Chapter 1
1.1 WHAT IS VENTURE CAPITAL?
A VC has five main characteristics:
1. A VC is a financial intermediary, meaning that it takes the investors’ capital and invests it
directly in portfolio companies. Thus, it does not invest with its own money, but with
investors’ capital.
2. A VC invests only in private companies. This means that once the investments are made, the
companies cannot be immediately traded on a public exchange.
3. A VC takes an active role in monitoring and helping the companies in its portfolio.
4. A VC’s primary goal is to maximize its financial return by exiting investments through a sale
or an initial public offering (IPO) .
5. A VC invests to fund the internal growth of companies.
Typically, a VC fund is organized as a limited partnership, with the venture capitalist acting as the
general partner (GP) of the fund and the investors acting as the limited partners (LP). Figure below
shows the flow of funds in the venture capital cycle.
Characteristics I: VCs are often compared to—and confused with—angel investors. Angel
investors, often just called angels, are similar to VCs in some ways but differ because angels
use their own capital.
Characteristics II: VC are defined as a type of private equity. Although the definitions of
“private company” and “public company” have some nuances, the key distinction is that a
public company’s securities can be traded in a formal market, like the NYSE or the
NASDAQ, whereas a private company’s securities cannot. Private equity is considered to be
a category of alternative investing, where “alternative” stands in contrast to “traditional”
investing in stocks and bonds.
Characteristics III: Without (3), a VC would only be providing capital, and his success (or
failure) would be entirely due to his ability to choose investments. Although success can, of
course, be entirely built on these choices, the comparative advantage of the VC would be
greatly improved if the investor could also help the company directly.
, o This help takes many forms. Most notably, VCs typically take at least one position on
the board of directors of their portfolio firms
o In addition to board service, VCs often act as unofficial recruiters and matchmakers
for their portfolio firms. Young companies often have a difficult time attracting high-
quality talent to a fledgling operation, and VCs can significantly mitigate this problem
by drawing on their reputation and industry contacts. A VC who performs these value-
added services well has a sustainable form of competitive advantage over other
investors.
Characteristics IV: the requirement to exit and the focus on financial return is a key
distinction between venture capital and strategic investing done by large corporations.
Moreover, a corporation may set up an internal venture capital division. In the industry, this is
referred to as corporate venture capital, which is something different than venture capitalism
since these corporate VC efforts will often have strategic objectives other than financial
returns and will have neither dedicated supplies of capital nor an expectation that capital will
be returned within a set time period.
Characteristics V: “internal growth” means that the investment proceeds are used to build
new businesses, not to acquire existing businesses. Characteristic (5) also allows us to
distinguish VC from other types of private equity. As a simple classification, we divide
portfolio companies into three stages:
o Early-stage include everything through the initial commercialization of a product.
o Mid-stage (also called expansion-stage) represent the vast landscape between early-
stage and late-stage.
o Late-stage are businesses with a proven product and either profits or a clear path
toward profitability.
,Mezzanine is when investors began to use the same capital structure—subordinated debt with some
equity participation—to provide another layer of debt financing for highly leveraged buyout (LBO)
transactions. Today, most private equity firms with “mezzanine” in their title are doing this second
type of investing.
Buyout investors pursue a variety of strategies, but a key feature of buyout investors is that they
almost always take majority control of their portfolio companies. (In contrast, VCs usually take
minority stakes in their portfolio companies.)
A related strategy to leveraged buyout is “buy-and-build”, where a buyout investor will acquire a
series of firms in a fragmented industry for the purpose of taking advantage of changes in the optimal
industrial scale. Although buy-and-build is a growth investment strategy, the growth comes externally
from the purchase of existing businesses.
The final category of private equity is distress investing, also called special situations. As the name
suggests, distress investors focus on troubled companies. Because many distress investments are
buyouts, this category intersects with the previous one. Some private equity investors do both
traditional leveraged buyouts and distress buyouts, but most investors specialize in either one or the
other.
Hedge funds are flexible investing vehicles that share many characteristics of private equity funds,
including the limited partnership structure and the forms of GP compensation. The main difference,
however, is that hedge funds tend to invest in public securities. Although there are exceptions to this
pattern, the basic distinction is that while private equity funds are long-term investors, hedge funds are
short-term traders. Also, because their investments are more liquid than those for private equity
investors, hedge funds can offer their investors faster access to their money, with withdrawals usually
allowed on a quarterly or annual basis.
