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.
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.