Invention and innovation drive the world economy. What’s more, they have a powerful grip on the nation’s collective imagination. The popular press is filled with against-all-odds success stories of entrepreneurs. In these sagas, the entrepreneur is the modern-day cowboy, roaming new industrial frontiers much the same way that earlier minds explored. At his side stands the venture capitalist, a trail-wise sidekick ready to help through all the tight spots—in exchange, of course, for a piece of the action.
As with most myths, there’s some truth to some stories.
The venture-capital industry is envied throughout the world as an engine of economic growth. Although the collective imagination romanticizes the industry, separating the popular myths from the current realities is crucial to understanding how this important piece of the economy operates. For entrepreneurs (and would-be entrepreneurs), such an analysis may prove especially beneficial.
EVC Fills a Void
Contrary to popular perception, venture capital plays only a minor role in funding basic innovation.
Where venture money plays an important role is in the next stage of the innovation life cycle—the period in a company’s life when it begins to commercialize its innovation. It is estimated that more than 80% of the money invested by venture capitalists goes into building the infrastructure required to grow the business—in expense investments (manufacturing, marketing, and sales) and the balance sheet (providing fixed assets and working capital).
Venture money is not long-term money. The idea is to invest in a company’s balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that the institutional public-equity markets can step in and provide liquidity. In essence, the venture capitalist buys a stake in an entrepreneur’s idea, nurtures it for a short period of time, and then exits with the help of an investment banker.
Venture capital’s niche exists because of the structure and rules of capital markets. Someone with an idea or a new technology often has no other institution to turn to. Usury laws limit the interest banks can charge on loans—and the risks inherent in start-ups usually justify higher rates than allowed by law. Thus bankers will only finance a new business to the extent that there are hard assets against which to secure the debt. And in today’s information-based economy, many start-ups have few hard assets.
Furthermore, investment banks and public equity are both constrained by regulations and operating practices meant to protect the public investor. Historically, a company could not access the public market without sales of about $15 million, assets of $10 million, and reasonable profit history. To put this in perspective, less than 2% of the more than 5 million corporations in the United States have more than $10 million in revenues. Although the IPO threshold has been lowered recently through the issuance of development-stage company stocks, in general, the financing window for companies with less than $10 million in revenue remains closed to the entrepreneur.
Venture capital fills the void between sources of funds for innovation (chiefly corporations, government bodies, and the entrepreneur’s friends and family) and traditional, lower-cost sources of capital available to ongoing concerns. Filling that void successfully requires the venture capital industry to provide a sufficient return on capital to attract private equity funds, attractive returns for its own participants, and sufficient upside potential to entrepreneurs to attract high-quality ideas that will generate high returns. Put simply, the challenge is to earn a consistently superior return on investments in inherently risky business ventures.
Sufficient Returns at Acceptable Risk
Investors in venture capital funds are typically very large institutions such as pension funds, financial firms, insurance companies, and university endowments—all of which put a small percentage of their total funds into high-risk investments. They expect a return of between 25% and 35% per year over the lifetime of the investment. Because these investments represent such a tiny part of the institutional investors’ portfolios, venture capitalists have a lot of latitudes. What leads these institutions to invest in a fund is not the specific investments but the firm’s overall track record, the fund’s “story,” and their confidence in the partners themselves.
How do venture capitalists meet their investors’ expectations at acceptable risk levels? The answer lies in their investment profile and in how they structure each deal.
The Investment Profile
One myth is that venture capitalist invest in good people and good ideas. The reality is that they invest in good industries—that is, industries that are more competitively forgiving than the market as a whole. In 1980, for example, nearly 20% of venture capital investments went to the energy industry. More recently, the flow of capital has shifted rapidly from genetic engineering, specialty retailing, and computer hardware to CD-ROMs, multimedia, telecommunications, and software companies. Now, more than 25% of disbursements are devoted to the Internet “space.” The apparent randomness of these shifts among technologies and industry segments is misleading; the targeted segment in each case was growing fast, and its capacity promised to be constrained in the next five years. To put this in context, we estimate that less than 10% of all economic activity occurs in segments projected to grow more than 15% a year over the next five years.
The myth is that venture capitalist invest in good people and good ideas. The reality is that they invest in good industries.
In effect, venture capitalists focus on the middle part of the classic industry S-curve. They avoid both the early stages when technologies are uncertain and market needs are unknown and the later stages when competitive shakeouts and consolidations are inevitable and growth rates slow dramatically. Consider the disk drive industry.
