A Brief Introduction to Venture Capital by gregoria

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									A Brief Introduction to Venture Capital
                   Jonathan Aberman, Amplifier Venture Partners, LP




WHAT IS VENTURE CAPITAL?

Venture Capital describes the process of wealthy and institutional investors aggregating
capital to provide financing to certain types of businesses in exchange for potentially
large investment returns. The investors pool their capital into legal entities (usually
limited partnerships) that are called “Venture Funds”. Venture Funds are managed on
behalf of the investors by professional investment managers (“Venture Capitalists” or
“VCs”) that specialize in evaluating and executing investments in technology-driven
companies. Venture Capitalists are compensated in two ways (i) current management
fees (paid on a percentage of the Venture Fund being managed) and (ii) a portion of the
gains derived from the Venture Fund’s investments (the “Carry”). The Carry can be very
large in a successful fund (usually 20% of fund gains), so Venture Capitalists are driven
to invest in companies that will generate large capital gains over time.

HOW DO VENTURE FUNDS INVEST?

Venture Funds achieve investment returns through application of the old cliché “buy
low/sell high.” Almost always, VCs invest through the purchase of an equity interest in a
corporation. This interest, usually held in preferred stock, affords the VC certain
contractual rights to monitor the investment and influence the development of the
invested company. The Venture Fund will not usually see any money back from its
investment until either (i) the invested company has a public offering of its shares
(allowing the VC to sell the Venture Fund’s shares in the public market) or (ii) the
invested company is sold as a whole. Therefore, it is many years before a Venture Fund
realizes any return on its investment, and furthermore, during the time that the Venture
Fund’s investment is in a company it is subject to the various risks of failure inherent in
all young and emerging businesses.

WHAT INVESTMENT RETURN RATES ARE VCS LOOKING FOR?

An expected rate of return for an investment by a Venture Fund depends upon the stage
of development of the target company. Measuring the expected return is accomplished
by calculating the internal rate of return (the “IRR”) for an investment from the time it is
made to the time money is returned. To give you an idea of the magnitude of returns that
VCs expect from an investment, consider the required IRR for an investment in a seed


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stage company: it’s 75%. If you apply that to the real world, it means that a $1,000,000
investment in a seed stage company must be worth $16,000,000 five years later to be an
attractive seed stage investment.

The expected rates of returns differ by the stages of development of the target company.

Type       of   Company Attributes                      Sample Uses of Capital          Target     Target
investment                                                                              Per-Co.    Portfolio
                                                                                        Return     Return
Seed            No customers; limited management        Product development;            75%        40%+
                team; incomplete product but proven     Recruit management team;        Annual     Annual IRR
stage           technology; corporate structure and     Pre-marketing;                  Internal
                intellectual property not fully         Implement corporate             Rate of
                developed; commercialization plan       structure and ESOP;             Return
                incomplete.                             IP Protection;                  (“IRR”)
                                                        Working capital.
Early           Limited customers; initial              Aggressive sales and            50%        30%+
                management team in place; beta or       marketing roll-out;             Annual     Annual IRR
stage           complete product; corporate             Begin development of            IRR
                structure and intellectual property     additional products;
                substantially complete;                 Expand management team;
                commercialization plan completed        G&A working capital to
                and being executed.                     support rapid growth.
Late            Customer adoption; developing           International expansion;        35%        25%+
                support team to supplement              Acquisitive growth;             Annual     Annual IRR
stage           management team; complete               Contemporaneous launch of       IRR
                products and additional products        multiple new products;
                under development; structure and        Monetize portion of
                intellectual property established and   founder(s)’ ownership.
                expanding to accommodate growth;
                commercialization plan executed.
Pre-IPO         Widespread customer adoption;           Acquisitions;                   15%+       15%+
                professional management, support        Liquidity for founders and      Annual      Annual IRR
                team and board of directors;            venture investors;              IRR
                multiple products; established          Future product development;
                corporate structure and intellectual    Future territorial expansion.
                property position; customer support
                and research and development;
                significant revenue and earnings.




