VCPE Industry Overview
• VCPE Market Overview
• Research Resources
Total U.S. Capital Markets
Private Equity is just a sliver of total capital markets, but plays an important role in driving economy
For-Profit Capital Market by Segment
Total = $48.4 trillion
Private Equity = 2%
Bank Deposits LBO Funds
Equity Securities 12% $740B
Private Debt VC Funds
Sources: ―The Economics of Private Equity Funds‖, Private Equity Analyst, McKinsey
Forces at Work in Industry
reliant on new ideas—
both in technology/IP
and business models
Market Trends Liquidity
Market forces and Private Equity Industry Successful exit
social/economic Industry fills critical role in American economy— reliant on
trends create and enables entrepreneurs to take risks. potential buyers
influence Banks constrained by risk parameters and usury and/or ability to
opportunities (e.g., laws; VCPE firms provide necessary capital and list in the public
Baby Boomers & industry/ management experience to fledgling markets
Availability of Capital
Ability to access funds
can be dictated by fickle
markets and shifting
priorities of investors 4
Segments of Private Equity
Late-stage VC Leverage
Early- to mid-
Angel Investors and small Buyout (LBO) Hedge Funds
Description – Wealthy – Limited – LPs or – LPs or – Generally invest in
individuals partnerships corporations that corporations that public markets, but
(approx. 240k (LPs) or invest in later buys control of occasionally make
active) who corporations that stage private companies using private investments
typically invest typically invest companies that private capital in PIPEs (Private
$50k-$1.5mm in between $250k have revenue combined with Investment in
nascent and $20mm in traction; debt (leverage) Public Equities)
companies seed companies investment financing from – A number of
– Sometimes invest in exchange for generally ranges third-party banks; strategies from
as groups (e.g., equity. from $5mm to generally $4 debt macro- (directional
Band of Angels) – Some corporate hundreds of to every $1 cash bets on markets &
– Highly fragmented VCs (e.g., Intel millions – Transactions currencies) to
market—51k Capital) generally multi- value investing
investments made million to billions (picking
in ‗06 of dollars undervalued stocks
Stage of – Seed – Seed – Growth/ – Mature private – Private and public
Investment – Start-up expansion stage and public companies
Example firms • Band of Angels • KPCB • Summit Capital • KKR • Moore Capital
• Ron Conway • Sequoia Capital • TA Associates • Blackstone Group • Tudor Capital
• Mayfield Fund • Bain Capital
Sources: WSJ, VentureOne, Wikipedia, NVCA
Segments of Private Equity cont..
Late-stage VC Leverage
Early- to mid-
Angel Investors and small Buyout (LBO) Hedge Funds
Size of Market
(2006) – $25.6B under – Raised $29B in 2006 – Raised $212B – Raised $126.6B
mgmt across – $260B under management – Approx. $740B – $1.4 trillion assets
240k investors under mgmt under mgmt
Risk Profile – Highly risky; – Over 50% fail or – Higher rate of – ―Club‖ deals – Very
many failures barely survive success (but common: in opportunistic—
lower returns) 2006, 2+ firms capitalize on
invested together market
in 91% of deals inefficiencies
Return – Goal of very high – 10x return over 5 – Approximately 5x – Target 20-25% – Avg return of 13%
Objective returns—20+x– yrs from return in 2-5 yr return in ‗06, below S&P
on successful investments, to period, also target – Rising interest return of 15.8%
investments return 25-35% per 15-35% return rates may affect – Top funds return
year to LPs returns 30-40%
Trends – Greater – For first time, U.S. – VC firms that – Deals getting – Private
organization in firms aggressively traditionally larger (e.g. $15B endowments
the industry and seeking foreign focused on early buyout of Hertz increased
insight into best opportunities in stage (e.g., Corp in 2006) allocation to
practices China and India Highland Capital, – Firms starting to hedge funds in
– Hot areas include BVP) starting to explore options to 2006 from 7.3%
―Web 2.0‖ and also pursue later raise money in to 8.7% of capital;
―Greentech‖ stage public markets for universities
opportunities allocate average
lower cost of
Sources: The Deal, Congressional Testimony, Center for Venture Research capital of 22.4%
Investment Activity in Venture Capital Market
Investments in venture capital deals peaked in 2000 with a greater number of large, later-stage deals
Amount Invested in VCPE by Year & Stage, with # of Deals per year
$ Billions (left axis), # deals (right axis)
# of deals
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 7
Source: PriceWaterhouse Coopers
Sector Focus in Venture Capital
Information Technology is consistently over 50% of funds invested, but Healthcare has been growing
in importance after tech/dotcom frenzy of 2000 as Baby Boomers age
% Invested in Sectors of VC by Year
Total = 100%
Sector $94.8B $36.4B $22.1B $19.7B $22.4B $23.8B $25.7B 2006 Median Deal Size
2000 2001 2002 2003 2004 2005 2006
Market Opportunity Affects Potential for VC Funding
Common traits of attractive Subsequently, certain sectors are
investment opportunities include: more ―VC-friendly‖ than others:
• Barriers to entry • High-growth tech companies with
• Solid founder and/or management patented IP trade on public markets
team in place and are valued in venture capital
with higher revenue multiples than
• Large, rapidly growing addressable slow-growth capital-intensive retail
market companies—~3-7x for the former,
• High margins and closer to ~1-2x for the latter
• Ability to scale business quickly • Subsequently, to attain returns
• Customer demand established— commensurate with risk, most VC
limited education needed firms focus on technology—be it
software, semiconductors, biotech,
• Clear potential acquirer and/or path
or medical devices
Old Favorites and Hot New Sectors
Software still dominates new investments, though a few sectors have shifted in priority, particularly
energy (over half a billion was invested in ―Clean Tech‖—alternative fuels and fuel-efficient devices)
Top Ten Sectors, by $ invested, 1997-2006 Top Ten Sectors, by 1st round $ invested, 2006
Total = $347.8B, $ Billions Total = $5.8B, $ Billions
- 20 40 60 80 - 0.2 0.4 0.6 0.8 1.0 1.2
Medical Devices and
IT Services Media and
Medical Devices and
and Services Semiconductors
Recovery from Internet Bubble
Public markets are recovering from dot.com turmoil…
Nasdaq Index Historical Closing Price*
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
*1/2/1990-4/2/07, Adjusted Closing Price
Source: Yahoo! Finance
Recovery from 2000 Bubble
…and commitments to venture capital firms have been rebounding. In 2001, 25% of active VC firms
were new funds—scarcity of capital in ensuing years weeded out poor performers
Commitments to U.S. VC Funds in Past 10 Years Survival of the fittest
• In 1990, there were
just 398 VC firms.