Growing within high-growth segments is a lot easier than doing so in low-, no-, or negative-growth ones, as every businessperson knows. In other words, regardless of the talent or charisma of individual entrepreneurs, they rarely receive backing from a VC if their businesses are in low-growth market segments. What these investment flows reflect, then, is a consistent pattern of capital allocation into industries where most companies are likely to look good in the near term.
During this adolescent period of high and accelerating growth, it can be extremely hard to distinguish the eventual winners from the losers because their financial performance and growth rates look strikingly similar. At this stage, all companies are struggling to deliver products to a product-starved market. Thus the critical challenge for the venture capitalist is to identify competent management that can execute—that is, supply the growing demand.
More than 80% of the money invested by venture capitalists goes into the adolescent phase of a company’s life cycle. In this period of accelerated growth, the financials of both the eventual winners and losers look strikingly similar.
Picking the wrong industry or betting on a technology risk in an unproven market segment is something VCs avoid. Exceptions to this rule tend to involve “concept” stocks, those that hold great promise but that takes an extremely long time to succeed. Genetic engineering companies illustrate this point. In that industry, the venture capitalist’s challenge is to identify entrepreneurs who can advance a key technology to a certain stage—FDA approval, for example—at which point the company can be taken public or sold to a major corporation.
By investing in areas with high growth rates, VCs primarily consign their risks to the ability of the company’s management to execute. VC investments in high-growth segments are likely to have exit opportunities because investment bankers are continually looking for new high-growth issues to bring to the market. The issues will be easier to sell and likely to support high relative valuations—and therefore high commissions for the investment bankers. Given the risk of these types of deals, investment bankers’ commissions are typically 6% to 8% of the money raised through an IPO. Thus an effort of only several months on the part of a few professionals and brokers can result in millions of dollars in commissions.
As long as venture capitalists are able to exit the company and industry before it tops out, they can reap extraordinary returns at relatively low risk. Astute venture capitalists operate in a secure niche where traditional, low-cost financing is unavailable. High rewards can be paid to successful management teams, and institutional investors will be available to provide liquidity in a relatively short period of time.
The Logic of the Deal
There are many variants of the basic deal structure, but whatever the specifics, the logic of the deal is always the same: to give investors in the venture capital fund both ample downside protection and a favorable position for additional investment if the company proves to be a winner.
In a typical start-up deal, for example, the venture capital fund will invest $3 million in exchange for a 40% preferred-equity ownership position, although recent valuations have been much higher. The preferred provisions offer downside protection. For instance, the venture capitalists receive a liquidation preference. A liquidation feature simulates debt by giving 100% preference over common shares held by management until the VC’s $3 million is returned. In other words, should the venture fail, they are given the first claim to all the company’s assets and technology. In addition, the deal often includes blocking rights or disproportional voting rights over key decisions, including the sale of the company or the timing of an IPO.
The contract is also likely to contain downside protection in the form of anti-dilution clauses, or ratchets. Such clauses protect against equity dilution if subsequent rounds of financing at lower values take place. Should the company stumble and have to raise more money at a lower valuation, the venture firm will be given enough shares to maintain its original equity position—that is, the total percentage of equity owned. That preferential treatment typically comes at the expense of the common shareholders, or management, as well as investors who are not affiliated with the VC firm and who do not continue to invest on a basis.
Alternatively, if a company is doing well, investors enjoy upside provisions, sometimes giving them the right to put additional money into the venture at a predetermined price. That means venture investors can increase their stakes in successful ventures at below-market prices.
The venture capital industry has four main players: entrepreneurs who need funding; investors who want high returns; investment bankers who need companies to sell; and venture capitalists who make money for themselves by making a market for the other three.
VC firms also protect themselves from risk by co-investing with other firms. Typically, there will be a “lead” investor and several “followers.” It is the exception, not the rule, for one VC to finance an individual company entirely. Rather, venture firms prefer to have two or three groups involved in most stages of financing. Such relationships provide further portfolio diversification—that is, the ability to invest in more deals per dollar of invested capital. They also decrease the workload of the VC partners by getting others involved in assessing the risks during the due diligence period and in managing the deal. And the presence of several VC firms adds credibility. In fact, some observers have suggested that the truly smart fund will always be a follower of the top-tier firms.
