to have a wide range of
opportunities resulting from a rigorous pre-selection activity to ensure that the
investment process generates satisfactory results. However, the incorrect selection
of investment projects causes a waste of time and resources.
Thus, defining the pre-selection parameters to adopt during the scouting activity
is needed to profile the target company. Generally, private equity and venture capital
funds adopt similar criteria in selecting target companies. In absolute terms, the
characteristics sought in the target company represent the necessary preconditions
for achieving investment success and can be summarised as follows:
• Possibility to create value over a while compatible with the investor’s time
horizon.
68 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

• Professionals’ and humans skills of the management are needed to create a

synergistic relationship and strict collaboration between the investment team
and the old management.
• Compatibility between the possible entry price and the fair value of the company
to ensure an adequate profit to the investor.
• Sharing the modality and timing of divestment needed to avoid potential concerns
related to hold-up.
Once the selection criteria have been defined, institutional investors adopt tech-
niques to identify companies potentially targeted for investment. Regarding these
techniques, it is possible to distinguish two types of scouting: indirect and direct.
In the case of indirect scouting, requests for financial intervention come directly
from the entrepreneurial world. It may require a wasteful screening process by
private equity and venture capital investors in identifying the better investment
decision.
In direct scouting, the private equity and venture capital investors pursue a robust
independent research system of target companies in which to invest. The private
equity and venture capital operators usually combine a relational and desktop
approach, constituting informal partnership with local entities and operators.

3.5.2 The Investment Decision and Closing

Once the negotiation phase is over, and due diligence has been adopted, the
agreement is formalised by drafting and signing the final text of the contract.
Usually, from the beginning of the negotiating procedure to the acquisition con-
tract’s signing elapses about 3 months. Moreover, the process could take several
months in case of unforeseen events.
It is possible to identify some specific aspects of the investment contract:
• The object of the contract
• Price, payment methods, and any economic conditions
• The operation structure, financial instruments subscripted by investors, such as
ordinary shares, convertible bonds, cum warrants and others
• Non-competition commitments
• Corporate governance aspects, such as the representativeness on the board of
directors, presence on the board of auditors, the adoption of incentivisation
mechanisms of the top management
• Clauses safeguarding the value of the investment. For instance, the possibility to
revise the admission price retrospectively based on the results achieved by the
company
• Mandatory certification of financial statements by auditors
• Limits on the transfer of shareholdings, such as the so-called lock-up clauses or
preemption clauses
• The identification of disinvestment modalities
3.6 Divestment: Volume and Modality of Way-out 69

After signing the investment agreement, the contract is executed. The agreed
price can be paid in cash in one or several instalments. Investors acquire participation
within the target company, and the guarantees are issued from this point onwards.
Therefore, institutional investors and entrepreneurs share the same initiative and
should adopt collaborative behaviour. They have the same purpose: to maximise the
firms’ value.
Nevertheless, between entrepreneur and investor may create risks of moral
hazard. For instance, whether entrepreneurs and investors have different investments
horizons, they may ascribe to the concept of value maximisation a non-coincidental
meaning. In this case, it is possible that an entrepreneur, once obtaining the financial
sustain by venture capital and private equity funds, pushes towards the adoption of
investment strategies less risky to guarantee the firm’s survival over the long term.
Therefore, adopting a conservative behaviour by entrepreneur may be not satisfac-
tory for venture capital and private equity operators that want to realise a valuable
capital gain. Institutional investors could be interested in pushing toward the adop-
tion of aggressive and risky initiatives, like earning management politics. However,
once the investment has begun, implementing shareholders’ agreements could help
counter moral hazard behaviours.

3.6 Divestment: Volume and Modality of Way-out

The divestment phase constitutes the final step of the investment process performed
by the private equity and venture capital firms. This phase is extremely sensitive
since the private equity and venture capital operators sell the stake to realise a capital
gain. Investors in this phase can observe whether their investment activity has
created value-added. Indeed, It is broadly acknowledged that private equity and
especially venture capital operators’ decision to invest within a company’s risk
capital is firmly based on the exit potential.
The disposal of shareholdings is a critical step for two fundamental aspects:
1. Investors cannot determine ex-ante, the moment in which they will exit from the
investment.
2. The choice of the modality of way-out from the investment is highly problematic.
For these reasons, for private equity and venture capital funds, the exiting is
delicate since it is needed to identify the best time for divestment and the choice of
appropriate channels to be used. These two elements are highly correlated since they
can affect each other. However, It is arguable that the selling of participation cannot
be set ex-ante with an absolute degree of certainty. According to the academic
literature [9, 10], the exiting strategy is affected by the following variables: the
firms’ sector, investment length, economic environment, and development stage.
Specifically, the firms’ sector represents an important variable in defining the timing
and the modality of exit. In addition, the exit strategy is also affected by the features
70 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

