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INNOVATION
& DESIGN Home Page Architecture Brand Equity Auto Design Game Room SMALLBIZ Smart Answers Success Stories Today's Tip FINANCE Investing: Europe Annual Reports Bloomberg BW50 SCOREBOARDS Hot Growth Companies: 2008 Mutual Funds Info Tech 100 B-SCHOOLS Undergrad Programs Rankings & Profiles | | SEPTEMBER 16, 2003
By Gabor Garai What VCs Don't Tell You [Page 2 of 2] HERD MENTALITY. In order to achieve sizable returns for the institutions, the venture fund has to do extremely well. Because the managers are receiving both the 2.5% annual management fee plus 20% of any gains, the math works out that a fund must achieve a 45% to 50% compounded rate of return in order for the institutional investors to realize a 30% compounded rate of return on their investment. It's also important to understand that institutions often come to investment funds with extra baggage in the form of political considerations. University endowments, for example, may prohibit investments in companies that have any connection with child labor or gambling. In addition, institutions will want to know, especially if things don't go well, that the fund's managers "did the same things as everyone else" -- in other words, that he or she invested in industries popular with other investment funds. If one fund takes it on itself to venture into a new industry that others are avoiding, such as a promising but unproven technology, and the investments do poorly, it could be criticized and possibly even sued. This helps explain the so-called "herd mentality" for which venture capitalists often have been criticized. What does all this mean for entrepreneurs? Here are several potential lessons: • Approach venture funds that have been recently formed, rather than those that are two or three years old. Because venture funds tend to have five-year time horizons, they seek to make as many of their investments as possible in the first few years; institutional investors expect that the proceeds of most of the portfolio will be distributed five years to seven years after launch of a fund. Companies seeking funding that come along in the second and third years will be expected to show extremely sharp growth potential. • Investigate as carefully as possible the goals a venture fund spells out for institutional investors. Ideally, you would like to see the documents it uses to make its pitches to prospective investors. If you can't obtain them, study the fund's Web site very carefully for clues as to investment goals, political issues, and other such factors. • Seek out fund managers who will be receptive to what you are trying to achieve. For example, if your company has complex technology, seek out funds managed by technical types. • Figure out how your company fits into a trend or industry that venture capital firms have deemed to be "hot." They follow the crowd, no doubt about that. • Check the fund's risk tolerance. Is it a seed round, B-Round, or later round investor? As in all kinds of marketing, it is key for the entrepreneur to understand the VC firms' goals, preferences and interests and sell accordingly.
 Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.
BW MALL
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