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Bob Zider
From the November-December 1998 Issue
Invention and innovation drive the U.S. economy. What s more, they have a
powerful grip on the nation s collective imagination. The popular press is
filled with against-all-odds success stories of Silicon Valley entrepreneurs.
In these sagas, the entrepreneur is the modern-day cowboy, roaming new
industrial frontiers much the same way that earlier Americans explored the
West. At his side stands the venture capitalist, a trail-wise sidekick ready to
help the hero through all the tight spots in exchange, of course, for a piece
of the action.
As with most myths, there s some truth to this story. Arthur Rock, Tommy Davis,
Tom Perkins, Eugene Kleiner, and other early venture capitalists are legendary
for the parts they played in creating the modern computer industry. Their
investing knowledge and operating experience were as valuable as their capital.
But as the venture capital business has evolved over the past 30 years, the
image of a cowboy with his sidekick has become increasingly outdated. Today s
venture capitalists look more like bankers, and the entrepreneurs they fund
look more like M.B.A. s.
The U.S. venture-capital industry is envied throughout the world as an engine
of economic growth. Although the collective imagination romanticizes the
industry, separating the popular myths from the current realities is crucial to
understanding how this important piece of the U.S. economy operates. For
entrepreneurs (and would-be entrepreneurs), such an analysis may prove
especially beneficial.
---
Profile of the Ideal Entrepreneur
From a venture capitalist s perspective, the ideal entrepreneur:
is qualified in a hot area of interest,
delivers sales or technical advances such as FDA approval with reasonable
probability,
tells a compelling story and is presentable to outside investors,
recognizes the need for speed to an IPO for liquidity,
has a good reputation and can provide references that show competence and
skill,
understands the need for a team with a variety of skills and therefore sees why
equity has to be allocated to other people,
works diligently toward a goal but maintains flexibility,
gets along with the investor group,
understands the cost of capital and typical deal structures and is not offended
by them,
is sought after by many VCs,
has realistic expectations about process and outcome.
---
Venture Capital Fills a Void
Contrary to popular perception, venture capital plays only a minor role in
funding basic innovation. Venture capitalists invested more than $10 billion in
1997, but only 6%, or $600 million, went to startups. Moreover, we estimate
that less than $1 billion of the total venture-capital pool went to R&D. The
majority of that capital went to follow-on funding for projects originally
developed through the far greater expenditures of governments ($63 billion) and
corporations ($133 billion).
Where venture money plays an important role is in the next stage of the
innovation life cycle the period in a company s life when it begins to
commercialize its innovation. We estimate that more than 80% of the money
invested by venture capitalists goes into building the infrastructure required
to grow the business in expense investments (manufacturing, marketing, and
sales) and the balance sheet (providing fixed assets and working capital).
Venture money is not long-term money. The idea is to invest in a company s
balance sheet and infrastructure until it reaches a sufficient size and
credibility so that it can be sold to a corporation or so that the
institutional public-equity markets can step in and provide liquidity. In
essence, the venture capitalist buys a stake in an entrepreneur s idea,
nurtures it for a short period of time, and then exits with the help of an
investment banker.
Venture capital s niche exists because of the structure and rules of capital
markets. Someone with an idea or a new technology often has no other
institution to turn to. Usury laws limit the interest banks can charge on loans
and the risks inherent in start-ups usually justify higher rates than allowed
by law. Thus bankers will only finance a new business to the extent that there
are hard assets against which to secure the debt. And in today s
information-based economy, many start-ups have few hard assets.
Furthermore, investment banks and public equity are both constrained by
regulations and operating practices meant to protect the public investor.
Historically, a company could not access the public market without sales of
about $15 million, assets of $10 million, and a reasonable profit history. To
put this in perspective, less than 2% of the more than 5 million corporations
in the United States have more than $10 million in revenues. Although the IPO
threshold has been lowered recently through the issuance of development-stage
company stocks, in general the financing window for companies with less than
$10 million in revenue remains closed to the entrepreneur.