of individuals and governance aspects, such as the dividend policy and financial
leverage.
Concerning the differences between Europe and the USA:
• The length of divestment is higher in Europe.
• The financial instruments used to exit from the investment are less innovative.
• The European deals present a higher lack of liquidity.
Nevertheless, during the exit strategy plan, the venture capital and private equity
investors should be taken into consideration the following aspects and pursue
specific principles. In general terms, the venture capital and private equity investors
must foresee the main characteristics that the divestment process will take over the
years from the moment of entering within the corporate structure. Specifically, in the
case of the acquisition of minority participation by the venture capital operators, it is
needed that no constraints are imposed regarding the potential exit of financial
partners. Indeed, venture capital and private equity investors should be able to
enact the divestment process within a certain period. In practice, after a certain
period has elapsed from the time of the investment, institutional investors should
have the possibility to initiate the selling process of their participation. Additionally,
during the disposal of the involvement, the value of shareholdings must be set based
on objective and definable market criteria.
Specifically, during the exit strategy plan, the investors should focus on the
following aspects:
• Timing Opportunity: The moment of exit can affect by the life cycle of the
company and external factors, such as global recession.
• Deal Agreements: Every deal should have specific contracts that set the relation-
ship between the main parties involved.
• Capital Requirements: Financial companies must adopt detailed capital ratios
according to the Basel accords. Therefore, investors may pursue an early exit in
the case of the needs of recapitalisation to satisfy the capital ratios.
• Constraints related to the maturity of the investment: since venture capital and
private equity investors determine the internal rate of return (IRR) according to
the duration of the investment, they may stay within the investment until maturity
and consequently achieve the desired IRR.
Concerning the modalities of exit, the venture capital and private equity investors
have different available mechanisms of way-out. As discussed in the previous
chapter of this book, the equity investment by the venture capital and private equity
funds can take a different types of profiles, such as seed, start-up, expansion,
replacement and vulture. However, even if equity investment can assume a different
shape, the academic literature argues that the investment stage cannot affect the exit
strategy chosen. Indeed, every deal pursues a specific strategy and modality of exit
that are strongly influenced by the goals of both the institutional investors and
entrepreneurs. The main exiting strategies in the private equity and venture capital
market are the following [11, 12]:
3.6 Divestment: Volume and Modality of Way-out 71

% of global private equity exits by type, $ billion

Sale to PE Trade sale IPO

100 = 735 318 197 474 588 518 647 1,047 931 805 935 911
5
10 12 13
16 16
23 25 25
30 31
35

52
51 48
56 44
51
42
30 47
58 41 40

43
35 39 39 40
33 32 33
29 28 29
19

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Fig. 3.15 Private equity exits by type of strategy. Source: McKinsey & Company (2019)

• Trade Sale: The disposal of the participation to an industrial shareholder.

• Buyback: The repurchase of the participation by the original shareholder who
remained in the shareholding for the duration of the operation.
• Replacement or Secondary Buyout: The disposal of the participation to other
private equity or venture capital investors.
• Initial Public Offering (IPO): The selling of the participation on the stock market.
• Write-off: Loss of shareholding value that leads to reduction or disappearance
within the balance sheet.
In the following sections, the modalities of the way-out will be discussed in detail.
According to McKinsey & Company, the exit landscape has changed concerning the
private equity market. Indeed, unlike in past years, IPOs strategy has represented
only a small fraction of private equity modality if exit. While the sales to other
private equity operators and trade sales have represented the preferred exit strategy,
as shown in Fig. 3.15.

3.6.1 Modality of Way-out: Trade Sale

This section discusses the main aspects of a Trade Sale, namely the modality of
way-out that has been adopted mainly over the recent years in the private equity and
venture capital market.
In the case of trade sale, the venture capital or private equity investors proceed to
sell their stake to a corporation or an industrial shareholder. The trade sale represents
the divestment possibility more widespread at the international level, especially
72 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

across European markets. This modality is considered, sometimes, more elaborate

than the exit through an IPO. The reasons are to be sought in the constitution of a
complex relationship among the private equity or venture capital investors, the new
buyer, and the company’s management, representing a prerequisite to achieving the
trade sale’s success.
Typically, from a technical point of view, a trade sale can be implemented with a
public tender or private negotiations between the parties involved in the deal.
Recently, the negotiation has occurred mainly through a mechanism of public
tender. In this case, the first implemented step regards the identification of a
specialised advisor who will manage the whole process.
The types of trade sales that can be realised are different based on the kind of
participation acquired:
• In the case of minority participation, once the buyer enters the company and
develops an alliance with it.
• In the case of majority participation, the buyer becomes the majority shareholder
and wants to consolidate its position within the company.
The advantages of implementing a trade sale are remarkable for the following
motivations. Firstly, in the case of a trade sale, the parties negotiate with fewer
potential buyers than in the IPO case, where the entire financial market can be
involved in the negotiation. Secondly, the operation is cheaper and faster than an
IPO. For this reason, it is possible to achieve a higher premium price. Finally, small
and medium firms can realise an exit option only through a trade sale since they are
not listed on the stock market.

3.6.2 Modality of Way-out: IPO

This exit strategy is realised when the private equity or venture capital investors sell
their stake through the stock exchange. The achievement of the success’s sale
through an IPO presents several issues, although this exit strategy is precious in
terms of economic profits and reputation for the operators. This type of exit strategy
is appropriate when the target company has achieved a certain degree of develop-
ment and seniority. For this reason, it is considered a long-term exit strategy. Several
types of IPOs can be identified. The following points attempt to summarise the main
typologies of IPO sales:
• Investors conduct the IPO, and the selling of their participation is written into a
document called info memorandum.
• Investors drive the IPO, and the selling of their participation is realised at the
beginning of negotiations. It is acknowledged as the type of IPO sale that pro-
duces the most profitable results.
• Investors drive the IPO and realise the selling of their participation after a certain
period of time, with or without the presence of the agreement of lock-up. This
3.6 Divestment: Volume and Modality of Way-out 73

clause prohibits the exit from the investment by selling the stake to third parties
just before realising an IPO.
As with any strategy, it has advantages and disadvantages. Advantages regard the
possibility to sell the stake by realising a higher premium price. Usually, the IPO exit
strategy results are considered valuable in terms of capital gain for both management
of the target company and institutional investors involved. Regarding disadvantages,
it is necessary to note the high costs associated with an IPO sale and the lack of
liquidity, especially in the European markets. In addition, this type of exit strategy is
not viable for small and medium enterprises since it requires a large proportion of
investors to realise a successful IPO sale.

