Venture Finance - Reality versus Rumor
with Dick BrownEntrepreneurs are asked: “Where do you plan to get funding for your venture?”
Most give the same response, “Venture Capital companies”.
Yet, not one entrepreneur in ten knows anything about this financial industry nor how it works. The following (along with a few “rules of the road”) may help.
Venture Capital companies invest OPM (Other People’s Money).
Investors give money to the VC’s to earn a higher return-on-investment than more traditional investments such as the stock market or bonds. The VC’s role is to make as much money as possible while assuming prudent risks. Their target is a very high ROI. Venture Capital became a fledgling US “happening” in the 1950's … initially financed by wealthy individuals and small investor syndicates.
Not so long ago, there was only one venture capital company, American Research and Development in Boston, founded in 1946 by Ralph Flanders, president of Boston’s Federal Reserve Bank and General George Doriot, a native of France who taught at the Harvard Business School and had served with the American Army in World War II.
Early on, AR&D made a modest investment of some $70,000 (for 77% of the company!) in a then unknown computer company known as Digital Equipment Corporation. Their modest investment blossomed into a value of some $100 million as Digital flourished.
AR&D caught a lot of attention in the staid, New England banking community. The potential for huge profits soon spawned a number of new, copycat VC’s and the formation of these became a major sport in the US financial community. In just a few years, it was estimated that there were 725 VC’s operating in the US … up from 507 only three years earlier.
Why this breakneck growth? The average annual return on VC funds was 48%, 40%, and 36% for 1995, 1996 and 1997 respectively … and, the industry as a whole had averaged 13.1 percent annual returns over two decades … Not too shabby to the existing bankers used to financing cars, boats and houses. Private equity such as VC’s became the fastest growing market for corporate finance.
Venture capital really blossomed until “Black Friday”, 14 April 2000, when the Internet craze crashed and the NASDAQ composite index dropped by 355.49 points. Analysts and investors wrote off the IPO market as retail and institutional investors quickly wised up to the game. The halcyon days of B2C’s and B2B’s that acquired market cap values greater than Ford Motors came to a shrieking halt.
Today, VC’s have bounced back, even in our current recession. Although venture capitalists now longer pour money into “the Internet”, it is now earmarked for different kinds of companies. The actual industry targets change constantly, but the “acid test” is:
- The ability of a company to grow rapidly;
- To dominate or be a major factor in a specific market segment; and,
- Be attractive for an IPO - so the VC’s and their investors can cash out and “get liquid”.
Rule 1: If your company doesn’t have these characteristics, VC’s are not interested.
All VC funds seek very high ROI’s where there is inherently more risk than with other investments. In the early days of venture capital, if you traced back the actual source of the working capital you would quickly find that most of it came from wealthy families such as the Rockefellers and Rothschilds. Today, the great majority of money going into venture capital funds comes from institutional investors.
In any VC fund, part of the capital may come from the VC’s inside partners and some of the money will usually come from wealthy, private individuals or institutions that probably made a great return on their last investment with the same VC fund.
It’s not a game for the small investor. For instance, the minimum investment for a limited partner in Highland Capital Partners in Boston is $10 million.
The traditional hunting ground of VC’s has always been high-tech and its cousin, biotech. These markets are attractive since they are:
- Volatile and rapidly changing,
- Founded on continuing advances in leading edge technology,
- “Non-traditional” industries with few entrenched leaders. (It’s much easier to form an Apple, Netscape or Amazon.com from a industry void than it is to try to dislodge market share from traditional corporations (“gorillas”) such as US Steel, General Electric or Prudential Life Insurance.
Today’s VC’s are also interested in “derivative” and newer, emerging markets, such as “Green Products”
Rule 2: If your company doesn’t have “hot products in hot markets”, VC’s are not interested.
You and I Start a VC firm - Probably we both have had successful, management careers (maybe in high tech) and have made money for friends, outsiders and ourselves in a couple of our career stops. We know some of these people have faith in our judgment and they have funds to invest.
First, we form a type of company known as a Limited Partnership (LP). You and I are the General (or Managing) Partners and our investors are the Limited Partners. As the name implies, the investors’ losses are limited to the amount they choose to invest. The situation is very different for you and me. An LP is not the same as a corporation. As the Managing Partners in an LP as, we can be held personally liable for anything we do that is criminal, stupid or ill advised. We can also be on the hook for the liabilities of the LP. Newer forms of companies, such as a Limited Liability Partnership (LLP) limit the extent of this personal exposure.
Let’s say we plan to start “small”” and our first fund will be only $10,000,000 of investors’ money. Just as any entrepreneurs, we plan get this money from friends and insiders. We work on their expectations that our expertise and VC fund will outperform almost any other investment they may consider. We may invest some of our personal money as well. Our sales job is to get the $10 million and this usually takes us 3-6 months, along with a great deal of legal work.
As Managing Partners, you and I earn a management fee, usually 2% (and unusually as high as 5%) or $200,000 to $500,000. This takes care of our initial salaries, expenses and the outrageously expensive offices that most VC’s occupy, from Sand Hill Road in Palo Alto to State Street in Boston. In addition, we receive 20% of the net profits of the fund (Most VC deals are "two and 20").
[Let’s say we’re a well-established VC creating a $1 billion fund with only a 2% fee. That’s a whopping $20 million fee. Most mature VC companies have around 10 partners. If half the fee goes to overhead and the rest is split amongst the partners, that’s $1 million each!]
The split of the profits from the fund is determined in the partnership agreement and each one may be somewhat different. Since we’re new VC’s, maybe you and I don’t begin to profit from the investment side until all our investors make money. Or, maybe part of our management fee must be repaid first or deducted from our long-term gains.
