Class Note:
Overview of Venture Capital and Start-up Financing
Professor Michael Horvath
Tuck School of Business
Copyright 2001, All Rights Reserved
Venture capital is a type of capital that is particularly suitable to the financing of
innovation: the financing of enterprises that are attempting to do something new
and untested. While not limited to this use, the prominent examples of venturefinanced firms of the 1980s and 90s –Compaq, Netscape Communications,
Apple Computer, Network General, Cisco Systems, Yahoo!, eBay--underscores
the association of venture capital with the creation of new technologies.
However, the use of venture capital in the financing of innovation is a fairly recent
phenomenon, accelerating slowly since the 1950s to its current brisk growth
rates. Venture capital has blossomed, over the decade of the 1990s, from a small
fraction of total flows of funding for R&D to a level where total venture capital
flows are roughly equal in magnitude to Federal government spending on R&D
activity. Venture capital has come of age and has, to a large extent, become
institutionalized. It is an industry that cut its teeth on semiconductors, learned to
walk with the personal computer, and exhibited adolescent tendencies with the
internet.
Definition of venture capital
When discussing and studying venture capital it is crucial to first define what is
meant by the term since venture capital is simply a subset of the far vaster
capital market. Table 1 presents venture capital within a continuum of financing
alternatives for entrepreneurs and entrepreneurial companies. You should expect
to draw on sources of funding listed prior to Venture Capital on Table 1. The first
thing you do after devising a business plan is not pitch it to a VC. You need to
execute on the plan in some meaningful way before you are ready to talk to
professional outside investors.
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Table 1: Financing Alternatives
Type of Financing
Entrepreneur Personal Funds
Personal credit card and other borrowings
“Friends and Family”
Angel investors
Amount Raised($000s)
5-50+
5-30
25-100
100-500
Venture capital
500-10,000
Corporate direct investment
Venture leasing
Mezzanine Financing
Merger and Acquisition
Initial Public Offering
Secondary/Follow-on Public Offering
Private Placements – Debt & Equity
Buyout/Acquisition Financing
Corporate Debt
2,500-5,000
500-2,000
10,000-25,000
10,000-100,000+
25,000-50,000+
25,000-100,000+
10,000-100,000+
10,000-100,000+
10,000-100,000+
Early Money and “Making it Real”
When you are just beginning your venture you will most likely need a small bit of
working capital to cover the expenses of “making it real.” “Making it real” includes
incorporating1, generating corporate collateral like business cards, stationary, and
product descriptions, establishing a working space, and traveling to meet with
potential customers. Therefore, you may need to draw on your own funds or
borrowing ability to accomplish your goals. While it may seem risky to run a couple of
credit cards up to their limit you need to remember that your prospects of paying off a
few thousand dollars of credit card debt should your venture fail are quite good
assuming you can find gainful employment by traditional standards. “Friends and
Family” money is a term used to refer to working capital lent to or invested in a startup by the founders’ family and/or friends. There are two good reasons to take money
from this personal source. First, it builds “good DNA” into your start-up. Professional
venture investors like to see that the people who know the founders the best, their
friends and family, believe in them sufficiently to put up their own funds to see them
succeed. Second, the amount of money you can raise from friends and family, on the
order of $50-100K can usually go a long way for a newly formed start-up. By taking
these funds you dramatically increase your chances of successfully raising a
professional venture round. If you are reluctant to take an investment-for-equity from
your friends and family because you want to avoid losing their money, consider
structuring the investment as a convertible loan. In the event you are unsuccessful in
raising a larger venture capital round, you and they agree that you will pay back the
loan plus interest on a specified schedule. If you succeed in raising venture capital
they have the option to convert their loan into equity at the same terms as the VCs.
You can even “compensate” them for the additional risk they are taking with warrants
to purchase additional shares2 at the same price for a specified period of time after
the closing of the first round of financing.
1
Alternatively, it may make more sense to establish a limited partnership but the effect is the same: legal
bills.
2
A 20-25% warrant coverage is typical here. So, for example, if your family puts up $100,000 and receives
20% warrant coverage, they would be given warrants to purchase an additional $20,000 of shares at the
price at which the initial $100,000 was converted to shares, the series A price.
