On Venture Capital An introduction to an alternative asset class

Shane Ninai

(shane.ninai@gmail.com)

Jack Saba

(jack.k.saba@gmail.com)

Every successful company is founded on one premise: they see a problem or opportunity, and they have a

solution. Great companies such as Google, Apple, Tesla, and Skype have all been backed by Venture

Capitalist. These companies saw a problem, created a solution, had a team that could execute, but they

needed money.

The need for capital creates a marketplace for investors. Venture Capital is the business of

providing early-stage high-growth-potential companies money, access, and resources for an equity

stake.

There are several stages to invest: Seed, Series A, Series B, Series C, etc. The majority of

companies fail, so the earlier the stage a Venture Capitalist invests the larger the risk and possible

returns. We will go into more detail later about the risks and opportunities of each stage.

To de-risk a venture capital portfolio investors invest in many companies, and along side other

Venture Capitalist. If a company is raising $2m, one investor may only invest $250k. This allows the

investor to fund more companies, which improves their chance of finding companies that reach a

successful exit.

The best market today for venture capital is in Silicon Valley USA. For limited partners outside

of the USA interested in participating and investing in Silicon Valley companies, investing in a cross-

border venture capital fund with a strong Silicon Valley network is an ideal place to start.

This paper will discuss the structure and operations of a fund, as well as the risks and rewards

of investing at various stages.

1. An Alternative Asset Class

Venture Capital is an Alternative Asset Class that is risky and illiquid, but the ROI is

discussed in terms of multiples, not percentages. For those willing to participate this

Alternative Asset is usually 5% of their portfolio, but can return 30% of the entire

portfolio’s performance.

The challenge for investors is gaining access to Venture Capital Funds for these

opportunities.

1.1 Risk and Reward

A VC Fund operates for 10 years. As an alternative asset class the high risk high reward

payoffs are understood to deliver multiples on an investment, not a percentage. As such they

are attractive to investors and those seeking to diversify their portfolio.

Seed Stage: 84% of seed stage companies fail to make it to the next round (series A).

However the returns on a single successful investment are around 644%, and have been

known to be much higher.

Series A: 70% of series A companies fail to raise a subsequent round. Though a failed

investment can lose $100k-$750k, a successful investment at series A can yield a return of

almost 300%. This is a sweet spot of low loss and big returns.

Series B: If a company raises a Series B round they have a 56% chance of reaching an exit.

Series B investments are also in a sweet spot for risk and reward. Typical investments are

$1-$5m, but have an ROI of 94%.

Series C: 83% of companies that close a Series C investment successfully reach an exit.

These are much more stable investments, but they typically only yield a 20% return.

2. The Fund 2.1 The people involved

Limited Partners provide the capital for a VC Fund to invest. Traditionally LPs are

institutions, pensions, high net-worth individuals, and funds of funds. Though Venture

Capital is risky each LP wants to invest in a fund because they understand the ROI is a

multiple of their investment, not a percentage.

General Partners are the people responsible for the operations and success of the fund.

Their responsibilities include managing the operations, finding companies, and making

investment decisions.

Entrepreneurs by nature are resilient, creative, tenacious, and calculated risk takers. Many

people may see a similar opportunity and solution, but entrepreneurs take the steps to

assemble a company. Investment opportunities would not be possible without them.

2.2 The structure of a fund

There are two fundamental parts to a Fund. The Limited Partnership and the Management

Company.

LPs invest in a fund through a Limited Partnership entity. It is also the vehicle that the Fund

uses to directly invest in companies.

The controlling entity of a Fund is the Management Company. This the legal entity that

employs all the people associated with the Fund such as partners, associates, analyst, and

support staff. The management company is responsible for all expenses associated with the

Fund’s operations including taxes, salaries, and overhead. During the life of the fund 1.5%-

3% annually is committed to the Management Company as a management fee. The size of

the Management Fee is inversely related to the size of the fund1.

Under the Management Company there can be multiple Funds. If a Management Company is

doing well, and wishes to raise a new Fund as a current one is being depleted they do so

under the same entity. Traditionally these Funds are denoted with Roman Numerals i.e. DFJ

Fund I, DFJ Fund II, DFJ Fund III, and are raised every 3-5 years.