Venture capital fills the void between sources of funds for innovation (chiefly
corporations, government bodies, and the entrepreneur s friends and family) and
traditional, lower-cost sources of capital available to ongoing concerns.
Filling that void successfully requires the venture capital industry to provide
a sufficient return on capital to attract private equity funds, attractive
returns for its own participants, and sufficient upside potential to
entrepreneurs to attract high-quality ideas that will generate high returns.
Put simply, the challenge is to earn a consistently superior return on
investments in inherently risky business ventures.
Sufficient Returns at Acceptable Risk
Investors in venture capital funds are typically very large institutions such
as pension funds, financial firms, insurance companies, and university
endowments all of which put a small percentage of their total funds into
high-risk investments. They expect a return of between 25% and 35% per year
over the lifetime of the investment. Because these investments represent such a
tiny part of the institutional investors portfolios, venture capitalists have
a lot of latitude. What leads these institutions to invest in a fund is not the
specific investments but the firm s overall track record, the fund s story,
and their confidence in the partners themselves.
How do venture capitalists meet their investors expectations at acceptable
risk levels? The answer lies in their investment profile and in how they
structure each deal.
The Investment Profile.
One myth is that venture capitalists invest in good people and good ideas. The
reality is that they invest in good industries that is, industries that are
more competitively forgiving than the market as a whole. In 1980, for example,
nearly 20% of venture capital investments went to the energy industry. More
recently, the flow of capital has shifted rapidly from genetic engineering,
specialty retailing, and computer hardware to CD-ROMs, multimedia,
telecommunications, and software companies. Now, more than 25% of disbursements
are devoted to the Internet space. The apparent randomness of these shifts
among technologies and industry segments is misleading; the targeted segment in
each case was growing fast, and its capacity promised to be constrained in the
next five years. To put this in context, we estimate that less than 10% of all
U.S. economic activity occurs in segments projected to grow more than 15% a
year over the next five years.
The myth is that venture capitalists invest in good people and good ideas. The
reality is that they invest in good industries.
In effect, venture capitalists focus on the middle part of the classic industry
S-curve. They avoid both the early stages, when technologies are uncertain and
market needs are unknown, and the later stages, when competitive shakeouts and
consolidations are inevitable and growth rates slow dramatically. Consider the
disk drive industry. In 1983, more than 40 venture-funded companies and more
than 80 others existed. By late 1984, the industry market value had plunged
from $5.4 billion to $1.4 billion. Today only five major players remain.
Growing within high-growth segments is a lot easier than doing so in low-, no-,
or negative-growth ones, as every businessperson knows. In other words,
regardless of the talent or charisma of individual entrepreneurs, they rarely
receive backing from a VC if their businesses are in low-growth market
segments. What these investment flows reflect, then, is a consistent pattern of
capital allocation into industries where most companies are likely to look good
in the near term.
During this adolescent period of high and accelerating growth, it can be
extremely hard to distinguish the eventual winners from the losers because
their financial performance and growth rates look strikingly similar. (See the
chart Timing Is Everything. ) At this stage, all companies are struggling to
deliver products to a product-starved market. Thus the critical challenge for
the venture capitalist is to identify competent management that can execute
that is, supply the growing demand.
Timing Is Everything More than 80% of the money invested by venture capitalists
goes into the adolescent phase of a company s life cycle. In this period of
accelerated growth, the financials of both the eventual winners and losers look
strikingly similar.
Picking the wrong industry or betting on a technology risk in an unproven
market segment is something VCs avoid. Exceptions to this rule tend to involve
concept stocks, those that hold great promise but that take an extremely long
time to succeed. Genetic engineering companies illustrate this point. In that
industry, the venture capitalist s challenge is to identify entrepreneurs who
can advance a key technology to a certain stage FDA approval, for example at
which point the company can be taken public or sold to a major corporation.
