Many entrepreneurial ventures raise money from venture capitalists. Getting venture capital funding is a complex process of
Question:
Many entrepreneurial ventures raise money from venture capitalists. Getting venture capital funding is a complex process of finding one or more partners to commit to back the company on its journey. The relationship between entrepreneurs and venture capitalists is important – it can be very positive and help a venture succeed, or it can be stressful and have negative implications. We will spend quite a bit of time trying to understand what venture capitalists do and how they structure deals with entrepreneurial ventures. The big question – Can venture capitalists help you and your venture succeed? Venture capitalists are professionals who specialize in investing in high growth potential ventures. They typically raise funds from institutional investors, corporations or individuals and form partnerships that deploy capital over a period of up to ten years. The venture capitalists act as General Partners and the investors are Limited Partners. Venture capital firms have two income streams. They charge a management fee based on the amount in the fund and they take a share of the profits – that share is called the carried interest. For most funds, the management fee is under 2% per year and the carried interest percentage is between 15 and 30%. Most venture capital firms have several partners and invest in multiple companies, often in separate rounds of financing for each company. Venture capital firms tend to specialize in geography, stage of investment, and/or industry. At one end of the spectrum, some funds only invest in early-stage companies. Other firms invest in more established companies to fund growth. The professional venture capital industry has existed since the 1940s though the industry remained small until the mid-1990s as the Internet revolution took hold. Total capital deployed in the industry is under $300 billion. There are several hundred active venture capital funds in the United States and around the world. Venture capital is a “hits” business. Even the best investors lose money or make modest returns on a majority of the companies they back. A few great successes generate most of the value, as was true with companies like Intel, Genentech, Apple, Amazon, Google, Facebook and more recent companies like Uber and Airbnb. A small number of venture capital firms consistently back big winners. In recent years, Sequoia, Benchmark, Accel, and Greylock have had a disproportionate number of “Unicorn” hits – these are companies that attain valuations of $1 billion or more. There is enormous variety in the industry. Some funds are small – from $10 million up to $100 million. These firms are willing to back new companies and write initial checks of several hundred thousand up to a few million dollars. Most venture funds reserve capital to make follow-on investments in companies that are doing well. Larger funds – those up to $1 billion in capital – will only invest in companies that might need tens of millions of dollars over the life of the fund. Venture capitalists are active investors. They often insist on a seat on the board of directors and they negotiate for certain control rights such as the right to replace the CEO or to approve any large capital expenditure or corporate action. Venture capitalists almost always use a standard investment vehicle – convertible preferred stock – though the exact terms depend on many factors. Some venture capitalists have been successful entrepreneurs while others have experience in large companies or finance.
What do you think about raising money from venture capital firms? How do you decide whether you should do so?
Foundations of Financial Management
ISBN: 978-1259024979
10th Canadian edition
Authors: Stanley Block, Geoffrey Hirt, Bartley Danielsen, Doug Short, Michael Perretta