Venture capital
Dean A. Shepherd and Andrew Zacharakis
Venture capitalists are those individuals or institutions that invest their own or others’ money as risk capital to fund entrepreneurial firms. Al though all investments can be considered risky, the investments of venture capitalists are often described as risky because of the firms in which they invest and the fact that this capital is typic ally unsecured by long term assets – a venture capitalist invests money in an entrepreneurial firm and typically receives equity in that firm and/or lends the money to that firm as un secured convertible debt. Entrepreneurs most often seek venture capital when they do not have sufficient access to secondary markets (initial public offerings: IPOs) or debt funding (e.g., banks). Entrepreneurial firms typically require capital from venture capitalists to grow, turn around, or change the ownership of the business. Venture capitalist equity is not easily tradable, thus venture capitalists expect their investment to be tied up until a liquidity event. The liquidity events that provide the best returns are IPOs or acquisition of the portfolio company.
There are many different forms of venture capitalists that can be characterized in terms of two dimensions: (1) the extent to which they are individual or institutional, and (2) whether they invest their own or others’ money. Figure 1 captures these two dimensions and details the different types of venture capitalists.
Business angels are individuals who invest their own money in entrepreneurial firms. Classically, angels are defined as wealthy individuals, often entrepreneurs or former entrepreneurs, who invest in industries where they have deep experience. Friends and family can also be considered angels (petite angels). They invest in businesses
due to strong personal relationships with the entrepreneur (although they still expect a return). Angels typically are involved early in the pre or post formation stage of entrepreneurial firms and often invest the first money in the business after the entrepreneur’s own money has been exhausted.
Brokers are individuals who invest others’ money in entrepreneurial firms. Most often, the broker organizes a private placement which entails completing an ‘‘offering memorandum’’ (business plan with legal caveats to comply with government regulations) and then presenting the opportunity to investors (preferably those who are qualified, meaning that they have income greater than $200,000 per year or net worth greater than $1 million). The money is raised in lots (e.g., $25,000, $50,000, or $100,000) whereby investors buy a single lot or multiple lots up to the total amount specified in the offering memorandum. This round of financing usually follows angel investments and tends to focus on early stage ventures.
Corporate venture capitalists are institutions that invest their own money in entrepreneurial firms. Typically, these are Fortune 500 corporations that set up a venture capital subsidiary to invest in companies that have some strategic relevance to the corporation. Corporate venture capital is especially common in high technology industries. The goal is to keep informed about the best new technologies with the idea that these companies may ultimately be acquired by the corporation. This type of venture capital mostly follows angels and brokers and occurs during the expansion or later stages of venture development.
Traditional venture capitalists are institutions that invest others’ money in entrepreneurial firms. The most common form in the US is a limited partnership. The venture capitalist be comes a general partner contributing minimal dollars to the fund (usually 1 percent or less) and the limited partners (mostly corporations, endowments, and wealthy individuals) contribute the remainder of the money to the fund. In essence, limited partners are investing in the venture capitalist’s expertise at identifying and building winning entrepreneurial companies. In return, limited partners receive 70–80 percent of the capital gain on the venture capitalist’s investment. Venture capitalists receive the remaining 20–30 percent of the capital gain (carried interest), plus an operating expense fee of 2–3 percent of the capital under management. Venture capitalists can invest at all stages of a company’s development depending upon the venture capitalist’s charter, but most commonly come in during expansion and later stages. Traditional venture capitalists invest in only about one tenth of 1 percent of all business, although these businesses represent 50 percent of the entrepreneurial firms that are sufficiently successful to be registered on the stock exchange (i.e., have an IPO).
Venture Capital Process
The process that venture capitalists use can be thought of as a series of activities or stages that each entrepreneurial firm must work through from the time the firm is first proposed, up until the time when the venture capitalist successfully exits from the entrepreneurial firm and takes its profit. We propose two broad categories. The first category, ‘‘pre investment activities,’’ refers to all of the venture capitalist’s tasks up to and including the signing of an investment contract; for example, soliciting business plans from entrepreneurs requiring funding, deter mining whether these proposals meet the venture capitalist’s broad screening criteria, con ducting due diligence (more extensive research to determine the likely success of the entrepreneurial firm), and then negotiating and structuring a relationship with the entrepreneur.
The second category, ‘‘post investment activities,’’ includes all actions by the venture capitalist after the initial investment deal has been signed with the entrepreneur. In general, this involves providing guidance (and possibly additional funding) to help improve the performance of the entrepreneurial firm. One of the most important benefits arising from a relationship with a venture capitalist is access to their extensive network. This is often utilized to find and recruit top quality management, to find other co investors for immediate or follow up investment, to introduce the entrepreneur to important service providers such as specialized accountants, and to help find and develop necessary strategic alliances. Furthermore, venture capitalists can serve as sounding boards for management ideas, and can be a valuable source of strategic and operational advice. The emphasis on these different activities varies among types of venture capitalists and among venture capitalists within a type (e.g., there is considerable variation between traditional venture capitalists in the time they spend in helping improve the performance of those entrepreneurial firms in which they have invested). Ultimately, the venture capitalist’s final action is to exit from (i.e., harvest his or her investment in) the entrepreneurial firm.