ECONOMICS AND TRADE | Achieving growth through open markets
14 May 2008
Venture Capital: A Primer
How professional capitalists evaluate start-ups and decide where to invest
By: Joseph W. Bartlett
Joseph W. Bartlett is counsel in the New York City office of Sonnenschein Nath & Rosenthal LLP. A former U.S. undersecretary of commerce, he is a courtesy professor with the Johnson School of Business, Cornell University, and former adjunct/visiting professor at the Stanford University and New York University law schools. Bartlett is the founder and chairman of VC Experts Inc. and editor-in-chief of The Encyclopedia of Private Equity and Venture Capital. [www.vcexperts.com]
The U.S. economy owes much of its postwar growth to emerging, tech-flavored enterprises, many of which have expanded smartly and contributed significantly to employment, wealth, and innovation — the emblems of our prosperity over the last 50 years. The story of how these small businesses attract the investment, or venture capital, they need first to survive and then to grow draws on a culture that values optimism and risk-taking, farsighted and investment-friendly government policies, and the energy and drive of the individual businessperson.
Because the United States has no monopoly on these traits, it seems likely that the intertwined stories of venture-capital investors and high-tech entrepreneurs increasingly will be a shared, global phenomenon.
Knowing the Terms
The world of venture capital employs a specialized insiders’ nomenclature. A new business is a “start-up.” Because high-tech giants such as Hewlett-Packard and Apple Computer literally trace their origins to workshops set up in automobile garages, today’s start-ups originate in their founder’s “garage.” Because founders seek fast growth, successful start-ups are sometimes referred to as “gazelles.”
A new business is initially built on the founder’s hard work, or “sweat equity,” plus outside financing from “friends and family,” then from “angels” — wealthy individuals whose investments may appear, to the founder at least, as acts of virtue — and culminating in the commitment of capital from professionally managed venture capital funds, often known by the English acronym “VCs.” One or more rounds of financing, known as “Series A,” “Series B,” and so on, can occur at this juncture. The arc of the gazelle as it proceeds from private financing to publicly traded company is often called “the embryo to the IPO” (initial public offering of stock).
Each of these labels, and others not mentioned here, are just that — shorthand for items and phenomena that vary widely in actual practice. I focus here on how gazelles have successfully gestated in the United States.
The Cultural Imperative
How does a founder, starting in his or her garage, successfully solicit growth capital from the angels and then the VCs? What are the core elements in the process? A start-up’s very first assets are the brains, energy, and commitment of its founder. To put it another way, the entrepreneur’s character traits are themselves a form of venture capital.
The United States, in this sense, has been particularly blessed with individuals who combine optimism, confidence, and an enormous appetite for risk. After all, the odds suggest that initiating a successful start-up in one’s garage (or, as in the case of Apple Computer’s Steve Jobs, his parents’ garage) is not, statistically speaking, a sensible use of time and energy. The failure rate is high. It takes an enormous level of optimism and confidence for the founder to say to herself or himself: “Despite the odds, I can make it big time — and have a lot of fun and satisfaction along the way.”
A healthy appetite for risk also is central. For this reason, venture capital is unlikely to flourish in societies where cultural norms, government policy, and bureaucratic inertia discourage risk-taking. Venture capital instead requires a proper balance of risk and reward. If the consequences of failure entail not just legal bankruptcy but also personal ruin, the venture capital model will not get off the ground.
On the other side of the coin, the founder’s appetite for risk needs to be whetted by the possibility, however long the odds, of sensational rewards; this means, in turn, a low tax environment and the absence of bureaucratic obstacles to entrepreneurial success. It is this possibility of an enormous win that lures American entrepreneurs — not the odds, but the economic and psychological delights when the gamble pays off.
A founder’s ability to seize opportunity, act with confidence, and tolerate risk is only the beginning of the story. Crucial, too, is a system of laws and social norms that protect intellectual property; ensure universal public education; afford employers the ability to hire and, more importantly, fire employees as business needs dictate; and guarantee within reasonable legal limits the investor’s ability to invest his capital in those ventures he views as promising.
Obtaining Venture Capital
Assuming that adequate investment capital is available, how does the typical U.S. start-up access it on terms that reward fairly both the founder’s sweat equity and the investor’s risk of capital? Over the years, Americans have devised structures and processes that shape the bargaining between entrepreneurs and investors and that assure a continued flow of capital to the start-up businesses that need it.