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Angel Investors
After any personal funds and friends-and-family money, “angel money” serves as
a very important early source of capital for start-ups. Angel investors are
individuals with considerable wealth who place capital inside new and existing
firms in return for equity. Their preferred investment style is to invest in
companies in industries in which they have domain expertise or previous
operating experience. What distinguishes angel investors from professional
venture capitalists is that they are typically investing their own funds while
professional venture capitalists typically are investing funds of a limited
partnership (see below). Estimates from 1995 (see Freear, Sohl and Wetzel
University of New Hampshire, manuscript, 1996) put the number of active angel
investors in the U.S. at 250,000 making roughly 30,000 investments per year for
an aggregate of $20 billion. The dollar flows from angels are therefore roughly
double the flows from professional venture firms but because they are typically
much smaller in size, angels make roughly 15 times the number of placements.
Angel investors are difficult to find, often preferring to remain anonymous, unlike
professional venture capital firms. 3
The structure of venture capital firms
The most common legal form taken by professional venture capital firms is that of
the limited partnership. A professional venture capital firm is a collection of
general partners who make investment decisions for the partnership.
Investments involve exchanging capital for equity positions, typically preferred
shares, in new or expanding enterprises.4 The funds that get invested are
contributed by the all the partners but the limited partners contribute the lion’s
share (often over 95% of the funds). The limited partners are typically comprised
of corporate investors with long time-horizons such as pension funds, insurance
companies, university endowments, but may also include exceptionally wealthy
individuals. A venture fund exists legally as a limited partnership for a specific
period of time, typically on the order of seven to ten years. During this time it is
expected that the general partners will invest the fund in accordance with any
guidelines established at the fund’s inception and will monitor the performance of
the fund’s investee companies.
For their services as intermediaries, the general partners typically receive an
annual management fee of a few percentage points of the fund’s total assets and
a carried interest, or “carry,” specified as a fixed percentage, typically on the
order of 20-30%, of the capital gains realized at the close of the fund. At the
termination of the fund’s (limited partnership’s) life, all proceeds from the
investments less the carry are distributed to the investing partners.
The venture capital firm (the general partners) typically do not disband at the
termination and distribution of a fund, but rather they go on to raise another fund
3
Some angels or “bands of angels” have not remained anonymous, but have developed their practice of
investing in new companies to the point where they attract considerable attention in the venture capital
community, taking on identities separate from those of the angels themselves; for example, the Band of
Angels in Silicon Valley and Zero Stage Capital in New England.
4
To be precise, venture capital investments often take the form of “convertible preferred” securities which
have elements of both debt and equity financing and are so designed to protect the venture capital firms
from moral hazard on the part of management in the companies at which they invest.
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with the same or new limited partners. In fact, it is common for a venture capital
firm to operate several funds simultaneously, often denoting them by Roman
numerals following the fund’s name (e.g. Investors’ LP Fund III and IV). The need
to raise new funds with which to make more investments creates an incentive for
the general partners to achieve superior rates of return. The most common
metric used in the venture capital industry is the internal rate of return (IRR) on
placements. This calculates the rate of return on each investment at an annual
rate. Therefore, it penalizes the general partners for investments that perform
poorly in their absolute rates of return over the investment’s life and also for
investments that take longer to reach profitability. The quest for superior
performance inside the venture capital firm also creates an incentive for
specialization by industry and stage of development of the investee company. It
is typical for the general partners to have specific education, work experience,
and skills in the industries in which they search for potential investee companies.
This description is purposely general and simplistic.5 It stresses the role that
venture capitalists play as the intermediaries between the pure capital or money
on the one hand and the investee companies on the other. In this intermediary
role, the professional venture capital firm is expected to filter out bad deals,
provide managerial, board room, and technical advice to the companies that
receive financing, and protect the ultimate liquidity of the investment for the
limited partners within the time frame of the life of the limited partnership.