3.6.3 Modality of Way-out: Buyback and Sale to Other

Private Equity and Venture Capital Investors

This section discusses the last two types of exit strategy in the private equity and
venture capital market: Buyback and Sale to other private equity and venture capital
investors.
In the case of the selling is achieved through the mechanism of Buyback, the
private equity and venture capital investors sell their stake to the original share-
holders in the corporation or their representatives. This alternative of exit is partic-
ularly valuable when the existing shareholders do not want to leave the target
company. Typically, the exit strategy that is performed through a buyback occurs
for the following three reasons:
• Shareholders have launched venture capital or private equity operations to sup-
port their business development and growth.
• Shareholders are employed in managing a governance turnaround.
• Shareholders want to transfer their ownership to other individuals.
The realisation of exiting can also be performed through selling to other private
equity operators. This type of exit is typically used in the US market. The strategy is
successful when there is a strong relationship among private equity investors.
The sales among private equity investors are frequently implemented when:
• Seed investors sell their participation to start-up investors.
• Start-up investors sell their participation to an expansion investor who wants to
support their business growth.
• Expansion investors sell their participation to a replacement investor who wants
to develop acquisitions or IPO operations.
• Vulture investors sell their participation to a replacement investor who wants to
finish the work of restructuring.
This type of deal can be profitable if certain conditions are satisfied by private
equity operators. Firstly, the existence of a strong network of relationships among
74 3 A Snapshot of Private Equity and Venture Capital Industry: Pre-. . .

private equity investors is necessary to find the most suitable counterpart for the
operation. Secondly, there is a strong market in which there are several investment
vehicles. In addition, the existing shareholders want to develop and help to grow the
target company.

3.6.4 Write-off of the Stake

To conclude the discussion about the disinvestment strategy, it is needed to argue the
write-off process. It consists of devaluation of the participation in the target com-
pany. This process may be a consequence of the transfer of property that has
generated a considerable loss of value. As a result of the write-off, there is a
reduction of the value of the participation or even the removal of the specific assets
on the balance sheet. Therefore, the private equity or venture capital investors could
adopt the write-off when they believe that the target company is not able to generate
value in the foreseeable future. Consequently, the stake in the company cannot
produce profits in terms of economic returns for investors.

References

1. Haves, J., Wilke, P., Meixner, M., Reich, E., & Vitols, S. (2014). Private equity and labour in
Europe: Did the crisis change the perception and role of private equity. Hans-Böckler-Stiftung.
2. Schaefer, S., Ashu, F., & Neubert, M. (2021). The impact of GDP and governance on venture
capital investments for the period 2010-2019 (after the financial crisis and before the Covid-19
pandemic). International Journal of Teaching and Case Studies, 12(3), 219–232.
3. Alfaro, L., Chari, A., Greenland, A., & Schott, P. K. (2020). Aggregate and firm-level stock
returns during pandemics, in real time. Covid Economics (4), 2–24.
4. Bellucci, A., Borisov, A., Gucciardi, G., & Zazzaro, A. (2022). The reallocation effects of
COVID-19: Evidence from venture capital investments around the world. Journal of Banking &
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5. Cumming, D., Gill, A., & Walz, U. (2009). International PE and disclosure. Northwestern
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6. Klonowski, D. (2010). The venture capital investment process. Springer.
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structural aspects of RI management systems in large established firms.
8. Heinz, R., Gillig, H., & Stephan, Y. (2017). Scouting of early-stage start-ups. 2017 IEEE
European Technology and Engineering Management Summit, 19.
9. Hege, U., Palomino, F., & Schwienbacher, A. (2003). Determinants of venture capital perfor-
mance: Europe and the United States (p. 4). Working paper, HEC School of Management.
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12. Smith, D. G. (2005). The exit structure of venture capital. UCLa L. Rev., 53, 315.
Chapter 4
Highlights of Private Equity and Venture
Capital Valuation

4.1 Introduction to Private Equity and Venture Capital

Valuation

The valuation of a company is a challenging process. However, understanding the

mechanism of company value assessment is essential not only in the acquisitions and
mergers operations but also in identifying sources of economic value creation within
the company’s business units.
According to the theory of company valuation, value and price often lead to
unequal results because they are determined and influenced by different factors. The
most prominent example of this is in listed companies, where the price is affected
daily by many factors unrelated to the company’s actual characteristics and pros-
pects. The value of a company may differ for buyers and sellers. For example, a pool
of buyers might assess the value of a company that might vary from the valuation of
the same company by another group of buyers. A company may be evaluated
differently for several buyers because of, for instance, economies of scale, econo-
mies of scope, or different conceptions about the company. The value should not be
mistaken for the price of a company, as the price is nothing more than the quantity
agreed between buyer and seller during the negotiating phase. The classical theory
defines value as Economic Capital; that is to say, the value of a company is given by
the income it will be able to yield by discounting the expected economic results. In
this way, the company is valued as a unitary entity based on the profitability/value
ratio.
The determination of value as the economic capital of a company disregards of:
• The nature of the parties
• Their bargaining power
• The state of the M&A market and
• In general, any element deriving from the interests or factors linked to the specific
parties involved

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 75

S. Gallo, V. Verdoliva, Private Equity and Venture Capital, Contributions to Finance
and Accounting, https://doi.org/10.1007/978-3-031-07630-5_4
76 4 Highlights of Private Equity and Venture Capital Valuation

However, the company’s price refers to the market value, which is influenced by
uncontrollable, exogenous phenomena. For example, the company’s market value
can be affected by the efficiency of financial markets and the listed company. For
these reasons, the coincidence of value and price must be considered a purely
occasional event rather than an expression of the efficiency of the markets.
The valuation of a company may be used for several purposes:
1. In Buying and Selling Operations:
– The valuation will indicate to the buyers the highest price they should pay and
the sellers the minimum price they may sell the company.
2. In Listed Company:
– The valuation mechanism is typically used to make a comparison of the value
of the share’s price on the stock market and then decide whether to buy, sell, or
hold the shares.
– The valuation of different companies is also adopted to compare between
companies. For instance, whether an investor believes that in the short term,
the future course of Apple’s share price will be better than Microsoft, he may
buy Apple shares and short-sell Microsoft shares.
3. Public Offerings Operations:
– The valuation techniques are adopted to determine the price at which the
shares will be offered.
4. Compensation Schemes:
– The valuation of a company helps quantify the value creation and the perfor-
mance of executives.
5. Identification of Value Drivers:
– The valuation of a company is fundamental for detecting the primary value
drivers within the business units.
6. Strategic Decisions:
– The valuation of a company is an essential step concerning the strategic
decisions, for instance, whether to continue in the business, sell, merge, buy
other companies, implement a partnership with other entities, and so on.
7. Strategic Planning:
– The valuation of a company is crucial for determining what product, in what
countries, what customers, etc.
– The valuation is also helpful for assessing the impact of the company’s
policies and strategies in improving value creation.
4.2 Valuation in Private Equity and Venture Capital: Techniques and Issues 77

