| Venture capital is money provided by professionals | | | | opportunities for existing and new investors. It is not |
| who invest alongside management in young, rapidly | | | | uncommon to see a successful firm raise six or |
| growing companies that have the potential to | | | | seven funds consecutively over the span of ten to |
| develop into significant economic contributors. | | | | fifteen years. Each fund is managed separately and |
| Venture capital is an important source of equity for | | | | has its own investors or limited partners and its own |
| start-up companies. | | | | general partner. These funds' investment strategy |
| Professionally managed venture capital firms generally | | | | may be similar to other funds in the firm. However, |
| are private partnerships or closely-held corporations | | | | the firm may have one fund with a specific focus |
| funded by private and public pension funds, | | | | and another with a different focus and yet another |
| endowment funds, foundations, corporations, wealthy | | | | with a broadly diversified portfolio. This depends on |
| individuals, foreign investors, and the venture | | | | the strategy and focus of the venture firm itself. |
| capitalists themselves. | | | | Corporate Venturing |
| Venture capitalists generally: | | | | One form of investing that was popular in the 1980s |
| - Finance new and rapidly growing companies; | | | | and is again very popular is corporate venturing. This |
| - Purchase equity securities; | | | | is usually called "direct investing" in portfolio |
| - Assist in the development of new products or | | | | companies by venture capital programs or subsidiaries |
| services; | | | | of nonfinancial corporations. These investment |
| - Add value to the company through active | | | | vehicles seek to find qualified investment |
| participation; | | | | opportunities that are congruent with the parent |
| - Take higher risks with the expectation of higher | | | | company's strategic technology or that provide |
| rewards; | | | | synergy or cost savings. |
| - Have a long-term orientation | | | | These corporate venturing programs may be loosely |
| When considering an investment, venture capitalists | | | | organized programs affiliated with existing business |
| carefully screen the technical and business merits of | | | | development programs or may be self-contained |
| the proposed company. Venture capitalists only | | | | entities with a strategic charter and mission to make |
| invest in a small percentage of the businesses they | | | | investments congruent with the parent's strategic |
| review and have a long-term perspective. Going | | | | mission. There are some venture firms that specialize |
| forward, they actively work with the company's | | | | in advising, consulting and managing a corporation's |
| management by contributing their experience and | | | | venturing program. |
| business savvy gained from helping other companies | | | | The typical distinction between corporate venturing |
| with similar growth challenges. | | | | and other types of venture investment vehicles is |
| Venture capitalists mitigate the risk of venture | | | | that corporate venturing is usually performed with |
| investing by developing a portfolio of young | | | | corporate strategic objectives in mind while other |
| companies in a single venture fund. Many times they | | | | venture investment vehicles typically have |
| will co-invest with other professional venture capital | | | | investment return or financial objectives as their |
| firms. In addition, many venture partnership will | | | | primary goal. This may be a generalization as |
| manage multiple funds simultaneously. For decades, | | | | corporate venture programs are not immune to |
| venture capitalists have nurtured the growth of | | | | financial considerations, but the distinction can be |
| America's high technology and entrepreneurial | | | | made. |
| communities resulting in significant job creation, | | | | The other distinction of corporate venture programs |
| economic growth and international competitiveness. | | | | is that they usually invest their parent's capital while |
| Companies such as Digital Equipment Corporation, | | | | other venture investment vehicles invest outside |
| Apple, Federal Express, Compaq, Sun Microsystems, | | | | investors' capital. |
| Intel, Microsoft and Genentech are famous examples | | | | Commitments and Fund Raising |
| of companies that received venture capital early in | | | | The process that venture firms go through in seeking |
| their development. | | | | investment commitments from investors is typically |
| Private Equity Investing | | | | called "fund raising." This should not be confused with |
| Venture capital investing has grown from a small | | | | the actual investment in investee or "portfolio" |
| investment pool in the 1960s and early 1970s to a | | | | companies by the venture capital firms, which is also |
| mainstream asset class that is a viable and significant | | | | sometimes called "fund raising" in some circles. The |
| part of the institutional and corporate investment | | | | commitments of capital are raised from the investors |
| portfolio. Recently, some investors have been | | | | during the formation of the fund. A venture firm will |
| referring to venture investing and buyout investing as | | | | set out prospecting for investors with a target fund |
| "private equity investing." This term can be confusing | | | | size. It will distribute a prospectus to potential |
| because some in the investment industry use the | | | | investors and may take from several weeks to |
| term "private equity" to refer only to buyout fund | | | | several months to raise the requisite capital. The fund |
| investing. | | | | will seek commitments of capital from institutional |
| In any case, an institutional investor will allocate 2% | | | | investors, endowments, foundations and individuals |
| to 3% of their institutional portfolio for investment in | | | | who seek to invest part of their portfolio in |
| alternative assets such as private equity or venture | | | | opportunities with a higher risk factor and |
