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Venture Capital > Lecture 1 > Flashcards

Lecture 1 Flashcards

1
Q

What is venture capital?

A

Financing is provided to companies and entrepreneurs. It is an asset class that yields higher risk and higher potential return to investors

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2
Q

Financial returns in the venture capital industry rely on what?

A

The power law

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3
Q

What are venture capitalists seeking by taking high-risk bets on companies?

A

Seeking alpha on companies capable of returning crazy multiples of their initial investment to make the power law work

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4
Q

What is alpha?

A

the excess return of an investment relative to the return of a benchmark index.

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5
Q

What does the venture model rely on?

A

Match time spent with capital invested, leading to difficult decisions

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6
Q

What characteristics of technology startups make venture capital a good model for funding?

A
  • High R&D spend
  • Negative cash flows for a long period of time
  • no assets collateralize
  • value in equity not in dividends
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7
Q

What is underwriting?

A

Underwriting is the process by which a financial institution or other entity evaluates the creditworthiness of a potential borrower and decides whether to extend credit to them.

Matching risk of the asset with the type of financing

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8
Q

What are the types of financing types and the methods for underwriting for each?

A

Debt: good for underwriting cash
Working capital: good for underwriting assets
Venture: good for underwriting development

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9
Q

What is working capital?

A

The amount of money that a business has available to cover its day-to-day operational expenses.

Working Capital: Current Assets - Current Liabilities

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10
Q

What is the structure of a typical VC Fund?

A

1.5-2% management fee
3 series B deals
6 series A deals
12 seed deals
40-50% in reserves

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11
Q

What leads to funds targeting 20-25 deals in total?

A

diversification

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12
Q

What impact the percentage of the management fee?

A

depending on the track record and experience of the managers (GP)

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13
Q

How many stages of growth do most funds focus on?

A

Focus on one stage of growth (early stage vs. late stage) but do multiple rounds throughout the stage

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14
Q

What is the purpose of holding reserves?

A

To double down on the VC’s most promising companies

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15
Q

What is the equation for investable capital?

A

Fund size - management fees = investable capital

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16
Q

What is the term for the set of rules that underpin how you build your portfolio?

A

Portfolio construction

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17
Q

What is venture capital fund recycling?

A

when GPs choose to reinvest returns from early exits back into the fund for deployment.

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18
Q

Up to what point can a firm recycle returned capital?

A

Up to the management fee

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19
Q

What is a management fee in the venture capital compensation model?

A

1-2% of total fund size
- Guaranteed for the entire life of the fund regardless of performance
- payable annually

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20
Q

What are the main uses of management fees in the compensation model?

A
  • salaries of GPs
  • Hiring employees
  • bonuses
  • software
  • travel
  • events
  • swag
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21
Q

What is carried interest?

A

Carried interest, also known as carry, is a share in the profits that general partners receive in compensation for the management of a venture capital fund

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22
Q

How does carried interest in the VC compensation model work?

A
  • Performance-based on fund returns
  • Must clear a ‘hurdle’ before receiving it (ranges from 0% to 10% annual IRR)
  • Carry split
    20% GP
    80% LP
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23
Q

What are the roles and responsibilities within a VC fund?

A
  1. Limited Partner (LP)
  2. General Partner (GP)
  3. Partner
  4. Employees
  5. Entrepreneurs/Executives in residence (EiR/XiR)
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24
Q

What is a limited partner?

A
  • Providers of capital for the fund
  • banks, endowments, fund-of-funds, High net worth (HNW) individuals, family offices, government programs, corporations, etc.
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25
Q

How do Limited Partners govern the General Partners?

A

Through a Limited Partner Advisory Counsel (LPAC). All rules of the General Partners are documented in a Limited Partner Agreement (LPA), any deviations from the LPA must be approved by the LPAC

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26
Q

What are General Partners?

A
  • full-time managers of the capital
  • allocate carry
  • responsible for investment decisions
  • manage all funds at a given institution
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27
Q

What is a partner in VC?

A
  • Full or part-time at the fund managing capital
  • allocated carry on a fund-per-fund basis
  • if part-time, referred to as a ‘venture partner’ or ‘operating partner’
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28
Q

What are employees at a VC fund?

