There's more money than ever in the startup funding market across all funding stages. In previous articles we discussed the financing options available to startups and also the criteria used by investors when deciding which startups to back. Now it's time to get a little bit closer to the elephant in the room: Venture Capital firms.
As we've previously mentioned, Venture Capital is a form of a financing that's self-explained: it consists of funds or firms that provide 'venture capital', meaning high risk capital that supports companies and organizations with the hope that these provide a great return on investment (ROI).
There are many terms associated to the Venture Capital industry that might not be known to other investors and entrepreneurs, and in this article we'll try to explain the main ones.
How does a Venture Capital firm work? There are two key elements within a VC fund: general and limited partners. The general partners are the people in charge of making investment decisions (finding and agreeing to terms with startups and companies) and working with startups to grow and meet their goals. On the other hand there are limited partners, the people and organizations who provide the capital necessary to complete those investments.
In other words, general partners make the investments and limited partners provide the funds.
This is one of the key differences between VC funds and other investment vehicles: Venture Capital funds don't invest the money of their own partners, but that of limited partners such as pension funds, public venture funds, endowments, hedge funds, etc. General partners might invest some of their own money through the fund, but this tends to account for only 1% of the size of the fund.
Does this mean that VC firms also need to 'fundraise'?
Yup, that's exactly right. Startups need to fundraise to convince Venture Capital firms, business angels, etc to give them money in exchange for equity. The case for VC firms is similar. General partners must convince some of the organizations aforementioned to invest in the fund with the promise of big returns (between 5X and 10X) in a certain period of time (usually 10 years).
The VC firms must then go on to make clever investments so they can give the limited partners their money back… plus a profit.
How do Venture Capital firms make money?
The way Venture Capital funds make money are two fold: via management fees and carries (carried interest).
Management fees: management fees are usually defined as the 'cost of having your assets professionally managed'. How does this translate into the Venture Capital industry? VC funds typically pay an annual management fee to the fund's management company, as a form of salary and a way to cover organizational and fund expenses. Management fees are usually calculated on a percentage of the capital commitments of the fund, or about 2 to 2.5 per cent. Carried interest or carry: share of the profits of an investment or investment fund that is paid to the investment manager in excess of the amount that the manager contributes to the partnership. This is the way Wikipedia defines what a carry is. In plain English: when an investment is successful, a carry represents the share of the profits that is paid to the fund managers. Carried interesting in Venture Capital is usually 20 to 25 per cent, meaning that while 20% of the profits go to the general partners, 80% belongs to the limited partners.
How does this influence startups?
It's important that startups recognize how Venture Capital firms work. As we've mentioned countless times before, investors back startups with one main objective in mind: getting a return on their investment. They're in for the money, mostly.
It's also worth noting that Venture Capital funds have a fixed life of about 10 years, thus establishing investing cycles that last for about three to five years. After that the firms will work alongside the startups and founders to scale and seek an exit, providing the returns that they sought in the first place.
Furthermore, investment banks and public equity are both constrained by regulations and operating practices meant to protect the public investor. Historically, a company could not access the public market without sales of about $15 million, assets of $10 million, and a reasonable profit history. To put this in perspective, less than 2% of the more than 5 million corporations in the United States have more than $10 million in revenues. Although the IPO threshold has been lowered recently through the issuance of development-stage company stocks, in general the financing window for companies with less than $10 million in revenue remains closed to the entrepreneur.
Venture capital fills the void between sources of funds for innovation (chiefly corporations, government bodies, and the entrepreneur's friends and family) and traditional, lower-cost sources of capital available to ongoing concerns. Filling that void successfully requires the venture capital industry to provide a sufficient return on capital to attract private equity funds, attractive returns for its own participants, and sufficient upside potential to entrepreneurs to attract high-quality ideas that will generate high returns. Put simply, the challenge is to earn a consistently superior return on investments in inherently risky business ventures.
Sufficient Returns at Acceptable Risk
Investors in venture capital funds are typically very large institutions such as pension funds, financial firms, insurance companies, and university endowments—all of which put a small percentage of their total funds into high-risk investments. They expect a return of between 25% and 35% per year over the lifetime of the investment. Because these investments represent such a tiny part of the institutional investors' portfolios, venture capitalists have a lot of latitude. What leads these institutions to invest in a fund is not the specific investments but the firm's overall track record, the fund's "story," and their confidence in the partners themselves.
How do venture capitalists meet their investors' expectations at acceptable risk levels? The answer lies in their investment profile and in how they structure each deal.
The Investment Profile.
One myth is that venture capitalists invest in good people and good ideas. The reality is that they invest in good industries—that is, industries that are more competitively forgiving than the market as a whole. In 1980, for example, nearly 20% of venture capital investments went to the energy industry. More recently, the flow of capital has shifted rapidly from genetic engineering, specialty retailing, and computer hardware to CD-ROMs, multimedia, telecommunications, and software companies. Now, more than 25% of disbursements are devoted to the Internet "space." The apparent randomness of these shifts among technologies and industry segments is misleading; the targeted segment in each case was growing fast, and its capacity promised to be constrained in the next five years. To put this in context, we estimate that less than 10% of all U.S. economic activity occurs in segments projected to grow more than 15% a year over the next five years.
The myth is that venture capitalists invest in good people and good ideas. The reality is that they invest in good industries.
