Class Note: Overview of Venture Capital and Start-up Financing. Professor Michael Horvath Tuck School of Business

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1 Class Note: Overview of Venture Capital and Start-up Financing Professor Michael Horvath Tuck School of Business Copyright 2001, All Rights Reserved Venture capital is a type of capital that is particularly suitable to the financing of innovation: the financing of enterprises that are attempting to do something new and untested. While not limited to this use, the prominent examples of venturefinanced firms of the 1980s and 90s Compaq, Netscape Communications, Apple Computer, Network General, Cisco Systems, Yahoo!, ebay--underscores the association of venture capital with the creation of new technologies. However, the use of venture capital in the financing of innovation is a fairly recent phenomenon, accelerating slowly since the 1950s to its current brisk growth rates. Venture capital has blossomed, over the decade of the 1990s, from a small fraction of total flows of funding for R&D to a level where total venture capital flows are roughly equal in magnitude to Federal government spending on R&D activity. Venture capital has come of age and has, to a large extent, become institutionalized. It is an industry that cut its teeth on semiconductors, learned to walk with the personal computer, and exhibited adolescent tendencies with the internet. Definition of venture capital When discussing and studying venture capital it is crucial to first define what is meant by the term since venture capital is simply a subset of the far vaster capital market. Table 1 presents venture capital within a continuum of financing alternatives for entrepreneurs and entrepreneurial companies. You should expect to draw on sources of funding listed prior to Venture Capital on Table 1. The first thing you do after devising a business plan is not pitch it to a VC. You need to execute on the plan in some meaningful way before you are ready to talk to professional outside investors. 1

2 Table 1: Financing Alternatives Overview of Venture Capital and Start-up Financing Type of Financing Amount Raised($000s) Entrepreneur Personal Funds Personal credit card and other borrowings 5-30 Friends and Family Angel investors Venture capital ,000 Corporate direct investment 2,500-5,000 Venture leasing 500-2,000 Mezzanine Financing 10,000-25,000 Merger and Acquisition 10, ,000+ Initial Public Offering 25,000-50,000+ Secondary/Follow-on Public Offering 25, ,000+ Private Placements Debt & Equity 10, ,000+ Buyout/Acquisition Financing 10, ,000+ Corporate Debt 10, ,000+ Early Money and Making it Real When you are just beginning your venture you will most likely need a small bit of working capital to cover the expenses of making it real. Making it real includes incorporating 1, generating corporate collateral like business cards, stationary, and product descriptions, establishing a working space, and traveling to meet with potential customers. Therefore, you may need to draw on your own funds or borrowing ability to accomplish your goals. While it may seem risky to run a couple of credit cards up to their limit you need to remember that your prospects of paying off a few thousand dollars of credit card debt should your venture fail are quite good assuming you can find gainful employment by traditional standards. Friends and Family money is a term used to refer to working capital lent to or invested in a startup by the founders family and/or friends. There are two good reasons to take money from this personal source. First, it builds good DNA into your start-up. Professional venture investors like to see that the people who know the founders the best, their friends and family, believe in them sufficiently to put up their own funds to see them succeed. Second, the amount of money you can raise from friends and family, on the order of $50-100K can usually go a long way for a newly formed start-up. By taking these funds you dramatically increase your chances of successfully raising a professional venture round. If you are reluctant to take an investment-for-equity from your friends and family because you want to avoid losing their money, consider structuring the investment as a convertible loan. In the event you are unsuccessful in raising a larger venture capital round, you and they agree that you will pay back the loan plus interest on a specified schedule. If you succeed in raising venture capital they have the option to convert their loan into equity at the same terms as the VCs. You can even compensate them for the additional risk they are taking with warrants to purchase additional shares 2 at the same price for a specified period of time after the closing of the first round of financing. 1 Alternatively, it may make more sense to establish a limited partnership but the effect is the same: legal bills. 2 A 20-25% warrant coverage is typical here. So, for example, if your family puts up $100,000 and receives 20% warrant coverage, they would be given warrants to purchase an additional $20,000 of shares at the price at which the initial $100,000 was converted to shares, the series A price. 2

