A Note On Venture Capital Industry

A Note on Venture
Capital Industry
Introduction
 Prior to 1980, large firms created the majority of new jobs in the American
economy
 During the last two decades, however, a major structural shift occurred
 Fortune 500 companies lost 4 million jobs
 Firms with fewer than 100 employees added 16 million new jobs
 The rate of new firm incorporation rose dramatically.
 Firms with fewer than 500 employees, created 322 innovations annually per million
employees
 Large companies contributed only 225 innovations per million employees
 The availability of venture capital has clearly grown of the last twenty five years
 The availability is cyclic in nature and this cyclicality is more than just an
intellectual curiosity to venture groups.
 Often, periods of accelerated fundraising activity have preceded an alarming
downturn in returns which in turn triggers a decline in funds raised.
 This latest surge of activity brought with it much of the criticism of the early
booms in the venture capital industry.
Start-up Financing and Venture Capital
 Entrepreneurs often develop products and ideas that require substantial
capital during the formative stages of their companies’ life-cycles
 They lack sufficient funds to finance projects themselves, and they must
therefore seek outside financing.
 Several alternative capital sources exist.
 Angel Investing
 The informal risk capital market consists of individuals known as “angels.”
 These “angels” are wealthy business-people, doctors, lawyers, and others who are willing
to take an equity stake in a fledgling company in return for money to “start-up.”
 Wetzel (1987) estimates that 250,000 individuals are active in the informal risk capital
market and invest between $20 and $30 billion annually.
 Banks are an important source of start-up financing for a subset of new businesses.
 Companies that lack substantial tangible assets and have uncertain prospects are unlikely
to receive significant bank loans
 Venture capital firms will finance high-risk, potentially high-reward projects.

 They take an equity stake in the firms they finance, sharing in both upside and downside
risks
Start-up Financing and Venture Capital
 Most firms that receive venture capital financing are
 Unlikely candidates for alternative sources of funding
 They have few tangible assets to pledge as collateral
 They produce operating losses for many years
 Misperception - venture capital funds only high technology companies
 Low-tech companies such as Staples, TCBY, and Federal Express have also received
significant amounts of venture capital money
 Venture capitalists are
 Active investors
 They monitor the progress of firms
 They sit on boards of directors
 Venture capitalists retain the right to appoint key managers and remove members of the
entrepreneurial team.
 Venture capitalists provide entrepreneurs with access to consultants, investment
bankers, and lawyers.
Excel – Venture Capital Trends
Control Mechanism
• Sahlman’s extensive field study (1990) describes venture capital in terms of the control
mechanisms employed to manage costs.
• Three control mechanisms are common to nearly all venture capital financing:
• The use of convertible securities
• syndication of investment at each stage; and
• the staging of capital infusions.
• When the entrepreneur and the venture capitalist negotiate a deal, they usually sign an extensive
document that contains many covenants and restrictions as well as the actual terms of the
financing
• Form of investment (e.g., convertible preferred)
• Terms of the investment (e.g., conversion price, liquidation preference, dividend rate, voting
rights)
• Puts and call rights
• Registration rights
• Preemptive rights and rights of first refusal
• Option pools
• Employment contracts
• Vesting schedules and buy-back provisions
• Information rights
• Board of director representation.
Control Mechanism
 Convertible Preferred Stock and Venture Capital Investments
 Convertible debt and convertible preferred stock are the financial instruments that
venture capitalists employ most often. The most important role of convertible
securities is to properly align the incentives of entrepreneurs and provide
information to venture capitalists.
 Key feature of the contracts and operating procedures is that risk is shifted from
the venture capitalists to the entrepreneur.
 The entrepreneur’s response to these (contractual) terms enables the venture
capitalist to make informed evaluations and judgments.
 Staged capital infusions
 Staged capital infusions are the most potent control mechanism a venture
capitalist can employ. Prospects for the firm are periodically reevaluated. The
shorter the duration of an individual round of financing, the tighter the venture
capitalist monitors the progress of the entrepreneur.
 The role of staged capital infusion is analogous to that of debt in highly leveraged
transactions. It keeps the entrepreneur on a “tight leash” and reduces potential
losses from bad decisions.
Control Mechanism
 Why can other financial intermediaries (e.g., banks) not do the same sort
of evaluation?
 First, banks cannot use equity to fund the project because regulations limit banks’
share holdings. Furthermore, banks do not have the necessary skills to evaluate
projects with few collateralizable assets and significant uncertainty.
 In addition, Petersen and Rajan (1994) argue that banks in competitive markets
will be unable to finance high risk projects because they cannot extract rents
insubsequent transactions. Many venture capital partnerships specialize by industry
and are in better positions to determine the value of continuing funding. Also,
because the probability of failure is so high, venture capitalists need a substantial
fraction of the equity in order to recoup their investment.
 Most banks are unlikely to lend money to high risk projects. Even if they did, the
required interest payments on a bank loan for a project with these risk
characteristics would be extraordinarily high and might cause liquidity problems
that would severely limit the firm’s growth.
Issues Confronting the Venture Capital Industry
 Will venture capital thrive in the 2000s?
 Policies of Bush administration in implementing to stimulate small business
determines growth in VC industry. Small businesses make venture capital a
central part of any future economic growth
 New initiatives and regulations should be aligned to aid the growth of
venture capital.
 Federal government should increase the financing of basic science research.
 Profitability potential is enormous.
 It is an important element of any economic proposal to foster new businesses
 To lower capital gain tax. Reduction of it will increase their personal return.
 Public venture capital firms must be exempted from the double taxation of
corporate profits.
 Filing requirements needs to be simplified.
 If the appropriate measures are taken, a cut in the capital gains tax may
increase funds available to venture capitalists

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A Note on Venture

 Venture capital firms will finance high-risk, potentially high-reward projects.

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