• This grew to 1,200
80 active funds in 2000
• By the end of 2006,
the number of active
funds had dropped to
837 (50 less than in
• Even with less funds,
firms raising larger
pools of capital
20 • With mega-deals,
LBO firms outraised
10 VC‘s by 3.5x in ‘06
(vs. 1-2x in ‗98-‘00)
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 12
Source: VentureOne, Harvard Business Review, Dow Jones, SandHill.com, NVCA
Sources of Funding in Private Equity
Key sources Percentage Portfolio Profile
Pension Funds 42% • Public equity - 61.2%
• Bonds/fixed income - 24.5%
• Real estate- 7.2%
• Private equity - 5.7%
• Cash equivalents - 1.4%
• Varies greatly by institution and goals
Financial & • Generally weighted towards low-risk
Insurance Firms debt/notes, but some private equity
Educational Institution Mean:
Endowments & • Public equity – 49.1%
Foundations • Debt/notes – 32.9%
• Real assets & cash – 11.7%
• Private equity – 6.4%
Families 10% • Varies greatly by risk tolerance and
sophistication of investment managers 13
Source: NVCA , CalPERS Annual Report 2006, Yale University Endowment Report 2006
Case Study of Funding Source: Yale Endowment
Shrewd management and access to top VCPE firms = superior returns:
• Yale University‘s Endowment pioneered diversification into alternative asset classes—only 16% of
assets are invested in traditional U.S. marketable securities, vs. 50% in average endowment.
• The University‘s target allocation to private equity of 17.0% far exceeds the 6.4% actual allocation of
the average educational institution.
Asset Allocation – Yale vs. Peers
University Institution Mean
Real Assets 27.80% 8.40%
Absolute Return 23.30% 18.60%
Private Equity 16.40% 6.40%
Foreign Equity 14.60% 20%
Domestic Equity 11.60% 28.10%
Fixed Income 3.80% 14.30%
Cash 2.50% 3.30%
Sources: Yale Endowment Report 2006
Private Equity Pipeline and Diligence Process
Private Equity investments result from robust pipeline and rigorous filtering process:
100 Business Plans
Dealflow • Initial meeting with 10 Promising Opportunities
• Total Addressable Intensive Due Diligence
Market (TAM) • In-depth meetings with
• Competitive management 1 Investment
landscape • Analysis of potential returns
Industry • Barriers to entry based on industry comparables
Events (patented IP, head and probability of successful exit
start on R&D, • Reference calls with customers,
founder/ industry experts,
management management/board contacts
expertise) • Modeling of financials
• Initial review of
Source: NVCA, HBS materials
Success Not Guaranteed
Due to number of factors, even with rigorous diligence process, over half of start-ups fail
Factors affecting success of start-up: Outcomes of Companies First Funded 1991-2000
Total = 11,688 companies
• Company has sufficient capital
• Management is capable and focused
Acquired - 33%
• Product development goes as planned Went/Going
• Production and component sourcing goes Public - 14%
• Competitors behave as expected
• Customers want product
• Pricing is forecast correctly
• Patents are issued and are enforceable
Combined probability of success = 17% Still private or
unknown* - 35% Known Failed - 18%
*Of those whose outcome is unknown, most have ―quietly failed‖
Source: Harvard Business Review, NVCA
According to a study in the Harvard Business Review, the typical performance of $1,000 invested by a
VC firm breaks out as follows:
Payout in Year 5 Gross Return Net Return
Great - $100 20x $2,000 $1,900
Good - $100 10x $1,000 $900
Okay - $200 5x $1,000 $800
Alive - $400 1x $400 $-
Bad - $200 0 $- $(200)
TOTAL $4,400 $3,400 17
Source: Harvard Business Review
Liquidity in Venture Capital Market
M&A has long provided greatest opportunity for liquidity of private investments, particularly
following internet bust of 2000-01, amid increased regulation and scrutiny of public companies
Amount Raised/Paid for Venture-backed Companies, by Market
$120 Only 12% of 2006
transactions were IPOs
• In 2006, 404 VC-
$100 backed companies
were sold through
M&A, while just 56
$80 companies were
listed on public
M&A • The median time for
business to go
$40 public is now 6.2
years, up from 3.1
years in 1997
1999 2000 2001 2002 2003 2004 2005 2006
Sources: WSJ, VentureOne
Key Practices of VCPE Investors
To mitigate risk and increase likelihood of success, VCPE investors adhere to key practices:
Key activities Key practices
Lifecycle – Personal networks for dealflow and conferences
alignment – Deal pipeline & screening
– Meetings with management to review business plan
Risk/return – Review & discussion by partnership
alignment • Valuation and Investment presentation
– Due diligence
• Analysis of projections versus market forces/trends,
• Analysis of likely return based on valuation
– Investment memo
Co-funding – Form syndicate when applicable
alignment – Align interests and skillsets between existing and new
• Different types of investors and board members for
difference stages of lifecycle 19
Importance of Private Equity Managers
Success of private equity investments highly correlated to skill of investors:
• The Yale University Endowment analyzed and ranked investment returns across a range of asset
classes between first and third quartile managers over a 10 year period.
