Understanding Venture Capital Where Does VC Fit

Understanding Venture Capital

Where Does VC Fit in the Financial Cosmos? Users of Capital Sources of Capital Money Managers • Pension Funds • Stock Funds Public markets • Bond Funds • Wealthy Families • 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 1 st 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 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 1 st 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 2 x 7. 2% 10. 4% 3 x 11. 6% 17. 0% 4 x 14. 9% 21. 9% 5 x 17. 5% 25. 8% 8 x 23. 1% 34. 6% 10 x 25. 9% 38. 9%

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

So, What Really Happens? Fund III Fund IV

So, What Really Happens? • Fund I – 9. 2 x overall – 2 @ 20 -40 x; 3 @ 10 x; . 529 avg. • Fund II – 3. 7 x overall – 2 @ 20 -40 x; 2 @ 10 -15 x; . 560 avg. • Fund III – 4. 1 x overall – 2 @ 40 -50 x; . 409 avg. • Fund IV – 12. 5 x overall – 1 @ 140 x; 3 @ 10 -20 x; . 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