3 Angel Investors After any personal funds and friends-and-family money, angel money serves as a very important early source of capital for start-ups. Angel investors are individuals with considerable wealth who place capital inside new and existing firms in return for equity. Their preferred investment style is to invest in companies in industries in which they have domain expertise or previous operating experience. What distinguishes angel investors from professional venture capitalists is that they are typically investing their own funds while professional venture capitalists typically are investing funds of a limited partnership (see below). Estimates from 1995 (see Freear, Sohl and Wetzel University of New Hampshire, manuscript, 1996) put the number of active angel investors in the U.S. at 250,000 making roughly 30,000 investments per year for an aggregate of $20 billion. The dollar flows from angels are therefore roughly double the flows from professional venture firms but because they are typically much smaller in size, angels make roughly 15 times the number of placements. Angel investors are difficult to find, often preferring to remain anonymous, unlike professional venture capital firms. 3 The structure of venture capital firms The most common legal form taken by professional venture capital firms is that of the limited partnership. A professional venture capital firm is a collection of general partners who make investment decisions for the partnership. Investments involve exchanging capital for equity positions, typically preferred shares, in new or expanding enterprises. 4 The funds that get invested are contributed by the all the partners but the limited partners contribute the lion s share (often over 95% of the funds). The limited partners are typically comprised of corporate investors with long time-horizons such as pension funds, insurance companies, university endowments, but may also include exceptionally wealthy individuals. A venture fund exists legally as a limited partnership for a specific period of time, typically on the order of seven to ten years. During this time it is expected that the general partners will invest the fund in accordance with any guidelines established at the fund s inception and will monitor the performance of the fund s investee companies. For their services as intermediaries, the general partners typically receive an annual management fee of a few percentage points of the fund s total assets and a carried interest, or carry, specified as a fixed percentage, typically on the order of 20-30%, of the capital gains realized at the close of the fund. At the termination of the fund s (limited partnership s) life, all proceeds from the investments less the carry are distributed to the investing partners. The venture capital firm (the general partners) typically do not disband at the termination and distribution of a fund, but rather they go on to raise another fund 3 Some angels or bands of angels have not remained anonymous, but have developed their practice of investing in new companies to the point where they attract considerable attention in the venture capital community, taking on identities separate from those of the angels themselves; for example, the Band of Angels in Silicon Valley and Zero Stage Capital in New England. 4 To be precise, venture capital investments often take the form of convertible preferred securities which have elements of both debt and equity financing and are so designed to protect the venture capital firms from moral hazard on the part of management in the companies at which they invest. 3