Exiting and Liquidity
This last point deserves some clarification. Since a venture capital firm typically
receives unregistered stock in return for investing capital in a company, it is
necessary to describe how this stock gets turned into profits that ultimately get
distributed to the limited partners. This is referred to as the exit strategy.6 The
venture capital firm tries to ensure that its equity position within a firm will be
liquid by the termination date of the fund, or sooner, when the limited partnership
dissolves and proceeds are distributed.
Simplifying again, there are three means of exit: acquisition or merger, initial
public offering (IPO), and liquidation. Liquidation, the simplest to explain, is
tantamount to failure. In liquidation the firm is unable to continue operating,
usually due to the lack of capital and its inability to raise more. All assets,
including any sellable patents, are sold off and the proceeds are distributed to the
shareholders according to formulae that heavily favor the preferred shareholders.
The first exit category, acquisition or merger, provides liquidity for the venture
capital firm if the acquiring or merging firm is a publicly traded corporation. In this
case, it is typical for the transaction to involve the exchange of stock of the
5
There are many variants to this basic formula for a professional venture capital firm. Importantly, the
description has ignored the practice of syndication where several venture capital firms co-invest in the same
company, with one venture capital firm taking the lead investment. There are also substantial contractual
details that shape the conduct and performance of the venture capital industry. For further reading, see
Gompers and Lerner (1999), Lerner (1999), Bygrave and Timmons (1992), Fenn, Liang, and Prowse
(1995), Sahlman (1990), and Trester (1998). For descriptions of datasets used in research on venture
capital see Fenn and Liang (1998)
6
Both venture capital firms and the managers/founders of investee companies can have exit strategies.
This phrase simply refers to the strategy these participants hold on how to create a liquid market for their
shares.
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investee company for stock in the publicly traded firm. It is sometimes difficult to
assess whether acquisitions or mergers are failures or successes. The valuation
placed on the firm may never become public information, and even then, the
amounts invested in the firm prior to the merger or acquisition and the valuations
at each round of investment are often unknown.
The third form of exit, the IPO, involves registering shares of the investee
company with the Securities and Exchange Commission (SEC) and selling these
on a public stock exchange. The proceeds from this sale of new shares provide
capital for the company. But the act of registering the shares of the corporation
with the SEC also provides the holders of the inside shares, those held by
founders and investors prior to the IPO, a liquid market for their shares. There is
a caveat, however. Typically, insiders are permitted to sell their shares on the
public markets only after a period of time (e.g. 6 months) has elapsed from the
date of the IPO and even then they typically must sell their shares under SEC
Rule 144 restrictions.7
Venture Financing and Enterprise Formation
At its heart, the purpose of venture capital investing is to finance the creation and
expansion of new enterprises. Start-ups facing large fixed costs of installing
infrastructure or product development use venture capital to meet cash flow
needs before demand and revenues materialize. The marriage between venture
capital and enterprise is more than one of cash-flow financing, though.
Figure 1 shows a prototypical path for a venture-financed enterprise. Early-stage
development work may be financed from founders’ personal funds, “friends and
family,” angel investors, or a professional venture firm engaged in start-up/seedstage venture finance. A professional venture round six months after company
inception permits an acceleration of product/service development and results in a
higher expense burn rate. This would be categorized as an early-stage
investment. Another venture round, one which would be classified as expansionstage, occurs in month 18 and coincides with a first-product release. While
revenues are now non-zero, costs jump significantly higher due to a rapid
expansion of the company’s operations into full-scale sales and marketing. A
venture round in month 30 may bring in a strategic investor such as a large
technology partner or a key customer of the start-up’s products or services.
Proceeds from this round are used to further increase the scale of operations,
driving up both costs and revenues—growth via venture capital is preferred by
management and existing shareholders to the slower strategy of growth via
retained profits. Figure 1 ends at the point where the start-up has achieved cashflow positive operations. Further venture rounds may be required or desirable
depending on the size of the market opportunity being pursued by the start-up
and these would be categorized as profitable-stage investments. Depending on
future growth prospects possible exit strategies for the venture investors include
a company sale or an initial public offering of shares in the company.
