Chapter 10.2 Flashcards
Venture Capital
How long does the bootstrapping period usually last?
No more than 1 or 2 years
What do founders typically use to obtain venture capital funding to grow the business?
A developed prototype of the product and business plan
Why the period of trying to obtain venture capital funding a critical time for more entrepreneurs?
Determines whether they have viable business concept that will be funded or will disband because of lack of investor interest
What are venture capitalists?
Individuals or firms that invest by purchasing equity in new businesses and often provide entrepreneurs with business advice
How do venture capitalists help new businesses?
Help new businesses get started and provide much of their early-stage financing
Are venture capitalists individuals or firms?
Can be either
What are angels (angel investors)?
Wealthy individuals who invest their own money in new ventures
At what stage do angel investors usually invest?
In emerging businesses at the very early stages
How do venture capital firms differ from angel investors?
Angel investors: individual venture capitalists who invest their own money
Venture capital firms: typically pool money from various sources to invest in new businesses
What are the primary sources of funds for venture capital firms?
- Financial and insurance firms
- Private and public pension funds
- Wealthy individuals and families
- Corporate investments not associated w/ employee pensions
- Endowments and foundations
Have venture capitalists always operated in the US?
Yes, they’ve existed in one form or another
When and how did the venture capital industry as we know it today emerge?
After venture capital firms began raising capital thru venture capital limited partnerships (funds) in the late 1960s
What was the impact of the venture capital limited partnerships (funds) of the 1960s on the industry?
Revolutionized the industry and the annual flow of capital into venture capital firms increased greatly after they first appeared
At the end of 2016, how many venture capital firms and separate venture capital funds there in the US?
898 firms
1562 funds
Is it common for firms to manage more than one fund at a given time?
Yes, in the US many firms are managing more than one fund at a given time
In 2016 in the US, how much on average did funds have access to?
$213.5 million of capital
In 2016, in the US, how much had venture capital firms invested in total, in how many deals, with an average of how many dollars per deal?
Invested a total of $69.0 billion in 8,136 deals during 2016, for an average of $8.5 million per deal ($69.0 billion/8,136 deals = $8.5 million).
Today, the venture capital industry employs several thousand professional, with what 2 states having the biggest concentration of firms?
California and Massachussetts
Besides California and Massachusetts, what are other areas of concentration for the venture capital industry?
Research Triangle in North Carolina; Austin, Texas; the New York City/New Jersey area; and the Dulles Airport corridor near Washington, D.C
Modern venture capital firms tend to specialize in a specific line of business, give examples of common specializations.
Clean energy, business software, hospitality (lodging, restaurants, and related services), or medical devices.
A significant number of these firms focus on high-technology investments
Why is venture capital important?
Because entrepreneurs have only limited access to traditional sources of funding
In general, what are the 3 reasons why traditional sources of funding don’t work for new/emerging businesses?
- The high degree of risk involved
- Types of productive assets
- Information asymmetry problems
How is there a high degree of risk involved in traditional sources of funding for new/emerging businesses?
Starting a new business is a risky proposition. The fact is that most new businesses fail, and it is difficult to identify which firms will be successful
Why does a high degree of risk involved with traditional sources of funding not work for new/emerging businesses?
Most suppliers of capital, such as banks, pension funds, and insurance companies, are averse to undertaking high-risk investments, and much of their risk-averse behaviour is mandated in regulations that restrict their conduct.
Why do types of productive assets matter in traditional sources of funding for new/emerging businesses?
Most commercial loans are made to firms that have tangible assets, such as machinery, equipment, and physical inventory. Lenders understand the operations of these firms and their inherent risks; thus, they are comfortable making loans to them
Why does not having a type of productive asset with traditional sources of funding not work for new/emerging businesses?
New firms whose primary assets are often intangibles, such as patents or trade secrets, find it difficult to secure financing from traditional lending sources.
How is there information asymmetry problems in traditional sources of funding for new/emerging businesses?
Information asymmetry arises when one party to a transaction has knowledge that the other party does not. An entrepreneur knows more about his or her company’s prospects than a lender does.
Why do information asymmetry problems with traditional sources of funding not work for new/emerging businesses?
When dealing with highly specialized technologies, or companies emerging in new business areas, most investors do not have the expertise to distinguish between competent and incompetent entrepreneurs. As a result, they are reluctant to invest in these firms.
What types of investors find it difficult to participate directly in the venture capital market?
Financial and insurance firms, pension funds, endowment funds, and university foundations
How do investors such as financial and insurance firms, pension funds, endowment funds, and university foundations invest in venture capital funds as they’re unable to do it directly?
Instead, they invest in venture capital funds that specialize in identifying attractive investments in new businesses, managing those investments, and selling (exiting) them at the appropriate time
What are the stages of the venture capital funding cycle?