When a Management Company is raising a fund LPs do not write a check at the time of the

closing. Instead they engage in a Capital Commitment. This means that they are legally

obligated to release funds when the GPs decide to make an investment. The process of

requesting the funds is a Capital Call2.

Fig1: Structure of a fund.

1 Mendelson, Jason. "How Venture Capital Funds Work." Venture Deals. By Brad Feld. 2nd ed. Hoboken: John Wiley &

Sons, 2013. 119. Print.

2 Mendelson, Jason. "How Venture Capital Funds Work." Venture Deals. By Brad Feld. 2nd ed. Hoboken: John Wiley &

Sons, 2013. 117. Print.

MANAGEMENT COMPANY (general partners, analysts, employees etc) identify companies and make investments

VENTURE CAPITAL FUND (a pool of committed capital from LP’s that the management company will call upon when deploying capital to investments made by General

Partners in startups)

LIMITED PARTNERS

(Institutional investors, insurance companies, pensions, companies, high net worth individuals etc)

2.3 Operations

A fund typically operates for ten years. The first three to five years are about finding

investments to create the portfolio. The remaining seven to five years are for follow on

investments to companies doing well. During this time the Fund is focused on portfolio

management, and helping the companies reach an exit.

The commitment period is the predetermined period of time a VC Fund can invest in

companies to create the portfolio. Typically it is five years. This is because it takes a few

years to see returns, so you don’t want to find new investments towards the end of the

funds life3.

During this commitment period roughly 50% of the Fund is invested4. The remaining funds

are for follow on investments. Follow on investments are important because they allow you

to maintain your ownership stake in the company. If you do not provide follow on

investments your ownership stake will be diluted as a company raises future rounds.

Dilution is not necessarily a bad thing. It just means that you own less of a more valuable

company5. For instance if a company is raising $100 at a post money valuation of $200 and

we invest $10 then we own 5% of the company. If in the next round they raise an additional

$100 at a $300 post money valuation, but we do not invest, we will only own 3.3%. For this

reason it is important to have sufficient capital to reinvest in the companies that are doing

the best in the portfolio.

Receiving a return on your investment in Venture Capital is different than in other Private

Equity markets. To realize a return the company you invested in has to have an Exit. Exits

can occur in the form of an IPO, an M&A, or if a Fund sells their equity stake on a secondary

market.

Upon successful exits the initial investment amounts are returned to the LPs. The remaining

profit is split 80%-20% between the LPs and GPs respectively.

3 Fagundes, Laura. "Understanding Venture Capital Life Cycle Will Help Choose an Investor." Securedocs. N.p., 12 Nov.

2013. Web. 17 Mar. 2016.

4 Mendelson, Jason. "How Venture Capital Funds Work." Venture Deals. By Brad Feld. 2nd ed. Hoboken: John Wiley &

Sons, 2013. 125. Print.

5 Davies, Thomas. "Why Dilution Isn't Always a Bad Thing | Seedrs Learn."Why Dilution Isn't Always a Bad Thing |

Seedrs Learn. N.p., 14 June 2013. Web. 22 Mar. 2016.

3 Investing

3.1 Sourcing Deals

The fist step in investing is sourcing deals. The challenge is that the good deals are

hard to gain access to. The process is dependent on close connections, and strong networks.

Most early stage companies are unknown. They haven’t taken enough of the market

share to be on everyone’s radar, but that doesn’t mean they are not worth investing in. To

find these companies you need to know the founders, or know people who know the

founders.

Building a reputation and network is necessary for success.

3.2 Mitigating risks

Venture Capital is about purchasing equity, not writing loans. If a company fails then you

lose all the money invested. This is a very real risk, and ultimately failed companies become

write offs in the portfolio.

There are a few ways to mitigate this risk. Among them are time diversification, sector

diversification, and the number of investments in the portfolio.

There are many micro cycles in tech and investing. Creating the portfolio by investing

steadily over the entire commitment period increases your chances of missing a bubble.

Funds that invested their entire fund in 1999 underperformed because of the dot-com

bubble. The Funds that started investing in 1999, but created their portfolio over three

years were able to find companies that survived the bubble, and ultimately succeed6.

Companies are building services in all sectors. Several of the verticals are Finance, Energy,

the Sharing Economy, Logistics, Internet of Things, etc. Each vertical has its own ups and

downs. By investing across several different sectors you create a diverse portfolio that can

preform regardless if one sector underperformance7.