• While fixed income and public equities had a fairly narrow band of potential returns, VCPE returns
varied greatly, dependent on dealflow and skill of investors
• Despite wide variance, VCPE firms above median still outperformed other asset classes
Investment Returns Over 10 Year Period*
Active Management Returns1
0% 5% 10% 15% 20% 25% 30%
US Fixed Income
US Large Cap
US Small Cap
Third Quartile Median Top Quartile
*Analysis conducted for years 1987-1997
Source: Yale University Endowment 2000 Report
Skills of Top VCPE Investors
Following are ideal skillsets for investor to add value to portfolio companies:
Personal Strong personal networks enable investors to generate dealflow, be the first
Networks to learn about industry developments, help portfolio companies secure
talent, and provide critical business development introductions.
With large pipeline of deals and limited time and resources, must efficiently
Selectivity & sift through potential investment opportunities. Critical to leverage
Specialization technical knowledge and to prioritize opportunities based on anticipated
return. Each Partner in a firm generally actively manages only around 5-10
investments at a time, depending on lifecycle, so must choose wisely.
Investor generally sits on Board and serves as close advisor to CEO and
management team. When company faces tough decisions (e.g., firing vs.
making payroll in a down quarter), it is helpful for investor to be able to
draw on personal experience and serve as advisor.
Important for investor to know lay of the land—key competitors, industry
developments, technical specifications—to make informed decision about
making investment, as well as how to manage development and exit.
Unlike public companies, ownership and management are generally
Focus on aligned because of shared economic interests, focused on an exit. It is in
Value Creation investor‘s best interest to remain involved and watchful, guiding strategic
decisions to create value.
Case Study of Personal Networks: PayPal
PayPal was a highly successful start-up founded in 1998 and sold in 2002 to eBay for $1.5B. The
founders and top management have gone on to significant success and remain interconnected:
Max Levchin Peter Thiel Roelof Botha Jeremy Stoppelman Russel Simmons
Co-founder Co-founder CFO VP Engineering Engineer
Founded web Started hedge Joined top VC
property: fund, Clarium, & vc firm Sequoia Co-founded
firm, Founders Capital in 2003 successful internet
Capital. Personally site yelp in 2004
Involved with: Advised:
Invested in: Google for $1.6B
Sources: Wikipedia, Sequoia Capital, PayPal, Facebook, LinkedIn, Slide, Thank You for Smoking, YouTube
• VCPE Market Overview
• Research Resources
Key Individuals and Organizations
Category Individual Organization Description Location
Angels Ron Conway - Top angel investor in Silicon Valley--Google, CA
Hedge Funds Bruce Kovner Caxton Founder of one of world's top hedge funds, NY
Caxton; also very civic minded--particularly the
arts (Lincoln Center)
Paul Tudor Jones Tudor Group Founder of top fund, Tudor; also founder of Robin NY
Industry Expert Daniel Primack PE Week Wire Publishes daily newsletter on industry MA
developments read by most in VCPE community
John Lerner HBS Professor at HBS and expert in VCPE MA
William Sahlman HBS Professor at HBS and expert in entrepreneurship MA
Organization - Kauffman Fellows Awards fellowships each year to encourage VC KS
firms to hire recent MBA grads; focused on
- NVCA VC Industry Association VA
- Keiretsu Forum Angel Investor group CA
PE George Roberts KKR Private equity pioneer and Co-Founder of KKR CA
Henry Kravis KKR Private equity pioneer and Co-Founder of KKR NY
Stephen Schwarzman Blackstone Founder of Blackstone; very civic minded NY
David Rubenstein Carlyle Group Co-Founder of Carlyle Group; extensive DC
VC Arthur Rock Davis & Rock One of first VCs in U.S.; funded Apple, Intel, etc. CA
Endowed HBS with Arthur Rock Center for
Brook Byers KPCB Top VC and Co-Founder of KPCB CA
Felda Hardymon Bessemer Venture Partners Experienced VC investor and professor in VCPE MA
Henry McCance Greylock VC industry pioneer; Co-Founder of Greylock MA
John Doerr KPCB Top VC and Co-Founder of KPCB CA
Roelof Boetha Sequoia Capital Young, rising VC at Sequoia Capital; involved with CA 24
Full Circle Fund
Key Documents & Data Sources
Subject Title Author Description
Angels "Angel Investing Group Best Practices" Mike Franks and James Geshwiler 7 pgs; overview of angel investing practices