Bootstrap financing (before venture capital)
1. Seed-stage financing
2. Early-stage financing
3. Later-stage financing
Venture capitalists exit (after venture capital in public/private markets)
What happens at the bootstrap financing stage relative to the venture capital funding cycle?
Entrepreneur supplies funds, prepares business plan, and searches for initial outside funding
Financing source: none/personal funds
What is the first stage of the venture capital funding cycle and what happens during it?
Seed-stage financing: venture capitalists provide funds to finish development of the concept
Financing source: venture capital
How much in sales in time growth happens in the first stage of the venture capital funding cycle?
Seed-stage financing: slow sales and time growth
(looks like a cube root function)
What is the second stage of the venture capital funding cycle and what happens during it?
Early-stage financing: venture capitalists provide financing to get the business up and running
Financing source: venture capital
How much in sales in time growth happens in the second stage of the venture capital funding cycle?
Early-stage financing: fast sales and time growth
(looks like an exponential function)
What is the third stage of the venture capital funding cycle and what happens during it?
Later-stage financing (mezzanine financing): typically includes one to five additional stages
Financing source: venture capital
How much in sales in time growth happens in the third stage of the venture capital funding cycle?
Later-stage financing: sales and time growth slows down, curve becomes less steep
(switches to negative exponential function)
What happens after the venture capital funding cycle is complete?
Venture capitalists exit by selling to a strategic buyer, selling to a financial buyer, or selling stock to the public
Financing source: private/public markets
When/how does the typical venture capital funding cycle begin?
When the entrepreneur runs low on bootstrap financing
What do venture capitalists provide during the venture capital funding cycle when entrepreneurs run low on bootstrapping financing?
Equity financing
How do entrepreneurs exit the venture capital funding cycle?
Through a private or public sales of their equity
How long is the typical duration of the venture capital funding cycle?
3-7 years
How many new ventures make it all the way to the end of the venture capital funding cycle?
Only a small percentage
What does the business plan include?
- Describe what you want the business to become
- Why consumers will find your business attractive (the value proposition)
- How you are going to accomplish your objectives
- What resources you will need
What is a value proposition?
Why consumers will find your business attractive
Why is a venture capital firm expressing an interest in an entrepreneur’s finished business plan a serious inquiry?
Because venture capital firms receive many unsolicited business plans, but respond to very few
Even after a venture capital firm agrees to fund a project, what might be different than expected about the funding?
After many meetings w/ u and ur management team the venture capitalist can agree to fund the project but only in stages and for less than the full amount requested
Venture capitalists know that only a handful of new companies will survive to become successful firms, what tactics do they use to reduce this risk when investing in new ventures?
-Funding the ventures in stages
- Requiring entrepreneurs to make personal investments
- Syndicating investments
- Maintaining in-depth knowledge about the industry in which they specialize
What is the key idea behind staged funding?
Each stage gives the venture capitalist an opportunity to reassess the management team and firm’s financial performance
What happens if (after the venture capital firm caught interest) the performance of a new business doesn’t meet the venture capitalists’ expectations?
Venture capitalists can bail out and cut their losses
OR
If they still have confidence in project: can help management make some midcourse corrections so that the project can proceed
How many funding stages do companies typically go through and what does each stage passed mean?
3-7 funding stages, and each stage passed is a vote of confidence for that project
What did each of the 11 stock offerings that Snap (Snapchat) completed the years before its IPO represent?
A funding stage
What are the later stages of financing sometimes called and why?
Mezzanine financing because these investors didn’t get in on the ground floor
What do the venture capitalists’ investments give them in the company?
An equity interest typically in the form of preferred stock that’s convertible into common stock at the discretion of the venture capitalist
Why are venture capitalists typically given an equity interest in the company in the form of a preferred stock?
Ensures that they have the most senior claim among the stockholders if the firm fails
Why are stocks given to venture capitalists able to be converted from preferred to common?
Conversion feature enables them to share in the gains if the business if successful
Why do venture capitalists often require the entrepreneur to make substantial personal investments in the business?
To confirm that you’re confident in the business and highly motivated to make it succeed
Why is it unlikely that venture capitalists will allow you to pay yourself a large salary as manager of the business?
Want your financial rewards to come from building a successful business, not from your salary
What is a common practice done to seed- and early-stage venture capital investments?
To syndicate
What is syndication?
Occurs when the originating venture capitalist sells a percentage of a deal to other venture capitalists
How does syndication reduce risk?
- Increases diversification of the originating venture capitalists’ investment portfolio
- Provides independent corroboration that the investment is a reasonable decision
How does syndication increase diversification of the originating venture capitalists’ investment portfolio?
Since other venture capitalists now own a portion of the deal and the originating venture capitalist has less money invested
How does syndication provide independent corroboration that the investment is a reasonable decision?
Willingness of other venture capitalists to share in the investment provides independent corroboration that its reasonable
How does the typical venture capitalist’s in-depth knowledge of the industry and tech reduce risk?
Specialization gives them a comparative advantage over other investors or leaders who are generalists
Are venture capitalists long-term investors in the companies they back?
