How does the venture capital industry work?

Discussions About The Venture Capital Industry

Marc Andreessen, co-founder of Netscape, vividly describes an insider’s view to the venture capital industry’s food chain: The best venture capitalists (VCs) can see ahead and are willing to think they can fix things, put the management team together, do all this stuff. Any huge success story like Netscape or Apple is like a sausage factory. Everybody likes to eat sausage; no one likes to see how it gets made. These things are all sausage factories inside.

In their influential book, Venture Capital at the Crossroads, Bygrave and Timmons tell us that the lifeblood of the venture capital process consists of three essential components: entrepreneurial deals, money to invest in those deals, and a return on the money invested in them.

Depending on the investment focus and strategy of the venture capital firm, it will seek a liquidity event to exit the investment in the entrepreneur’s venture within three to seven years of the initial investment. While the initial public offering (IPO) may be the most glamorous and heralded type of exit for the venture capitalists and founders of the venture, most successful exits of venture investments occur through a merger or acquisition (M&A). In the case of an M&A, the venture firm will receive stock or cash from the acquiring company, and the proceeds of the sale will be returned to its limited partners.

Just like the entrepreneurs they finance, venture capitalists have to go out and raise money too. They get the majority of their funds from outside the partners of the firms. Most VCs raise their funds from institutional investors, such as pension funds, insurance companies, endowments, foundations, and high net-worth individuals. These investors who invest in venture capital funds are referred to as limited partners. Venture capitalists, who manage the fund, are referred to as general partners. Each year, a venture firm will set out prospecting for investors with a target fund size. It will distribute a prospectus to potential investors and may take from several weeks to several months to raise the requisite capital.

The commitments of capital are raised from the investors during the formation of the fund. In 2001 a total of $40 billion was committed to 299 venture capital funds. Private and public pension funds continued to dominate as limited partners, as 42 percent of the capital committed to venture capitalists came from them, 25 percent from financial and insurance organizations, 22 percent from endowments and foundations, and 9 percent from individuals and families; corporations committed the remaining 3 percent.

As an investment manager, the venture capital firm will typically charge a management fee to cover the costs of managing the committed capital. This fee ranges between 2 percent to 2.5 percent of the money they manage and will usually be paid quarterly for the life of the fund. This is most often negotiated with investors upon formation of the fund in the terms and conditions of the investment. “Carried interest” is the term used to denote the profit split of proceeds generated from a liquidity event between the VC firm and its limited partners. This carry is commonly paid to the VC firm only after investors have recovered their investment. 

Not all venture capitalists invest in start-ups and early-stage ventures. Venture capital firms have different preferences and practices, including how much money they will provide, where in the entrepreneurial life cycle they prefer to invest, and the cost of capital or expected annual rate of return they are seeking. The sources of capital change dramatically for entrepreneurs at different stages of development and rates of growth. According to Dan Bassett, a partner at InnoCal Partners based in Costa Mesa, California, “The number one piece of advice for entrepreneurs is to know where you are on the food chain. If you don’t know, seek advice and make use of the very high quality people in your environment.”

Stage Definitions used in the Venture Capital Industry
The five stages in the food chain of the venture capital industry are described in more detail below.

1. Seed-Stage Financing
The venture is in the gestation, or idea formation stage, as the product is not fully developed. A relatively small amount of capital is usually provided to an inventor or entrepreneur to prove a concept. This may involve product development and pre-marketing activities like market research, as well as building a venture team and completing a business plan.

2. Early Stage Financing
Early Stage or Start-Up Financing is used for completing product development and may include initial marketing efforts. Ventures eligible for this type of financing may be in the process of organizing, or they may already be in business for two years or less, but have not sold their product commercially. Investors want to see entrepreneurs that have conducted market studies, assembled the key players on their venture team, developed a business plan, and are ready to launch. Once launched, this opens the door to institutional investors, as the networking capabilities of the venture capitalists are used more here than in more advanced stages.

3. Development and Expansion-Stage Financing
Ventures here are usually more than three years old, demonstrating significant growth in revenues, and may or may not be showing a profit. Some of the uses of capital may include expansion of production capabilities, marketing, new product development, or developing new markets for the existing product line. The venture capitalists’ role in this stage evolves from a supportive role to a more strategic role, often bringing in more institutional investors along with initial investors from previous rounds.

4. Later-Stage and Bridge Financing
Investors provide capital for ventures in this stage that have reached a fairly stable growth rate and have either stable streams of profitable earnings, or highly predictable streams of top line revenues. VCs will provide bridge financing when a venture plans to go public within a year or so. This can be structured so that it gets repaid from the proceeds of a public underwriting. It can also involve the restructuring of major stockholders/early investors who want to reduce or liquidate their positions, or if management has changed and the stockholdings of the former management, their relative and associates are being bought out.

5. Acquisition and Leverage Buyout Financing
Investors provide funds to finance the acquisition of another private venture or public company. This includes money for mezzanine financing using subordinated debt, and bridge loans which are used to finance Leveraged Buyouts (LBOs), and recapitalizations. Financing for a Management Buyout (MBO) enables a group to acquire a product line or business, at any stage of development, from either a public company or a closely-held private venture. An MBO usually involves the revitalization, or a “turnaround” of an operation, where an entrepreneurial management team acquires a significant equity interest in exchange for improving the venture’s performance.

Understanding the Types of Securities
There are two types of financial offerings available to entrepreneurs, equity and debt. In exchange for private equity investments, the venture issues equity securities. There are three basic types of securities.