By investing in areas with high growth rates, VCs primarily consign their risks
to the ability of the company s management to execute. VC investments in
high-growth segments are likely to have exit opportunities because investment
bankers are continually looking for new high-growth issues to bring to market.
The issues will be easier to sell and likely to support high relative
valuations and therefore high commissions for the investment bankers. Given the
risk of these types of deals, investment bankers commissions are typically 6%
to 8% of the money raised through an IPO. Thus an effort of only several months
on the part of a few professionals and brokers can result in millions of
dollars in commissions.
As long as venture capitalists are able to exit the company and industry before
it tops out, they can reap extraordinary returns at relatively low risk. Astute
venture capitalists operate in a secure niche where traditional, low-cost
financing is unavailable. High rewards can be paid to successful management
teams, and institutional investment will be available to provide liquidity in a
relatively short period of time.
The Logic of the Deal.
There are many variants of the basic deal structure, but whatever the
specifics, the logic of the deal is always the same: to give investors in the
venture capital fund both ample downside protection and a favorable position
for additional investment if the company proves to be a winner.
In a typical start-up deal, for example, the venture capital fund will invest
$3 million in exchange for a 40% preferred-equity ownership position, although
recent valuations have been much higher. The preferred provisions offer
downside protection. For instance, the venture capitalists receive a
liquidation preference. A liquidation feature simulates debt by giving 100%
preference over common shares held by management until the VC s $3 million is
returned. In other words, should the venture fail, they are given first claim
to all the company s assets and technology. 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.
Typically, there will be a lead investor and several followers. It is the
exception, not the rule, for one VC to finance an individual company entirely.
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.
Attractive Returns for the VC
In return for financing one to two years of a company s start-up, venture
capitalists expect a ten times return of capital over five years. Combined with
the preferred position, this is very high-cost capital: a loan with a 58%
annual compound interest rate that cannot be prepaid. But that rate is
necessary to deliver average fund returns above 20%. Funds are structured to
guarantee partners a comfortable income while they work to generate those
returns. The venture capital partners agree to return all of the investors
capital before sharing in the upside. However, the fund typically pays for the
investors annual operating budget 2% to 3% of the pool s total capital which
they take as a management fee regardless of the fund s results. If there is a
$100 million pool and four or five partners, for example, the partners are
essentially assured salaries of $200,000 to $400,000 plus operating expenses
for seven to ten years. (If the fund fails, of course, the group will be unable
to raise funds in the future.) Compare those figures with Tommy Davis and
Arthur Rock s first fund, which was $5 million but had a total management fee
of only $75,000 a year.
The real upside lies in the appreciation of the portfolio. The investors get
70% to 80% of the gains; the venture capitalists get the remaining 20% to 30%.
The amount of money any partner receives beyond salary is a function of the
total growth of the portfolio s value and the amount of money managed per
partner. (See the exhibit Pay for Performance. )
Pay for Performance
Thus for a typical portfolio say, $20 million managed per partner and 30% total
appreciation on the fund the average annual compensation per partner will be
about $2.4 million per year, nearly all of which comes from fund appreciation.
And that compensation is multiplied for partners who manage several funds. From
an investor s perspective, this compensation is acceptable because the venture
capitalists have provided a very attractive return on investment and their
incentives are entirely aligned with making the investment a success.
What part does the venture capitalist play in maximizing the growth of the
portfolio s value? In an ideal world, all of the firm s investments would be
winners. But the world isn t ideal; even with the best management, the odds of
failure for any individual company are high.
On average, good plans, people, and businesses succeed only one in ten times.
To see why, consider that there are many components critical to a company s
success. The best companies might have an 80% probability of succeeding at each
of them. But even with these odds, the probability of eventual success will be
less than 20% because failing to execute on any one component can torpedo the
entire company.
If just one of the variables drops to a 50% probability, the combined chance of
success falls to 10%.
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.
