VENTURE CAPITAL

 Volatile: High Success and Failure Rates  Source of Innovation: New Ideas and Ways to do Things  Contribute Disproportionately to New Job Formation American Capitalism produces New/Small Businesses that are

VENTURE CAPITAL Adverse Selection Problem: How can Investor know whether Business Opportunity is Feasible? How can Entrepreneur Objectively Communicate likelihood of Market Acceptance? Moral Hazard Problem: How can Investor evaluate Entrepreneur's Ability? How can Entrepreneur communicate Capacity, Credibility and Commitment? Contracting Problem: How can Parties Agree (1) about How to Control Business in Dynamic, Uncertain Environment and (2) on Incentives that Reward Different, sometimes Conflicting, Motives?

VENTURE CAPITAL Customary Development Paths $ Independent Development  Founder Equity  Profitability/Retained Earnings  External Debt  External Equity (IPO) $ Strategic Alliances  Collaborative Relationships with Other Firms to Certify Legitimacy and Credibility. May be informal arrangements, joint venture or licensing agreements $ Merger/Acquisition  Sale of Partial/Complete Ownership (and Control) as Consideration for Necessary Investment Capital

VENTURE CAPITAL Financing by Venture Capital Funds $ Specialized Approach for Supplying Capital to New Ventures with Sufficient Managerial Expertise, Scale and Product/Market Innovation $ Addresses Financing Dilemma presented by Entrepreneurial Firms  No Verifiable Cash Flows or Tangible Assets  How to Exert Control Necessary to Obtain Desired Investment Performance and Minimize Risk

VENTURE CAPITAL Venture Capital Partnership $ Venture Capitalists are Specialized Financial Investment Intermediaries $ Organizational Form will be Limited Partnership  Limited Partner Investors: usually Pension Funds  General Partners select Portfolio Company Investments, Negotiate Terms and Monitor

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14 Organizational Structure of Venture Capital Investment Portfolio Companies –Value creation – Generate deal flow – Screen opportunities – Harvest investments – Negotiate deals – Monitor and advise General Partners Venture Capital Fund – Pension plan – Endowments – Life insurance companies – Corporations – Individuals Limited Partners Effort and 1% of capital Annual Management Fee 2-3% Carried Interest % of Gain 99% of Investment Capital Capital Appreciation 70-80% of Gain Investment Capital and Effort Financial Claims

VENTURE CAPITAL Hybrid Financing Techniques by VC Funds Because New Venture has No Verifiable Cash Flow or Tangible Assets for Collateral $ Debt not Viable Option $ Consideration for Investment is Transfer of Negotiated Ownership Interest (Stock Sale), which includes Measure of Control, from Entrepreneur/Founder to Venture Capitalist

VENTURE CAPITAL Hybrid Structure: Preferred Stock convertible into Common Stock  Dividends accrue at Debt-like Rate; Payable at Positive Cash Flow  When Milestones achieved, non-Voting Preferred Stock converts into Voting Common Stock  Venture Capitalist will have Board Membership and Control over Major Strategic Decisions

VENTURE CAPITAL Hybrid Financing used by VC Funds Ultimate Source of Repayment for Investment will be Initial Public Offering (IPO)  Managing General Partners paid  By Limited Partners/Investors for Management Services and …  Percentage of Capital Gain at IPO  Limited Partners/Investors earn Capital Gain  Investment Time Frame: 7 to 10 years

VENTURE CAPITAL Myths about Venture Capital Financing $ VCs want no less than 50% Ownership Fact: Fact: VC Funds customarily hold 47% to 53% Voting Interest $ VCs have the Right to Fire the Founder/CEO Fact: Customary Condition is Employment Contract authorizing Majority of Directors to fire Founder/CEO “ with or without cause.” Performance Issues vs. Company Needs: Administrator or Inspirational Leader

VENTURE CAPITAL Myths about Venture Capital Financing $ VCs dominate the Private Equity Market Fact: VCs account for less than 1% of the Private Equity Market $ VCs finance a Broad Range of Industry Types on a Nationwide Basis Fact: Most VC investments are in High-Technology or Bio-science Industries in California’s Silicon Valley or Boston area

VENTURE CAPITAL Myths about Venture Capital Financing $ VCs expect to Earn a 700% Rate of Return within Two to Three Years Fact: VCs aim to “harvest” their Investments within 7 to 10 Years (and try to earn no less than 700%) $ Governments invest in VC Funds because they are a “Win-Win” Situation: Eye-Popping Rates of Return and High-Paying Jobs Fact: Probable Returns will be around 25% with less than half of Firms surviving more than 3 years

VENTURE CAPITAL What is a VC Fund’s “Value Proposition”? Provide all Financing necessary for Firm’s Product Life Cycle Association with VC Fund brings Credibility and Legitimacy to Entrepreneur Access to Strategic Services and Tactical Advice from Sole Provider with Expertise

VENTURE CAPITAL Sources of Financing for New Venture pursuing Independent Development Founder’s Private Equity and Short-term Debt The Three “Fs”: Friends, Families and Fools Angels: Investors who are Risk-Sharers Bootstrapping: Suppliers and Customers with Stake in Firm’s Success Alliances with Resource Providers: Manufacturers, Distributors or Retailers (Beware of Hold-up Power; Evaluate Value of Current Marginal Resource Gain versus Constrained Future Flexibility)

VENTURE CAPITAL Characteristics of Firm Development when Venture Capitalist Funding Not Used Reliance on Informal Networks for Credibility and Necessary Services and Expertise Slower Growth Rate/Longer Life-Cycle Stages Multiple Sources of Funds that Provide Short- Term Funding Different Relationship between Control and Risk/Uncertainty

VENTURE CAPITAL Future for Firms needing Venture Capital Evolution of VC Fund Industry into (1) Mass Market and (2) Niche Providers differentiated by Industry, Geography or Development Stage For Everyone Else… Fundamentals Still and Will Always be the Rule  Well-conceived Opportunities always get Financed  Obtaining External Financing Must Follow and Will Be Determined by Strategic Development  Risk is always Financeable; Resolving Uncertainty is Entrepreneur’s Challenge