Transcript Slide 1

VC South Entrepreneur Resources . . .
How Do Venture Capitalists
Select Investments?
Full content credits to Catharine Merigold
Sources & Costs of Capital
Cost of Capital
Expensive!
Private
Equity /
Mezzanine
Venture
Lending
Cheap!
Stage of Company
Seed
Self
FF&F
Employer
SBA, SBIR
Banks - PG
Early
Late
Venture Capital
& Incubators
Mature
Banks - AB
Strategic
Investors
Venture Makes Sense for Very Few Companies
• MOST successful companies are NOT funded by
venture
• Venture Capital ONLY makes sense for very few
companies
• My own advice: If there is any way to build a business
without venture capital, you should
• Venture capitalists are not risk-takers, they are risk
managers
1st M: Money
• How a VC “selects” investments is a
function of:
1) “Whose” money they are investing;
2) What other rates of returns are
available to those who invest in the fund
(LPs) from other investment vehicles
3) The stage of company they invest in
Where do VCs Get Their Money?
Pension Funds
Foreign Investors
8%
11%
Foundations
7%
59%
11%
4%
Families &
Institutions
Banks & Insurance
Corporations
Commitment Sources to US VC Funds
The Entire Fund Has To Return Higher
Than Other “Less Risky” Investments
Venture Returns by Type, Q1 ‘00
250%
200%
Rate of Return
• Consistently
a higher rate
of return
than other
investments
• An
“alternative”
asset class
Early-Seed
Balanced
Late-Stage
All Venture
150%
100%
50%
0%
1 yr
3 yr
5 yr
Time Horizon
10 yr
If Fund to Return 30%, Avg. Investment Must
Return More Depending on Number of Losers
8%
20%
2%
40%
30%
“Typical “ Early-stage Venture Portfolio Returns
losses
1-2x
2-5x
5-10x
10x+
The Lesson: An Early-Stage Portfolio
Return is Determined by 2-3 Winners
Venture Fund Portfolio Model
Assume fund =
$ 100,000,000
Assume investments = 25
Lemons ripen early
Multiple
losses
1-2 x return
2-5 x return
5-10x
10x +
percentage
# of investments
total investment
40%
10 $
33,000,000
24%
6 $
21,000,000
20%
5 $
20,000,000
8%
2 $
11,000,000
8%
2 $
11,000,000
100%
25 $
total return
$
$ 29,400,000
$ 60,000,000
$ 82,500,000
$165,000,000
96,000,000 $336,900,000
How Much Does Venture Capital Cost?
Risk – Return Continuum
Seed
1st Prof
2nd-3rd
Rounds
0
0-1 yr
1-3 yr
3-5 yr
10-50 yr
Product Stage
Idea
Proto
1st Gen
2nd, 3rd gen
Mature
Sales Growth Rate
0%
explosive
100%
25-50%
10-15%
losses
losses
losses/BE
profit
stable profit
$250k-$1M
$2-$10 M
$10-$40 M
$5-30M
$5-$50M
15-20x
70%+
10-12x
8x
6x
3x
Age of Company
Profits
Captial Needs
Return Expectations
Mult of Inv
IRR
Emerging
Growth
Lever.
Buyout
2nd M: Market
• “Big” market
• Ability for rapid growth up to a substantial
sales level
• The opportunity to deploy significant capital
– For example, some funds want to invest
$10-20 million over the life of a company to
create an “impact” investment
Market Part 1: Market Size
• Market for the product/service should be more than $1B
or small & growing rapidly
• Why? Need for Exit
– Remember, VCs get their money from someone else,
and have to close out all investments in 10 years
• A large share of a small market, even with profitability,
means:
• No one will pay a premium in an M&A situation
• Can’t go public because growth limited
Market Part 2: Rapid Growth
• Ability for rapid growth up to a substantial sales level
– $50M+ in 4 years
– Why? Rate of Return
• Therefore, VCs look for:
– A company that solves a significant market “pain”
– Sustainable competitive advantage
• This means many good businesses are not fundable
because they either cannot grow quickly enough or are
not scalable – e.g.retail, many service-businesses
Market Part 3: Ability to Deploy Capital
• No matter what the rate of return, VCs will
typically NOT invest if a company needs less
than $5 million in capital
• Why? Fund Size and Rate of Return
• If a Fund has $300 million to invest, it would
take 30 “home runs” of 10x return on a $1
million investment just to return the fund
3rd M: Management
• VC mantra - management, management, management
• At the end of the day (unless an irrational market lifts all
boats), it is management that is responsible for success
• Depending on the particular VC, they may look for:
– “Recycled” entrepreneurs
– Domain expertise
– “Sticky” entrepreneurs
– “Real” entrepreneurs
Value Creation in Business and Product
PoC
alpha
Bet
a
Ship
Patent
Tech/Prod
Idea
Value
Sticky
Bus
Plan
Sr.
Team Customers
Partners
Rev
Ramp
Business
To Maximize Funding Potential and
Valuation – Minimize Risk Vectors
•
•
•
•
•
•
Management risk
Market risk
Sales risk
Technology risk
Business strategy risk
Financing risk
Finding the Right VC
• Choosing the right VC firm as your “partner” is
important
• Look for help beyond capital
– Industry expertise in your area
– Good track record
– Reputation for working well with
entrepreneurs
• Make sure the VC’s expectations on growth
strategy, future fundraising, and investment time
horizon are the same as yours
How Do VCs Choose Investments?
• Recap: The 3 M’s
–Money
–Market
–Management
Full content credits to Catharine Merigold