The Business of Venture Capital

Insights from Leading Practitioners on the Art of Raising a Fund, Deal Structuring, Value Creation, and Exit Strategies

Mahendra Ramsinghani

• Publisher: Wiley
• Year: 2014
• ISBN:
  9781118926611
• Edition: 2
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

The definitive guide to demystifying the venture capital business

The Business of Venture Capital, Second Edition covers the entire spectrum of this field, from raising funds and structuring investments to assessing exit pathways. Written by a practitioner for practitioners, the book provides the necessary breadth and depth, simplifies the jargon, and balances the analytical logic with experiential wisdom. Starting with a Foreword by Mark Heesen, President, National Venture Capital Association (NVCA), this important guide includes insights and perspectives from leading experts.

• Covers the process of raising the venture fund, including identifying and assessing the Limited Partner universe; fund due-diligence criteria; and fund investment terms in Part One
• Discusses the investment process, including sourcing investment opportunities; conducting due diligence and negotiating investment terms; adding value as a board member; and exploring exit pathways in Part Two
• Offers insights, anecdotes, and wisdom from the experiences of best-in-class practitioners
• Includes interviews conducted by Leading Limited Partners/Fund-of-Funds with Credit Suisse, Top Tier Capital Partners, Grove Street Advisors, Rho Capital, Pension Fund Managers, and Family Office Managers
• Features the insights of over twenty-five leading venture capital practitioners, frequently featured on Forbes' Midas List of top venture capitalists

Those aspiring to raise a fund, pursue a career in venture capital, or simply understand the art of investing can benefit from The Business of Venture Capital, Second Edition. The companion website offers various tools such as GP Fund Due Diligence Checklist, Investment Due Diligence Checklist, and more, as well as external links to industry white papers and other industry guidelines.

PART One
Raising the Venture Fund

Raising the venture fund, especially first-time funds, is not for the faint of heart. Institutional investors or limited partners (LPs) look for the following:

• Performance track record and background of fund managers
• Investment strategy and its relevance to (a) managers’ expertise and (b) market conditions

The LP universe is diverse. It includes pension funds, endowments and foundations, corporations, private family offices, and individuals. The motivations for each are primarily financial returns and asset diversification. LPs expect venture returns to be at least twice those offered by liquid securities, such as public market indices. Top quartile venture returns average upward of 20 percent of the internal rate of return (IRR).

According to Preqin research:

• Fifty-two percent of venture funds complete their fund-raising in 12 months. Others spend as much as 24 to 36 months on the road.
• Of the funds that successfully got off the ground, only 7 percent are first-time funds.
• About 70 percent of the funds successfully reach or exceed their targeted fund amount.

Placement agents are able to offer market intelligence and accelerate the fund-raising process via LP relationships for newer funds. Some LPs shun the venture asset class, as it is harder to establish determinants of consistent performance. Others play with only a select group of top-tier venture funds. Some choose to invest in a fund of funds or move over into other subclasses of private equity, such as middle market buy-out funds.

Part I covers the process of raising the venture fund. We look at how practitioners can find an entry point into the world of venture capital. Those brave enough to raise their own funds can gain a better understanding of the universe of institutional investors. Their asset allocation strategy and fund due diligence criteria are covered in this section.

CHAPTER 1
The Basics

“The key to making great investments is to assume that the past is wrong, and to do something that's not part of the past, to do something entirely differently.”

—Donald Valentine, Founder, Sequoia Capital¹

A day in venture capitalist's (VC's) life is like that of an entrepreneur—venture capitalists have to pitch a thousand pitches to institutional investors to raise their fund and execute a predetermined plan. If the plan goes well, rewards are distributed; egos are stroked and champagne flows. The partners then go back and raise another fund. If the plan goes really well, which is rare, the partners retire, join local nonprofit boards, or spend time aboard a fancy yacht. A VC's profession is driven by three primary functions: raise the venture fund, find investment opportunities, and generate financial returns.

RAISE THE VENTURE FUND

VCs raise money from financial institutions (called limited partners, or LPs in industry jargon) such as pension funds, foundations, family offices, and high net-worth individuals. (See Figure 1.1.) Investment professionals or general partners (GPs) develop an investment strategy. Based upon this thesis, its timeliness and robustness, investors commit capital to the venture fund. Investors or limited partners seek a blend of strong investment expertise, a compelling investment strategy, and supportive market conditions. Target returns for investors are typically in the range of 20 percent or more on an annualized basis.

FIGURE 1.1 Limited partners (LPs) in a venture fund.

The fund-raising process can be long and arduous, taking as much as 18 months, and is often compared to an uphill crawl on broken glass. Many a VC is humbled in this process and can empathize better with entrepreneurs when financial institutions do not return their calls, do not ask them to pitch their fund strategy in seven minutes, offer no feedback, and go dark.

A venture fund is a close-ended fund. Once the target amount is raised or the fund is subscribed, no new investors are admitted. The life of such a fund is typically 10 years.² The fund is dissolved after the 10th year or when all portfolio investments have been liquidated.

Successful firms do not necessarily wait until liquidation of the previous fund; they raise their next fund as soon as the majority of the capital of the current fund is invested or designated as reserved for existing portfolio companies. Leading venture firms raise a fund every three to five years. Typically, funds are labeled with Roman numerals, such as ABC Ventures Fund I, II, III, IV, and so on. Roman numerals are a soft indicator of a venture fund's ability to survive and to generate returns across the various economic cycles. A firm's true measure of success is its ability to generate consistent returns over multiple economic cycles.

FIND THE RIGHT INVESTMENT OPPORTUNITIES

Once the fund-raising process is complete, VCs are under pressure to deploy the capital. During this investment period, as seen in Figure 1.2, any fund actively seeks Facebook-like opportunities to generate target returns. Investment periods can be three years to five years. In this period, the start-ups come in—the mating dance begins. The pitch deck, term sheets, valuations, and boards are negotiated. A venture fund has to build a portfolio of companies that promise strong returns. Each portfolio company should demonstrate the potential to generate a return that equals a multiple of 8 to 10 times the capital invested. On a portfolio-wide basis, venture funds target a 20 percent annualized rate of r...