The methods used for the valuation of companies are classified into six groups:
1. Balance sheet
2. Income statement
3. Mixed method
4. Cash flow discounting
5. Value creation
6. Options
The most adopted methods are balance-sheet methods, income statement-based
methods, mixed methods, and Cash flow discounting-based methods. These
methods will be discussed in detail in the following sections of this chapter.
Furthermore, we focus mainly on the valuation methods adopted in the case of
private equity and venture capital transactions.

4.2 Valuation in Private Equity and Venture Capital:

Techniques and Issues

The enterprise value analysis is one of the most critical phases of investment activity
performed by private equity and venture capital investors.
The valuation phase is crucial when the object to valuation is a high risk and high
tech company since, usually, it has little or does not have historical data, and it is not
possible to evaluate previous economic and financial performance. The primary
documents used for the company valuation are the financial statement and balance
sheet. The calculation of the value of equity represents a delicate phase, and
therefore it is essential to adopt specific techniques to correctly identify the value
of a company.
To compute the equity value of a company financed by venture capital or private
equity investors, the following techniques, which are originated from the theory of
Corporate Finance, are used mainly:
• Comparables: The value of a company’s equity is measured by comparing similar
companies. For instance, companies with similar dimensions operating in the
same industry and country are compared.
• Net Present Value: The value of a company’s equity is calculated as the present
value of future cash flows of the company.
• Adjusted present value: The value of a company’s equity is calculated with the
same Net present value perspective. However, in this technique, the company’s
financial structure is also taken into consideration.
• Venture capital method: The value of a company’s equity is calculated as the
present value of the final value of the company by considering the expected return
of the investment in a defined holding period.
78 4 Highlights of Private Equity and Venture Capital Valuation

The techniques presented above have some limits and advantages in estimating
the company’s equity value. Generally, the most adopted approach is the Net Present
Value, also known as Discounted Cash Flow. The venture capital method is typically
used when the correct price setting is more important than the enterprise value
analysis.
The following section focuses mainly on the Discounted cash flow technique in
the private equity and venture capital market.

4.2.1 Discounted Cash Flow Valuation

The Valuation analysis is a core concept in entrepreneurial finance. In the context of

private equity and venture capital, the valuation process is performed by investors
with high rigour and care to avoid errors and incorrect assumptions in the determi-
nation of the company value. Indeed, in the private equity and venture capital
market, the valuation analysis is maybe more critical than in other contexts. Thus,
given the riskiness of the investment, a fair valuation of the company is fundamental.
Therefore, the techniques discussed in this section are based on reasonable assump-
tions and thereby, they can lead to a better investment decision. The primary purpose
of valuation methodologies is to maximise the probability of making the right
investment decision. Private equity and venture capital managers adopt several
techniques of valuation to choose the best investment opportunity.
Furthermore, the methods most employed by private equity and venture capital
managers are the followings: The Capital Cash Flows (CCF) and Weighted average
cost of capital (WACC). These valuation methodologies represent the foundation of
other advanced techniques.
The discounted cash flow (DCF) involves a valuation based mainly on the
potential of assets to generate cash flows. The added value of this model regards
the adoption of the principle of cash flows which represent an excellent indicator of
company performance, as well as providing a result stripped of fiscal policies that
public documents, such as balance sheets and income statements, usually present.
The DCF enables the expected return to be estimated with more accuracy.
The DCF is a financial model that values a company by estimating its cash flows
and discounting them to arrive at a present value. It is focused on determining future
cash flows generated by the firm over a given period, usually 5 or 10 years. In the
discounted cash flow model, the assets within the company are valued by
discounting future cash flows at an interest rate that takes into account the riskiness
of the market in which the company operates. Thus, the intrinsic value of the ability
to generate liquidity from the company’s assets is determined by considering the life
of the assets, the growth rate and the risks associated with the operating flows. The
DCF model is explained as follows:
4.2 Valuation in Private Equity and Venture Capital: Techniques and Issues 79

X
T ¼N
EðCash flowt Þ
W Asset ¼
t¼1 ð1 þ r Þt

where N is the life of the assets and r is the discount rate of the cash flows (i.e. the
opportunity cost of capital).
Therefore, the company’s value is generated from the actual value of this flow
added to the net financial position, which will be added if it is positive and deducted
if it is negative.
The two primary steps that will be performed in the determination of the
company’s value process are:
– Cash flow determination and
– The discount rate to adopt.
Based on the type of cash flows (levered or unlevered) and the discount rate used
(WACC or cost of equity capital), it is possible to identify two different methodol-
ogies of DCF: Net present value and Adjusted present value. The following sections
focus on determining cash flow and the discount rate. The estimation of cash flows is
much more significant than defining the discount rate. Generally, people in valuing
risky projects tend to increase the discount rate if they think that the project’s returns
are uncertain.

