How venture capital works

1. How venture capital works Zider, R. 1998. How venture capital works, Harvard Business Review, November-December, 131-139

2. VC system works for • Entrepreneurs • Institutional investors • Investment bankers • Venture capitalists

3. Zider, 1998

4. Filling the void • Venture capital plays an important role in the stage of the company’s innovation life cycle when it begins to commercialize its innovation • > 80% of VC $ goes into building infrastructure needed to grow the business – in expense investments (mfrg capacity, marketing, sales) and the balance sheet (working capital and fixed assets) Zider, 1998

5. Timing is everything • > 80% $ invested by VCs goes into adolescent phage of a company’s life cycle • During this phase the financials of eventual winners and losers look highly similar Zider, 1998

6. Zider, 1998

7. Several moving parts in execution: Assume 80% probability of success each Failure on any single step is NOT an option Zider, 1998

8. Logic of the deal • Term sheets offer downside and upside protections • Downside • Preferred stock gives VCs liquidation preference • Ratchets protect VCs from dilution if more $ needs to be raised at lower valuation – they keep their same % ownership position • Upside – can put additional $ into firm at predetermined prices – they can increase the stakes in successful firms below market prices

9. Typical portfolio payout per $1,000 invested Zider, 1998

10. Zider, 1998

11. Profile of the ideal entrepreneur • Is qualified in a “hot” area of interest • Delivers sales or technical advances such as FDA approval with reasonable probability • Tells a compelling story and is presentable to outside investors • Recognizes the need for speed to an IPO for liquidity • Has a good reputation and can provide references that show competence and skill • Understands the need for a team with a variety of skills and therefore sees why equity has to be allocated to other people Zider, 1998

12. Profile of the ideal entrepreneur • Works diligently toward a goal but maintains flexibility • Gets along with the investor group • Understands the cost of capital and typical deal structures and is not offended by them • Is sought after by many VCs • Has realistic expectations about process and outcome Zider, 1998

13. Value of an individual to a VC • Is a function of these conditions: • # of people within the high-growth industry who are qualified for the position • The position itself (CEO, CFO, CTO, technician) • Match of person’s skills, reputation, and incentives to the VC firm • Willingness to take risks • Ability to sell oneself • Entrepreneurs who satisfy these conditions have strong negotiating position with VCs Zider, 1998

14. Entrepreneurs sought by multiple VCs should ask: • Who will serve on board and what is that person’s position in the firm? • How many other boards does the VC serve on? • Has the VC ever written and funded his or her own business plan successfully? • What, if any, is the VC’s direct operating or technical experience in this industry? • What is the firm’s reputation with entrepreneurs who have been fired or involved in unsuccessful ventures? Zider, 1998

15. VC system works for • Entrepreneurs • Institutional investors • Investment bankers • Venture capitalists • The public?