7
Among other reasons, the underwriters request this temporary moratorium on the trading of insider shares
in order to ensure the best chance at stability in a corporation’s share price following an IPO. SEC Rule 144
imposes volume restrictions and reporting requirements for inside shareholders selling unregistered shares.
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A Social Anthropology of Venture Capitalists
The individual GP: Each venture partner’s network of contacts is only so big and the
value of this network for each portfolio company the partner takes on gets diluted as he
or she takes on more companies. This means that VC partners have to heavily screen
deals. Only the most compelling ideas are worthy of close investigation and only a
handful of those get funded. The first line of defense for the VC partner is the reference
or introduction of a prospective deal. It virtually pointless to cold-call a partner or e-mail
your business plan unannounced. You have to be introduced by someone who knows
the partner already.
The VC Firm: Because venture firms are lasting entities, they develop reputations,
mostly revolving around their historical rates of return. Benchmark Capital
(www.benchmark.com) was a very young fund when it exploded onto the VC scene with
its eBay investment. Until many of their .com companies started going under, it was “the
Fund” in the valley, replacing Kleiner Perkins Caufield and Byers (www.kpcb.com) as
top-dog. There is a VC social order, especially in places like Silicon Valley, Boston, and
New York. Some funds are “top-tier”, some are second or third tier. The social rankings
of your VCs has a lasting effect on your start-up, affecting things such as who you are
able to recruit into senior management and which banker you are able to land as
underwriter if you go public.
The VC Industry: Specialization abounds in venture capital. VC firms specialize
geographically, often choosing to invest close to home, especially on early-stage deals.
VCs specialize by stage of financing and by industry as well. This means you have to
know what kind of deals a VC is interested in seeing before you try to get in the door
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there. There is no use in asking the wrong people for money. But specialization is
important for the value VCs can bring to their portfolio companies. “Mullet money” is a
term used to describe low-value added VCs who have neither relevant industry expertise
nor a strong network of partner/customers to introduce your start-up to. Sure, start-ups
need money but they need the non-monetary value provided by an actively engaged VC
too.
What to Expect from a Start-up’s Perspective
There is enormous variation across companies, regions, and across time in the VC
funding process. Silicon Valley VCs in 1999 doled out funds at a furious rate. It was not
unheard of for start-ups to get funded without a written business plan, after 1-2 meetings
and with little more than a Powerpoint presentation to leave as collateral. But, other
regions of the country operate on a slower clock than Silicon Valley and it is important to
view 1999 as the aberration rather than the norm. You can expect the initial funding
process to take anywhere from 3-9 months, depending mostly on whether the founding
team has the patience to wait that long. You should take the attitude that you are going
forward with or without venture money and devise funding alternatives to professional
venture capital. This will actually make your chances of attracting venture money higher.
The funding process breaks easily into 5 distinct phases: introduction, pitch, duediligence, term sheets, and legal. In the introduction phase your start-up must get
introduced to VCs by an outside reference. It is helpful for a start-up to form both a small
advisory board (2-3 industry experts) and a small board of directors (founders plus 2
others), all individuals incentivized with stock, prior to getting funded. This greatly
increases the network reach of your start-up allowing you to get in the door at more VC
funds.
The pitch phase involves meeting one or more partners at each VC firm you begin
talking with. If things go well in the initial meeting you will get called back for further
presentations and grilling. Since you can’t simply repeat yourself at the second meeting
it is important to plan your presentations strategically to offer something new and
insightful every time you meet with your prospective backers. Having a working demo of
your product or offering drastically improves the chances that you will be able to fully
convey what you are trying to build. Having names of individuals you want to hire once
you are funded also helps convince the VCs that your start-up is a powder keg, ready to
explode once they add a little gasoline in the form of cash. Finally, while having the
demo is a valuable presentation tool, do not make the mistake of “selling” the VCs the
demo, sell them the company. VCs do not invest in what you have already built. They
invest in your vision of what you are going to build. That vision should be sharp with
milestones and deliverables running 9-12 months out, blurring to vague but ambitious
12-36 months out.
“Due-diligence” simply means the process of assessing the prospects for your start-up.