4.2.2 Valuing Cash Flows

The methodologies of valuation based on the principle of cash flow start the process
by determining the cash flows generated by the company objected to the valuation.
In the models of DCF are determined the cash flows from operations are determined,
namely the so-called cash flows pre-financing that are independent of the firms’
capital structure. The following equation shows the calculation of cash flows:

CFt ¼ EBITt  ð1  τÞ þ DEPRt  CAPEXt  ΔWKt þ othert :

CF ¼ Cash Flow
EBIT ¼ Earnings Before Interest and Taxes
Τ ¼ Corporate Tax Rate
DEPR ¼ Depreciation
CAPEX ¼ Capital Expenditures
ΔWK¼ Increases in Working Capital
Other ¼ Increases in Taxes Payable, Wages Payable, etc.
These cash flows represent the most significant determinants to the firms and
investors. In the models of DCF, the cash flows are estimated by considering an
unlevered firm, namely only the equity.
80 4 Highlights of Private Equity and Venture Capital Valuation

To calculate the company’s value, the first step consists of calculating future cash
flows by adopting the equation above. The terminal value is calculated after calcu-
lating cash flows for periods 1 to T, as shown in the equation below:

CFT  ð1 þ gÞ
TVT ¼
ra  g

The discount rate (i.e. ra) for the unlevered firm is identified by the riskiness of the
firms’ assets. From the equation, it is possible to observe a strong assumption in the
valuation method. The model assumes that the firm will grow forever at a rate
g. Indeed, the company valuation through the DCF models the growth rate
concerning cash flows is a binding parameter. Therefore, a brief discussion regarding
the appropriate growth rate is needed. Company growth is the most important but
also the most complex variable for determining corporate value. It is the main
component of the expected profitability of the company. Indeed, a slight change in
the growth rate results in a significant difference in the business value under analysis.
Therefore a tiny increase in terminal value can significantly affect the analysis of
the value attributable to the company in the issue.
Concerning the choice of the appropriate growth rate in estimating the company
value through the DCF models, another issue to take into consideration is inflation.
Indeed, if the nominal discount rate is adopted, the terminal value of the company in
issue should reflect inflation expectations. Therefore, the real growth rate represents
the nominal growth rate adjusted for the expected inflation rate. Usually, a growth
rate marginally larger than the expected inflation rate is chosen to offset the case of
faster company growth now and zero growth in the future. In the long term, it is
assumed that most firms will grow based on a rate that lies between the rate of
inflation and the global growth rate of the economy (i.e., nominal GDP). Once
estimated the future cash flows over a short period of time, the terminal value of
the company serves as a basis to calculate the Net Present Value [1–4]. The
following equation shows the calculation of the Net Present value of future cash
flows of a company:

CF1 CF2 CF þ TVT

PVU ¼ þ þ ... þ T
1 þ r a ð1 þ r a Þ2 ð1 þ r a ÞT

where:
CF1 ¼ Cash flow in time 1
CF2 ¼ Cash flow in time 2
ra ¼ Discount rate
Therefore, The net present value is the current value of the cash flows at the
expected rate of return on the project you are investing in compared to your initial
investment. If the project generates cash flow for 7 years, the equation above is
4.2 Valuation in Private Equity and Venture Capital: Techniques and Issues 81

adopted for each year. Then, the initial investment is subtracted from the equation to
get the Net Present Value.
Net Present value represents the difference between the present value of incoming
cash flows and the present value of outgoing cash flows over a period of time. Net
Present value, thus, is the value of all cash flows, both positive and negative,
generated by the company. If the equation gives a negative Net Present Value, the
project is not good. Thus, the implementation of the project will not create any
wealth for the investor. Instead, if the equation gives a positive Net Present Value,
the project should be implemented since it will make profits for investors. The
greater the positive number, the higher the benefit for the company.
Cash flows in net present value analysis are discounted for two key
considerations:
• To correct for the risk of an investment opportunity and
• To take into account the time value of money (TVM)
The first point (adjusting for risk) is required because not all businesses, projects
or investment opportunities carry the same risk. In other words, the likelihood of
getting a cash flow from a US Treasury bond is much greater than the likelihood of
getting a cash flow from a young technology start-up. Thereby, the discount rate is
higher for riskier investments and lower for more secure ones.
The second point, namely the time value of money, is needed because money is
more valued the earlier it is received due to inflation, interest rates, and opportunity
costs. For instance, getting $1 million today is much more valuable than getting $1
million in 5 years. If the money is received today, it can be put into investments and
earn interest so that it will be more valuable than $1 million in 5 years.
The Present value calculation presented above does not consider the debt value.
However, firms that finance themselves with debt can have some advantages as the
interest on the debt are tax-deductible. The equation below assumes the value of the
tax shield (TS) from debt level D with the interest payment at a rate rd in period t:

TSt ¼ τ  r d  D

However, the tax shield should be discounted at a rate that takes account of the
enterprise’s riskiness. For instance, if the firms use a level of debt proportional to the
firm value, the risk of tax shields is strongly affected by the firm’s assets. If the firms
have a long run debt level that is not proportional to the firm value, the Present Value
should be adjusted for the debt tax shield.
Discount Rates
The discount rate estimation is carried out using the Capital Asset Pricing Model
(CAPM). The following formulas show the calculation of the discount rate through
the CAPM:
82 4 Highlights of Private Equity and Venture Capital Valuation