A

Principals, associates, analysts, interns
legal counsel, admin, accounting, CFO

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29
Q

What are an EiR and XiR?

A

Entrepreneurs or executives in residence explore their next opportunity while working at the fun

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30
Q

When is capital committed, and when is it called?

A

Capital is committed at T=0 but is called over the life of the fund
- typically LPs are asked to contribute 15% per year or as needed

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31
Q

How do you measure VC fund performance?

A

Realized Value and Unrealized Value

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32
Q

What is realized value?

A

Cash returned to the fund
- exit realized

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33
Q

What is unrealized value?

A

book value
- what I hold it for on my fund financial statements

34
Q

What is a write-up and write down?

A

An upward or downward adjustment of the value of an asset for accounting and reporting purposes. These adjustments are estimates and tend to be subjective, although they are usually based on events affecting the investee company or its securities.

35
Q

What does it mean to write up on your books?

A

an increase made to the book value of an asset because its carrying value is less than fair market value.

36
Q

What does it mean to write down on your books?

A

the reduction in the book value of an asset when its fair market value (FMV) has fallen below the carrying book value, and thus becomes an impaired asset

37
Q

When do funds write up an investment?

A

Most funds NEVER write up an investment without a pricing event in the market

38
Q

When do funds write down an investment?

A
  • when there is an external pricing event (e.g., down round)
  • most funs also should proactively write down their investments as value is destroying or the investment deviates from planned value creation
39
Q

Which type of funds can write up their own investments and what does this pose?

A

Full-stack funds can write up their own investment

40
Q

What is a full-stack fund?

A

Providing capital and connections, expertise and experience, support and solidarity for founders at every step of their journey.

For example, my growth fund can write up my early-stage fund

41
Q

How do funds remove subjectivity from the write-down process?

A

They have internal policies

42
Q

What can be said about the dispersion of VC funds in the market?

A

There is a huge dispersion in the performance of VC funds, whereby top-tier funds outperform the market by A LOT

  • Top Tier IRR’s can be 40% IRR+
  • this implies 3-5x return on the total capital of the fund
43
Q

How are managers at VC firms evaluated?

A

Total Value to Paid-In (TVPI):
considers both realized and unrealized value

Net IRR (Internal Rate of Return) metrics:
The internal rate of return (IRR) is the annual rate of growth that an investment is expected to generate - after fees and carried interest are factored in (net IRR)

44
Q

How does knowing about the power law influence how you would evaluate a deal?

A
45
Q

What is the power law?

A

the observation that a small number of investments in a VC portfolio generate the majority of returns.

This phenomenon is also known as the “80/20 rule,” where 80% of the returns come from 20% of the investments.

46
Q

How does knowing about the power law influence how you would evaluate a deal?

A
  1. Focus on potential outliers
  2. Conduct extensive due diligence
  3. Look for strong founders and teams:
  4. Consider the market size and potential
  5. Diversify investments
  6. Keep a long-term perspective
  7. Be aware of biases
47
Q

How does understanding the VC business model and power law influence the way you might treat an underperforming company you’ve already invested in?

A
  1. Conduct a thorough analysis of the reasons for underperformance
  2. Work with the company to develop a plan for improvement
  3. Provide additional support and resources
  4. Write down on books slowly not to a shock GP’s
  5. Consider exit options
  6. Avoid the “sunk cost fallacy”
48
Q

What about how you might allocate re-investment dollars?

A
  1. focus on outliers (power law)
  2. Asses potential growth
  3. Evaluate cost of capital
  4. Diversify portfolio and don’t put “all eggs in one basket”
  5. maintain realistic expectations for company
  6. Evaluate all investment opportunity
49
Q

What are the different VC fund structures?

A
  1. Stage Focused fund
  2. Full-Stacked Fund
  3. Venture Studio
  4. Evergreen Fund
  5. Solo-Capitalist
  6. Crossover Fund
  7. Private Equity Fund
50
Q

What is a stage focused fund?

A
  • Pre-seed
  • early
  • growth
51
Q

What is a full stack fund?