| capital as part of their overall asset allocation. | | | | commensurate opportunity for higher returns. |
| Currently, over 50% of investments in venture | | | | Because of the risk, length of investment and |
| capital/private equity comes from institutional public | | | | illiquidity involved in venture investing, and because |
| and private pension funds, with the balance coming | | | | the minimum commitment requirements are so high, |
| from endowments, foundations, insurance companies, | | | | venture capital fund investing is generally out of |
| banks, individuals and other entities who seek to | | | | reach for the average individual. The venture fund will |
| diversify their portfolio with this investment class. | | | | have from a few to almost 100 limited partners |
| What is a Venture Capitalist? | | | | depending on the target size of the fund. Once the |
| The typical person-on-the-street depiction of a | | | | firm has raised enough commitments, it will start |
| venture capitalist is that of a wealthy financier who | | | | making investments in portfolio companies. |
| wants to fund start-up companies. The perception is | | | | Capital Calls |
| that a person who develops a brand new | | | | Making investments in portfolio companies requires |
| change-the-world invention needs capital; thus, if they | | | | the venture firm to start "calling" its limited partners |
| can't get capital from a bank or from their own | | | | commitments. The firm will collect or "call" the needed |
| pockets, they enlist the help of a venture capitalist. | | | | investment capital from the limited partner in a series |
| In truth, venture capital and private equity firms are | | | | of tranches commonly known as "capital calls". These |
| pools of capital, typically organized as a limited | | | | capital calls from the limited partners to the venture |
| partnership, that invests in companies that represent | | | | fund are sometimes called "takedowns" or "paid-in |
| the opportunity for a high rate of return within five | | | | capital." Some years ago, the venture firm would |
| to seven years. The venture capitalist may look at | | | | "call" this capital down in three equal installments over |
| several hundred investment opportunities before | | | | a three year period. More recently, venture firms |
| investing in only a few selected companies with | | | | have synchronized their funding cycles and call their |
| favorable investment opportunities. Far from being | | | | capital on an as-needed basis for investment. |
| simply passive financiers, venture capitalists foster | | | | Illiquidity |
| growth in companies through their involvement in the | | | | Limited partners make these investments in venture |
| management, strategic marketing and planning of | | | | funds knowing that the investment will be long-term. |
| their investee companies. They are entrepreneurs | | | | It may take several years before the first |
| first and financiers second. | | | | investments starts to return proceeds; in many cases |
| Even individuals may be venture capitalists. In the | | | | the invested capital may be tied up in an investment |
| early days of venture capital investment, in the 1950s | | | | for seven to ten years. Limited partners understand |
| and 1960s, individual investors were the archetypal | | | | that this illiquidity must be factored into their |
| venture investor. While this type of individual | | | | investment decision. |
| investment did not totally disappear, the modern | | | | Other Types of Funds |
| venture firm emerged as the dominant venture | | | | Since venture firms are private firms, there is |
| investment vehicle. However, in the last few years, | | | | typically no way to exit before the partnership totally |
| individuals have again become a potent and | | | | matures or expires. In recent years, a new form of |
| increasingly larger part of the early stage start-up | | | | venture firm has evolved: so-called "secondary" |
| venture life cycle. These "angel investors" will mentor | | | | partnerships that specialize in purchasing the portfolios |
| a company and provide needed capital and expertise | | | | of investee company investments of an existing |
| to help develop companies. Angel investors may | | | | venture firm. This type of partnership provides some |
| either be wealthy people with management expertise | | | | liquidity for the original investors. These secondary |
| or retired business men and women who seek the | | | | partnerships, expecting a large return, invest in what |
| opportunity for first-hand business development. | | | | they consider to be undervalued companies. |
| Investment Focus | | | | Advisors and Fund of Funds |
| Venture capitalists may be generalist or specialist | | | | Evaluating which funds to invest in is akin to choosing |
| investors depending on their investment strategy. | | | | a good stock manager or mutual fund, except the |
| Venture capitalists can be generalists, investing in | | | | decision to invest is a long-term commitment. This |
| various industry sectors, or various geographic | | | | investment decision takes considerable investment |
| locations, or various stages of a company's life. | | | | knowledge and time on the part of the limited |
| Alternatively, they may be specialists in one or two | | | | partner investor. The larger institutions have |
| industry sectors, or may seek to invest in only a | | | | investments in excess of 100 different venture |
| localized geographic area. | | | | capital and buyout funds and continually invest in new |
| Not all venture capitalists invest in "start-ups." While | | | | funds as they are formed. |
| venture firms will invest in companies that are in their | | | | Some limited partner investors may have neither the |
| initial start-up modes, venture capitalists will also | | | | resources nor the expertise to manage and invest in |
| invest in companies at various stages of the business | | | | many funds and thus, may seek to delegate this |