e ¼ r f þ β  ðr m  r f Þ
rU U

a ¼ discount rate for the firm’s assets. It represents the rate in the case of unlevered
rU
firms.
rf¼ the risk-free rate.
βU¼ unlevered beta.
rm¼ market rate of return on common stocks.
(rm  rf) ¼ market risk premium.
The CAPM has been discussed widely in the academic and financial literature, as
well as their underlying assumptions. One of its advantages is the possibility of
relating sectoral risk and company-specific risk in the same formula. It represents the
most popular model for calculating the cost of equity because of the straightfor-
wardness of the calculation and the relative simplicity of identifying the values of the
individual components.
One of the main issues to be addressed is the choice of the appropriate risk-free
rate to be used. In determining the right risk-free rate, the analyst should try to use a
risk-free rate (rf) that takes into account the maturity of the investment. For instance,
if the valuation regards a long-term investment project, the appropriate risk-free rate
would be the yield on the long-term Treasury. In the case that the valuation concerns
a short-term investment project, the cash flows should be discounted with the short-
term Treasury rate.
Therefore, the evaluator, in selecting the most appropriate risk-free rate, must
consider two aspects:
• The time horizon
• Geographical relevance
For example, if the estimated cash flows have a time horizon of 5 years, a rate
with a maturity of 5 years could be used. Another solution could be to employ a rate
with a 10-year horizon, regardless of the estimated cash flows. A period of 10 years
is long enough to reduce the effects of short-term volatility and better reflect the
length of an economic cycle. Usually, the final solution is the most adopted in the
valuation of the firms, except in certain circumstances that the valuer has to take into
account.
Another issue that should need to be considered is geographical relevance.
Indeed, each country has a specific rating and a different risk-free rate.
The difference between the market risk and risk-free rate (rm  rf) represents the
market premium risk. The market risk premium measures the expected return that
investors require as an addition to the risk-free rate to compensate for the risk of an
investment. The investor is exposed to two risks: specific risk and systematic risk.
The specific risk is industry-specific (unlevered beta) and company-specific
(levered beta). It is related to the features of the specific industry and reflects a
broad set of variables. On the other hand, systematic risk is related to the country in
which the company is active. Understandably, a country with a high rating has better
4.2 Valuation in Private Equity and Venture Capital: Techniques and Issues 83

Table 4.1 Historical Equity Premium (HEP) across countries

Sources: Caporale et al (2021), Journal of Economics and Finance

stability than a country with a low rating, with beneficial consequences on a range of
macroeconomic variables, such as the tax rate, the interest rate, the country’s growth
rate, etc.
The market risk premium is one of the most critical issues in finance. Estimating
and understanding its worth has proven difficult. The market risk premium, however,
used in the equation can vary. Some empirical evidence has shown as the market risk
premium has decreased over the years. For instance, Dimson et al. (2006) have
analysed the market risk premium across 17 countries over 106 years. They have
estimated an average value of approximately 5%, which is lower than the estimation
provided by Ross et al. (2010). Table 4.1 reports an example of Historical Equity
Premium (HEP) calculation across countries.
In this example, the Historical Equity Premium (HEP) is calculated as the
difference between the yield on 2, 5 and 10-year government bonds and the stock
market return over the corresponding time horizon on both a weekly and monthly
basis. Specifically, in the example presented in Table 4.1: for the USA is used
Treasury bond yields and S&P500 returns; for Germany, Bund yields and DAX
returns; for Japan, Japanese Government Bond (JGB) yields and NIKKEI returns.
84 4 Highlights of Private Equity and Venture Capital Valuation

Concerning the private equity and venture capital market, academic studies gener-
ally tend to use a risk premium between 5% and 6% [5].
Nevertheless, the most challenging parameter to estimate in the equation of
CAPM is βU that represents the systematic risk of the evaluated investment. βU,
however, is the systematic risk by assuming that the investment is being financed
totally with equity (i.e. Beta unlevered). Usually, in the case of public firms, the Beta
unlevered (βU) is obtained by applying a regression analysis of stock returns for that
firm on the market return. The beta resulting from stock returns is defined as equity
betas for levered companies, namely βL. In other terms, unlevered beta is a metric of
operational risk only, not taking into account the financial structure. To get from the
equity beta the unlevered beta, we need to apply an equation in order to “unlever” the
beta.

βL
βU ¼ h  i i
1 þ ð1  t Þ  D
Ei

Di ¼ Total debt of the company i.

Ei ¼ market value of equity for the company i.
t ¼ tax rate.
For example, assuming a levered beta ¼ 1.54, a tax rate ¼ 22% and D/E ¼ 0.85,
the unlevered beta can be calculated as follows:

1:54
βU ¼
1 þ ½ð1  0:22Þ  ð0:85Þ

βU ¼ 0:92

This means that with a levered beta ¼ 1.24, the operational risk is 0.82.
The evaluator can subsequently calculate the levered beta of the target company
based on the specific Debt-to-Equity (D/E) ratio through the following formula:

βL ¼ βU  f1 þ ½ð1  tÞ  D=Eg

Assuming that the D/E of the target company ¼ 0.65, the levered beta is thus
calculated:

βL ¼ 0:92 X f1 þ ½ð1  0:22ÞX 0:65g

βL ¼ 1:38

Thanks to a more favourable D/E (0.65 vs. 0.85), the target company’s overall
risk, as measured by levered beta, is lower than the industry average (1.38 vs. 1.54).
4.2 Valuation in Private Equity and Venture Capital: Techniques and Issues 85

Several public companies from services regularly publish betas levered of listed
companies, such as Bloomberg, Morgan Stanley Beta Book and Merrill Lynch Beta
Book. Some sources such as Merrill Lynch and Bloomberg also released the
so-called Adjusted betas measure. The Adjusted betas are corrected for a better
estimate of the future and typically are a weighted average of the historical beta
levered and 1. Bloomberg, for instance, calculates adjusted betas as a weighted
average between the regression beta (row beta) and the beta of the whole market,
which is 1. The weights adopted have the advantage of moving all the betas obtained
with the regression closer to 1. It is done because numerous empirical studies have
proven that, for most companies, the beta, over time, tends to be closer to the average
beta of the market [6].
In addition, one of the biggest concerns for investors is the possibility of
obtaining valuable profits from the investment. Therefore, a correct estimation of
βL and thus, systematic risk can help in a forward-looking context. This parameter
can help the investor understand how the firm’s value is sensitive to macroeconomic
and environmental changes. Indeed, the systematic risk can be affected by several
external factors, such as changes in the governmental system, natural disasters,
pandemics etc. Furthermore, the expected beta cannot be observable in the market,
and its estimation is not an easy task for the evaluator. Academic studies [7–9] on
this issue have presented different techniques useful to estimate the beta parameter.
However, the practitioners’ most adopted model incorporates fundamental risk
factors with stock market movements. This mechanism allows getting reliable pre-
dictors of the expected betas of a company on a prospective basis. According to this
approach, the beta of a company is predicted based on its underlying features. The
Barra [10–12] represents such models that estimate beta based on this approach. The
predicted betas levered relied upon the Barra model are frequently adopted by
academics and investors. The expected betas in the Barra model are defined as
follows:
Predicted beta, the beta Barra derives from its risk model, is a forecast of a stock’s sensitivity
to the market. It is also known as a fundamental beta because it is derived from fundamental
risk factors- such as size, yield, and volatility—plus industry exposure. Because we
re-estimate these risk factors daily, the predicted beta reflects changes in the company’s
underlying risk structure in a timely manner.