"Angles on angels: financing technology- John Freear, Jeffrey E. Sohl, and William 13 pgs; historical perspective on angel
based ventures - a historical perspective" Wetzel (Whittemore School of Business) investing
Data "Global Trends in Venture Capital: 2006 Deloitte & Touche and NVCA 28 pgs; survey of investment trends in
"MoneyTree Report 2006" PricewaterhouseCoopers 12 pgs; powerpoint slides outlining results
of 2005-06 MoneyTree report on PE deals
"Venture Impact 2007" Global Insight & NVCA 24 pgs; summary of data and analysis of
VC's impact on U.S. economy
Funding Sources Yale University Endowment Annual Yale University Endowment 28 pgs; 2006 report on performance of
Report 2006 Yale University endowment and analysis of
Methodology "How Venture Capital Works" Bob Zider (Harvard Business Review, 12 pgs;
"Note on Angel Investing" Tuck School of Business 18 pgs; teaching materials explaining angel
"Note on Due Diligence in Venture Tuck School of Business 11 pgs; teaching materials explaining due
Capital" diligence process
"Note on Leveraged Buyouts" Tuck School of Business 23 pgs; teaching materials explaining LBOs
"Note on Private Equity Asset Allocation" Tuck School of Business 18 pgs; teaching materials explaining asset
"Note on Private Equity Deal Structures" Tuck School of Business 15 pgs; teaching materials explaining PE
"Note on Venture Capital Portfolio Tuck School of Business 18 pgs; teaching materials explaining VC
Management" portfolio management
"Private Equity Glossary" Tuck School of Business 30 pgs; definitions of key private equity
"The Syndication of Venture Capital Josh Lerner (Financial Management, 23 pages; seminal article that examines 3
Investments" September 1994) key rationales for syndicates in vc investing
Key Documents & Data Sources cont…
Subject Title Author Description
Methodology "Trends in Terms of Venture Financings Fenwick & West, LLP 4 pgs; analysis of standard terms in vc
in the San Francisco Bay Area" deals in Bay area
"Valuation Survey Results 2002" Tuck School of Business 108 pgs; analysis of the results of a survey
on guidelines, policies and practices for
valuation in the vc industry
Venture Capital and Private Equity: A Josh Lerner (HBS Press) 540 pgs; coursebook for VCPE class at
Casebook HBS; includes description of vcpe process
and numerous case studies of principles in
News/Blog Infectious Greed blog Paul Kedrosky Blog by vc professional providing
http://paul.kedrosky.com/ commentary/analysis of industry
PE Hub www.pehub.com Thomson News blog on industry by Thomson;
distribute daily newsletter by Dan Primack
(PE Week Wire) summarizing deals and
The Daily Deal www.thedeal.com Daily industry publication providing news
VentureWire Daily newsletter providing in-depth analysis
of recent VCPE deals and industry
Nonprofit "Virtuous Capital: What Foundations Can Christine W. Letts William Ryan Allen 10 pgs; analysis of vc practices that can be
Learn from Venture Capitalists" Grossman (Harvard Business Review, used in nonprofit sector
PE "The Economics of Private Equity" Andrew Metrick and Ayako Yasuda 45 pgs; graduate paper by Wharton
(Wharton) students analyzing economics of PE
VC "On the fundamental role of venture Thomas Hellmann and Manju Puri 8 pgs; analysis by Federal Reserve
capital" (Economic Review, Federal Reserve Bank economists of VC's impact on economy
of Atlanta, 2002)
"Patient Capital" David Goodman and Anthony Stolis 44 pgs; analysis of impact of private equity
(NVCA) in healthcare market
"What Venture Trends Can Tell You" Matthew R. Cohler, William F. Meehan, 2 pgs; analysis of vc industry and
and Ron Lemmens (Harvard Business prediction of impact on economy in coming
Review, 2003) years
Nothing Ventured: The Perils and Robert J. Kunze (HarperBusiness 252 pgs; written in 1990; provides
Payoffs of the Great American Venture Publishing) 26
anecdotal guide to vc process and analysis
Capital Game of important early deals (e.g., Apple,
Glossary of Terms
• ―A‖ round – a financing event whereby angel groups and / or venture capitalists become involved in a fast growth company that was previously
financed by founders and their friends and families.
• Angel – a wealthy individual that invests in companies in relatively early stages of development. Usually angels invest less than $1 million per
• Anti-dilution – a contract clause that protects an investor from a substantial reduction in percentage ownership in a company due to the issuance by
the company of additional shares to other entities. The mechanism for making adjustments is called a Ratchet.