4 with the same or new limited partners. In fact, it is common for a venture capital firm to operate several funds simultaneously, often denoting them by Roman numerals following the fund s name (e.g. Investors LP Fund III and IV). The need to raise new funds with which to make more investments creates an incentive for the general partners to achieve superior rates of return. The most common metric used in the venture capital industry is the internal rate of return (IRR) on placements. This calculates the rate of return on each investment at an annual rate. Therefore, it penalizes the general partners for investments that perform poorly in their absolute rates of return over the investment s life and also for investments that take longer to reach profitability. The quest for superior performance inside the venture capital firm also creates an incentive for specialization by industry and stage of development of the investee company. It is typical for the general partners to have specific education, work experience, and skills in the industries in which they search for potential investee companies. This description is purposely general and simplistic. 5 It stresses the role that venture capitalists play as the intermediaries between the pure capital or money on the one hand and the investee companies on the other. In this intermediary role, the professional venture capital firm is expected to filter out bad deals, provide managerial, board room, and technical advice to the companies that receive financing, and protect the ultimate liquidity of the investment for the limited partners within the time frame of the life of the limited partnership. Exiting and Liquidity This last point deserves some clarification. Since a venture capital firm typically receives unregistered stock in return for investing capital in a company, it is necessary to describe how this stock gets turned into profits that ultimately get distributed to the limited partners. This is referred to as the exit strategy. 6 The venture capital firm tries to ensure that its equity position within a firm will be liquid by the termination date of the fund, or sooner, when the limited partnership dissolves and proceeds are distributed. Simplifying again, there are three means of exit: acquisition or merger, initial public offering (IPO), and liquidation. Liquidation, the simplest to explain, is tantamount to failure. In liquidation the firm is unable to continue operating, usually due to the lack of capital and its inability to raise more. All assets, including any sellable patents, are sold off and the proceeds are distributed to the shareholders according to formulae that heavily favor the preferred shareholders. The first exit category, acquisition or merger, provides liquidity for the venture capital firm if the acquiring or merging firm is a publicly traded corporation. In this case, it is typical for the transaction to involve the exchange of stock of the 5 There are many variants to this basic formula for a professional venture capital firm. Importantly, the description has ignored the practice of syndication where several venture capital firms co-invest in the same company, with one venture capital firm taking the lead investment. There are also substantial contractual details that shape the conduct and performance of the venture capital industry. For further reading, see Gompers and Lerner (1999), Lerner (1999), Bygrave and Timmons (1992), Fenn, Liang, and Prowse (1995), Sahlman (1990), and Trester (1998). For descriptions of datasets used in research on venture capital see Fenn and Liang (1998) 6 Both venture capital firms and the managers/founders of investee companies can have exit strategies. This phrase simply refers to the strategy these participants hold on how to create a liquid market for their shares. 4

5 investee company for stock in the publicly traded firm. It is sometimes difficult to assess whether acquisitions or mergers are failures or successes. The valuation placed on the firm may never become public information, and even then, the amounts invested in the firm prior to the merger or acquisition and the valuations at each round of investment are often unknown. The third form of exit, the IPO, involves registering shares of the investee company with the Securities and Exchange Commission (SEC) and selling these on a public stock exchange. The proceeds from this sale of new shares provide capital for the company. But the act of registering the shares of the corporation with the SEC also provides the holders of the inside shares, those held by founders and investors prior to the IPO, a liquid market for their shares. There is a caveat, however. Typically, insiders are permitted to sell their shares on the public markets only after a period of time (e.g. 6 months) has elapsed from the date of the IPO and even then they typically must sell their shares under SEC Rule 144 restrictions. 7 Venture Financing and Enterprise Formation At its heart, the purpose of venture capital investing is to finance the creation and expansion of new enterprises. Start-ups facing large fixed costs of installing infrastructure or product development use venture capital to meet cash flow needs before demand and revenues materialize. The marriage between venture capital and enterprise is more than one of cash-flow financing, though. Figure 1 shows a prototypical path for a venture-financed enterprise. Early-stage development work may be financed from founders personal funds, friends and family, angel investors, or a professional venture firm engaged in start-up/seedstage venture finance. A professional venture round six months after company inception permits an acceleration of product/service development and results in a higher expense burn rate. This would be categorized as an early-stage investment. Another venture round, one which would be classified as expansionstage, occurs in month 18 and coincides with a first-product release. While revenues are now non-zero, costs jump significantly higher due to a rapid expansion of the company s operations into full-scale sales and marketing. A venture round in month 30 may bring in a strategic investor such as a large technology partner or a key customer of the start-up s products or services. Proceeds from this round are used to further increase the scale of operations, driving up both costs and revenues growth via venture capital is preferred by management and existing shareholders to the slower strategy of growth via retained profits. Figure 1 ends at the point where the start-up has achieved cashflow positive operations. Further venture rounds may be required or desirable depending on the size of the market opportunity being pursued by the start-up and these would be categorized as profitable-stage investments. Depending on future growth prospects possible exit strategies for the venture investors include a company sale or an initial public offering of shares in the company. 7 Among other reasons, the underwriters request this temporary moratorium on the trading of insider shares in order to ensure the best chance at stability in a corporation s share price following an IPO. SEC Rule 144 imposes volume restrictions and reporting requirements for inside shareholders selling unregistered shares. 5