Given the portfolio approach and the deal structure VCs use, however, only 10%
to 20% of the companies funded need to be real winners to achieve the targeted
return rate of 25% to 30%. In fact, VC reputations are often built on one or
two good investments.
A typical breakout of portfolio performance per $1,000 invested is shown below:
Those probabilities also have a great impact on how the venture capitalists
spend their time. Little time is required (and sometimes best not spent) on the
real winners or the worst performers, called numnuts ( no money, no 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.
Most VCs distribute their time among many activities (see the exhibit How
Venture Capitalists Spend Their Time ). 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.
How Venture Capitalists Spend Their Time
Assuming that each partner has a typical portfolio of ten companies and a
2,000-hour work year, the amount of time spent on each company with each
activity is relatively small. If the total time spent with portfolio companies
serving as directors and acting as consultants is 40%, then partners spend 800
hours per year with portfolio companies. 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. In fact, virtual CEOs are
now being added to the equity pool to counsel company management, which is the
role that VCs used to play.
Today s venture capital fund is structurally similar to its late 1970s and
early 1980s predecessors: the partnership includes both limited and general
partners, and the life of the fund is seven to ten years. (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. In 1980, the average fund
was about $20 million, and its two or three general partners each managed three
to five investments. 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.
The Upside for 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?
Venture-funded companies attract talented people by appealing to a lottery
mentality. 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. But perhaps the entrepreneur s behavior is not so
irrational.
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. But those institutions are better at helping people find
new ideas than at turning them into new businesses (see the exhibit Who Else
Funds Innovation? ). Entrepreneurs recognize that their upside in companies or
universities is limited by the institution s pay structure. The VC has no such
caps.
---
Who Else Funds Innovation?
The venture model provides an engine for commercializing technologies that
formerly lay dormant in corporations and in the halls of academia. Despite the
$133 billion U.S. corporations spend on R&D, their basic structure makes
entrepreneurship nearly impossible. Because R&D relies on a cooperative and
collaborative environment, it is difficult, if not impossible, for companies to
differentially reward employees working side by side, even if one has a
brilliant idea and the other doesn t. Compensation typically comes in the form
of status and promotion, not money. It would be an organizational and
compensation nightmare for companies to try to duplicate the venture capital
strategy.
Furthermore, companies typically invest in and protect their existing market
positions; they tend to fund only those ideas that are central to their
strategies. The result is a reservoir of talent and new ideas, which creates
the pool for new ventures.
For its part, the government provides two incentives to develop and
commercialize new technology. The first is the patent and trademark system,
which provides monopolies for inventive products in return for full disclosure
of the technology. That, in turn, provides a base for future technology
development. The second is the direct funding of speculative projects that
corporations and individuals can t or won t fund. Such seed funding is expected
to create jobs and boost the economy.
Although many universities bemoan the fact that some professors are getting
rich from their research, remember that most of the research is funded by the
government. From the government s perspective, that is exactly what their $63
billion in R&D funding is intended to do.
The newest funding source for entrepreneurs are so-called angels, wealthy
individuals who typically contribute seed capital, advice, and support for
businesses in which they themselves are experienced. We estimate that they
provide $20 billion to start-ups, a far greater amount than venture capitalists
do. Turning to angels may be an excellent strategy, particularly for businesses
in industries that are not currently in favor among the venture community. But
for angels, these investments are a sideline, not a primary business.
---
Downsizing and reengineering have shattered the historical security of
corporate employment. The corporation has shown employees its version of
loyalty. Good employees today recognize the inherent insecurity of their
positions and, in return, have little loyalty themselves.
Additionally, the United States is unique in its willingness to embrace
risk-taking and entrepreneurship. Unlike many Far Eastern and European
cultures, the culture of the United States attaches little, if any, stigma to
trying and failing in a new enterprise. Leaving and returning to a corporation
is often rewarded.
For all these reasons, venture capital is an attractive deal for entrepreneurs.