In return for financing one to two years of a company’s start-up, venture capitalists expect a ten times return of capital over five years. Combined with the preferred position, this is very high-cost capital: a loan with a 58% annual compound interest rate that cannot be prepaid. But that rate is necessary to deliver average fund returns above 20%. Funds are structured to guarantee partners a comfortable income while they work to generate those returns. The venture capital partners agree to return all of the investors’ capital before sharing in the upside. However, the fund typically pays for the investors’ annual operating budget—2% to 3% of the pool’s total capital—which they take as a management fee regardless of the fund’s results. If there is a $10 Billion pool and four or five partners, for example, the partners are essentially assured salaries of $2M to $4M plus operating expenses for seven to ten years. (If the fund fails, of course, the group will be unable to raise funds in the future).
The real upside lies in the appreciation of the portfolio. The investors get 70% to 80% of the gains; the venture capitalists get the remaining 20% to 30%. The amount of money any partner receives beyond salary is a function of the total growth of the portfolio’s value and the amount of money managed per partner.
Thus for a typical portfolio—say, $20 million managed per partner and 30% total appreciation on the fund—the average annual compensation per partner will be about $2.4 million per year, nearly all of which comes from fund appreciation. And that compensation is multiplied for partners who manage several funds. From an investor’s perspective, this compensation is acceptable because the venture capitalists have provided a very attractive return on investment and their incentives are entirely aligned with making the investment a success.
What part does the venture capitalist play in maximizing the growth of the portfolio’s value? In an ideal world, all of the firm’s investments would be winners. But the world isn’t ideal; even with the best management, the odds of failure for any individual company are high.
The Upside for Entrepreneurs
Even though the structure of venture capital deals seems to put entrepreneurs at a steep disadvantage, they continue to submit far more plans than actually get funded, typically by a ratio of more than ten to one. Why do seemingly bright and capable people seek such high-cost capital?
Venture-funded companies attract talented people by appealing to a “lottery” mentality. Despite the high risk of failure in new ventures, engineers and businesspeople leave their jobs because they are unable or unwilling to perceive how risky a start-up can be. Their situation may be compared to that of hopeful high school basketball players, devoting hours to their sport despite the overwhelming odds against turning professional and earning million-dollar incomes. But perhaps the entrepreneur’s behavior is not so irrational.
Consider the options. Entrepreneurs—and their friends and families—usually lack the funds to finance the opportunity. Many entrepreneurs also recognize the risks in starting their own businesses, so they shy away from using their own money. Some also recognize that they do not possess all the talent and skills required to grow and run a successful business.
Most of the entrepreneurs and management teams that start new companies come from corporations or, more recently, universities. This is logical because nearly all basic research money, and therefore invention, comes from corporate or government funding. But those institutions are better at helping people find new ideas than at turning them into new businesses (see the exhibit “Who Else Funds Innovation?”). Entrepreneurs recognize that their upside in companies or universities is limited by the institution’s pay structure. The VC has no such caps.
Downsizing and reengineering have shattered the historical security of corporate employment. The corporation has shown employees its version of loyalty. Good employees today recognize the inherent insecurity of their positions and, in return, have little loyalty themselves.
Additionally, the World is unique in its willingness to embrace risk-taking and entrepreneurship. Unlike many cultures, the culture of the world attaches little, if any, stigma to trying and failing in a new enterprise. Leaving and returning to a corporation is often rewarded.
For all these reasons, venture capital is an attractive deal for entrepreneurs. Those who lack new ideas, funds, skills, or tolerance for risk to start something alone may be quite willing to be hired into a well-funded and supported venture. Corporate and academic training provides many of the technological and business skills necessary for the task while venture capital contributes both the financing and an economic reward structure well beyond what corporations or universities afford. Even if a founder is ultimately demoted as the company grows, he or she can still get rich because the value of the stock will far outweigh the value of any forgone salary.
By understanding how venture capital actually works, astute entrepreneurs can mitigate their risks and increase their potential rewards. Many entrepreneurs make the mistake of thinking that venture capitalists are looking for good ideas when, in fact, they are looking for good managers in particular industry segments. The value of any individual to a VC is thus a function of the following conditions:
- the number of people within the high-growth industry that are qualified for the position
- the position itself (CEO, CFO, VP of R&D, technician)
- the match of the person’s skills, reputation, and incentives to the VC firm
- the willingness to take risks
- the ability to sell oneself
Entrepreneurs who satisfy these conditions come to the table with a strong negotiating position. The ideal candidate will also have a business track record, preferably in a prior successful IPO, which makes the VC comfortable. His reputation will be such that the investment in him will be seen as a prudent risk. VCs want to invest in proven, successful people.