• ―B‖ round – a financing event whereby investors such as venture capitalists and organized angel groups are sufficiently interested in a company to
provide additional funds after the ―A‖ round of financing. Subsequent rounds are called ―C‖, ―D‖ and so on.
• Bootstrapping – the actions of a startup to minimize expenses and build cash flow, thereby reducing or eliminating the need for outside investors.
• Bridge financing – temporary funding that will eventually be replaced by permanent capital from equity investors or debt lenders. In venture cap ital,
a bridge is usually a short term note (6 to 12 months) that converts to preferred stock. Typically, the bridge lender has the right to convert the note to
preferred stock at a price that is a 20% to 25% discount from the price of the preferred stock in the next financing round.
• Broad-based weighted average ratchet - a type of anti-dilution mechanism. A weighted average ratchet adjusts downward the price per share of
the preferred stock of investor A due to the issuance of new preferred shares to new investor B at a price lower than the price investor A originally
received. Investor A‘s preferred stock is repriced to a weighted average of investor A‘s price and investor B‘s price. A broad-based ratchet uses all
common stock outstanding on a fully diluted basis (including all convertible securities, warrants and options) in the denomin ator of the formula for
determining the new weighted average price.
• Burn rate – the rate at which a startup with little or no revenue uses available cash to cover expenses. Usually expressed on a monthly or weekly
• Business plan – a document that describes a new concept for a business opportunity. A business plan typically includes the following sections:
executive summary, market need, solution, technology, competition, marketing, management, operations and financials.
• Buyout – a sector of the private equity industry. Also, the purchase of a controlling interest of a company by an outside investor (in a leveraged
buyout) or a management team (in a management buyout).
• Capital call – when a private equity fund manager (usually a ―general partner‖ in a partnership) requests that an investor in the fund (a ―limited
partner‖) provide additional capital. Usually a limited partner will agree to a maximum investment amount and the general partner will make a series
of capital calls over time to the limited partner as opportunities arise to finance startups and buyouts.
• Capitalization table – a table showing the owners of a company‘s shares and their ownership percentages as well as the debt holders. It also lists
the forms of ownership, such as common stock, preferred stock, warrants, options, senior debt, and subordinated debt.
• Carried interest – a share in the profits of a private equity fund. Typically, a fund must return the capital given to it by limited partners plus any
preferential rate of return before the general partner can share in the profits of the fund. The general partner will then receive a 20% carried interest,
although some successful firms receive 25%-30%. Also known as ―carry‖ or ―promote.‖
• Catch-up – a clause in the agreement between the general partner and the limited partners of a private equity fund. Once the limited partners have
received a certain portion of their expected return, the general partner can then receive a majority of profits until the previously agreed upon profit
split is reached.
Glossary of Terms cont…
• Clawback – a clause in the agreement between the general partner and the limited partners of a private equity fund. The clawback gives limited
partners the right to reclaim a portion of disbursements to a general partner for profitable investments based on significant losses from later
investments in a portfolio.
• Closing – the conclusion of a financing round whereby all necessary legal documents are signed and capital has been transferred.
• Co-investment –either a) the right of a limited partner to invest with a general partner in portfolio companies, or b) the act of investing by two or more
entities in the same target company (also known as a Club deal).
• Common stock – a type of security representing ownership rights in a company. Usually, company founders, management and employees own
common stock while investors own preferred stock. In the event of a liquidation of the company, the claims of secured and unsecured creditors,
bondholders and preferred stockholders take precedence over common stockholders. See Preferred stock.
• Comparable – a publicly traded company with similar characteristics to a private company that is being valued. For example, a telecommunications
equipment manufacturer whose market value is 2 times revenues can be used to estimate the value of a similar and relatively n ew company with a
new product in the same industry.
• Conversion – the right of an investor or lender to force a company to replace the investor‘s preferred shares or the lender‘s debt with common
shares at a preset conversion ratio. A conversion feature was first used in railroad bonds in the 1800‘s.
• Convertible debt – a loan which allows the lender to exchange the debt for common shares in a company at a preset conversion ratio
• Convertible preferred stock – a type of stock that gives an owner the right to convert to common shares of stock. Usually, preferred stock has
certain rights that common stock doesn‘t have, such as decision-making management control, a promised return on investment (dividend), or senior
priority in receiving proceeds from a sale or liquidation of the company. Typically, convertible preferred stock automatically converts to common stock
if the company makes an initial public offering (IPO). Convertible preferred is the most common tool for private equity funds to invest in companies.
• Covenant – a legal promise to do or not do a certain thing. For example, in a financing arrangement, company management may agree to a negative
covenant, whereby it promises not to incur additional debt. The penalties for violation of a covenant may vary from repairing the mistake to losing
control of the company.
• Cram down round – a financing event upon which new investors with substantial capital are able to demand and receive contractual terms that
effectively cause the issuance of sufficient new shares by the startup company to significantly reduce (―dilute‖) the ownership percentage of previous
• Cumulative dividends – the owner of preferred stock with cumulative dividends has the right to receive accrued (previously unpaid) dividends in full
before dividends are paid to any other classes of stock.
• Deal flow – a measure of the number of potential investments that a fund reviews in any given period.
• Demand rights – a type of registration right. Demand rights give an investor the right to force a startup to register its shares with the SEC and
prepare for a public sale of stock (IPO).