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WHY ARE EXPECTED RATES OF RETURN SO HIGH?

Simply put, investing in emerging companies is risky! For each company that is a huge
home run like Google, there are countless companies that fail. And, since VCs only
generate returns from their investments through subsequent sales or initial public
offerings, their cash is at risk of business failure for a long period of time. Compare that
with your bank account – you can get the money whenever you want, and the government
guarantees your balance even if the bank goes under. There’s not much risk there, so the
bank doesn’t have to compensate you much for your business. If you think about bank
interest rates paid to you, or the cash that comes from a VC investment, as the same thing
– compensation for taking a risk – you will understand why Venture Fund’s seek high
returns. You might not like it, but at least you’ll understand it.

ARE THERE DIFFERENT TYPES OF VENTURE FUNDS?

VCs generally specialize in certain types of businesses (sometimes called “sectors”), in
geographic regions and stages of target company development. For example, a Venture
Fund might specialize in late stage investment in information technology companies in
Silicon Valley. This specialization occurs for a number of reasons:

    • Since Venture Capitalists try to manage the inherent risk of having investments in
      emerging companies through active monitoring, they tend to invest locally.
      Therefore, funds tend to have regional focuses.

    • Emerging companies usually involve technology, so that a domain expertise in a
      technology and relevant markets is a very important aspect of VC investment
      activities.

    • Investors in Venture Funds often invest in more than one fund at a time, so they
      look for differentiation in the funds, as a way to manage their portfolio of
      investments. Think of this like managing your stock portfolio: if you are lucky
      enough to have money in stocks, you have probably heard the advice that you
      should have your eggs in more than one basket.

WHAT TYPE OF COMPANY WOULD BE ATTRACTIVE TO A VC?

As you can conclude from the discussion above, VCs look at companies that have the
potential to be explosive, hyper growth businesses. There are many businesses that are
exciting, good businesses, that are not suitable for venture capital. Generally, businesses
that are suitable for investment by a Venture Fund have the following common
characteristics:

    • Innovative technology that can be commercialized and generally protectable.

    • A large potential market with potential for ready adoption.



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    • Strong competitive posture and favorable road map to recovery of the Venture
      Fund’s investment.

    • Great management or coachable founders.

    • A match between the valuation expectations of the owners, and the valuation
      requirements of the Venture Capitalist.

WHAT IF A COMPANY IS NOT ATTRACTIVE TO A VENTURE CAPITALIST?

There are generally two reasons why a company would not be attractive to a VC: (i) the
company’s development to date is not sufficient to provide a match between the
company’s value to the VC as an investment and the existing stockholders’ expectations
or (ii) the company will never develop in a way that would make it an attractive
investment for a Venture Fund. Firstly, it’s important to note that failure to obtain
venture capital does not mean that a business is not viable. Factually, it’s rare that any
business obtains venture capital – only 150 or so companies a year receive venture capital
in the DC region in a normal year.

Secondly, just because a company isn’t suitable for venture capital at a certain point does
not prevent it from being suitable at a later date. The important thing is for the
entrepreneur who is looking for venture capital to get good insight into the reasons for
“no”, and reevaluate his business plans. The challenge of course is getting good
information, and that is where networking and having good advisors and allies is
extremely helpful.

ARE THERE OTHER SOURCES OF CAPITAL?

For an emerging company there are sources of capital other than Venture Funds. The
most often used sources are:

   1. Personal savings, credit cards and personal debt.

   2. Investment by friends and family.

   3. Federal government grants for technology development.

   4. Local government grants and investments.

   5. Investment by wealthy individuals (so-called “Angel Investors”).

   6. Debt secured by the assets of the business (often available only after the
      company’s business is established and successful).




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   7. Financing from customers through contract prepayment or development fees.




Jonathan Aberman is Managing Director of Amplifier Venture Partners, LP, a seed and early stage
venture capital fund. He can be contacted at jaberman@amplifierventures.com.




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