6 A Social Anthropology of Venture Capitalists The individual GP: Each venture partner s network of contacts is only so big and the value of this network for each portfolio company the partner takes on gets diluted as he or she takes on more companies. This means that VC partners have to heavily screen deals. Only the most compelling ideas are worthy of close investigation and only a handful of those get funded. The first line of defense for the VC partner is the reference or introduction of a prospective deal. It virtually pointless to cold-call a partner or your business plan unannounced. You have to be introduced by someone who knows the partner already. The VC Firm: Because venture firms are lasting entities, they develop reputations, mostly revolving around their historical rates of return. Benchmark Capital ( was a very young fund when it exploded onto the VC scene with its ebay investment. Until many of their.com companies started going under, it was the Fund in the valley, replacing Kleiner Perkins Caufield and Byers ( as top-dog. There is a VC social order, especially in places like Silicon Valley, Boston, and New York. Some funds are top-tier, some are second or third tier. The social rankings of your VCs has a lasting effect on your start-up, affecting things such as who you are able to recruit into senior management and which banker you are able to land as underwriter if you go public. The VC Industry: Specialization abounds in venture capital. VC firms specialize geographically, often choosing to invest close to home, especially on early-stage deals. VCs specialize by stage of financing and by industry as well. This means you have to know what kind of deals a VC is interested in seeing before you try to get in the door 6

7 there. There is no use in asking the wrong people for money. But specialization is important for the value VCs can bring to their portfolio companies. Mullet money is a term used to describe low-value added VCs who have neither relevant industry expertise nor a strong network of partner/customers to introduce your start-up to. Sure, start-ups need money but they need the non-monetary value provided by an actively engaged VC too. What to Expect from a Start-up s Perspective There is enormous variation across companies, regions, and across time in the VC funding process. Silicon Valley VCs in 1999 doled out funds at a furious rate. It was not unheard of for start-ups to get funded without a written business plan, after 1-2 meetings and with little more than a Powerpoint presentation to leave as collateral. But, other regions of the country operate on a slower clock than Silicon Valley and it is important to view 1999 as the aberration rather than the norm. You can expect the initial funding process to take anywhere from 3-9 months, depending mostly on whether the founding team has the patience to wait that long. You should take the attitude that you are going forward with or without venture money and devise funding alternatives to professional venture capital. This will actually make your chances of attracting venture money higher. The funding process breaks easily into 5 distinct phases: introduction, pitch, duediligence, term sheets, and legal. In the introduction phase your start-up must get introduced to VCs by an outside reference. It is helpful for a start-up to form both a small advisory board (2-3 industry experts) and a small board of directors (founders plus 2 others), all individuals incentivized with stock, prior to getting funded. This greatly increases the network reach of your start-up allowing you to get in the door at more VC funds. The pitch phase involves meeting one or more partners at each VC firm you begin talking with. If things go well in the initial meeting you will get called back for further presentations and grilling. Since you can t simply repeat yourself at the second meeting it is important to plan your presentations strategically to offer something new and insightful every time you meet with your prospective backers. Having a working demo of your product or offering drastically improves the chances that you will be able to fully convey what you are trying to build. Having names of individuals you want to hire once you are funded also helps convince the VCs that your start-up is a powder keg, ready to explode once they add a little gasoline in the form of cash. Finally, while having the demo is a valuable presentation tool, do not make the mistake of selling the VCs the demo, sell them the company. VCs do not invest in what you have already built. They invest in your vision of what you are going to build. That vision should be sharp with milestones and deliverables running 9-12 months out, blurring to vague but ambitious months out. Due-diligence simply means the process of assessing the prospects for your start-up. The VCs will tap into industry analysts opinions regarding your market space. They will check personal references you provide on your character and previous work experiences. If you have a prospective customer or partner who has seen your demo and is willing to vouch for how valuable your product or service would be to his or her company, that reference could be crucial. The VC is trying to get comfortable with the thought of parting with $x-million dollars in return for illiquid shares in your company. The due-diligence phase lasts until the day the deal closes and money and shares change 7

