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Understanding Venture Capital

Understanding Venture Capital. Public markets. Where Does VC Fit in the Financial Cosmos?. Users of Capital. Money Managers. Sources of Capital. Stock Funds Bond Funds Hedge Funds Private Equity VC LBO Other. Pension Funds Wealthy Families University Endowments Foundations Others.

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Understanding Venture Capital

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  1. Understanding Venture Capital

  2. Public markets Where Does VC Fit in the Financial Cosmos? Users of Capital Money Managers Sources of Capital • Stock Funds • Bond Funds • Hedge Funds • Private Equity • VC • LBO • Other • Pension Funds • Wealthy Families • University Endowments • Foundations • Others • Entrepreneurs trying to start a business Fund of Funds • Entrepreneurs trying to buy a business

  3. Within VC Asset Class Seed / Incubation • Or by … • Industry • Technology Early Stage Multi-Stage Late Stage / Mezzanine

  4. What Is The Point? • Raise money • Invest it • Give back lots more than we took in • Repeat

  5. Why Do It? • Oh, yeah, we keep some for ourselves • Management fees – 2-2.5% per year • Profits interest: 20-30%

  6. 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

  7. Exactly What Do We Do? • Raise money • Make investments • Monitor investments • Exit investments

  8. Examples • COMPAQ • CIENA • Citrix Systems

  9. 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”

  10. 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

  11. 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

  12. What is a Fund? • Legally: a limited partnership • Characteristics: • Committed capital • Term • Takedown schedule • Investment restrictions • Lots more

  13. Objective • Make n investments over 1sty years of the fund • Exit those investments in the 10-12 year term at a profit

  14. 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

  15. 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

  16. How to Set Fund Size • Function of: • $ per deal (d) – physics of companies • # of GP equivalents • Companies / GP • Steady state board capacity • Turnover rate

  17. 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

  18. Objective Revisited – Make Money for LPs and GP • Given 10 year life, we need to make a multiple of the fund:

  19. 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

  20. So, What Really Happens? Fund I Fund II Fund IV Fund III

  21. 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.

  22. 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

  23. 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

  24. 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

  25. 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

  26. 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

  27. 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

  28. 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

  29. What Breaks Down? • Management fee • Role of multiple funds • Carry • Fund by fund • Sharing philosophy

  30. Wait – What Happens When Fund is Fully Invested • You raise another fund • You don’t

  31. 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

  32. What Can Go Wrong – New Investments? • Unseen scar tissue • Bad chemistry • Bad hair day • Misjudge the DMU • Ego crowding

  33. 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

  34. What Can Go Right? • Well established firm • Capital access – direct and referrals • GP – operating and domain experience • Other resources • Know your partner

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