| life cycle. A venture capitalist may invest before | | | | decision to an investment advisor or so-called |
| there is a real product or company organized (so | | | | "gatekeeper". This advisor will pool the assets of its |
| called "seed investing"), or may provide capital to | | | | various clients and invest these proceeds as a limited |
| start up a company in its first or second stages of | | | | partner into a venture or buyout fund currently |
| development known as "early stage investing." Also, | | | | raising capital. Alternatively, an investor may invest in |
| the venture capitalist may provide needed financing | | | | a "fund of funds," which is a partnership organized to |
| to help a company grow beyond a critical mass to | | | | invest in other partnerships, thus providing the limited |
| become more successful ("expansion stage | | | | partner investor with added diversification and the |
| financing"). | | | | ability to invest smaller amounts into a variety of |
| The venture capitalist may invest in a company | | | | funds. |
| throughout the company's life cycle and therefore | | | | Disbursements |
| some funds focus on later stage investing by | | | | The investment by venture funds into investee |
| providing financing to help the company grow to a | | | | portfolio companies is called "disbursements". A |
| critical mass to attract public financing through a | | | | company will receive capital in one or more rounds of |
| stock offering. Alternatively, the venture capitalist | | | | financing. A venture firm may make these |
| may help the company attract a merger or | | | | disbursements by itself or in many cases will |
| acquisition with another company by providing liquidity | | | | co-invest in a company with other venture firms |
| and exit for the company's founders. | | | | ("co-investment" or "syndication"). This syndication |
| At the other end of the spectrum, some venture | | | | provides more capital resources for the investee |
| funds specialize in the acquisition, turnaround or | | | | company. Firms co-invest because the company |
| recapitalization of public and private companies that | | | | investment is congruent with the investment |
| represent favorable investment opportunities. | | | | strategies of various venture firms and each firm will |
| There are venture funds that will be broadly | | | | bring some competitive advantage to the investment. |
| diversified and will invest in companies in various | | | | The venture firm will provide capital and management |
| industry sectors as diverse as semiconductors, | | | | expertise and will usually also take a seat on the |
| software, retailing and restaurants and others that | | | | board of the company to ensure that the investment |
| may be specialists in only one technology. | | | | has the best chance of being successful. A portfolio |
| While high technology investment makes up most of | | | | company may receive one round, or in many cases, |
| the venture investing in the U.S., and the venture | | | | several rounds of venture financing in its life as |
| industry gets a lot of attention for its high | | | | needed. A venture firm may not invest all of its |
| technology investments, venture capitalists also | | | | committed capital, but will reserve some capital for |
| invest in companies such as construction, industrial | | | | later investment in some of its successful companies |
| products, business services, etc. There are several | | | | with additional capital needs. |
| firms that have specialized in retail company | | | | Exits |
| investment and others that have a focus in investing | | | | Depending on the investment focus and strategy of |
| only in "socially responsible" start-up endeavors. | | | | the venture firm, it will seek to exit the investment in |
| Venture firms come in various sizes from small seed | | | | the portfolio company within three to five years of |
| specialist firms of only a few million dollars under | | | | the initial investment. While the initial public offering |
| management to firms with over a billion dollars in | | | | may be the most glamourous and heralded type of |
| invested capital around the world. The common | | | | exit for the venture capitalist and owners of the |
| denominator in all of these types of venture investing | | | | company, most successful exits of venture |
| is that the venture capitalist is not a passive investor, | | | | investments occur through a merger or acquisition of |
| but has an active and vested interest in guiding, | | | | the company by either the original founders or |
| leading and growing the companies they have | | | | another company. Again, the expertise of the |
| invested in. They seek to add value through their | | | | venture firm in successfully exiting its investment will |
| experience in investing in tens and hundreds of | | | | dictate the success of the exit for themselves and |
| companies. | | | | the owner of the company. |
| Some venture firms are successful by creating | | | | IPO |
| synergies between the various companies they have | | | | The initial public offering is the most glamourous and |
| invested in; for example one company that has a | | | | visible type of exit for a venture investment. In |
| great software product, but does not have adequate | | | | recent years technology IPOs have been in the |
| distribution technology may be paired with another | | | | limelight during the IPO boom of the last six years. At |
| company or its management in the venture portfolio | | | | public offering, the venture firm is considered an |
| that has better distribution technology. | | | | insider and will receive stock in the company, but the |
| Length of Investment | | | | firm is regulated and restricted in how that stock can |
| Venture capitalists will help companies grow, but they | | | | be sold or liquidated for several years. Once this |
| eventually seek to exit the investment in three to | | | | stock is freely tradable, usually after about two |
| seven years. An early stage investment make take | | | | years, the venture fund will distribute this stock or |