A

Support founders through all stages of the journey

52
Q

What is a venture studio?

A

A team of entrepreneurs, investors, and operators work together to build new companies. The team often has a specific industry focus or expertise and uses that knowledge to identify market opportunities and create new business concepts

53
Q

What is an evergreen fund?

A

There is no time horizon (dont prescribe to the 10 year timeline policy)

54
Q

What is a solo capitalist?

A

An individual who invests their capital in various ventures (e.g., dragons den)

55
Q

What is a crossover fund?

A
  • Invests in both private companies and public ones
  • can raise funds or sell down public positions to invest privately
56
Q

What is a private equity fund?

A

Looking at bringing companies public, buyouts, distressed assets, slower growth, etc.

57
Q

What are the types of internal hierarchy?

A
  1. Partner only
  2. Partner and Support
  3. Partner and Successors
58
Q

What is a partner-only internal hierarchy model?

A

They believe that entrepreneurs only want to talk to partners and support staff are not helpful.

e.g.) Benchmark

59
Q

What is the partner & support internal hierarchy model?

A

The organization is typically divided into two main categories of employees: partners and support staff. Partners are typically highly experienced and specialized professionals responsible for managing client relationships and delivering high-quality services. Support staff, on the other hand, are responsible for providing administrative, operational, and technical support to the partners

  • Some firms hire junior analysts as
    ‘support only’ and cycle out these analysts after 2 year terms
60
Q

What is the partner & successors internal hierarchy model?

A

Incorporates succession planning for the firm, knowing that the future partnership will come from investing in juniors rising up the ranks

61
Q

What creates the gender gap in venture capital?

A
  1. Always looking for those that are most similar to us
  2. Always looking first at our own networks
62
Q

What is trying to be done to improve diversity in VC?

A

Increased reporting requirements on diversity

63
Q

What are the types of decision making in venture capital funds?

A

Consensus-driven:
- Majority vote
- unanimous vote
- sponsor

Conviction Driven
- each partner can do what deal they want

Committee Driven
- must present to the investment committee
- could be compromised of a CEO decision maker and/or external advisors present to evaluate deals

64
Q

What is the internal process at a VC fund? What do they do?

A
  • Log deals into CRM with an owner and history (e.g., Affinity)
  • document memos for investments they want to present to other partners
  • team pitches on Mondays (admin days for VC’s) as they usually travel other days of the week
  • VCs prepare quarterly reports 45 days after quarter end for LPs to give update on progress on each company
    (financial info on fund)
65
Q

What determines the AMOUNT of process within a VC firm?

A

The fund structure model

66
Q

What is pro-rata?

A

pro-rata refers to the right of an investor to maintain their proportional ownership in a company by investing additional funds in subsequent funding rounds.

67
Q

What do VC’s do internally to participate in future rounds?

A

They keep reserves

68
Q

How do reserve allocation open up a new element of the VC fund?

A
  • Internal decision making
  • ownership of the process
  • reserve policies
69
Q

How can the deployment of reserves impact the power-law?

A
  1. If a venture capital firm deploys TOO MUCH of its reserves into underperforming or low-potential investments, it may reduce the potential returns of its portfolio.
  2. if a firm is TOO CONSERVATIVE with its reserves and fails to support high-potential investments, it may miss out on significant returns.
70
Q

How would you structure dealmaking to maximize the odds of finding a ‘fund maker’?

A
  • Spray and Pray or very focused investments with high conviction?
71
Q

How does the way you structure your fund influence the deals you do and your internal decision-making?

A
  • Types of deals
  • the size of the fund
  • number of employees
  • time horizon
  • internal policies
  • lots of limited partners vs. just a small amount
  • ## the amount of dedication to supporting the CEO (full stack or not)
72
Q

You are a General Partner at a new full-stack venture fund and working to set up the policies and processes your fund adheres to. You are aware that this is an important exercise because you know that the policies in place will help to mitigate any potential internal politics and set you and your employees up for success.

List 3 examples of decisions you hold as a General Partner internally that could lead to agency or conflict with your Limited Partners.

