Venture Capital

Terms:


Portfolio: 
At other points in the course, we have referred to investment portfolios. In the case of an individual investor, a “portfolio” refers to that group of stocks, bonds, and other assets that the person owns. In the case of a venture capital fund, a portfolio refers to that group of companies in which the fund has made investments.

Diversification: 
An element of the thinking that leads to an individual choosing to balance her portfolio. The idea behind diversification is that owning a little bit of a lot of different investment types is the best way to minimize risk across a portfolio. Thus, an individual might choose to buy into a variety of different investments – known as “diversifying” one’s portfolio – in order to balance the risks and returns of the various investments in the portfolio.

Founder: 
Founders are the individuals who first form and start an entrepreneurial firm. Typically, a founding group might include the inventor of the idea or product and possibly a business person who is brought in to begin the company’s operations. Over the company’s early life span, the founder group might also include the first few employees who are hired to start the company’s operations.

Introduction to Private Equity and Alternative Investments

As defined in the previous section, “private equity” is an asset class unto itself. Probably the two largest types of investments in the private equity class are “venture capital” investments and leveraged buyout funds (to be discussed in next section). In some contexts, the various investment forms in the private equity category are also referred to as “alternative investment” classes for the simple reason that they are relatively recent innovations to the financial landscape, and are not consistently included in a typical investor’s portfolio given certain restrictions on involvement in such funds. 

In general, these investment classes are defined by two key characteristics. The first of these characteristics is high risk. Investors who choose to place money in venture capital (“VC”) funds and “leveraged buyout” funds (LBO) are investing in situations that have a great deal of risk associated with that investment. In the case of venture capital funds, the risk is typically an operational risk; the risk is that the company will founder and fail to perform as management and investors hope. In the case of LBO funds, the risk is one that the company will simply fail outright.

The second characteristic of these methods of alternative investing is that of high return. The reason that investors are willing to take the high levels of risk associated with alternative investing is the fact that these types of investments have the potential to payoff at rates equating to high multiples of the amounts of money invested.

Ultimately, an educated investor with sufficient cash on hand (LBO and VC funds often require extremely large sums of cash to invest) will likely subscribe to a plan known as “portfolio investing”. The basis underlying the plan is that in an individual’s portfolio, there should be a wide mix of investments ranging from low-risk investments, such as municipal bonds and federal bonds, right up through extremely high risk investments such as those in the alternative investment class.

EXAMPLE: Roger has had a successful career throughout his life and invested his money in basic mutual funds and CD accounts with banks. After speaking to a financial advisor, he decides that the best course of action for him would be to diversify his portfolio such that he holds low risk investments, like slowly growing mutual funds, some mid-level investments with balanced risk / return potential – such as corporate stocks and bonds, and a small number of high risk investments in things such as VC and LBO funds.

Entrepreneurism in General

In the context of the venture capitalist investment system, there are two parties involved. On the one hand is the VC fund (discussed below) and on the other hand there is the new company, founded by inspired management who want to see that company succeed. Thus, in order to competently discuss VC investments, a word about the new businesses and the entrepreneurs who found them is in order.

Entrepreneurism is the act of creating new companies, often from new ideas or the modification of old ideas, to create products and services that expand the scope of what is offered in the marketplace. Entrepreneurs, the people who make these new companies happen, are characterized by a variety of traits. Typically, they are individuals with high levels of self-motivation and low levels of risk aversion. In other words, entrepreneurs are the type of people that inspire themselves and other people to work hard and to put their best efforts behind an idea. Moreover, they are people who are not afraid of the potential losses inherent in the founding and formation of a new firm. 

Entrepreneurial ventures are created every day, and every day, some of them fail. Those that survive operate on the hope that they will one day be large, valuable firms, or will be acquired by large firms – thus proving the validity of the entrepreneurs’ idea and enriching themselves at the same time. Those ventures that fail are more common, and can be classified as either simply being bad ideas, or good ideas that were poorly executed or managed. 

EXAMPLE: Peg and Susan have invented a new system of sending data across telephone wires faster and cheaper than it is currently being done. Their enthusiasm for the project is such that they decide to form a new company to help bring their idea to fruition. They raise funds to form the company and start development of a product from their personal finances, from investments from friends and family, and from any other individual investors they can sell on the promise of their idea. Ultimately, the company gets underway and is proceeding well towards rolling-out their first product. However, Peg and Susan are inventors, not business people, and they realize that in order to see their idea succeed, they will need two things. First, they will need people to help them manage the company and to teach them how to sell their product. Secondly, they will need a lot of cash in order to mass produce, advertise, and sell their new product. Given the situation, the two founders begin seeking professional help in the form of a venture capital investor.