• Dilution – the reduction in the ownership percentage of current investors, founders and employees caused by the issuance of new shares to new
Distribution – the transfer of cash or securities to a limited partner resulting from the sale, liquidation or IPO of one or more portfolio companies in
which a general partner chose to invest.
Glossary of Terms cont…
• Dividends – payments made by a company to the owners of certain securities. Typically, dividends are paid quarterly, by approval of the board of
directors, to owners of preferred stock.
• Down round – a round of financing whereby the valuation of the company is lower than the value determined by investors in an earlier round.
• Drag-along rights – the contractual right of an investor in a company to force all other investors to agree to a specific action, such as the sale of the
• Due diligence – the investigatory process performed by investors to assess the viability of a potential investment and the accuracy of the
information provided by the target company.
• Early stage – the state of a company after the seed (formation) stage but before middle stage (generating revenues). Typically, a company in early
stage will have a core management team and a proven concept or product, but no positive cash flow.
• Earn out- an arrangement in which sellers of a business receive additional future payments, usually based on financial performance metrics such
as revenue or net income.
• Employee Stock Ownership Program (ESOP) – a plan established by a company to reserve shares for employees.
• Exit strategy – the plan for generating profits for owners and investors of a company. Typically, the options are to merge, be acquired or make an
initial public offering (IPO). An alternative is to recapitalize (releverage the company and then pay dividends to shareholders).
• Expansion stage – the stage of a company characterized by a complete management team and a substantial increase in revenues.
• Founders stock – nominally priced common stock issued to founders, officers, employees, directors, and consultants.
• Friends and family financing – capital provided by the friends and family of founders of an early stage company. Founders should be careful not
to create an ownership structure that may hinder the participation of professional investors once the company begins to achieve success.
• Full ratchet – an anti-dilution protection mechanism whereby the price per share of the preferred stock of investor A is adjusted downward due to
the issuance of new preferred shares to new investor B at a price lower than the price investor A originally received. Investor A‘s preferred stock is
repriced to match the price of investor B‘s preferred stock. Usually as a result of the implementation of a ratchet, company management and
employees who own a fixed amount of common shares suffer significant dilution.
• Fully diluted basis – a methodology for calculating any per share ratios whereby the denominator is the total number of shares issued by the
company on the assumption that all warrants and options are exercised and preferred stock.
• Fund-of-funds – a fund created to invest in private equity funds. Typically, individual investors and relatively small institutional investors participate
in a fundof- funds to minimize their portfolio management efforts.
• General partner (GP) – a class of partner in a partnership. The general partner retains liability for the actions of the partnership. In the private
equity world, the GP is the fund manager while the limited partners (LPs) are the institutional and high net worth investors in the partnership. The
GP earns a management fee and a percentage of profits.
• Going-private transaction – when a public company chooses to pay off all public investors, delist from all stock exchanges, and become owned by
management, employees, and select private investors.
Growth stage – the state of a company when it has received one or more rounds of financing and is generating revenue from its product or service.
Also known as ―middle stage.‖
Glossary of Terms cont…
• Hedge fund – an investment fund that has the ability to use leverage, take short positions in securities, or use a variety of derivative instruments in
order to achieve a return that is relatively less correlated to the performance of typical indices (such as the S&P 500) than traditional long-only
funds. Hedge fund managers are typically compensated based on assets under management as well as fund performance.
• Hockey stick – the general shape and form of a chart showing revenue, customers, cash or some other financial or operational measure that
increases dramatically at some point in the future. Entrepreneurs often develop business plans with hockey stick charts to impress potential
• Hurdle rate – a minimum rate of return required before an investor will make an investment.
• Initial public offering (IPO) – the first offering of stock by a company to the public. New public offerings must be registered with the Securities and
Exchange Commission. An IPO is one of the methods that a startup that has achieved significant success can use to raise additional capital for
• Inside round – a round of financing in which the investors are the same investors as the previous round. An inside round raises liability issues
since the valuation of the company has no third party verification in the form of an outside investor. In addition, the terms of the inside round may be
considered self-dealing if they are onerous to any set of shareholders or if the investors give themselves additional preferential rights.
• Institutional investor – professional entities that invest capital on behalf of companies or individuals. Examples are: pension plans, insurance
companies and university endowments.
• Internal rate of return (IRR) – the interest rate at which a certain amount of capital today would have to be invested in order to grow to a specific
value at a specific time in the future.
• Investment thesis / Investment philosophy – the fundamental ideas which determine the types of investments that an investment fund will
choose in order to achieve its financial goals.
• Later stage – the state of a company that has proven its concept, achieved significant revenues compared to its competition, and is approaching
cash flow break even or positive net income. Typically, a later stage company is about 6 to 12 months away from a liquidity event such as an IPO or
buyout. The rate of return for venture capitalists that invest in later stage, less risky ventures is lower than in earlier stage ventures.
• Lead investor – the venture capital investor that makes the largest investment in a financing round and manages the documentation and closing of
that round. The lead investor sets the price per share of the financing round, thereby determining the valuation of the company.
• Letter of intent – a document confirming the intent of an investor to participate in a round of financing for a company. By signing this document, the
subject company agrees to begin the legal and due diligence process prior to the closing of the transaction. Also known as a ―Term Sheet‖.