A
  1. Investment strategy: The strategy of the GP’s and how they make decisions internally can create conflict with LP’s who are looking to take on more or less risk. GPs could also believe that certain companies should be invested in while LPs might disagree
  2. Compensation structure: What is the split of returns between GP’s and LP’s. Who gets the carried interest?
  3. Running the lead on deals: The LP may not like that the GP’s are consistently the lead investor on deals
  4. Write-downs: timing, the methodology behind the decision, and communication of choosing to write down needs to go smoothly between GPs and LP’s to avoid conflict
  5. Allocation of reserves: Investment into later stage companies that the firm has worked with rather than newer early-stage portfolio companies
  6. Companies within the portfolio: If the firm is an early stage firm and they are investing more into seed rather than growth or vice-versa this may differ from what LPs may believe
  7. Costs of Inhouse Expertise: LPs may feel that some of the hired experts are not necessary and haven’t brought extra value to a company. Might believe the GP is not allocating the management fees or reserves effectively
73
Q

What is working capital financing?

A

a loan that is taken to finance a company’s everyday operations.

74
Q

Pros vs. Cons: Early stage deals vs growth stage deals

A

PROS: Buy more ownership for less money, build relationship and favorability with CEO

CONS: More companies go to zero, might be emotionally invested and not think objectively

75
Q

Pros vs. Cons: Consensus-driven dealmaking vs conviction-driven dealmaking

A

CONS: lots of internal politics, have to get other people to vote for your idea, could create people supporting ideas to get in good graces with other co-workers

PROS: avoids rogue investing, so members within the firm are not just going out and investing in whatever they want

76
Q

Pros vs. Cons: Spray and pray vs concentrated portfolio construction

A

PROS: more diversification and get to benefit from the profits of successful companies that you otherwise would not have focused on

CONS: no strong investment strategy meaning that profit although there is very minimal given little capital allocation

77
Q

Pros vs. Cons: Writing off underperformers vs holding on to them

A

Holding on: Companies may take longer to mature, maybe the down-fall is due to an external environmental factor out of the control of the founder. If you write -off too early you could miss a potential future opportunity/profit and could harm brand and relationship with CEO

Writing off: Can cut losses early and spend that money into companies that support the power law. Writing-off before the company gets even worse can allow GPs to save face with LPs and show their intellect and value of resources given

78
Q

Pros vs. Cons: Saving reserves for outperformers vs allocating more capital to initial investments

A

Outperformers: putting money into your outperformers gives them more resources to excel and grow. Money may not be needed (growing too quickly), paying more for future rounds given the additional invested capital

Initial Investments: Allocates resources more effectively, allows more companies to reach the same place as outperformed and ensure continuous growth within the fund. These companies have not shown to be apart of the power-law yet so its a serious risk

79
Q

If you wanted to calculate how much of the fund was investable capital, what information do you need?

A
  • Size of the fund
  • management fee
  • fund stage
  • amount already into the investment period
  • carried interest model
  • amount in reserves
  • life of the entire fund
  • other fees and expenses

if the fund believes in recycling financing

80
Q

If all of a sudden 3 of your companies were written up by follow-on external market rounds generating an additional $20M of value above your cost, what information would be missing for you to calculate your net IRR?

A

To calculate the net IRR in this case, we would need to know how much capital was invested into these three portfolio companies. Also, we don’t know the overall fund value and how much they invested of their entire fund into the 3 companies, this can make a huge difference if it was 5% or 50% of the total LP funding amount. We don’t know how much capital was invested to generate the $20M value. This is because Net IRR takes into consideration:

  1. Size of cash flow
  2. Time of cash flow
  3. The fund’s value
81
Q

If, after 3 years, one of your companies exited for $45M, a 10x from your initial investment in the company, what information would be missing for you to calculate your Carried interest payout as a GP?

A

You would need to know the GP and LP carried interest percentages.

The hurdle rate: The minimum rate of return that the fund must achieve before the GP can receive carried interest.

82
Q

What is the hurdle rate?

A

The hurdle rate: The minimum rate of return that the fund must achieve before the GP can receive carried interest.

Venture Capital (10 decks)

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