SEPTEMBER 16, 2003

By Gabor Garai
Gabor Garai

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VENTURE CAPITAL
By Gabor Garai


What VCs Don't Tell You
To secure funding, an entrepreneur needs to appreciate the goals and strategies at work on the other side the table. Here's a guide

Venture capitalists tend not to be very forthcoming when entrepreneurs ask why deals are rejected, beyond the maddeningly vague, "It's not for us." The reality is that there are a number of forces at work behind the scenes dictating investment decisions that are key to determining when, where, and how investments are made.


In my last column (see BW Online, 8/18/03, "How to Snag the Strategic Investor"), I examined the key factors that guide corporate venture investing, and how they are influenced by the long-term needs of the corporations providing the cash. Venture-capital firms are focused a bit differently, based on a division of labor and investment between the professionals running the fund and the institutions (pension funds, university endowment funds, investment banking pools, etc.) which provide the bulk of the investment funds. It's important for entrepreneurs shopping for cash to appreciate the motivations of these "end users," as it were.

DOING THE MATH.  First, entrepreneurs need to understand the investment structure of venture funds. The funds are managed by professionals, who are usually former entrepreneurs or investment professionals. In smaller funds, they typically invest from their own money between 5% and 10% of the fund's total assets. This means that, for a $100 million fund, these individuals are putting up $5 million to $10 million -- a significant amount. The remainder of the assets come from institutions.

The fund's managers are compensated in two ways -- from an annual management fee typically amounting to between 1.5% and 2.5% of the assets, and something called "carried interest," which is an amount based on the fund's value appreciation. The management fee is used mostly to cover ongoing expenses like rent and staff salaries. Also important to remember is that the fee is usually paid for five years, after which it declines to perhaps 1% to 1.5%. Thus, the fund's managers have an incentive to make things happen within a five-year window.

It's in the carried interest that the managers can make the "big hit," since any increases in fund value are typically divided 20% to the managers and 80% to the investors. Returning to the hypothetical $100 million fund, let's say it is worth $200 million after five years. In that situation, the managers would receive $20 million of the $100 million of appreciation and the investors $80 million. If the fund's value soared to $500 million, the managers would rake in 20% of a $400 million gain, or about $80 million -- not a bad bonus for five years of work.

CREDIBILITY CRUNCH.  On the other hand, if the fund stays even after five years, it would actually be worth $12.5 million less than when it started, since it will have paid $2.5 million annually in management fees, or $12.5 million over five years (assuming a 2.5% management fee). In that situation, the managers would receive no "carried interest" and, like the institutional investors, would lose a portion (12.5% to be exact) of their initial investment. Moreover, the managers would have little credibility in subsequent efforts to put together venture funds -- and might even have to give back some of their management fees.

Clearly, the incentives for managers to succeed are very attractive, and the penalties for failing to deliver an adequate return are severe.

It's important also to understand the viewpoint of the institutions putting up the bulk of the funds. They invest in venture funds largely to help achieve a diversification strategy. Institutions typically invest in stocks, bonds and real estate, which may well provide small but steady returns, so they view venture funds as an opportunity to get some some oomph into their overall returns. Or, if their other investments are down, it's hoped the venture fund will be countercyclical and provide an overall positive return.

Continued on next page>>  | 1 | 2



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