Understanding Venture Capital

•Stock Funds

•Bond Funds

•Hedge Funds

•Private Equity

•VC

•LBO

•Other

Where Does VC Fit in the Financial Cosmos?

• Pension Funds

• Wealthy Families

• University Endowments

• Foundations

• Others

Fund of Funds

•Entrepreneurs trying to start a business

•Entrepreneurs trying to buy a business

Public markets

Sources of Capital

Users of Capital

Money Managers

Within VC Asset Class

Seed / Incubation

Early Stage

Late Stage / Mezzanine

Multi-Stage

Or by …

• Industry

• Technology

What Is The Point?

• Raise money

• Invest it

• Give back lots more than we took in

• Repeat

Why Do It?

• Oh, yeah, we keep some for ourselves

• Management fees – 2-2.5% per year

• Profits interest: 20-30%

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

Exactly What Do We Do?

• Raise money

• Make investments

• Monitor investments

• Exit investments

Examples

• COMPAQ

• CIENA

• Citrix Systems

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”

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

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

What is a Fund?

• Legally: a limited partnership

• Characteristics:– Committed capital– Term– Takedown schedule– Investment restrictions– Lots more

Objective

• Make n investments over 1st y years of the fund

• Exit those investments in the 10-12 year term at a profit

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

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

How to Set Fund Size

• Function of:– $ per deal (d) – physics of companies– # of GP equivalents– Companies / GP

• Steady state board capacity• Turnover rate

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

Objective Revisited – Make Money for LPs

and GP• Given 10 year life, we need to make a

multiple of the fund:

10 year IRR 7 year IRR

2x 7.2% 10.4%

3x 11.6% 17.0%

4x 14.9% 21.9%

5x 17.5% 25.8%

8x 23.1% 34.6%

10x 25.9% 38.9%

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

So, What Really Happens?

FUND I

36.2x

20.9x

9.6x11.0x

10.4x6.3x

7.9x 9.0x3.2x

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

Capital Invested (in $mm)Capital Returned (in $mm)

Fund I =

$19.6MM

Total returned

$180.6MM9.2x CC

Total invested

$18.3MM93.4% of CC

FUND II

-- -- -- -- -- -- -- --

42.6x

14.7x

19.4x

9.1x

4.1x

3.0x5.6x 2.1x 3.1x

3.8x 4.0x3.9x 0.8x 1.8x 1.2x

0.8x 0.3x

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

Capital Invested (in $mm)Capital Returned (in $mm)

Fund II =

$60.6MM

Total returned

$223.0MM3.7x CC

Total invested

$53.68MM88.6% of CC

FUND III

-- -- -- -- -- -- -- -- -- --

39.3x

50.8x

4.2x 3.5x2.1x 3.5x 1.9x 0.6x 1.9x

1.0x 0.1x 2.5x

(10.00)

-

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

90.00

100.00

110.00

120.00

130.00

140.00

150.00

Capital Invested (in $mm)Capital Returned (in $mm)

Fund III =

$65MM

Total returned

$266.3MM4.1x CC

Total invested

$69.4MM106.8% of CC

FUND IV

1.0x0.4x0.2x

1.3x

3.2x3.4x3.2x

8.4x

19.6x

11.3x

13.1x

138.5x

(10.00)

-

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

Capital Invested (in $mm)

Capital Returned (in $mm)

590.00

Fund IV = $65MM

Total returned

$826MM

12.5x CC

Total invested

$66.3MM

102% of CC

Fund I

Fund IV

Fund III

Fund II

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.

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

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

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

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

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

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

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

What Breaks Down?

• Management fee– Role of multiple funds

• Carry– Fund by fund– Sharing philosophy

Wait – What Happens When Fund is Fully

Invested

• You raise another fund

• You don’t

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

What Can Go Wrong – New Investments?

• Unseen scar tissue

• Bad chemistry

• Bad hair day

• Misjudge the DMU

• Ego crowding

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

What Can Go Right?

• Well established firm

• Capital access – direct and referrals

• GP – operating and domain experience

• Other resources

• Know your partner