The VC company management earns a fee on all the profits. This is called the “carry”, the percentage of the return on their limited partners investment that they collect.
As a “rule of thumb” the VC Company typically keeps some 20% of the profits from the investments, with 80% going to the investors
As soon as we fully subscribe the fund we want to begin making investments. Our investors did not give us their cash so it could sit in a bank. They get very unhappy if we don’t actively make investments.
[Incidentally, when Limited Partners subscribe to a fund, they do not usually write a check for the entire amount. If they are old, trusted LP’s, they may just be called from time to time for specific amounts for specific deals. However, they are expected to immediately respond, without delay, and fulfill their commitment. The consequences of not meeting a “capital call” can be severe, including the loss of any capital previously committed.]
More typically, LP’s may sign a subscription agreement, pledging to invest specific amounts at specific times (e.g. $2 million a quarter for 2 years). These are also called “tranches” or installment payments.
As new VC’s we have a predilection to make investments in companies and technology that we already understand. Our first checks will probably be written to companies we already know or to kinsmen that are starting new ventures or need additional funding.
Since our “kitty” is only $10,000,000 we set a limit of the amount we’ll invest in any deal. Let’s say it’s 5% or $500,000 for each deal. So, we can do a maximum of 20 deals (also establishing a budget for our “troubled” investments that will require additional capital). As prudent risk takers, by spreading our money into several investments we have limited the chance of losing everything with a single, bad decision. We will also cap the minimum amount we’ll invest in any one venture since our time is valuable and limited as we always become involved in our investments, usually as directors.
Rule 3: If your company is looking for “small money” (say less than $500,000 for a new or “boutique” VC or much more for a large firm), VC’s are not interested.
Early in our venture fund, we’ll probably go into several “syndicated” deals where two or more, unrelated, VC funds all invest in the same venture. Often one of the groups, the lead investor, will perform the overall due diligence and negotiations. We all split up the investment required and then we pick one or two of the different VC people to sit on the board of directors to watch our money.
Such pooling of funds is very attractive for us. We get to know a lot of other VC’s and industry executives. We learn more as we begin to be asked to participate in deals where we don’t have direct expertise. We begin to sit on many boards of directors and we get to know people that are directors and officers in multiple companies.
Rule 4: If the people in your company don’t know any VC’s (or, have friends in other companies already financed by VC’s), VC’s will not be interested. The “club” despises outsiders.
We learn even more about different businesses. Even better, we get to know a very large number of people, some very rich and powerful. We’re beginning to become members in an intriguing, worldwide club. We love it!
Next, we want to expand our VC business. How do we do that?
We start another fund.
In the VC business, once an individual fund is fully invested, that fund is closed to any new investors. Therefore, each time a VC wants to raise more investment money, they must start a new fund. The participants in each fund may be very different people or companies ... and, if we didn’t do very well for our investors in our last fund, this is a certainty!
Such partnership funds also have a specified, fixed life … usually ten years.
We have to make money for our investors since our ability to start new funds is directly related to our past performance. If we have poor performance in a couple of our funds, we may not be able to raise money for the third and following ones. We are always looking for new money from investors and trying to get the largest ROI for our current investors.
Sound familiar? VC’s have exactly the same problem running their business as you do. VC’s even go out of business if they make some really bad investment decisions. Ain’t capitalism wonderful?
As new VC’s, you and I are very sensitive about our investment decisions. We hear from our investors (passionately and loudly) when we make bad decisions. This is not a pleasant occurrence.
Our investors are looking for “home runs”. This is not really surprising since we probably promised the long-ball when we originally took their money.
We discover a wonderful way to cover our butts for those of our investments that might turn out to be only singles ... or, God forbid, strikeouts.
We probably decide never to go into a deal as the sole investor and we develop a preferred list of the VC’s as our potential partners. Not surprising, this wish list probably contains all the larger VC players. Usually, one of these assumes the monitoring role for each investment and this way we can avoid becoming directors. Also, we don’t have the staff, time and money to watch anything outside our limited geographical area.
Rule 5: If your company is in an area that has few VC’s and/or would require significant travel time/expense for any to visit you, VC’s are not interested.
Now, if one of these deals goes bad and our investors’ call to complain, we can always say:
“Look, the guys from LF Rothschild brought us into that deal. They knew the principals from an earlier venture. LFR did all the due diligence and promised us a major success. Even Sevin-Rosen came in as an investor. It really isn’t our mistake.”
Thus we neatly transfer the blame from us to LFR and avoid an angry investor in our fund. And that, my friends, is exactly why there are so many “shared deals” and so few with a sole VC involved.
“Success has many fathers. Defeat is an orphan.”
This lemming principle ... “it’s all the fault of that crazy rat in front!” ... extends far beyond just the sharing of investment positions. VC’s all read the same trade magazines and they share nearly exactly same perceptions of many industries and what companies/products are hot or cold.
Rule 6: Raising money for areas that are “off the radar” (unknown) or perceived to be cold by VC’s is very difficult.
This is just a beginning along with a few rules for “The VC Game”.
Dick Brown is President/Founder of American World, a consulting company that helps entrepreneurs that are seeking capital. He has known dozens of these folks and has written or reviewed hundreds of Business Plans. He is author/publisher of two books - “How to Raise Money, the Truth”, a “how-to” for entrepreneurs and “The PC Revolution, an Anarchist’s Journal”, a first-person history that exposes the people and events that created the most brutal upheaval in the history of the computer industry. When it ended, giants such as Digital, Data General and Wang were out of business. Dick was an active participant. He knew all the players and lived with them throughout the insurrection.
Web: http://www.amerwld.com/
Email: dick@amerwld.com
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VENTURE FINANCE - REALITY VERSUS RUMOR: Outside, Looking In