| seven to ten years to mature, while a later stage | | | | cash to its limited partner investor who may then |
| investment many only take a few years, so the | | | | manage the public stock as a regular stock holding or |
| appetite for the investment life cycle must be | | | | may liquidate it upon receipt. Over the last |
| congruent with the limited partnerships' appetite for | | | | twenty-five years, almost 3000 companies financed |
| liquidity. The venture investment is neither a short | | | | by venture funds have gone public. |
| term nor a liquid investment, but an investment that | | | | Mergers and Acquisitions |
| must be made with careful diligence and expertise. | | | | Mergers and acquisitions represent the most common |
| Types of Firms | | | | type of successful exit for venture investments. In |
| There are several types of venture capital firms, but | | | | the case of a merger or acquisition, the venture firm |
| most mainstream firms invest their capital through | | | | will receive stock or cash from the acquiring company |
| funds organized as limited partnerships in which the | | | | and the venture investor will distribute the proceeds |
| venture capital firm serves as the general partner. | | | | from the sale to its limited partners. |
| The most common type of venture firm is an | | | | Valuations |
| independent venture firm that has no affiliations with | | | | Like a mutual fund, each venture fund has a net |
| any other financial institution. These are called "private | | | | asset value, or the value of an investor's holdings in |
| independent firms". Venture firms may also be | | | | that fund at any given time. However, unlike a mutual |
| affiliates or subsidiaries of a commercial bank, | | | | fund, this value is not determined through a public |
| investment bank or insurance company and make | | | | market transaction, but through a valuation of the |
| investments on behalf of outside investors or the | | | | underlying portfolio. Remember, the investment is |
| parent firm's clients. Still other firms may be | | | | illiquid and at any point, the partnership may have |
| subsidiaries of non-financial, industrial corporations | | | | both private companies and the stock of public |
| making investments on behalf of the parent itself. | | | | companies in its portfolio. These public stocks are |
| These latter firms are typically called "direct | | | | usually subject to restrictions for a holding period and |
| investors" or "corporate venture investors." | | | | are thus subject to a liquidity discount in the portfolio |
| Other organizations may include government affiliated | | | | valuation. |
| investment programs that help start up companies | | | | Each company is valued at an agreed-upon value |
| either through state, local or federal programs. One | | | | between the venture firms when invested in by the |
| common vehicle is the Small Business Investment | | | | venture fund or funds. In subsequent quarters, the |
| Company or SBIC program administered by the Small | | | | venture investor will usually keep this valuation intact |
| Business Administration, in which a venture capital | | | | until a material event occurs to change the value. |
| firm may augment its own funds with federal funds | | | | Venture investors try to conservatively value their |
| and leverage its investment in qualified investee | | | | investments using guidelines or standard industry |
| companies. | | | | practices and by terms outlined in the prospectus of |
| While the predominant form of organization is the | | | | the fund. The venture investor is usually conservative |
| limited partnership, in recent years the tax code has | | | | in the valuation of companies, but it is common to |
| allowed the formation of either Limited Liability | | | | find that early stage funds may have an even more |
| Partnerships, ("LLPs"), or Limited Liability Companies | | | | conservative valuation of their companies due to the |
| ("LLCs"), as alternative forms of organization. | | | | long lives of their investments when compared to |
| However, the limited partnership is still the | | | | other funds with shorter investment cycles. |
| predominant organizational form. The advantages and | | | | Management Fees |
| disadvantages of each has to do with liability, | | | | As an investment manager, the general partner will |
| taxation issues and management responsibility. | | | | typically charge a management fee to cover the |
| The venture capital firm will organize its partnership | | | | costs of managing the committed capital. The |
| as a pooled fund; that is, a fund made up of the | | | | management fee will usually be paid quarterly for the |
| general partner and the investors or limited partners. | | | | life of the fund or it may be tapered or curtailed in |
| These funds are typically organized as fixed life | | | | the later stages of a fund's life. This is most often |
| partnerships, usually having a life of ten years. Each | | | | negotiated with investors upon formation of the fund |
| fund is capitalized by commitments of capital from | | | | in the terms and conditions of the investment. |
| the limited partners. Once the partnership has | | | | Carried Interest |
| reached its target size, the partnership is closed to | | | | "Carried interest" is the term used to denote the |
| further investment from new investors or even | | | | profit split of proceeds to the general partner. This is |
| existing investors so the fund has a fixed capital pool | | | | the general partners' fee for carrying the |
| from which to make its investments. | | | | management responsibility plus all the liability and for |
| Like a mutual fund company, a venture capital firm | | | | providing the needed expertise to successfully |
| may have more than one fund in existence. A | | | | manage the investment. There are as many |
| venture firm may raise another fund a few years | | | | variations of this profit split both in the size and how |
| after closing the first fund in order to continue to | | | | it is calculated and accrued as there are firms. |
| invest in companies and to provide more | | | | |