Understanding Venture Capital

1. Understanding Venture Capital

2. Public markets Where Does VC Fit in the Financial Cosmos? Users of Capital Money Managers Sources of Capital • Stock Funds • Bond Funds • Hedge Funds • Private Equity • VC • LBO • Other • Pension Funds • Wealthy Families • University Endowments • Foundations • Others • Entrepreneurs trying to start a business Fund of Funds • Entrepreneurs trying to buy a business

3. Within VC Asset Class Seed / Incubation • Or by … • Industry • Technology Early Stage Multi-Stage Late Stage / Mezzanine

4. What Is The Point? • Raise money • Invest it • Give back lots more than we took in • Repeat

5. Why Do It? • Oh, yeah, we keep some for ourselves • Management fees – 2-2.5% per year • Profits interest: 20-30%

6. Really, Why Do It? • Spend all your time on the cutting edge • Meet very interesting people • Change the world • New challenge every day • Can be very lucrative

7. Exactly What Do We Do? • Raise money • Make investments • Monitor investments • Exit investments

8. Examples • COMPAQ • CIENA • Citrix Systems

10. What Does VC Mean to an Institutional Investor? • Illiquid • Takedown over time • Very long gestation • Series of pools, or “funds” • Part of small allocation (5-10%) to “alternative assets”

11. Institutional Investor Perspective • VC firm is just a money manager with multiple funds • Difference: • Stock fund money manager – different funds by strategy • VC fund money manager – different funds by vintage

12. Example: Sevin Rosen Funds • Early stage technology - constant • Multiple funds • Fund I (1981) - $25 million • Funds II (1983) through VII (1999) • Fund VIII (2000) - $600 million

13. What is a Fund? • Legally: a limited partnership • Characteristics: • Committed capital • Term • Takedown schedule • Investment restrictions • Lots more

14. Objective • Make n investments over 1sty years of the fund • Exit those investments in the 10-12 year term at a profit

15. What is y? • Usually target 2-1/2 to 4 years • Less – too much time raising funds • More – LPs want chance to re-up more often than that • Sometimes miss the target

16. What is n? • Balance: diversification vs. focus and impact • Inverse of targeted $ per deal (d) • d is over the life of the deal • Typically 1st investment is 30-40% of expected d

17. How to Set Fund Size • Function of: • $ per deal (d) – physics of companies • # of GP equivalents • Companies / GP • Steady state board capacity • Turnover rate

18. Objective Revisited – Make Money for LPs and GP • Measure success over 10-12 years • Metrics: IRR or cash-on-cash over the life of the fund • Looking to juice “returns” over public equity (15-20+% vs. 12-15%) • Spoiled in the boom with 100%+ IRRs

19. Objective Revisited – Make Money for LPs and GP • Given 10 year life, we need to make a multiple of the fund:

20. And That’s Not All • Layer on top of that: • Historical batting average - .500, plus or minus • So 5x the fund means 10x on the deals that work • On average

21. So, What Really Happens? Fund I Fund II Fund IV Fund III

22. So, What Really Happens? • Fund I – 9.2x overall • 2 @ 20-40x; 3 @ 10x; .529 avg. • Fund II – 3.7x overall • 2 @ 20-40x; 2 @ 10-15x; .560 avg. • Fund III – 4.1x overall • 2 @ 40-50x; .409 avg. • Fund IV – 12.5x overall • 1 @ 140x; 3 @ 10-20x; .526 avg.

23. Practical Impact • Capital invested matters • Valuation matters • VCs are sluggers, not looking for infield singles and walks • Focus on potential winners • Cents on dollar in bad deals not worth much

24. How Do We Manage Such a Process? • Deal making – very hard because: • Usually invest before market is clear • Feedback loop very long (and expensive) • Success (and failure) has large luck component • Success in other venues no guarantee • Like sailing blindfolded

25. Who Are Deal Makers? • Each firm has deal makers of varying experience • General partner, managing director, etc. • Partner, principal, etc. • Associate, more or less senior • Analysts

26. Key Role - General Partner • Make investment decisions • Initial investment is most important • Help each company be as successful as it can be • Sometimes less is more • Help others apprentice

27. Herding Cats • Very different models • Cowboy confederation model • Consensus models • Joe Blow Ventures – either you’re Joe or you’re not • Lots of blends of these • Explains a lot of behavior

28. How We Make Decisions • Slowly (these days) • Due diligence hell • Some never tell you no • The role of partners meetings • Type of investment matters • New investments • Follow-on investments

29. How we get paid • Depends on the model • Management fee • % of committed capital • Imagine 10 year revenue visibility • Profits interest (carry) • Helps if there are profits

30. What Breaks Down? • Management fee • Role of multiple funds • Carry • Fund by fund • Sharing philosophy

31. Wait – What Happens When Fund is Fully Invested • You raise another fund • You don’t

32. Multi-fund Firms • Series of partnerships every 2-4 years • Generally don’t overlap portfolios • Crossover investing is big issue • Know what fund you are in, and the rules • Amplifies the management fee issue

33. What Can Go Wrong – New Investments? • Unseen scar tissue • Bad chemistry • Bad hair day • Misjudge the DMU • Ego crowding

34. What Can Go Wrong – Existing Portfolio Companies? • The living dead syndrome • Chronic fatigue syndrome, VC style • No money left problem • Partner on the roof problem • With some firms, “it’s in their nature” • GP overload – drive-by board meetings

35. What Can Go Right? • Well established firm • Capital access – direct and referrals • GP – operating and domain experience • Other resources • Know your partner