Venture Capital Funds – Formation

Almost all venture capital funds are formed as limited partnerships. Typically, the general partner in the fund will represent that group of venture capital investors (sometimes referred to as “venture capitalists”) who will identify, select, invest in, and help manage the companies that the fund will provide with cash. The limited partners represent a group of investors who provide cash for the fund’s investments. Typically, investors in venture capital funds are wealthy individuals and institutions such as state pension funds, universities, large companies, and high net worth individuals.

The formation of the fund is fairly straightforward. A group of individuals, the venture capitalists, determine that they would like to raise a fund and begin searching for investors. This stage of the process, known as the “fund raising” stage, varies in its complexity and time for completion. In the case of management teams that have demonstrated themselves as successful investors by previous experience, it is often not that difficult (assuming a fairly strong economy) for those individuals to raise a fund. However, for new funds or funds with unproved management, the fund raising process can take years before sufficient capital is raised to support the fund. 

Typically, venture capital funds will focus their investments in a particular area – such as telecommunications or software products – in which the fund’s general partners have some experience and knowledge about the industry. Note that the SEC regulations for the forming of corporations and other funds also apply to venture capital funds. Thus, when forming such a fund, the founders must be aware of and must comply with the securities laws, mostly the SEC Acts. See Barthe v. Rizzo, 384 F. Supp. 1063 (S.D.N.Y. 1974).

EXAMPLE: Leon, Todd, and Kim, respectively with longstanding backgrounds in investment banking, software development, and corporate management, have decided to raise an investment fund. They produce information about the fund, which will focus on investments in high-tech software companies making software for the banking industry, and begin the process of fundraising. In the process, they make efforts to comply with the various federal disclosure schemes administered by the SEC for such funds, in addition to the tax code sections which deal with certain tax benefits available to a fund like their own which will invest in very early-stage (recently started) companies. After several months of work, the management team eventually manages to raise an initial fund of $6 million from a variety of sources including several very wealthy individuals, a local university, and the pension fund administered by the town where the fund will be located.

Venture Capital Funds – Operation

A venture capital fund operates in the same way as does any other limited liability partnership. The general partners, i.e., the fund managers, invest the fund’s capital in ways that they see fit. For their part, the limited partners simply sit on the sidelines and wait for distributions from the fund’s capital. 

While that sounds simple enough, the actual management of the fund’s capital and investment strategy varies a great deal from year-to-year and also varies based on market conditions. As mentioned above, a venture capital firm will generally identify a specific form of investment that they prefer to invest in. Additionally, a firm will also typically identify what size of investment, in terms of dollars, that the fund wants to make. Finally, a fund is also likely to identify a variety of other factors that will help it find the types of investments that it would prefer to make, including a specific area of the country or specific type of management team that it prefers to invest with.

When it comes to selecting and managing investments, the typical scenario is that venture capital fund invests in management, not necessarily in ideas. When contemplating an investment, a venture capital firm will conduct a thorough investigation and will scour the whole company – from its operations to its finances - but the one item above all that a venture capital fund is interested in is the firm’s management. 

The reason for this focus on management is the fact that it is a company’s management, not solely its idea, that will carry the company to success or lack thereof. Thus, when a venture capital fund is considering an investment, the managers of the venture capital firm will have a variety of meetings with the company’s managers in order to determine whether this management team has the strength, skills, and talent necessary to make the company succeed. 

Typically, once a venture capital fund has determined that it will make an investment in a firm, the fund and the company will begin a negotiation process with the goal of establishing terms that will apply to the investment that the firm is going to receive. Typically, an investment contract will be negotiated and signed between the parties. This contract has several features. First, a typical venture capital investment firm will be given preferred stock that will have special rights regarding distributions from the firm. Also, a venture capitalist investment will normally take the form of a series of small cash infusions that will ultimately make up the total value of the investment. Such cash infusions, typically referred to as “tranches” are normally tied to specific milestones that the company and its management are required to meet in order to receive additional funds. If the milestone requirements are met, then the venture fund will continue placing funds in the company until the full amount of the investment is placed in the firm.