In effect, venture capitalists focus on the middle part of the classic industry S-curve. They avoid both the early stages, when technologies are uncertain and market needs are unknown, and the later stages, when competitive shakeouts and consolidations are inevitable and growth rates slow dramatically. Consider the disk drive industry. In 1983, more than 40 venture-funded companies and more than 80 others existed. By late 1984, the industry market value had plunged from $5.4 billion to $1.4 billion. Today only five major players remain.
Growing within high-growth segments is a lot easier than doing so in low-, no-, or negative-growth ones, as every businessperson knows. In other words, regardless of the talent or charisma of individual entrepreneurs, they rarely receive backing from a VC if their businesses are in low-growth market segments. What these investment flows reflect, then, is a consistent pattern of capital allocation into industries where most companies are likely to look good in the near term.
During this adolescent period of high and accelerating growth, it can be extremely hard to distinguish the eventual winners from the losers because their financial performance and growth rates look strikingly similar. Timing Is Everything More than 80% of the money invested by venture capitalists goes into the adolescent phase of a company's life cycle. In this period of accelerated growth, the financials of both the eventual winners and losers look strikingly similar.
Picking the wrong industry or betting on a technology risk in an unproven market segment is something VCs avoid. Exceptions to this rule tend to involve "concept" stocks, those that hold great promise but that take an extremely long time to succeed. Genetic engineering companies illustrate this point. In that industry, the venture capitalist's challenge is to identify entrepreneurs who can advance a key technology to a certain stage—FDA approval, for example—at which point the company can be taken public or sold to a major corporation.
By investing in areas with high growth rates, VCs primarily consign their risks to the ability of the company's management to execute. VC investments in high-growth segments are likely to have exit opportunities because investment bankers are continually looking for new high-growth issues to bring to market. The issues will be easier to sell and likely to support high relative valuations—and therefore high commissions for the investment bankers. Given the risk of these types of deals, investment bankers' commissions are typically 6% to 8% of the money raised through an IPO. Thus an effort of only several months on the part of a few professionals and brokers can result in millions of dollars in commissions.
As long as venture capitalists are able to exit the company and industry before it tops out, they can reap extraordinary returns at relatively low risk. Astute venture capitalists operate in a secure niche where traditional, low-cost financing is unavailable. High rewards can be paid to successful management teams, and institutional investment will be available to provide liquidity in a relatively short period of time.
The Logic of the Deal.
There are many variants of the basic deal structure, but whatever the specifics, the logic of the deal is always the same: to give investors in the venture capital fund both ample downside protection and a favorable position for additional investment if the company proves to be a winner.
In a typical start-up deal, for example, the venture capital fund will invest $3 million in exchange for a 40% preferred-equity ownership position, although recent valuations have been much higher. The preferred provisions offer downside protection. For instance, the venture capitalists receive a liquidation preference. A liquidation feature simulates debt by giving 100% preference over common shares held by management until the VC's $3 million is returned. In other words, should the venture fail, they are given first claim to all the company's assets and technology. In addition, the deal often includes blocking rights or disproportional voting rights over key decisions, including the sale of the company or the timing of an IPO.
The contract is also likely to contain downside protection in the form of antidilution clauses, or ratchets. Such clauses protect against equity dilution if subsequent rounds of financing at lower values take place. Should the company stumble and have to raise more money at a lower valuation, the venture firm will be given enough shares to maintain its original equity position—that is, the total percentage of equity owned. That preferential treatment typically comes at the expense of the common shareholders, or management, as well as investors who are not affiliated with the VC firm and who do not continue to invest on a pro rata basis.
Alternatively, if a company is doing well, investors enjoy upside provisions, sometimes giving them the right to put additional money into the venture at a predetermined price. That means venture investors can increase their stakes in successful ventures at below market prices.
How the Venture Capital Industry Works The venture capital industry has four main players: entrepreneurs who need funding; investors who want high returns; investment bankers who need companies to sell; and the venture capitalists who make money for themselves by making a market for the other three.
VC firms also protect themselves from risk by coinvesting with other firms. Typically, there will be a "lead" investor and several "followers." It is the exception, not the rule, for one VC to finance an individual company entirely. Rather, venture firms prefer to have two or three groups involved in most stages of financing. Such relationships provide further portfolio diversification—that is, the ability to invest in more deals per dollar of invested capital. They also decrease the workload of the VC partners by getting others involved in assessing the risks during the due diligence period and in managing the deal. And the presence of several VC firms adds credibility. In fact, some observers have suggested that the truly smart fund will always be a follower of the top-tier firms.
Attractive Returns for the VC
In return for financing one to two years of a company's start-up, venture capitalists expect a ten times return of capital over five years. Combined with the preferred position, this is very high-cost capital: a loan with a 58% annual compound interest rate that cannot be prepaid. But that rate is necessary to deliver average fund returns above 20%. Funds are structured to guarantee partners a comfortable income while they work to generate those returns. The venture capital partners agree to return all of the investors' capital before sharing in the upside. However, the fund typically pays for the investors' annual operating budget—2% to 3% of the pool's total capital—which they take as a management fee regardless of the fund's results.
If there is a $100 million pool and four or five partners, for example, the partners are essentially assured salaries of $200,000 to $400,000 plus operating expenses for seven to ten years. (If the fund fails, of course, the group will be unable to raise funds in the future.) Compare those figures with Tommy Davis and Arthur Rock's first fund, which was $5 million but had a total management fee of only $75,000 a year.
The real upside lies in the appreciation of the portfolio. The investors get 70% to 80% of the gains; the venture capitalists get the remaining 20% to 30%. The amount of money any partner receives beyond salary is a function of the total growth of the portfolio's value and the amount of money managed per partner.
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