Furthermore, in some cases, it is possible that do not exist comparable firms. This
frequently occurs in the venture capital market since start-ups and highly innovative
projects do not have historical accounting and financial data. Thereby, the venture
capital industry seems to meet more challenges than private equity funds in estimat-
ing the systematic risk of the investee firms. Therefore, using an appropriate discount
rate in estimating the expected cash flows becomes fundamental.
However, even if it is possible to find companies that might be close to the project
or target company in the valuation process, the comparison is not an easy task. It is
always needed a detailed analysis of the comparables firms. In addition, the betas can
vary over time, from year to year, since, for instance, the systematic risk or the
capital structure has changed.
86 4 Highlights of Private Equity and Venture Capital Valuation

Table 4.2 Free cash flow EBIT

statement - Income taxes
+ Depreciation & Amortization
- Increase in net working capital
- CAPEX
¼ FREE CASH FLOW UNLEVERED
+ New debt
- Debt repayments
¼ FREE CASH FLOW LEVERED
Sources: Authors’ elaboration

4.3 Weighted Average Cost of Capital (WACC)

Usually, to value companies, through the discounting of their cash flows, two basic
methods are adopted:
Using the expected cash flow of equity (ECF) and the expected return on equity
(Ke);
Using the free cash flow and the WACC (weighted average cost of capital).
Free cash flow (FCF) is the hypothetical cash flow of capital if the company is
debt-free. Table 4.2 displays the free cash flow statement by highlighting the
calculation of free cash flow unlevered and free cash flow levered.
The WACC represents the rate at which the FCF is to be discounted (unlevered
cash flow), and it contains information on the whole financial structure. For this
reason, it can be calculated when the firm finances its activity with both equity
and debt.
Like in the CCF, also in the WACC method starts with the calculation of cash
flows and betas. However, in the WACC, debt tax advantages are included in the
analysis, unlike the CCF model. The equation of the WACC (Weighted Average
Cost of Capital) is given by:

E D
WACC ¼ K e  þ Kd   ð1  τ Þ
EþD EþD

WACC, is the weighted average cost of capital

Ke, is the cost of equity capital,
E/E+D, represents the weight of equity in the capital structure,
D/E+D, represents the weight of debt in the capital structure,
Kd, is the cost of debt capital,
(1 - τ), represents the tax shield, i.e. the benefit from the deductibility of tax charges
on debt.
Thus, the weighted average cost of capital (WACC) [13, 14] represents the
opportunity cost of operating net capital and is calculated as the weighted average
of the costs of the different sources of financing used by the company.
The WACC is a weighted average of two parameters:
4.3 Weighted Average Cost of Capital (WACC) 87

• The cost of debt (Kd) and

• A required return (Ke)
The first step in calculating WACC concerns the determination of the appropriate
discount rate. In WACC, the debt tax advantage impacts the discount rate through
the cash flows are determined. The following equation can express the discount rate
for WACC:

r Le  E þ r d  ð1  τÞ  D
r WACC ¼
DþE
 
In order to obtain the cost of equity r Le , it is needed to relever beta through the
following expression:
h i
D
βL ¼ β U  1 þ
E

The following equation gives the levered cost of equity:

r Le ¼ r f þ βL  ðr m  r f Þ

Then, the appropriate net present value of the firm is calculated through the
following equation:
n o
XT  CF
 CFT
rWACC g
PVWACC ¼ þ
t¼1 ð1 þ r WACC Þt ð1 þ r WACC ÞT

This equation can express the net present value of the firm:

NPVWACC ¼ PVWACC  1

The WACC discount rate is typically used in corporate finance studies. It is

considered an effective measure of the cost of all the liabilities to the shareholder and
financial institutions of the firms. The calculation of WACC is firmly based on the
capital structure of the company, the reason for which this method is more appro-
priate in circumstances in which the financial system tends to remain fairly stable
over time. The following sections present an example of WACC calculation for the
company valuation.
88 4 Highlights of Private Equity and Venture Capital Valuation