In addition to being a source of funds, another key reason that a start-up corporation will seek the services of a venture capital firm is that a venture capital fund’s managers are usually seasoned business professionals. As such, the fund’s managers act as more than just passive investment managers. In most cases, the venture fund will designate one or two of its members to manage the investment, and in most cases, sit on the corporation’s   board. In such a position, the fund’s managers are in a prime place to help management reach the goals that the corporation has set for itself. In some instances, companies feel threatened by the prospect of outside investors (i.e., the members of the venture capital firm) being on their boards and worry that the fund is interested solely in its own interests, and not those of the company. While this may be the case in a limited number of situations, it is not the standard, as venture capital firms create business largely on the basis of their reputation in the business community and would injure that reputation immensely if they created situations in which they fought with, rather than for, the company in which they invest.

Over the course of a venture capital fund’s life, the fund will typically make between five and ten major investments, depending on the markets and the availability of fund managers to act as liaisons between the fund and the boards of the target companies. Most venture capital funds are structured such that the limited partners make their investment in the fund for a period of about seven years. Over the course of that time, the fund may make limited distributions to the investors, but will often try to retain as much of the money as possible. The lifecycle of a fund is such that after the fund is formally “closed” – meaning that the fund has reached its target capital amount, the remainder of the fund’s life will consist of managing and “harvesting” those investments. 

In most cases, a venture capital fund will not make money on every investment it makes. Rather, only about one in every five investments will garner a return, often through a sale of the company to an acquirer. If the venture capital fund's managers are lucky, one or two of the fund’s portfolio companies will actually reach the stage of an IPO or major sale that nets the fund a big return. The reason venture capital funds are viewed as exceptionally risky is the corresponding fact that most firms in the fund’s portfolio usually consist of firms that can do no better than break even and those that fail outright.

In most circumstances, once a fund has reached the stage in its lifecycle where it has invested all of its capital and is now managing its investments and seeking exits from the companies in its portfolio, the fund’s general partners will begin to raise a new fund. In a case where the fund has performed well and investors are satisfied with the returns provided, then the general partners are likely to have an easy time raising new capital for a new fund, either from existing investors or from new investors who want a part of the action. However, in a case where the general partners have not performed well or where the economy has sagged in the interim, a second fund may be very difficult to raise.

EXAMPLE: After raising their fund, Leon, Todd and Kim begin searching for deals to invest in. They source deals from a variety of places, among them are deals that are brought to them by actual entrepreneurs, but more typically, the team co-invests in deals that are organized by other venture capital firms who wish to spread the risk of the deal by syndicating the investment. After three years of investing, the fund is fully invested in a total of seven investments. Three of the investments have received the full amount of the capital that the team promised, but several of the companies have either not yet met milestones or are in danger of failing. For the next three years, the team works hard to make sure that their investments pay off as well as possible. The trio goes to board meetings of portfolio firms, speaks often with management and customers, and generally works hard to make their investments garner strong returns. By the close of the fund’s life, seven years from its formation, the portfolio has performed well. One company went public through an IPO and two were sold at five times the value that the fund invested. Two of the fund’s investments are still alive but are only operating on a break-even basis, and the final two firms went bankrupt. Ultimately, the trio, after taking out its fees and “carried interest” (the percent of the fund that the general partner takes as his commission for operating the fund) the group is able to return to its investors a combined return of seven times the value that each investor initially provided. Given these strong results, the team should have no problem raising a second fund, with all of the same investors and/or several new investors.

“Angel Investors” 

Finally, a bit of information should be noted about a group of individuals known as “angel” investors. Often, there is a period of time in a company’s life between the time that the firm is formed – usually on cash provided by the company’s founders and friends – and when a “professional investor” such as a venture capitalist is willing to invest. During this formative stage in the company’s development, the company is often low on cash as it attempts to raise money sufficient to increase its research, production, and sales efforts. In these times, there is often a source of relief in high-net worth individuals, who, as part of their portfolio, are willing to make personal investments in such companies when they believe that the companies have high chances of success. 

Angel investors are typically individuals who have succeeded in their own personal careers and are now attempting to diversify their portfolio in a manner that adds a degree of high-risk/high-return potential to their   investments. In such a situation, the individual may chose to make a small investment in a start-up firm and will invest as an “angel investor” in the hopes that the firm goes on to some degree of success.