How venture capital works
Zider, R. 1998. How venture capital
works, Harvard Business Review,
November-December, 131-139
VCs invest in high potential growth companies that will be game
changers in their industries.
If you work in an industry that is attracting attention from VCs, be
ready for radical change
VC system works for
•
•
•
•
Entrepreneurs
Institutional investors
Investment bankers
Venture capitalists
Zider, 1998
Filling the void
• Venture capital plays an important role in the
stage of the company’s innovation life cycle
when it begins to commercialize its innovation
• > 80% of VC $ goes into building infrastructure
needed to grow the business – in expense
investments (mfrg capacity, marketing, sales)
and the balance sheet (working capital and
fixed assets)
Zider, 1998
Timing is everything
• > 80% $ invested by VCs
goes into adolescent
phase of a company’s
life cycle
• During this phase the
financials of eventual
winners and losers look
highly similar
Zider, 1998
The “adolescence” stage
Zider, 1998
Several moving parts in execution:
Assume 80% probability of success each
Failure on any single step is NOT an option
Zider, 1998
Logic of the deal
• Term sheets offer downside and upside
protections
• Downside
– Preferred stock gives VCs liquidation preference
– Ratchets protect VCs from dilution if more $ needs to
be raised at lower valuation – they keep their same %
ownership position
• Upside – can put additional $ into firm at
predetermined prices – they can increase the
stakes in successful firms below market prices
Typical portfolio payout per $1,000
invested
Zider, 1998
Zider, 1998
Profile of 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
Zider, 1998
allocated to other people
Profile of the ideal entrepreneur
• 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
Zider, 1998
Value of an individual to a VC
• Is a function of these conditions:
– # of people within the high-growth industry who are
qualified for the position
– The position itself (CEO, CFO, CTO, technician)
– Match of person’s skills, reputation, and incentives to
the VC firm
– Willingness to take risks
– Ability to sell oneself
• Entrepreneurs who satisfy these conditions have
strong negotiating position with VCs
Zider, 1998
Entrepreneurs sought by multiple VCs
should ask:
• Who will serve on board and what is that
person’s position in the 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?
• What is the firm’s reputation with entrepreneurs
who have been fired or involved in unsuccessful
ventures?
Zider, 1998
Considerations for entrepreneurs
• Understand what VCs want and reduce
the uncertainty in their decision making
• Understand how VCs will structure
capitalization – you want 20% of a
$500M company, not 100% of a
$100,000 one
• Innovate and sell into a new, highgrowth market