Understanding Venture Capital

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Understanding Venture Capital
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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

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Within VC Asset Class
Seed / Incubation

• Or by
• Industry
• Technology

Early Stage
Multi-Stage
Late Stage / Mezzanine
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What Is The Point?

• Raise money
• Invest it
• Give back lots more than we took in
• Repeat

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Why Do It?

• Oh, yeah, we keep some for ourselves
• Management fees 2-2.5 per year
• Profits interest 20-30

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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

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Exactly What Do We Do?

• Raise money
• Make investments
• Monitor investments
• Exit investments

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Examples

• COMPAQ
• CIENA
• Citrix Systems

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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

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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

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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

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What is a Fund?

• Legally a limited partnership
• Characteristics
• Committed capital
• Term
• Takedown schedule
• Investment restrictions
• Lots more

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Objective

• Make n investments over 1st y years of the fund
• Exit those investments in the 10-12 year term at
  a profit

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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

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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

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How to Set Fund Size

• Function of
• per deal (d) physics of companies
• of GP equivalents
• Companies / GP
• Steady state board capacity
• Turnover rate

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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

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Objective Revisited Make Money for LPs and GP

• Given 10 year life, we need to make a multiple of
  the fund

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And Thats 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

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

• Fund I 9.2x overall
• 2 _at_ 20-40x 3 _at_ 10x .529 avg.
• Fund II 3.7x overall
• 2 _at_ 20-40x 2 _at_ 10-15x .560 avg.
• Fund III 4.1x overall
• 2 _at_ 40-50x .409 avg.
• Fund IV 12.5x overall
• 1 _at_ 140x 3 _at_ 10-20x .526 avg.

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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

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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

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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

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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

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Herding Cats

• Very different models
• Cowboy confederation model
• Consensus models
• Joe Blow Ventures either youre Joe or youre
  not
• Lots of blends of these
• Explains a lot of behavior

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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

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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

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What Breaks Down?

• Management fee
• Role of multiple funds
• Carry
• Fund by fund
• Sharing philosophy

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Wait What Happens When Fund is Fully Invested

• You raise another fund
• You dont

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Multi-fund Firms

• Series of partnerships every 2-4 years
• Generally dont overlap portfolios
• Crossover investing is big issue
• Know what fund you are in, and the rules
• Amplifies the management fee issue

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What Can Go Wrong New Investments?

• Unseen scar tissue
• Bad chemistry
• Bad hair day
• Misjudge the DMU
• Ego crowding

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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, its in their nature
• GP overload drive-by board meetings

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What Can Go Right?

• Well established firm
• Capital access direct and referrals
• GP operating and domain experience
• Other resources
• Know your partner