This is a case of form following function: if you have an investment strategy in illiquid assets, then
you need to lock up your investors for a long period of time (private equity); if you have an investment
strategy in liquid assets, then you can allow for quicker withdrawals (hedge funds).
1.2 WHAT DO VENTURE CAPITALISTS DO?
VC activities can be broken into three main groups:
Investing: VCs prospecting for new opportunities and does not end until a contract has been
signed. The investment phase consists of the following stages:
1) Screen;
2) Term sheet (outlining the proposed valuation, type of security, and proposed
control rights for the investors),
3) Due diligence (analyzing every aspect of the company),
4) Closing (negotiation for formal set of contracts to be signed).
Monitoring: VC begins working with the company through board meetings, recruiting, and
regular advice. Together, these activities comprise the monitoring group.
Exiting: VCs are financial intermediaries with a contractual obligation to return capital to
their investors. The main sources of exists are IPO or a sale to a strategic buyer.
, Limited partners put up the capital, with a few percentage points of this capital paid every year for the
management fees of the fund. The remaining capital is then invested by the general partner in private
companies. The most common profit-sharing arrangement is an 80/20 split: after returning all the
original investment to the limited partners, the general partner keeps 20 percent of everything else.
The most common profit-sharing arrangement is an 80/20 split: after returning all the original
investment to the limited partners, the general partner keeps 20 percent of everything else. This profit
sharing, known as carried interest, is the incentive that makes private equity investing so enticing for
investment professionals.
1.4 PATTERNS OF VC INVESTMENT IN THE UNITED STATES
1.4.1 Investments by Stage
STAGES OF GROWTH
1. Seed/Startup Stage Financing - prove a concept
2. Early Stage Financing - provides financing to companies completing development where
products are mostly in testing or pilot production
3. Expansion (Mid) Stage Financing - involves applying working capital to the initial
expansion of a company. The company is now producing and shipping and has growing
accounts receivable and inventories. It may or may not be showing a profit.
4. Later Stage – capital is provided for companies that have reached a fairly stable growth rate
—that is, companies that are not growing as fast as the rates attained in the expansion stages.
1.1 WHAT IS VENTURE CAPITAL?
A VC has five main characteristics:
1. A VC is a financial intermediary, meaning that it takes the investors’ capital and invests it
directly in portfolio companies. Thus, it does not invest with its own money, but with
investors’ capital.
2. A VC invests only in private companies. This means that once the investments are made, the
companies cannot be immediately traded on a public exchange.
3. A VC takes an active role in monitoring and helping the companies in its portfolio.
4. A VC’s primary goal is to maximize its financial return by exiting investments through a sale
or an initial public offering (IPO) .
5. A VC invests to fund the internal growth of companies.
Typically, a VC fund is organized as a limited partnership, with the venture capitalist acting as the
general partner (GP) of the fund and the investors acting as the limited partners (LP). Figure below
shows the flow of funds in the venture capital cycle.
Characteristics I: VCs are often compared to—and confused with—angel investors. Angel
investors, often just called angels, are similar to VCs in some ways but differ because angels
use their own capital.
Characteristics II: VC are defined as a type of private equity. Although the definitions of
“private company” and “public company” have some nuances, the key distinction is that a
public company’s securities can be traded in a formal market, like the NYSE or the
NASDAQ, whereas a private company’s securities cannot. Private equity is considered to be
a category of alternative investing, where “alternative” stands in contrast to “traditional”
investing in stocks and bonds.
Characteristics III: Without (3), a VC would only be providing capital, and his success (or
failure) would be entirely due to his ability to choose investments. Although success can, of
course, be entirely built on these choices, the comparative advantage of the VC would be
greatly improved if the investor could also help the company directly.
, o This help takes many forms. Most notably, VCs typically take at least one position on
the board of directors of their portfolio firms
o In addition to board service, VCs often act as unofficial recruiters and matchmakers
for their portfolio firms. Young companies often have a difficult time attracting high-
quality talent to a fledgling operation, and VCs can significantly mitigate this problem
by drawing on their reputation and industry contacts. A VC who performs these value-
added services well has a sustainable form of competitive advantage over other
investors.
Characteristics IV: the requirement to exit and the focus on financial return is a key
distinction between venture capital and strategic investing done by large corporations.
