VENTURE CAPITAL

Volatile: High Success and Failure

Rates
Source of Innovation: New Ideas
and Ways to do Things
Contribute Disproportionately to
New Job Formation
AmericanCapitalismproduces
New/SmallBusinessesthatare
Adverse Selection Problem: How can Investor know
whether Business Opportunity is Feasible? How can
Entrepreneur Objectively Communicate likelihood of
Market Acceptance?
Moral Hazard Problem: How can Investor evaluate
Entrepreneur's Ability? How can Entrepreneur
communicate Capacity, Credibility and Commitment?
Contracting Problem: How can Parties Agree (1)
about How to Control Business in Dynamic,
Uncertain Environment and (2) on Incentives that
Reward Different, sometimes Conflicting, Motives?
CustomaryDevelopmentPaths
$ Independent Development
Founder Equity Profitability/Retained Earnings
External Debt External Equity (IPO)
$ Strategic Alliances
Collaborative Relationships with Other Firms to Certify
Legitimacy and Credibility. May be informal
arrangements, joint venture or licensing agreements
$ Merger/Acquisition
Sale of Partial/Complete Ownership (and Control) as
Consideration for Necessary Investment Capital
FinancingbyVentureCapitalFunds
$ Specialized Approach for Supplying Capital to New
Ventures with Sufficient Managerial Expertise,
Scale and Product/Market Innovation
$ Addresses Financing Dilemma presented by
Entrepreneurial Firms
No Verifiable Cash Flows or Tangible Assets
How to Exert Control Necessary to Obtain Desired
Investment Performance and Minimize Risk
VentureCapitalPartnership
$ Venture Capitalists are Specialized Financial
Investment Intermediaries
$ Organizational Form will be Limited Partnership
Limited Partner Investors: usually
Pension Funds
General Partners select Portfolio
Company Investments, Negotiate
Terms and Monitor
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14
Organizational Structure of
Venture Capital Investment
Portfolio
Companies
Value
creation
Generate deal flow
Screen opportunities
Harvest investments
Negotiate deals
Monitor and advise

General Partners
Venture Capital Fund
Pension plan
Endowments
Life insurance companies
Corporations
Individuals
Limited Partners
Effort and
1% of
capital
Annual
Management
Fee 2-3%
Carried
Interest 20-
30% of
Gain
99% of Investment
Capital
Capital Appreciation
70-80% of Gain
Investment
Capital and
Effort
Financial
Claims
HybridFinancingTechniquesbyVCFunds
Because New Venture has No Verifiable Cash
Flow or Tangible Assets for Collateral
$ Debt not Viable Option
$ Consideration for Investment is Transfer of
Negotiated Ownership Interest (Stock
Sale), which includes Measure of Control,
from Entrepreneur/Founder to Venture
Capitalist
HybridStructure:PreferredStock
convertibleintoCommonStock
Dividends accrue at Debt-like Rate; Payable
at Positive Cash Flow
When Milestones achieved, non-Voting
Preferred Stock converts into Voting
Common Stock
Venture Capitalist will have Board
Membership and Control over Major
Strategic Decisions
HybridFinancingusedbyVCFunds
Ultimate Source of Repayment for Investment will be
Initial Public Offering (IPO)
Managing General Partners paid
By Limited Partners/Investors for
Management Services and
Percentage of Capital Gain at IPO
Limited Partners/Investors earn Capital Gain
Investment Time Frame: 7 to 10 years
MythsaboutVentureCapitalFinancing
$ VCs want no less than 50% Ownership
Fact: VC Funds customarily hold 47% to 53% Voting
Interest
$ VCs have the Right to Fire the Founder/CEO
Fact: Customary Condition is Employment Contract
authorizing Majority of Directors to fire
Founder/CEO with or without cause.
Performance Issues vs. Company Needs:
Administrator or Inspirational Leader
MythsaboutVentureCapitalFinancing
$ VCs dominate the Private Equity Market
Fact: VCs account for less than 1% of the Private
Equity Market
$ VCs finance a Broad Range of Industry Types on a
Nationwide Basis
Fact: Most VC investments are in High-Technology or
Bio-science Industries in Californias Silicon
Valley or Boston area
MythsaboutVentureCapitalFinancing
$ VCs expect to Earn a 700% Rate of Return within Two to
Three Years
Fact: VCs aim to harvest their Investments within 7
to 10 Years (and try to earn no less than 700%)
$ Governments invest in VC Funds because they are a
Win-Win Situation: Eye-Popping Rates of Return and
High-Paying Jobs
Fact: Probable Returns will be around 25% with less than
half of Firms surviving more than 3 years
VENTURE CAPITAL
WhatisaVCFundsValueProposition?
Provide all Financing necessary for Firms Product
Life Cycle
Association with VC Fund brings Credibility and
Legitimacy to Entrepreneur
Access to Strategic Services and Tactical Advice
from Sole Provider with Expertise
VENTURE CAPITAL
SourcesofFinancingforNewVenture
pursuingIndependentDevelopment
Founders Private Equity and Short-term Debt
The Three Fs: Friends, Families and Fools
Angels: Investors who are Risk-Sharers
Bootstrapping: Suppliers and Customers with
Stake in Firms Success
Alliances with Resource Providers: Manufacturers,
Distributors or Retailers (Beware of Hold-up Power;
Evaluate Value of Current Marginal Resource Gain
versus Constrained Future Flexibility)
VENTURE CAPITAL
CharacteristicsofFirmDevelopmentwhen
VentureCapitalistFundingNotUsed
Reliance on Informal Networks for Credibility and
Necessary Services and Expertise
Slower Growth Rate/Longer Life-Cycle Stages
Multiple Sources of Funds that Provide Short-
Term Funding
Different Relationship between Control and
Risk/Uncertainty
VENTURE CAPITAL
FutureforFirmsneedingVentureCapital
Evolution of VC Fund Industry into (1) Mass Market
and (2) Niche Providers differentiated by Industry,
Geography or Development Stage
For Everyone Else Fundamentals Still and Will
Always be the Rule
Well-conceived Opportunities always get Financed
Obtaining External Financing Must Follow and Will
Be Determined by Strategic Development
Risk is always Financeable; Resolving Uncertainty
is Entrepreneurs Challenge