Understanding Venture Capital

Friday

Aug132010

Understanding Venture Capital

Friday, August 13, 2010 at 11:13AM |

Anyone looking to raise capital needs to understand how their potential investors work. To borrow a term from project management: you need to understand the stakeholders involved in the venture capital firm as well as how they are affected by investment in your company. We are going to use a Venture Capital fund in this article, but much of what is discussed is applicable to other forms of private equity investment.

Let’s talk first about structure. When an entrepreneur looks to raise capital, they usually think of the investor as a venture capital fund, end of story. Within the abstract idea of “venture capital fund,” however, are generally three distinct entities. First, is the Fund Manager. The fund manager is what is typically thought of as the Venture Capital Firm. Draper Fisher Jurvetson (DFJ), for example, is a fund manager. The fund manager makes the investment decisions and is the group you interact with when you are trying to raise capital.

The second entity is the fund itself. When DFJ invests in a company, the fund manager does not us its own capital or own the stock in the company. The fund managers create separate companies (often limited partnerships) that hold the capital that is invested and any stock in the portfolio companies. Consider this article that discusses how DFJ earlier this year raised its tenth technology fund. That means DFJ created a separate company and raised money from investors that this separate entity, called the Fund, holds. When DFJ finds a company it wants to invest in, it invests the Fund’s money and the Fund in return receives the equity.

The third group is the limited partners. These are the investors who put money into the Fund. The fund manager is the general partner of the Fund, and thus the one responsible for running it and liable for any wrongdoing, but these other individuals maintain an ownership interest in the Fund.

As you can see, there are two types of stakeholders in the Fund, the general partner and the limited partners. Each of these stakeholders benefits from the success of the fund, but how that plays out can be very different for each.

The next thing you should understand is the Fund lifecycle. Typically, a venture capital fund exists for only 10 years (with the possibility of an extension of one or two years to allow for liquidating the portfolio company stock). At the beginning of the Fund’s life, the fund manager identifies the Limited Partners and receives their investments into the newly created fund. These Limited Partners will not be able to control their invested capital, or realize a return on their investment, until the 10 year lifetime is over. At the end of 10 years, the Fund is dissolved and the capital it holds is distributed out to the partners. That means that any stock purchased by the fund (the investments it makes) must be sold prior to the Fund’s dissolution. Since a typical investment in a startup venture can be expected to last 3-5 years, you can see that there is a limited window of time in which the fund manager can choose to invest the Fund’s capital. This situation, combined with the weak economy, has led to some serious problems for the Venture Capital Industry, as discussed in this Wall Street Journal article.

Finally, it is important to understand how the stakeholders actually make money from the Fund’s investments. The Limited Partners are easily understood, at the end of the Fund’s life, the Fund is liquidated and they receive a distribution from that amount. The fund manager, however, is compensated somewhat differently. Fund managers are compensated in a manner similar to hedge funds, an arrangement called “2 and 20.” While the exact numbers vary slightly (sometimes it may be 1 and 20 or 3 and 20), the concept works as follows. Each year, the fund manager receives compensation in the form of 2% of the net asset value of the Fund. Thus, if the Fund’s net asset value is $100m, the fund manager receives $2m that year, regardless of how well or poorly the Fund’s investments are doing. In addition, the fund manager receives a performance fee of 20% of the return. For example, if the Fund starts out at a value of $100m when it is created and 10 years later has a value of $600m, the return would be $500m and the fund manager would make 20% of that ($100m). The remainder, ($400m plus the original $100m) would then be the amount distributed out to the Limited Partners.

Understanding this is important for several reasons. First, knowing how far into the life cycle of the Fund you are will give you an idea of how soon the investor expects you to have an exit. Second, when you are trying to determine if you can generate a substantial enough return on investment for a venture capital fund, remember to take into account not only that many of the other portfolio companies will fail (and if you are the one-in-ten big success you will have to make up for their failures), but also deduct the fund manager’s fees from the amount that will actual be returned to investors.

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