• Leverage – the use of debt to acquire assets, build operations and increase revenues. By using debt, a company is attempting to achieve results
faster than if it only used its cash available from pre-leverage operations. The risk is that the increase in assets and revenues does not generate
sufficient net income and cash flow to pay the interest costs of the debt.
• Leveraged buyout (LBO) – the purchase of a company or a business unit of a company by an outside investor using mostly borrowed capital.
• Leveraged recapitalization – the reorganization of a company‘s capital structure resulting in more debt added to the balance sheet. Private equity
funds can recapitalize a portfolio company and then direct the company to issue a one-time dividend to equity investors. This is often done when the
company is performing well financially and the debt markets are expanding. 31
• Limited liability company (LLC) – an ownership structure designed to limit the founders‘ losses to the amount of their investment. An LLC does
not pay taxes, rather its owners pay taxes on their proportion of the LLC profits at their individual tax rates.
Glossary of Terms cont…
• Limited partnership – a legal entity composed of a general partner and various limited partners. The general partner manages the investments and
is liable for the actions of the partnership while the limited partners are generally protected from legal actions and any losses beyond their original
investment. The general partner receives a management fee and a percentage of profits, while the limited partners receive income, capital gains
and tax benefits.
• Limited partner (LP) – an investor in a limited partnership. The general partner is liable for the actions of the partnership while the limited partners
are generally protected from legal actions and any losses beyond their original investment. The limited partner receives income, capital gains and
• Liquidation – the sale of a company. This may occur in the context of an acquisition by a larger company or in the context of selling off all assets
prior to cessation of operations (Chapter 7 bankruptcy). In a liquidation, the claims of secured and unsecured creditors, bondholders and preferred
stockholders take precedence over common stockholders.
• Liquidation preference – the contractual right of an investor to priority in receiving the proceeds from the liquidation of a company. For example, a
venture capital investor with a ―2x liquidation preference‖ has the right to receive two times its original investment upon liquidation.
• Liquidity event – a transaction whereby owners of a significant portion of the shares of a private company sell their shares in exchange for cash or
shares in another, usually larger company. For example, an IPO is a liquidity event.
• Lock-up agreement – investors, management and employees often agree not to sell their shares for a specific time period after an IPO, usually 6
to 12 months. By avoiding large sales of its stock, the company has time to build interest among potential buyers of its shares.
• Management buyout (MBO) – a leveraged buyout controlled by the members of the management team of a company or a division. Often an MBO
is conducted in partnership with a buyout fund.
• Management fee – a fee charged to the limited partners in a fund by the general partner. Management fees in a private equity fund typically range
from 0.75% to 3% of capital under management, depending on the type and size of fund.
• Mezzanine – a layer of financing that has intermediate priority (seniority) in the capital structure of a company. For example, mezzanine debt has
lower priority than senior debt but usually has a higher interest rate and often includes warrants. In venture capital, a mezzanine round is generally
the round of financing that is designed to help a company have enough resources to reach an IPO.
• Middle stage – the state of a company when it has received one or more rounds of financing and is generating revenue from its product or service.
Also known as ―growth stage.‖
• Multiples – a valuation methodology that compares public and private companies in terms of a ratio of value to an operations figure such as
revenue or net income. For example, if several publicly traded computer hardware companies are valued at approximately 2 times revenues, then it
is reasonable to assume that a startup computer hardware company that is growing fast has the potential to achieve a valuation of 2 times its
revenues. Before the startup issues its IPO, it will likely be valued at less than 2 times revenue because of the lack of liquidity of its shares.
• Narrow-based weighted average ratchet – a type of anti-dilution mechanism. A weighted average ratchet adjusts downward the price per share of
the preferred stock of investor A due to the issuance of new preferred shares to new investor B at a price lower than the price investor A originally
received. Investor A‘s preferred stock is repriced to a weighed average of investor A‘s price and investor B‘s price. A narrow-based ratchet uses
only common stock outstanding in the denominator of the formula for determining the new weighted average price.
Glossary of Terms cont…
• Non-cumulative dividends – dividends that are payable to owners of preferred stock at a specific point in time only if there is sufficient cash flow
available after all company expenses have been paid. If cash flow is insufficient, the owners of the preferred stock will not receive the dividends
owed for that time period and will have to wait until the board of directors declares another set of dividends.
• Non-disclosure agreement (NDA) – an agreement issued by entrepreneurs to protect the privacy of their ideas when disclosing those ideas to
• Outstanding shares – the total amount of common shares of a company, not including treasury stock, convertible preferred stock, warrants and
• Pay to play – a clause in a financing agreement whereby any investor that does not participate in a future round agrees to suffer significant dilution
compared to other investors. The most onerous version of ―pay to play‖ is automatic conversion to common shares, which in essence ends any
preferential rights of an investor, such as the right to influence key management decisions.
• Pari passu – a legal term referring to the equal treatment of two or more parties in an agreement. For example, a venture capitalist may agree to
have registration rights that are pari passu with the other investors in a financing round.
• Participating dividends – the right of holders of certain preferred stock to receive dividends and participate in additional distributions of cash, stock
or other assets.
