style="font-size:15px;"> Guide on Private Equity and Venture Capital for Entrepreneurs (2007) An EVCA Special Paper. European Venture Capital Association.
InvestEurope (2016) European Private Equity Activity—Statistics on Fundraising, Investments and Divestments, May, http://www.investeurope.eu/media/476271/2015-european-private-equity-activity.pdf.
Private Equity Principles, Institutional Limited Partners Association (ILPA).
Topping, M. (2014) Evergreen Alternatives to the 2/20 Term-Limited Fund, White & Case LLP, Emerging Markets Private Equity Association.
Vild, J. and Zeisberger, C. (2014) Strategic Buyers vs Private Equity Buyers in an Investment Process, INSEAD Working Paper No. 2014/39/DSC/EFE (SSRN), May 21.
2
VENTURE CAPITAL
From iconic brands, such as Google, Facebook, Uber and Alibaba to blockbuster biotech or renewable energy companies, venture capital (VC) has funded and nurtured some of the most influential companies in today’s global economy. Along with these runaway successes, however, VC has also been center-stage for some of the more spectacular flameouts in modern finance, from the bursting of the tech-bubble at the turn of the millennium to the storybook valuations of numerous billion-dollar “unicorns”25 a decade and a half later. This “hit-or-miss,” “all-or-nothing” character of venture investing drives both the mystique of the industry and on-the-ground decision-making bias of VC investors.This chapter explores the dynamics of the VC industry, starting with the defining characteristics of VC investing and the unique elements differentiating it from growth equity and buyouts.26 We then turn to the other side of the table and briefly touch on fundraising for early-stage firms and start-ups; first-time entrepreneurs preparing to raise funds will find this chapter useful to understand the dynamics inside a VC firm before entering into discussions with one of its partners.
VENTURE CAPITAL DEFINED
VC funds are minority investors betting on the future growth of early-stage companies – defined as pre-profit, often pre-revenue and at times even pre-product start-ups. Despite the lack of a controlling stake, VCs are among the most active investors in the PE industry and use their capital, experience, knowledge and personal networks to nurture and grow young companies. VCs may invest in specific verticals, technologies, and geographies, and often specialize in a distinct substage of investment, referred to as early-stage, mid-stage or late-stage VC funding. While every VC firm is unique, a few defining attributes apply to most, as detailed in Exhibit 2.1.
Exhibit 2.1 Defining Characteristics of Venture Capital
START-UP COMPANIES: VC funds invest in start-ups and guide them through their early years of development, as they seek to establish defensible market positions in rapidly expanding industries by disrupting existing products and services through innovation. A start-up can range from an early-stage company with a limited operating history – i.e., an entrepreneur, an idea, and a PowerPoint presentation – to a late-stage company with a fast-growing business. As a result, the capital requirements of start-ups vary widely, from a few thousand dollars to facilitate the development of an early prototype to significant injections in the tens or sometimes hundreds of millions of dollars to drive revenue growth at companies with billion dollar valuations.
Start-ups all face one common challenge: reaching the next stage of development and raising fresh capital before running out of cash. A negative monthly cash flow and high burn rates are the order of the day at a start-up, and regular injections of capital are needed to maintain and expand operations. This requires a management team that can carefully balance aggressive growth targets with the reality of a company at the pre-revenue stage. As such, venture capitalists carefully assess the founding team as much as the business concept of a start-up and prefer backing experienced entrepreneurs. A VC firm’s knowledge in a given vertical and its ability to add value through mentorship and active engagement can be critical elements of success for the start-up; for entrepreneurs, this expertise is a differentiating factor when choosing from a group of potential investors.
HIGH RETURNS AND HIGH RISKS: Research shows that on average two-thirds of the investments made by a VC fund lose money and one-third of VC-backed companies eventually fail. For VC funds to achieve their fund-level target return,27 low-performing and failed investments must be offset by at least one or two highly successful – and highly visible – investee companies that generate a return of 10 times (10×), 100 times (100×) or more on the VC’s invested capital. These “home runs” often return 100 % or more of a single fund’s committed capital and determine the success of an entire fund. This tail-heavy, feast-or-famine return profile underscores both the riskiness of VC investing and the significant risk appetite required from limited partners (LPs) to include VC funds in their private equity (PE) programs.28
The high risk of VC investments has a distinct impact on venture capitalists’ investment decisions and their portfolio management style. Reflecting on the risk of failure, VCs require high deal-level target returns when exploring the next investment: a 40−80 % target internal rate of return is not unusual and feeds directly into the valuation and equity stake underpinning the investment.29 VC funds typically invest in more companies per fund than growth or buyout funds to increase the chances of a “home run” and to diversify their risk. The larger number of portfolio companies and the high rate of failure require VCs to make tough decisions and (potentially) write off underperforming investments quickly to focus their time and resources on the most promising companies. Entrepreneurs are well advised to be aware of these dynamics before presenting their business plans to a VC fund.
The risk−return dynamics of VC investing are a concern for its investors. While limited partners remain intrigued by the industry’s well-publicized winners and its fabled returns, a landmark report by the Kauffman Foundation published in 201230 raised doubts on the return contributions from venture to an institutional portfolio, implying that the risks may outweigh the strategy’s return and that LPs make decisions based on “seductive narratives like vintage year and quartile performance.” It suggested that the LP investment process may be broken, and that LPs have themselves “created the conditions for the chronic misallocation of capital.”
FUNDING IN STAGES: VC funding is raised via discrete rounds of investments. Each round will fund a start-up’s operations for a specific period of time and enable the company to reach a predefined operating milestone.
Deploying funding in stages allows a VC fund to assess the progress of the company against milestones and allocate follow-on capital to the best performing companies in its portfolio. By spreading its capital out, the fund can invest in more companies thereby “buying an option” in more potential blockbusters. It also enables individual VC firms to specialize in a specific phase of company development, from early stage to late stage, and offer stage-appropriate expertise.
Successful VC-backed companies are typically funded through progressively larger rounds of preferred equity.31 Each subsequent VC investor will look for positive momentum (as proof of the company’s value proposition) and for signs of successful execution. The preferred shareholding structure establishes
Please refer to Chapter 3 Growth Equity and Chapter 4 Buyouts for in-depth discussions.
Chapter 18 LP Portfolio Management discusses the decision-making process when allocating to PE in detail.
Please refer to Chapter 7 Target Valuation for a worked-out example on VC valuation.
Kauffman Foundation; ‘We have met the enemy – and he is us’; (2012).
Please refer to Chapter 9 Deal Structuring and to the Glossary in the back of the book for more details on the different share classes used in VC.
