The preferred provisions offer downside protection. For instance, the venture capitalists receive a liquidation preference. 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 antidilution 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 pro rata 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.
How the Venture Capital Industry Works 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 the venture capitalists who make money for themselves by making a market for the other three. VC firms also protect themselves from risk by coinvesting with other firms. 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. Funds are structured to guarantee partners a comfortable income while they work to generate those returns. 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. And that compensation is multiplied for partners who manage several funds. On average, good plans, people, and businesses succeed only one in ten times. These odds play out in venture capital portfolios: more than half the companies will at best return only the original investment and at worst be total losses.
In fact, VC reputations are often built on one or two good investments. Those probabilities also have a great impact on how the venture capitalists spend their time. Instead, the VC allocates a significant amount of time to those middle portfolio companies, determining whether and how the investment can be turned around and whether continued participation is advisable.
The equity ownership and the deal structure described earlier give the VCs the flexibility to make management changes, particularly for those companies whose performance has been mediocre. They must identify and attract new deals, monitor existing deals, allocate additional capital to the most successful deals, and assist with exit options. Astute VCs are able to allocate their time wisely among the various functions and deals. Assuming that each partner has a typical portfolio of ten companies and a 2,hour work year, the amount of time spent on each company with each activity is relatively small.
That allows only 80 hours per year per company—less than 2 hours per week. The popular image of venture capitalists as sage advisors is at odds with the reality of their schedules. The financial incentive for partners in the VC firm is to manage as much money as possible.
The more money they manage, the less time they have to nurture and advise entrepreneurs. The fund makes investments over the course of the first two or three years, and any investment is active for up to five years.
The fund harvests the returns over the last two to three years. However, both the size of the typical fund and the amount of money managed per partner have changed dramatically. That left a lot of time for the venture capital partners to work directly with the companies, bringing their experience and industry expertise to bear.
Today the average fund is ten times larger, and each partner manages two to five times as many investments. Not surprisingly, then, the partners are usually far less knowledgeable about the industry and the technology than the 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? 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. 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. The VC has no such caps. The venture model provides an engine for commercializing technologies that formerly lay dormant in corporations and in the halls of academia.
These investors are also likely to offer to fund ventures that are involved in the same or similar industries or business sectors with which they are familiar. If they haven't actually worked in that field, they might have had academic training in it. Another common occurrence among angel investors is co-investing , in which one angel investor funds a venture alongside a trusted friend or associate, often another angel investor.
The first step for any business looking for venture capital is to submit a business plan, either to a venture capital firm or to an angel investor. If interested in the proposal, the firm or the investor must then perform due diligence , which includes a thorough investigation of the company's business model , products, management, and operating history, among other things. Since venture capital tends to invest larger dollar amounts in fewer companies, this background research is very important.
Many venture capital professionals have had prior investment experience, often as equity research analysts ; others have a Master in Business Administration MBA degree. Venture capital professionals also tend to concentrate on a particular industry. A venture capitalist that specializes in healthcare, for example, may have had prior experience as a healthcare industry analyst.
Once due diligence has been completed, the firm or the investor will pledge an investment of capital in exchange for equity in the company. These funds may be provided all at once, but more typically the capital is provided in rounds. The firm or investor then takes an active role in the funded company, advising and monitoring its progress before releasing additional funds.
The investor exits the company after a period of time, typically four to six years after the initial investment, by initiating a merger , acquisition, or initial public offering IPO.
Like most professionals in the financial industry, the venture capitalist tends to start his or her day with a copy of The Wall Street Journal , the Financial Times , and other respected business publications. Venture capitalists that specialize in an industry tend to also subscribe to the trade journals and papers that are specific to that industry. All of this information is often digested each day along with breakfast.
For the venture capital professional, most of the rest of the day is filled with meetings. At an early morning meeting, for example, there may be a firm-wide discussion of potential portfolio investments. The due diligence team will present the pros and cons of investing in the company. An "around the table" vote may be scheduled for the next day as to whether or not to add the company to the portfolio.
An afternoon meeting may be held with a current portfolio company. These visits are maintained on a regular basis in order to determine how smoothly the company is running and whether the investment made by the venture capital firm is being utilized wisely. The venture capitalist is responsible for taking evaluative notes during and after the meeting and circulating the conclusions among the rest of the firm.
After spending much of the afternoon writing up that report and reviewing other market news, there may be an early dinner meeting with a group of budding entrepreneurs who are seeking funding for their venture. The venture capital professional gets a sense of what type of potential the emerging company has, and determines whether further meetings with the venture capital firm are warranted.
After that dinner meeting, when the venture capitalist finally heads home for the night, they may take along the due diligence report on the company that will be voted on the next day, taking one more chance to review all the essential facts and figures before the morning meeting. The first venture capital funding was an attempt to kickstart an industry.
To that end, Georges Doriot adhered to a philosophy of actively participating in the startup's progress. He provided funding, counsel, and connections to entrepreneurs. An amendment to the SBIC Act in led to the entry of novice investors, who provided little more than money to investors.
The increase in funding levels for the industry was accompanied by a corresponding increase in the numbers for failed small businesses. Over time, VC industry participants have coalesced around Doriot's original philosophy of providing counsel and support to entrepreneurs building businesses. Due to the industry's proximity to Silicon Valley, the overwhelming majority of deals financed by venture capitalists are in the technology industry—the internet, healthcare, computer hardware and services, and mobile and telecommunications.
But other industries have also benefited from VC funding. Notable examples are Staples and Starbucks, which both received venture money. Venture capital is also no longer the preserve of elite firms. Institutional investors and established companies have also entered the fray.
For example, tech behemoths Google and Intel have separate venture funds to invest in emerging technology. With an increase in average deal sizes and the presence of more institutional players in the mix, venture capital has matured over time.
The industry now comprises an assortment of players and investor types who invest in different stages of a startup's evolution, depending on their appetite for risk. Late-stage financing has become more popular because institutional investors prefer to invest in less-risky ventures as opposed to early-stage companies where the risk of failure is high. Another noteworthy trend is the increasing number of deals with non-traditional VC investors, such as mutual funds, hedge funds, corporate investors, and crossover investors.
Meanwhile, the share of angel investors has gotten more robust, hitting record highs, as well. But the increase in funding does not translate into a bigger ecosystem as deal count or the number of deals financed by VC money. NVCA projects the number of deals in to be 8,—compared to 12, in Innovation and entrepreneurship are the kernels of a capitalist economy.
New businesses, however, are often highly-risky and cost-intensive ventures. As a result, external capital is often sought to spread the risk of failure. In return for taking on this risk through investment, investors in new companies are able to obtain equity and voting rights for cents on the potential dollar.
Venture capital, therefore, allows startups to get off the ground and founders to fulfill their vision. New companies often don't make it, and that means early investors can lose all of the money that they put into it. Future work can test this curse effect of VC reputation in other markets, and examine whether it is just a particular phenomenon in developing countries like China.
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