Moreover, a corporation may set up an internal venture capital division. In the industry, this is
referred to as corporate venture capital, which is something different than venture capitalism
since these corporate VC efforts will often have strategic objectives other than financial
returns and will have neither dedicated supplies of capital nor an expectation that capital will
be returned within a set time period.
Characteristics V: “internal growth” means that the investment proceeds are used to build
new businesses, not to acquire existing businesses. Characteristic (5) also allows us to
distinguish VC from other types of private equity. As a simple classification, we divide
portfolio companies into three stages:
o Early-stage include everything through the initial commercialization of a product.
o Mid-stage (also called expansion-stage) represent the vast landscape between early-
stage and late-stage.
o Late-stage are businesses with a proven product and either profits or a clear path
toward profitability.
,Mezzanine is when investors began to use the same capital structure—subordinated debt with some
equity participation—to provide another layer of debt financing for highly leveraged buyout (LBO)
transactions. Today, most private equity firms with “mezzanine” in their title are doing this second
type of investing.
Buyout investors pursue a variety of strategies, but a key feature of buyout investors is that they
almost always take majority control of their portfolio companies. (In contrast, VCs usually take
minority stakes in their portfolio companies.)
A related strategy to leveraged buyout is “buy-and-build”, where a buyout investor will acquire a
series of firms in a fragmented industry for the purpose of taking advantage of changes in the optimal
industrial scale. Although buy-and-build is a growth investment strategy, the growth comes externally
from the purchase of existing businesses.
The final category of private equity is distress investing, also called special situations. As the name
suggests, distress investors focus on troubled companies. Because many distress investments are
buyouts, this category intersects with the previous one. Some private equity investors do both
traditional leveraged buyouts and distress buyouts, but most investors specialize in either one or the
other.
Hedge funds are flexible investing vehicles that share many characteristics of private equity funds,
including the limited partnership structure and the forms of GP compensation. The main difference,
however, is that hedge funds tend to invest in public securities. Although there are exceptions to this
pattern, the basic distinction is that while private equity funds are long-term investors, hedge funds are
short-term traders. Also, because their investments are more liquid than those for private equity
investors, hedge funds can offer their investors faster access to their money, with withdrawals usually
allowed on a quarterly or annual basis.
This is a case of form following function: if you have an investment strategy in illiquid assets, then
you need to lock up your investors for a long period of time (private equity); if you have an investment
strategy in liquid assets, then you can allow for quicker withdrawals (hedge funds).
1.2 WHAT DO VENTURE CAPITALISTS DO?
VC activities can be broken into three main groups:
Investing: VCs prospecting for new opportunities and does not end until a contract has been
signed. The investment phase consists of the following stages:
1) Screen;
2) Term sheet (outlining the proposed valuation, type of security, and proposed
control rights for the investors),
3) Due diligence (analyzing every aspect of the company),
4) Closing (negotiation for formal set of contracts to be signed).
Monitoring: VC begins working with the company through board meetings, recruiting, and
regular advice. Together, these activities comprise the monitoring group.
Exiting: VCs are financial intermediaries with a contractual obligation to return capital to
their investors. The main sources of exists are IPO or a sale to a strategic buyer.
, Limited partners put up the capital, with a few percentage points of this capital paid every year for the
management fees of the fund. The remaining capital is then invested by the general partner in private
companies. The most common profit-sharing arrangement is an 80/20 split: after returning all the
original investment to the limited partners, the general partner keeps 20 percent of everything else.
The most common profit-sharing arrangement is an 80/20 split: after returning all the original
investment to the limited partners, the general partner keeps 20 percent of everything else. This profit
sharing, known as carried interest, is the incentive that makes private equity investing so enticing for
investment professionals.
1.4 PATTERNS OF VC INVESTMENT IN THE UNITED STATES
1.4.1 Investments by Stage
STAGES OF GROWTH
1. Seed/Startup Stage Financing - prove a concept
2. Early Stage Financing - provides financing to companies completing development where
products are mostly in testing or pilot production
3. Expansion (Mid) Stage Financing - involves applying working capital to the initial
expansion of a company. The company is now producing and shipping and has growing
accounts receivable and inventories. It may or may not be showing a profit.
4. Later Stage – capital is provided for companies that have reached a fairly stable growth rate
—that is, companies that are not growing as fast as the rates attained in the expansion stages.