 – Common shares are most often issued to those who manage the corporation, bear the major risks of the venture, and yet stand to profit the most if it is successful.

 – Preferred shares have liquidation and dividend preferences over common shares and may be converted into another class of shares, usually common shares.

 – Debentures are long-term, unsecured debt securities.

Debt financing is a method involving an interest-bearing instrument, usually thought of as a loan, and it requires that some asset be used as collateral. Debt requires the venture to pay back the amount of the borrowed funds as well as a fee for the use of the money for the time it was loaned out, which is called interest.

All entrepreneurs interested in raising capital must decide which vehicle is most appropriate for their situation. An equity offering will give share ownership and some level of control to others. Also, with an equity offering, working capital and financial leverage of the venture improves, as interest costs and debt service in future years are avoided. On the other hand, debt financing has the distinct advantage that it does not dilute the existing shareholder value. While the main focus of this book is on private equity financings, the process and information required—like the business plan, marketing plan, and financials—are very similar to what is required for debt financings.

What Are Typical Returns on the Investments?
Entrepreneurs are the source of consistent high-performance returns on investments. Performance for the venture capital industry is traditionally measured by the internal rate of return (IRR). The IRR considers “cash-on-cash” returns from the sale of shares and disbursements from the liquidity events back to investors, such as dividends. It is calculated by taking inflows of cash as negative cash flows, and distributions of cash and stock to investors as positive cash flows.

Venture capitalists have to have a good idea of the percentage returns they anticipate on their investments. Their limited partner investors—the “limiteds”—are IRR-driven, hence so are the VC’s practices of investing. Because VCs focus on delivering an average of 30 percent-plus back to their limiteds, they target for around 50 percent-plus on each investment. Private equity returns are derived from distributions back to investors and interim portfolio company valuations.

The venture funds have lives on average of ten to twelve years. Their performance during the first three years of investment activity are volatile and difficult to measure. A typical VC investment might have one of five potential outcomes: “Bad,” “Alive,” “Okay,” “Good,” and “Great.” The Bad, a complete “wipe-out,” does not return anything; the Alive returns maybe 1x the money invested; Okay returns 5x; Good returns 10x; and Great returns are 20x or higher.

On the average, the gross returns on each $1,000 invested would be $4,400, and the net, less the Bad, would be $3,400. For longer periods of time, returns on venture capital investments outpace all others. For comparison, by the end of 2001, the five-year rolling averages were 38 percent for venture capital, 17 percent for NASDAQ, and 14 percent for the S&P 500.

Understanding the Selection Process
Venture capitalists mitigate the risk of venture investing by developing a portfolio of companies in a single venture fund. They invest in a small percentage of the business plans that get placed and reviewed at their firms. When considering an investment, they carefully screen the technical and business merits of the deal before them. Jesse Reyes, vice president for Thompson Venture Economics, a New York-based venture capital research firm, says, “The key to this new environment, though, is that the venture investors can afford to be choosy about what deals they do, and they’re exercising that right.” Therefore, the selection process can be quite comprehensive. We continue this discussion in Financing The Emerging Growth Venture.

How A Venture Capital Firm Screens Its Deals

1. Placement of Completed Business Plan, through appropriate “warm” referrals.

2. Quickview and Routing, the plan is directed to the most appropriate reviewer based on partner’s domain expertise.

3. Business Plan Review, one or more partners will review the plan and evaluate it based on a number of factors related to the firm’s current area of focus. Based on the outcome of the review process, the entrepreneur will be contacted and informed of the next steps.

4. Informal Dialogue, whereby additional details are requested from the entrepreneur through email and phone calls. If there is significant interest, the entrepreneur and team will be invited to present before the firm’s investment professionals.

5. Initial Pre-Screening Meeting, much like an interview process, provides opportunity for the interested partners to be introduced to the entrepreneur and team and see them in action with the presentation. They discuss the next steps in the funding process, and how the firm can assist the entrepreneur and team.

6. Informal Due Diligence, a step for pre-investment analysis, typically it can be conducted in about a week but sometimes takes as much as three weeks. The investment committee, which is made up of all the partners in the firm, reviews and discusses the due diligence that has been conducted up to that point.

7. Formal Presentation, if a decision is made to continue, they will ask the entrepreneur to formally present before senior partners. After the presentation, the investment committee would then make a decision whether or not to make an offer for investment.

8. Investment Decision, during the initial phase of either the informal and/or formal due diligence process, the investors will present and finalize details of a “Term Sheet.” The Term Sheet will outline the general attributes of the relationship between the entrepreneur and the VC firm.

9. Formal Due Diligence, a full firm-wide effort is applied to the in-depth investment review process. Generally, one of the partners will take the lead in this extensive analysis. This process includes additional reference checks of the entrepreneur and team, dialogue with industry and customer references, and interviews with independent subject matter experts.

10. Closing Documents, a collaborative effort between the attorneys of the venture firm and the entrepreneur that will define the legal framework relationship between the venture and the investors.

11. Investment, provided that all reach an agreement, the VC then provides the funding and the two parties begin working together and creating sustainable value.

About Robert W Price

Executive Director: Global Entrepreneurship Institute. Founded in 1996 as a 501(c)(3) non-profit organization, we help entrepreneurs launch new businesses, grow them across national borders, and create wealth for their shareholders. We put "global" in global entrepreneurship. Using our exclusive “Roadmap to Entrepreneurial Success” we have helped entrepreneurs raise over $100 million.
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