The VCs will tap into industry analysts’ opinions regarding your market space. They will
check personal references you provide on your character and previous work
experiences. If you have a prospective customer or partner who has seen your demo
and is willing to vouch for how valuable your product or service would be to his or her
company, that reference could be crucial. The VC is trying to get comfortable with the
thought of parting with $x-million dollars in return for illiquid shares in your company. The
due-diligence phase lasts until the day the deal closes and money and shares change
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hands. (NB: Some people refer to the period between the signing of the term sheets and
the closing of the deal as the due diligence phase.)
Most VC partnerships typically make investment decisions by committee. The partner
who has been most actively engaged with your start-up brings the opportunity before all
the general partners of the fund at the regular partners’ meeting and acts as your
champion. If the partners are sold then you get handed a non-binding term sheet.
Otherwise, you get informed that the partners have decided to “pass” on your deal.8 The
term sheet spells out the economics of the investment: what percentage of your
company in terms of shares you are giving to the VC in return for how much working
capital. The term sheet typically also includes required allocations for an employee
option pool, vesting terms for founders9, board seat allocations to the VCs, and any other
conditions for the investment the VC wants to impose on the company or founders.
Remember, the term sheet is not a binding agreement. It simply specifies the terms
under which the VCs would be willing to make an investment and as such there is room
for bargaining back and forth on the terms. It always helps to have alternatives when
bargaining so if you can time your negotiations with VCs so as to get multiple term
sheets, you stand a good chance of getting movement on deal terms. Never, ever tell
your VCs who else you are talking to. This is part of entrepreneur etiquette and breaking
this rule will only serve to get the competing VCs talking to one another and colluding on
your deal, or worse, both walking away once they have talked each other out of
investing. Even once the term sheet is signed the VCs are still free to walk away from
the deal, though the company is typically obligated to cease further discussions with
other VCs for a specified number of days, until the deal either closes or blows up. This
simply gives the VCs a little more time and one last “out” after the deal terms have been
established, before they are fully committed.
Once the term sheet is signed by VC and company the deal enters legal. Your
company’s counsel and the VC firm’s counsel, if any, take over the task of converting the
1-2 page term sheet into two 40-50 page legal document, the Investors’ Rights
Agreement and the Shareholders Agreement, plus some ancillary documents. This
process can take 2-4 weeks and rack up legal bills of $15-25K. During this time, your
company may be asked to supply copies of various corporate documents to the VC’s law
firm as part of further due diligence. All the while, your VC firm could get cold feet if, for
example, they get wind of a close competitor to your company. Therefore, you and your
lawyer need to work fast to get “the money in the door.”
8
The “pass” is often accompanied by some complimentary language but don’t be fooled by the
terminology or their praise. They have decided to not invest in your company and that decision is
usually final. It is a waste of time to revisit them at a later point in time, even if your prospects have
materially changed for the better.
9
If stock or options “vest” to a founder or employee over time then if that individual terminates
employment prior to the fully vesting his or her shares/options, he or she only receives the portion
“vested” at that time. The remainder returns to the company.
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References
Bygrave, W. D and J. A. Timmons. 1992. Venture Capital at the Crossroads (Boston:
Harvard Business School Press).
Fenn, G. W., N. Liang, and S. Prowse. 1995 "The economics of the private equity
market," Board of Governors of the Federal Reserve System, Staff Study 168.
Fenn, G. W., N. Liang. 1998. "New resources and new ideas: Private equity for small
businesses," Journal of Banking and Finance, 22, 1077-1084.
Freear, J., S. Sohl, and W. Wetzel. 1996. "Creating new capital markets for emerging
ventures," manuscript, University of New Hampshire.
Gompers, P. and J. Lerner. 1999. The Venture Capital Cycle, (Cambridge: MIT Press).
Lerner, J. 1999. Venture Capital and Private Equity: A Casebook, (New York: John Wiley
& Sons).
Sahlman, W. A. 1990. "The structure and governance of venture capital organizations,"
Journal of Financial Economics, 27, 473-521.
Trester, Jeffrey J. 1998. "Venture capital contracting under asymmetric information,"
Journal of Banking & Finance, 22, 675-699.
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