4.4 Leverage Buy Out Valuation Models

The Leverage Buy Out (LBO) [15–17] Valuation model is frequently used to
valuation target companies in private equity deals. This model has been developed
to meet investors’ operational requirements.
This section presents how the LBO works in the venture capital and private equity
market and its relationship with the discounted cash flow methodology discussed
earlier. This valuation method is helpful in determining how much a venture capital
and private equity investor should pay for the acquisition of the target company in
order to achieve an adequate return.
Like the discounted cash flow model, the LBO valuation model starts with
forecasting a company’s revenues and net income over several years. Typically, a
company’s revenues and net income are projected for 5 years. Investors aim to apply
the LBO valuation model in order to identify the free cash flow that will be used for
debt repayment. Indeed, if any positive cash flow is derived from the investment, it
will be used to pay down debt. Instead, if there is negative cash flow for some years,
the firm will require additional debt to fund its liquidity deficit. It is essential to
clarify that the free cash flow is the cash flow available after payment of interest and
dividends.
Private equity and venture capital investors adopt some performance indicators to
determine the exit value at the terminal year, usually at the year 5. The exit value,
usually, is established with the application of EBITDA multiples or revenue multi-
ples. This valuation method, as discussed earlier, helps determine how much an
investor can afford to pay for the target company to obtain an adequate return on the
investment. However, this value depends on the highest level of debt it can bear and
the return on the capital invested in the purchase transaction, which can be deter-
mined using two different approaches:
• Identification of a target internal rate of return (IRR target method) [18, 19]
• Determination of the cost of capital using the CAPM (backward induction
method)
The internal rate of return (IRR) is the discount rate that equalises the present
value of outflows with the present value of inflows. Over recent years, investors have
often used IRR as an indicator of company value rather than as a measure of
performance. This method is more utilised than the backward induction method by
investors. The initial step involves the projection of cash flows for a time horizon
between 3 and 5 years, as in the discounted cash flow method.
The maximum level of debt that the target company is in a position to bear is then
estimated. Once the cash flows have been forecast, the value that the company could
have at the time of disinvestment is calculated by applying the Multiples method.
Therefore, private equity and venture capital investors estimate an IRR based on
their equity investment within the target company and what they think to receive for
their equity ownership at the exit moment, usually between 3 or 5 years. Typically,
the value of debt is deducted from the exit valuation by projecting out a debt
4.5 Case Study: A Valuation Example Using CCF and WACC 89

schedule. For this reason, it is said that private equity investors make a valuation
equity in-equity out.
Once the expected IRR is calculated, investors compare the IRR of their equity
investment to their hurdle rate. Usually, hurdles rate can vary based on several
parameters, such as firms size, typology of industry, firms stage, country, etc.
Generally, LBO hurdle rates [20–22] vary between 20% and 30%, which differ
enormously across firms and investments.
The crucial point lies in understanding how the IRR of the equity investment is
determined in an LBO valuation model. First of all, the value generated by the
intermediate payment of the debt is caught by deducting less debt from the output
than the total debt outstanding when the deal is completed. However, the value is
captured by the equity since debt is paid in subsequent years. Then, enterprise value
is enhanced through the improvements in EBITDA, operating performance, growth
in revenues, etc. Finally, the variation of multiples, mainly if a private equity firm
can acquire the right of the target company, results in the expansion of exit multiples
if the private equity firm can sell the right.

4.5 Case Study: A Valuation Example Using CCF

and WACC

Year 1 Year 2 Year 3 Year 4

EBIT 6.5 7.2 8.0 8.2
Depreciation 3.5 3.4 3.3 3.2
Capital expenditure 3.0 4.0 4.0 4.1
Working capital investment 2.3 2.9 2.9 2.5
Interest expense 0.56 0.56 0.56 0.56
Tax rate 30%
Current book value of debt 4.0
Equity Beta of comparable firm 1.80
Debt to equity ratio of comparable firm 30%
Target debt to Total capital ratio 30%
Long-term T-bond rate 8%
Long-term debt rate 10%
Long-term growth rate 3%
90 4 Highlights of Private Equity and Venture Capital Valuation

Calculating Free Cash Flows

FCF ¼ EBIT ð1  τÞ þ Depreciation  Capital Expenditure

 Change in Working Capital

Year 1 Year 2 Year 3 Year 4

FCF 3.5 2.22 2.6 2.92

Discount Rate
It is assumed an equity risk premium of 7%, and therefore:

βU ¼ βL =½1 þ ðD=EÞ
βU ¼ 1:80=½1 þ ð0:30=0:70Þ ¼ 1:26
r a ¼ r f þ βU  7
r a ¼ 8 þ 1:26  7 ¼ 16:82%

Thereby, for the calculation of CCF, we will adopt a discount rate of 16.82%
To estimate the discount rate for WACC, we should assume a debt to equity ratio.
Therefore, we will assume that the company is financed by 30% debt and 70%
equity. Using the previous formula adopted above, we have:

βL ¼ βU =½1 þ ðD=EÞ
βL ¼ 1:26=½1 þ ð0:30=0:70Þ ¼ 0:89
r Le ¼ rf þ βL  7
r Le ¼ 8 þ 0:89  7 ¼ 14:23%
r WACC ¼ E=ðD þ EÞ  r Le þ D=ðD þ EÞ  ð1  τÞ  rd
r WACC ¼ 0:7  14:23% þ 0:3  ð1  0:30Þ  10% ¼ 12:06%

Thus, for WACC we will adopt a discount rate of 12.06%

Terminal Value
We use the cash flow in year 4, 2.92, and we assume that this cash flow will grow at
3% forever. The terminal values are:

TVCCF ¼ 2:92  ð1:03Þ=ð0:1682  0:03Þ ¼ 21:76

TVWACC ¼ 2:92  ð1:03Þ=ð0:1206  0:03Þ ¼ 33:19
References 91

Present Value

PVCCF ¼ 7:8
PVWACC ¼ 8:57
PVTVCCF ¼ TVCCF =ð1 þ r a Þ
PVTVCCF ¼ 21:76=ð1 þ 0:1682Þ4 ¼ 11:68
PVTVWACC ¼ TVWACC =ð1 þ r a Þ
PVTVWACC ¼ 33:19=ð1 þ 0:1206Þ ¼ 21:04

At this stage, we should calculate the present value of the tax shield for the CCF
method by assuming that the debt level is held constant at 3:

PVTSCCF ¼ ðt  rd DÞ=r a ¼ ð0:3 0:10 3Þ=0:1682 ¼ 0:53

Summing the present value, we get:

PVCCF ¼ PVCF þ PVTV þ PVTS ¼ 7:8 þ 11:68 þ 0:53 ¼ 20:01

PVWACC ¼ PVCF þ PVTV ¼ 8:57 þ 21:04 ¼ 29:61

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