One of the most important ways to de-risk a portfolio is to invest in many companies. Many

companies fail, but one success has the ability to payoff the entire fund. Consequently most

Funds have a portfolio of about 25-30 companies8.

4.0 Stages of Investment

As a company grows from proof of concept, to validating a product market fit, and

ultimately to growth and expansion they will need funding. These key stages provide

opportunities for VCs to invest.

6 "How Do VCs Mitigate Risk In Their Investment Portfolios?" How Do VCs Mitigate Risk In Their Investment

Portfolios? N.p., n.d. Web. 22 Mar. 2016.

7 "How Do VCs Mitigate Risk In Their Investment Portfolios?" How Do VCs Mitigate Risk In Their Investment

Portfolios? N.p., n.d. Web. 22 Mar. 2016.

8 "Thoughts on VC Portfolio Construction." Information Arbitrage -. N.p., 18 Mar. 2012. Web. 19 Mar. 2016.

The opportunities can be grouped into three phases: early stage financing (Seed and

Series A), growth and expansion (series B and C), and acquisition and buy out financing

(Series C and beyond).

In this section we will speak in general terms of what companies look like, what

their objectives are, and what information VCs are analyzing; additionally, to better

illustrate how and why a company raises each round we will use Facebook as an example.

4.1 Seed Stage

Generally speaking

As friends move from bouncing around an idea to building a product their initial focus is targeting a

specific market and demographic. Generally, Seed Stage companies consist of two founders, and

possibly a very small development team.

At this stage a company would receive investments from friends and family, Angel Investors, or early

stage VC Funds. A Seed Round is typically $100k-$1m for 20% of the company. Each investor

typically writes a check of $50-$250k9. A Seed stage company does not have a financial history, or

much traction for the investor to analyze. At this stage investors are evaluating the strength of the

team, the magnitude of the problem that they are solving, and the adequacy of their solution.

4.1.1 Risk and Opportunity

Investing at this stage is extremely risky. The company has an unproven product, and usually

no monetization strategy. However, an investor is usually writing a smaller check, so the loss

is not as dramatic. Here you are investing in the strength and expertise of the team.

Though 84% of startups funded in a Seed Round fail to raise additional rounds, the returns on

a winner can be as high as 644%10. Potential for high returns coupled with small losses make

this an appealing investment stage for some investors.

4.2 Series A

Generally Speaking

After the company has a product and found a product market fit they need to initiate their go to

market strategy. This requires growing the team, and possibly incurring additional cost for targeting

new markets.

Typical Series A rounds are $2m-$15m for 30% of the company, and each investor writes a check of

$100k-$750k. The Funds investing in Series A company typically have $10m-$100m in assets under

management. Due to large check requirements Series A deals are predominantly done by VC Funds,

but occasionally Angel Investors will provide a follow on investment.

When a VC is analyzing a Series A deal it is still done subjectively. In addition to the team, problem,

and solution a VC wants to understand a company’s Traction, Burn Rate, and Projections.

For social companies traction is user growth month over month. If a company had a hardware

product or a service then traction would be growth in sales month over month.

9 Vital, Ana. "How Funding Works - Splitting The Equity With Investors - Infographic." Funders and Founders. N.p., 09

May 2013. Web. 22 Mar. 2016. 10 https://medium.com/@DunRobinVentures/evaluating-the-risk-reward-relationship-across-funding-rounds-5c951f21236b#.jr8xty93c

Burn Rate is the amount of money that a company is spending every month. This tells a VC how long

the current round of fundraising will last until the company needs to raise again.

At this stage a company's revenue and growth projections act like more of a road map than a

concrete objective. Projections allow a VC to understand a company’s perceived potential.

4.2.1 Risks and Opportunities

Investing in Series A rounds is significantly less risky than investing at the Seed Stage. If a

company closes a Series A round then they are a part of the 16% of companies that have not

failed. 84% of companies fail to make it past series A.

Series A investing is in a sweet spot of lower loss and higher return. Though a failed

investment can lose $100k-$750k, a success can yield a return of almost 300%11.

4.3 Series B

Generally Speaking

Series B funding is traditionally used for scaling a product. For most companies this means not just

reaching new users, but growing a sales team, marketing team, finance team, and purchasing other

companies. A typical Series B round is anywhere from $10m-10s of millions.