Those who lack new ideas, funds, skills, or tolerance for risk to start
something alone may be quite willing to be hired into a well-funded and
supported venture. Corporate and academic training provides many of the
technological and business skills necessary for the task while venture capital
contributes both the financing and an economic reward structure well beyond
what corporations or universities afford. Even if a founder is ultimately
demoted as the company grows, he or she can still get rich because the value of
the stock will far outweigh the value of any forgone salary.
By understanding how venture capital actually works, astute entrepreneurs can
mitigate their risks and increase their potential rewards. Many entrepreneurs
make the mistake of thinking that venture capitalists are looking for good
ideas when, in fact, they are looking for good managers in particular industry
segments. The value of any individual to a VC is thus a function of the
following conditions:
the number of people within the high-growth industry that are qualified for the
position;
the position itself (CEO, CFO, VP of R&D, technician);
the match of the person s skills, reputation, and incentives to the VC firm;
the willingness to take risks; and
the ability to sell oneself.
Entrepreneurs who satisfy these conditions come to the table with a strong
negotiating position. The ideal candidate will also have a business track
record, preferably in a prior successful IPO, that makes the VC comfortable.
His reputation will be such that the investment in him will be seen as a
prudent risk. VCs want to invest in proven, successful people.
Just like VCs, entrepreneurs need to make their own assessments of the industry
fundamentals, the skills and funding needed, and the probability of success
over a reasonably short time frame. Many excellent entrepreneurs are frustrated
by what they see as an unfair deal process and equity position. They don t
understand the basic economics of the venture business and the lack of
financial alternatives available to them. The VCs are usually in the position
of power by being the only source of capital and by having the ability to
influence the network. But the lack of good managers who can deal with
uncertainty, high growth, and high risk can provide leverage to the truly
competent entrepreneur. Entrepreneurs who are sought after by competing VCs
would be wise to ask the following questions:
Who will serve on our board and what is that person s position in the VC firm?
How many other boards does the VC serve on?
Has the VC ever written and funded his or her own business plan successfully?
What, if any, is the VC s direct operating or technical experience in this
industry segment?
What is the firm s reputation with entrepreneurs who have been fired or
involved in unsuccessful ventures?
The VC partner with solid experience and proven skill is a true trail-wise
sidekick. Most VCs, however, have never worked in the funded industry or have
never been in a down cycle. And, unfortunately, many entrepreneurs are
self-absorbed and believe that their own ideas or skills are the key to
success. In fact, the VC s financial and business skills play an important role
in the company s eventual success. Moreover, every company goes through a life
cycle; each stage requires a different set of management skills. The person who
starts the business is seldom the person who can grow it, and that person is
seldom the one who can lead a much larger company. Thus it is unlikely that the
founder will be the same person who takes the company public.
Ultimately, the entrepreneur needs to show the venture capitalist that his team
and idea fit into the VC s current focus and that his equity participation and
management skills will make the VC s job easier and the returns higher. When
the entrepreneur understands the needs of the funding source and sets
expectations properly, both the VC and entrepreneur can profit handsomely.
Although venture capital has grown dramatically over the past ten years, it
still constitutes only a tiny part of the U.S. economy. Thus in principle, it
could grow exponentially. More likely, however, the cyclical nature of the
public markets, with their historic booms and busts, will check the industry s
growth. Companies are now going public with valuations in the hundreds of
millions of dollars without ever making a penny. And if history is any guide,
most of these companies never will.
The system described here works well for the players it serves: entrepreneurs,
institutional investors, investment bankers, and the venture capitalists
themselves. It also serves the supporting cast of lawyers, advisers, and
accountants. Whether it meets the needs of the investing public is still an
open question.
A version of this article appeared in the November-December 1998 issue of
Harvard Business Review.
Bob Zider is president of the Beta Group, a firm that develops and
commercializes new technology with funding from individuals, companies, and
venture capitalists. It is located in Menlo Park, California.