Understanding Venture Capital
Where Does VC Fit in the
Financial Cosmos?
Users of Capital
Sources of Capital
Money Managers
• Pension Funds
•Stock Funds
• Wealthy Families
•Bond Funds
Public markets
•Hedge Funds
• University
Endowments
• Foundations
• Others
•Private Equity
Fund
of
Funds
•VC
•Entrepreneurs trying
to start a business
•LBO
•Other
•Entrepreneurs trying
to buy a business
Within VC Asset Class
Seed / Incubation
Or by …
Early Stage
Late Stage /
Mezzanine
Multi-Stage
• Industry
• Technology
What Is The Point?
•
•
•
•
Raise money
Invest it
Give back lots more than we took in
Repeat
Why Do It?
• Oh, yeah, we keep some for ourselves
• Management fees – 2-2.5% per year
• Profits interest: 20-30%
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
Exactly What Do We Do?
•
•
•
•
Raise money
Make investments
Monitor investments
Exit investments
Examples
• COMPAQ
• CIENA
• Citrix Systems
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”
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
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
What is a Fund?
• Legally: a limited partnership
• Characteristics:
– Committed capital
– Term
– Takedown schedule
– Investment restrictions
– Lots more
Objective
• Make n investments over 1st y years of
the fund
• Exit those investments in the 10-12 year
term at a profit
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
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
How to Set Fund Size
• Function of:
– $ per deal (d) – physics of companies
– # of GP equivalents
– Companies / GP
• Steady state board capacity
• Turnover rate
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
Objective Revisited – Make
Money for LPs and GP
• Given 10 year life, we need to make a
multiple of the fund:
10 year IRR
7 year IRR
2x
7.2%
10.4%
3x
11.6%
17.0%
4x
14.9%
21.9%
5x
17.5%
25.8%
8x
23.1%
34.6%
10x
25.9%
38.9%
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
So, What Really Happens?
Fund I
Fund II
FUND I
FUND II
36.2x
42.6x
60.0
Fund II =
$60.6MM
60.0
50.0
50.0
20.9x
40.0
Capital Invested (in $mm)
Capital Returned (in $mm)
30.0
40.0
Capital Invested (in $mm)
Capital Returned (in $mm)
14.7x
19.4x
30.0
9.1x
9.6x
11.0x
20.0
4.1x
20.0
Fund I =
$19.6MM
Total returned
$223.0MM
3.7x CC
10.4x
6.3x
10.0
7.9x
9.0x
Total returned
$180.6MM
9.2x CC
3.2x
10.0
3.0x
5.6x
2.1x
3.1x
3.8x
4.0x
3.9x
0.8x
1.8x
1.2x
0.8x
0.0
0.0
0.3x
--
Total invested
$18.3MM
93.4% of CC
-10.0
--
--
--
--
--
--
--
Total invested
$53.68MM
88.6% of CC
-10.0
Fund IV
Fund III
FUND III
590.00
FUND IV
138.5x
80.00
150.00
140.00
13.1x
70.00
39.3x
130.00
Fund IV = $65MM
120.00
60.00
110.00
11.3x
100.00
50.00
Capital Invested (in $mm)
Capital Returned (in $mm)
90.00
80.00
50.8x
40.00
Capital Invested (in $mm)
19.6x
Capital Returned (in $mm)
70.00
Fund III =
$65MM
60.00
30.00
8.4x
50.00
Total returned
$266.3MM
4.1x CC
40.00
30.00
20.00
10.00
(10.00)
3.2x
10.00
4.2x
3.4x
Total returned
$826MM
12.5x CC
3.2x
1.3x
0.2x
3.5x
2.1x
3.5x
0.4x
1.9x
0.6x
1.9x
1.0x
-
20.00
0.1x
2.5x
--
--
--
--
--
--
--
--
--
--
Total invested
$69.4MM
106.8% of CC
(10.00)
1.0x
Total invested
$66.3MM
102% of CC
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.
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
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
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
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
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
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
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
What Breaks Down?
• Management fee
– Role of multiple funds
• Carry
– Fund by fund
– Sharing philosophy
Wait – What Happens When
Fund is Fully Invested
• You raise another fund
• You don’t
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
What Can Go Wrong – New
Investments?
• Unseen scar tissue
• Bad chemistry
• Bad hair day
• Misjudge the DMU
• Ego crowding
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
What Can Go Right?
• Well established firm
• Capital access – direct and referrals
• GP – operating and domain experience
• Other resources
• Know your partner