Founders have had to develop the tools and the knowledge to present proposals that allow investors fairly to evaluate a start-up’s prospects for success. The investors, in turn, have developed financial terms that afford them a fair opportunity to earn profits competitive with those they might earn on other kinds of investments, adjusted for risk, and without being confiscatory. Financial terms that favor the entrepreneur risk an inability to attract venture capital, while deals too harsh from a founder’s perspective deprive the entrepreneur of the incentive to invest his or her sweat equity in the fledgling business.
The long history of negotiations between entrepreneur and investor have produced a relatively clear and well-defined road map of venture capital investment. As one involved during the evolution of this process in the early 1960s, I can testify that trial and error, spread across literally hundreds of thousands of transactions, has produced consensus and standardization of the necessary metrics.
The founder of a start-up typically raises organizational money by maxing out his or her credit cards and taking out a home equity loan. He or she “slow pays” creditors in order to buy time to beta test the product in her garage. If the results are promising, she arranges the friends-and-family round, seeking investments from college roommates, relatives, old friends, and day-job colleagues.
Next, she turns to angels, those financial investors who specialize in providing venture capital for small start-ups and entrepreneurs. The angel round is trickier, but there are organized angel groups around the United States, as well as industry conferences, business plan competitions, venture capital clubs, and other established venues where angels come together and review proposals.
Serial angels, those who already have invested successfully in start-ups, are the most desirable investors, particularly when they can “add value” — business advice, contacts, sales leads, and the like — to the enterprise. Securing angel capital requires a lot of phone calls, a lot of knocking on doors, and a lot of networking. Placement agents frequently can help find the lead, or “bell cow,” venture investor. Once a lead investor is in place, it can be easier to attract others.
The process is not an easy one, but certain provisions of U.S. law help it along. American law is friendly to the solicitation of high-net-worth individuals, assuming they possess sufficient net worth. Also, the tax treatment of angel investments can be attractive, with the federal government picking up half the bill in the form of tax deductions.
Structuring the Deal
The road maps outlining the terms of the deal between entrepreneur and venture capital investor also are becoming easier to read. A number of surveys are available to indicate market/industry standard deal terms. Model forms are available from trade groups such as the National Venture Capital Association and from the libraries of the law firms and advisers that routinely practice in this area.
Entrepreneurs understand that venture capital investors expect an average 20 percent internal rate of return (IRR) compounded on the portfolio as a whole. IRR is the industry benchmark that combines the rate of appreciation of a holding between investment and sale and an assured rate of return on interim distributions. In other words, it measures the investor’s return during the five- to seven-year expected time horizon between investment and exit (when the investor sells his investment).
Thus, the start-up founder, when approaching venture capitalists, understands that he or she must be able to present realistic projections that are based typically on actual revenues and that, when adjusted for risk, meet the investor’s target internal rate of return. Since early-stage valuations tend to be influenced by VC-perceived trends and herd instinct, many investors rely instead on “pre-money valuations” offered by various score-keeping organizations.
The critical point is that the lessons drawn from legions of transactions have lent efficiency and ease to deal structuring. Unnecessary haggling over relatively trivial issues is less and less prevalent. Based on hard-won experience, investors and entrepreneurs have a fair idea of what they want to give and what they need to take in order to make the process work. When the buy side and the sell side are in alignment, the transaction closes with a minimum of frictional costs and wasted time. The parties can focus on the main variables: the value of the start-up’s technology, its competition, the quality of its management, the time horizon to exit, and likely exit pricing. The players contribute collectively to an environment that minimizes eccentric and superfluous risks.
U.S. federal and state governments have contributed to this process by loosening restrictive regulations. The state courts in Delaware, home to many U.S. corporations, have clarified and explained applicable corporate governance rules. Meanwhile, the leading law, accounting, and investment banking firms have worked to standardize deal structure and contract language. The process has been gradual, of course, and cumulative, with success begetting success. At bottom, again one finds the U.S. cultural imperative of optimism, confidence, and risk appetite. These values have spurred both venture capitalists and entrepreneurs to build together an integrated system that serves their collective needs. It has been a mainstay of American economic growth and prosperity.
An Open Horizon
One promising consequence is that over the past several years, students from around the globe have, in my classes and others like them, studied this venture capital phenomenon and taken the lessons back home. The success stories are spreading worldwide, particularly in the “Three I’s” — Ireland, India, and Israel.
Competing models based on low-cost labor arbitrage and petroleum wealth will carry an economy only so far. In the final analysis, innovation and technology offer an open horizon and an inexhaustible resource.
The opinions expressed in this article do not necessarily reflect the views or policies of the U.S. government.