8 hands. (NB: Some people refer to the period between the signing of the term sheets and the closing of the deal as the due diligence phase.) Most VC partnerships typically make investment decisions by committee. The partner who has been most actively engaged with your start-up brings the opportunity before all the general partners of the fund at the regular partners meeting and acts as your champion. If the partners are sold then you get handed a non-binding term sheet. Otherwise, you get informed that the partners have decided to pass on your deal. 8 The term sheet spells out the economics of the investment: what percentage of your company in terms of shares you are giving to the VC in return for how much working capital. The term sheet typically also includes required allocations for an employee option pool, vesting terms for founders 9, board seat allocations to the VCs, and any other conditions for the investment the VC wants to impose on the company or founders. Remember, the term sheet is not a binding agreement. It simply specifies the terms under which the VCs would be willing to make an investment and as such there is room for bargaining back and forth on the terms. It always helps to have alternatives when bargaining so if you can time your negotiations with VCs so as to get multiple term sheets, you stand a good chance of getting movement on deal terms. Never, ever tell your VCs who else you are talking to. This is part of entrepreneur etiquette and breaking this rule will only serve to get the competing VCs talking to one another and colluding on your deal, or worse, both walking away once they have talked each other out of investing. Even once the term sheet is signed the VCs are still free to walk away from the deal, though the company is typically obligated to cease further discussions with other VCs for a specified number of days, until the deal either closes or blows up. This simply gives the VCs a little more time and one last out after the deal terms have been established, before they are fully committed. Once the term sheet is signed by VC and company the deal enters legal. Your company s counsel and the VC firm s counsel, if any, take over the task of converting the 1-2 page term sheet into two page legal document, the Investors Rights Agreement and the Shareholders Agreement, plus some ancillary documents. This process can take 2-4 weeks and rack up legal bills of $15-25K. During this time, your company may be asked to supply copies of various corporate documents to the VC s law firm as part of further due diligence. All the while, your VC firm could get cold feet if, for example, they get wind of a close competitor to your company. Therefore, you and your lawyer need to work fast to get the money in the door. 8 The pass is often accompanied by some complimentary language but don t be fooled by the terminology or their praise. They have decided to not invest in your company and that decision is usually final. It is a waste of time to revisit them at a later point in time, even if your prospects have materially changed for the better. 9 If stock or options vest to a founder or employee over time then if that individual terminates employment prior to the fully vesting his or her shares/options, he or she only receives the portion vested at that time. The remainder returns to the company. 8

9 References Bygrave, W. D and J. A. Timmons Venture Capital at the Crossroads (Boston: Harvard Business School Press). Fenn, G. W., N. Liang, and S. Prowse "The economics of the private equity market," Board of Governors of the Federal Reserve System, Staff Study 168. Fenn, G. W., N. Liang "New resources and new ideas: Private equity for small businesses," Journal of Banking and Finance, 22, Freear, J., S. Sohl, and W. Wetzel "Creating new capital markets for emerging ventures," manuscript, University of New Hampshire. Gompers, P. and J. Lerner The Venture Capital Cycle, (Cambridge: MIT Press). Lerner, J Venture Capital and Private Equity: A Casebook, (New York: John Wiley & Sons). Sahlman, W. A "The structure and governance of venture capital organizations," Journal of Financial Economics, 27, Trester, Jeffrey J "Venture capital contracting under asymmetric information," Journal of Banking & Finance, 22,