• Participating preferred stock – a unit of ownership composed of preferred stock and common stock. The preferred stock entitles the owner to
receive a predetermined sum of cash (usually the original investment plus accrued dividends) if the company is sold or has an IPO. The common
stock represents additional continued ownership in the company. Participating preferred stock has been characterized as ―having your cake and
eating it too.‖
• Placement agent – a company that specializes in finding institutional investors that are willing and able to invest in a private equity fund.
Sometimes a private equity fund will hire a placement agent so the fund partners can focus on making and managing investmentsin companies
rather than on raising capital.
• Portfolio company – a company that has received an investment from a private equity fund.
• Post-money valuation – the valuation of a company including the capital provided by the current round of financing. For example, a venture
capitalist may invest $5 million in a company valued at $2 million ―pre-money‖ (before the investment was made). As a result, the startup will have a
post-money valuation of $7 million.
• Preferred stock – a type of stock that has certain rights that common stock does not have. These special rights may include dividends,
participation, liquidity preference, anti-dilution protection and veto provisions, among others. Private equity investors usually purchase preferred
stock when they make investments in companies.
• Pre-money valuation – the valuation of a company prior to the current round of financing. For example, a venture capitalist may invest $5 million in
a company valued at $2 million pre-money. As a result, the startup will have a ―post-money‖ valuation of $7 million.
• Price earnings ratio (PE ratio) – the ratio of a public company‘s price per share and its net income after taxes on a per share basis.
• Private placement – the sale of a security directly to a limited number of institutional and qualified individual investors. If structured correctly, a
private placement avoids registration with the Securities and Exchange Commission. 33
Glossary of Terms cont…
• Redemption rights – the right of an investor to force the startup company to buy back the shares issued as a result of the investment. In effect, the
investor has the right to take back his/her investment and may even negotiate a right to receive an additional sum in excess of the original
• Registration rights – the rights of an investor in a startup regarding the registration of a portion of the startup‘s shares for sale to the public.
Piggyback rights give the shareholders the right to have their shares included in a registration. Demand rights give the shareholders the option to
force management to register the company‘s shares for a public offering. Often, registration rights are hotly negotiated among venture capitalists in
multiple rounds of financing.
• Round – a financing event usually involving several private equity investors.
• Scalability – a characteristic of a new business concept that entails the growth of sales and revenues with a much slower growth of organizational
complexity and expenses. Venture capitalists look for scalability in the startups they select to finance.
• Secondary market – a market for the sale of limited partnership interests in private equity funds. Sometimes limited partners chose to sell their
interest in a partnership, typically to raise cash or because they cannot meet their obligation to invest more capital according to the takedown
schedule. Certain investment companies specialize in buying these partnership interests at a discount.
• Seed capital – investment provided by angels, friends and family to the founders of a startup in seed stage.
• Seed stage – the state of a company when it has just been incorporated and its founders are developing their product or service.
• Series A preferred stock – preferred stock issued by a fast growth company in exchange for capital from investors in the ―A‖ round of financing.
This preferred stock is usually convertible to common shares upon the IPO or sale of the company.
• Stock option – a right to purchase or sell a share of stock at a specific price within a specific period of time. Stock purchase options are commonly
used as long term incentive compensation for employees and management of fast growth companies.
• Strategic investor – a relatively large corporation that agrees to invest in a young company in order to have access to a proprietary technology,
product or service. By having this access, the corporation can potentially achieve its strategic goals.
• Syndicate – a group of investors that agree to participate in a round of funding for a company. Alternatively, a syndicate can refer to a group of
investment banks that agree to participate in the sale of stock to the public as part of an IPO.
• Tag-along right – the right of a minority investor to receive the same benefits as a majority investor. Usually applies to a sale of securities by
• Term sheet – a document confirming the intent of an investor to participate in a round of financing for a company. By signing this document, the
subject company agrees to begin the legal and due diligence process prior to the closing of the transaction. Also known as ―Letter of Intent‖.
• Venture capital – a segment of the private equity industry which focuses on investing in new companies with high growth rates.
• Venture capital method – a valuation method whereby an estimate of the future value of a company is discounted by a certain interest rate and
adjusted for future anticipated dilution in order to determine the current value. Usually, discount rates for the venture capital method are
considerably higher than public stock return rates, representing the fact that venture capitalists must achieve significant returns on investment in
order to compensate for the risks they take in funding unproven companies. 34
Glossary of Terms cont…
• Vesting – a schedule by which employees gain ownership over time of a previously agreed upon amount of retirement funding or stock options.
• Warrant – a security which gives the holder the right to purchase shares in a company at a pre-determined price. A warrant is a long term option,
usually valid for several years or indefinitely. Typically, warrants are issued concurrently with preferred stocks or bonds in order to increase the
appeal of the stocks or bonds to potential investors.
• Weighted average ratchet – an anti-dilution protection mechanism whereby the conversion rate of preferred stock is adjusted in order to reduce an
investor‘s loss due to an increase in the number of shares in a company. Without a ratchet, an investor would suffer from a dilution of his or her
percentage ownership. Usually as a result of the implementation of a weighted average ratchet, company management and employees who own a
fixed amount of common shares suffer significant dilution, but not as badly as in the case of a full ratchet.