Understanding Venture Capital

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.

Lean vs. Fat Startups

Last week, Ben Horowitz and Fred Wilson debated the “Lean Startup / Fat Startup” discussion at TC Disrupt in New York City (video is available at Fred’s blog).  The debate is actually quite good and both men make good, compelling arguments for the side they are representing.  In fact, I do not disagree with either person’s beliefs, which may seem a strange position to take since the debate, ostensibly, attempted to position them as being in disagreement with each other.  I do, however, think the general debate of this issue deserves a post, not to disagree with either of the debaters, but because I believe many other people taking sides on the debate view it as a black-and-white issue where one investment model (fat or lean) is clearly superior.

A little background on the issue: 

“Fat” startups represent a somewhat older idea around investment.  In the 1990’s, when venture capital boomed as an industry, starting a web-based company often required the entrepreneur to hire a sizable, local development staff and IT personnel, in addition to management, sales, marketing, etc.  In addition, I remember working at a small startup and still needing to rent space at a local server farm as well as having large, expensive computers on site.  Hype was an important driver of startups, so having a nice office space, hosting events, and having hats, laptop bags, and just about anything you could branded with your logo was important.  In short, if you wanted to be successful you needed a lot of money to start off with. 

In the 2000’s, however, the market has changed dramatically.  The barriers to entry for an internet company are low.  Outsourcing development and IT to offshore locations is commonplace.  Few small businesses need to maintain large servers, inexpensively hiring companies to host everything for them.  Most importantly, the hype is gone.  In the wake of the internet bubble bursting, backlash against the extravagance of startups in the 90’s has made startups wary of doing large promotional parties.  The growth of shared office spaces, virtual offices, and cloud computing has made it such that startups need not even have an office until they grow to the point it becomes necessary.  As a result, theorists and investors have begun to promote the idea of the “lean startup.”

The lean startup ideology is that the startup should raise as little money as possible and keep their expenses as low as possible.  The result is better for both the entrepreneur and the investor.  Take as an example ABC Company.  Let’s assume, as a given, that however much money ABC raises, it will be worth $100m in 5 years and has a present valuation of $10m.  Under the fat plan, ABC raises $10m, giving the investor a 50% stake in the company.  Under the lean plan, ABC raises only $5m with the investor taking a 33% stake in the company.  From the entrepreneur’s perspective, under the fat plan they own $50m in stock in 5 years, while under the lean plan they own $67m in stock.  Lean provides a clear advantage.

If the investor holds more of the company under the fat plan, why would they prefer the lean plan?  Investors are less concerned with the absolute dollars returned from an investment than they are in the rate of return on that investment.  Here is how the math works.  Under the fat plan, the company invests $10m to make $50m, a 5x return on their investment.  Under the lean plan, however, they invest $5m and make $33m, a 6.67x return on their investment.  The investor can then use the remaining $5m to invest in another company that it hopes will result in an equally good return.

Looking at this example, then, it is obvious that every company should be lean and that fat startups are a bad idea right?  Why does Ben Horowitz, a venture capitalist who was previously an entrepreneur working at Netscape and Opsware, support this model (you can read his arguments on his blog)?

The choice between lean and fat is not a black-and-white one.  Both are viable models for a business and both are tools to be used.  The key to success is not blindly following one or the other of the ideas, but understanding the value of each and developing a strategy that takes advantage of that fact.  If your strategy is to operate under the radar and you don’t see any major players to compete with on the horizon, going lean is a perfect choice.  If, however, your strategy involves pushing out established players in your market or creating a large presence very quickly to prevent other companies from gaining market share, you may need to spend a lot of money on marketing to create awareness and technology to ensure your product is so far superior to the existing alternatives that even larger, established companies will have difficulty catching up on that front  (Ben Horowitz’s example of LoudCloud from his blog post is a great example of this). 

The key is to consider both options and decide what sort of financing you need to achieve your goals based on your strategy.  Returning to the example above, if the terminal valuation is not fixed, meaning that if you raise more money the value in 5 years is dramatically higher, then raising more money most certainly does make sense.  In particular, if remaining lean dramatically increases the risk of business failure, going fat is likely a better choice.  How better to own a smaller piece of a larger pie, than to own a large piece of no pie at all? 

Unfortunately, those who watch the video of the debate will note that it resulted in a decisive victory (by audience polling) in favor of lean startups.  While this may be simply because the majority of them have businesses where a lean startup is appropriate, I fear it is more likely the herd mentality of following the latest trend, when even the two people leading the discussion would agree that the side they were supporting is not always right. 

Articles This Month

I just wanted to take a moment to promote the two articles I published this month.

The first is entitled "Do I Need A Business Plan?" and can be found on the PaPers NYC website or by following this link.  The article discusses the benefits of creating a business plan and why every business owner should spend some time in developing one (even if the result is an informal plan).

The second discusses some of the possible sources of funding for small businesses and can be found at Buzzle.com.  There are a number of possible sources of capital for small businesses and entrepreneurs, and the article not only sets forth what some of those are, but helps entrepreneurs understand some of the advantages and disadvantages of different types of funding. 

I would also like to take a minute to promote my friends at PaPers NYC.  PaPers is the brainchild of Lloyd Cambridge and Terry Proctor and is a great resource for small business owners.  The company provides seminars and classes on topics ranging from Excel skills to marketing.  In addition to classes, they publish some excellent online content, often written by them or the teachers they work with.  If you have a few minutes, I highly recommend spending some time on their site: www.papersnyc.com.