No, they typically stay w/ a new firm until it’s a successful going concern which usually takes 3-7 years then they exit by selling their equity position
What does every venture capital agreement include?
Provisions identifying who has the authority to make critical decisions concerning the exit process
What 3 provisions are usually included in venture capital agreements (concerning authority over decision-making in the exit process)?
- Timing (when to exit)
- The method of exit
- What price is acceptable
Why may exit strategies be controversial?
Because the venture capitalist and the other owners may not agree on the 3 important provisions included in the venture capital agreement
What are the 3 principal ways in which venture capital firms exit venture-backed companies?
- Selling to a strategic buyer
- Selling to a financial buyer
- Offering stock to the public
What is a common way for venture capitalists to exit?
To sell the firm’s equity to a strategic buyer in the private market
Give an example of a strategic buyer for a casual pizzeria?
A restaurant firm such as McDonald’s Corporation
Might view purchase as strategic acquisition bc one of the company goals is to move into non hamburger food market w/ new brands as it did when acquiring Chipotle Mexican Grill
What is the strategic buyer looking to create between the acquisition and the firm’s existing productive assets?
Create value through synergies
Sales to financial buyers are another way for venture capitalists to _____ a firm
Exit
How does a sale to a financial buyer occur?
When a financial group, often private equity (leveraged buyout) firm, buys the new firm w/ intention of holding it for a period of time then selling it for a higher price
How long does a financial group hold onto newly bought firm before selling it for a higher price?
Usually 3-5 years
What is the difference between a strategic and a financial buyout?
A financial buyer doesn’t expect to gain from operating or marketing synergies
How does a financial buyer not expect to gain from operating/marketing synergies in a financial buyout?
Firm operates independently and the buyer focuses on creating value by improving operations as much as possible
What happens if the firm is performing poorly in a financial buyout?
The buyer will likely bring in a new management team
What does IPO stand for?
Initial public offering
What do venture capitalists do to obtain the highest price possible in the IPO?
Will not sell all of the shares they hold at the time of the IPO
Why do venture capitalists not sell all the shares they hold at the time of a company’s IPO?
Selling everything would send bad signal to investors
Once the firm’s shares are publicly traded, how can the venture capital sell the remaining shares?
In the public market
How do the majority of venture capitalists exit?
Through strategic and financial sales rather than IPOs
Comparing strategic & financial (M&A) sales of new businesses vs # of venture-backed IPOs from 2003-2016 shows M&As were much more common
What is a common misconception about venture capitalists?
Their sole function is to provide financing for new firms
In reality: one of their most important roles is to provide advice to entrepreneurs
Why are venture capitalists able to provide counsel to entrepreneurs when a business is being started and during the early period of the business’s operation?
Because of their industry knowledge and their general knowledge about what it takes for a business to succeed
In the early stages of development of a business, the ppl managing it (incl. the entrepreneur) often are long on technical skills, but what are they short on?
The skills necessary to successfully manage growth
What does the extent of the venture capitalists’ involvement in the management of the firm depends on?
The experience + depth of the management team
What position of the company may venture capitalists want to ensure involvement in the management of the firm?
May want seat on the board of directors
At minimum what kind of agreement will venture capitalists want to ensure involvement in the management of the firm?
An agreement that gives them unrestricted access to info about the firm’s operation and financial performance and the right to attend + observe any board meeting
What actions can venture capitalists take if a company they invest in performs poorly, what gives them this authority?
By insisting on a mechanism giving them the authority, they can assume control of the firm and install a new management team if necessary
How high are the costs of venture capital funding and the rates of return earned by venture capitalists?
Cost of venture capital funding is very high, but high rates of return earned by venture capitalists aren’t unreasonable
Why are the high rates of return earned by venture capitalists not unreasonable?
- They bear a substantial amount of risk when they fund a new business
- They spend a considerable amount of their time monitoring the process of businesses they fund + intervening when business’ management team needs help
How do venture capitalists bear a substantial amount of risk when they fund a new business?
On avg for every 10 businesses backed by venture capitalists, only 1 or 2 will prove successful. The winners have to cover the losses on businesses that fial
How do venture capitalists spend a considerable amount of their time monitoring the process of businesses they fund?
If a venture capital–financed new business is successful, more than likely the venture capitalists will have made a substantial contribution to creating value for the other owners.
How do the earnings venture capitalists make on their investments in new businesses vary?
Annual rate of return varies substantially from year to year, and the returns earned by different venture capitalists can differ considerably
Although it’s difficult to generalize, how much does a typical venture capital fund generate?
Annual returns of 15-25% on the money it invests
How did the annual returns of venture capital funds compare to the avg annual return for the S&P 500 over the 1926-2015 period?
Venture capital funds: 15-25%
S&P 500: 11.95%
What is a key characteristic of venture capital investing?
It involves very high risk and is not for the faint of heart.