At this point a company has been operating long enough that their projects are more reliable. This

enables VCs to make objective judgments about the quality of a deal. In this round a Series A VC Fund

will provide a follow on investment, but new investments come from VC Funds that specialize in

Series B companies. Series B Funds typically have $100m-$400m under management, and each

investor will typically write a check of $1m-$5m.

4.3.1 Risk and Opportunity

70% of the companies that receive Series A funding fail to close a Series B round12.

Series A and B have a similar weight adjusted return. Though Series B is less risky, you are

investing significantly more money, and seeing a smaller return. The typical return on a

Series B investment is 94%13.

4.4 Series C and beyond

Generally speaking

Series C, and the subsequent rounds, are about continuing to Scale and purchasing companies.

Though there are Series C VC funds this is where companies may start to target institutional

investors and Private Equity groups.

4.4.1 Risk and Opportunity

83% of companies that close a Series C investment successfully reach an exit. These are

much more stable investments, but they typically only yield a 20% return.

Example: Facebook

Seed Stage:

In the case of Facebook Mark Zuckerberg and two co-founders launched their first product in

February of 2004. Their initial product was a social version of a traditional Facebook that you receive

11 https://medium.com/@DunRobinVentures/evaluating-the-risk-reward-relationship-across-funding-rounds-5c951f21236b#.jr8xty93c 12 https://medium.com/@DunRobinVentures/evaluating-the-risk-reward-relationship-across-funding-rounds-5c951f21236b#.jr8xty93c 13 https://medium.com/@DunRobinVentures/evaluating-the-risk-reward-relationship-across-funding-rounds-5c951f21236b#.jr8xty93c

in college. A Facebook provides your classmates’ photo, hometown, and age. Their first users were

their Harvard classmates.

Like all new companies Facebook built their product and validated their idea at their own cost.

Bootstrapping, as it is called, can only last so long before it becomes necessary to raise a Seed Round.

From June to July of 2004 Facebook raised $500k from Peter Thiel of Clarium Capital14. This money

would enable them to pay for their overhead while they continued to build.

Peter saw a strong team, and a big opportunity. The $500k was a good investment as Facebook used

it to validate their idea. By December of 2004 they had reached one million users.

Series A: Facebook

Facebook had amazing traction. Reaching one million users in under a year is big. What is really

interesting is that they were able to do it by hitting an insignificant portion of their addressable

market, which at the time were colleges.

In May of 2005 Facebook raised $12.5m from Peter Thiel (a follow on investment) and Accel

Partners. At this point they had reached 5.5m active users. This traction warranted a valuation of

$87.5m, which means they gave up about 14% of the company15.

Series B: Facebook

Facebook had a burn rate that caused them to use their Series A funding in one year. This is not

uncommon. Facebook spent their money on entering several new markets, but not diving deeply into

them.

In April of 2006 Facebook raised $27.5m at a valuation of $500m. Facebook used this money to grow

from 12m active users in December of 2006 to 20m active users in April of 2007. At this point

Facebook’s valuation is well over $8b16.

Series C: Facebook

From October 2007 to May of 2008 Facebook raised four Series C rounds for a total of $375m in

funding. This money was used to aggressively acquire companies that complimented Facebook’s

services.

Conclusion

In conclusion Venture Capital is the business of investing Limited Partner’s money into high-growth-

potential companies. It is the General Partner’s responsibility to de-risk the portfolio as much as

possible in order to return a multiple of the original investment17.

14 Managalidan, JP. "Timeline: Where Facebook Got Its Funding." Fortune Timeline Where Facebook Got Its Funding

Comments. N.p., 11 Jan. 2011. Web. 20 Mar. 2016.

15 Managalidan, JP. "Timeline: Where Facebook Got Its Funding." Fortune Timeline Where Facebook Got Its Funding

Comments. N.p., 11 Jan. 2011. Web. 20 Mar. 2016.

16 Managalidan, JP. "Timeline: Where Facebook Got Its Funding." Fortune Timeline Where Facebook Got Its Funding

Comments. N.p., 11 Jan. 2011. Web. 20 Mar. 2016. 17 https://medium.com/@DunRobinVentures/evaluating-the-risk-reward-relationship-across-funding-rounds-5c951f21236b#.jr8xty93c