Building on Bedrock

by Derek Lidow

  After all the tales of socializing, and assuming there are no issues with deal flow, the first official agenda item of Monday partner meetings is to discuss which of the interesting companies that the firm recently discovered—early stage or more mature—might be worthy of an investment. The partners review the potential opportunities and risks associated with a theoretical investment in each company presented. For those companies that could be an interesting investment, the firm makes plans to send a senior partner, along with a junior partner and maybe an analyst, to go visit and get an in-depth “feel” for the entrepreneur, the team, and the opportunity. The senior and junior partners will also be expected to call people they know in the general business area of the company they’re investigating. If the company is in the information business, they might call up a person like me and ask, “Based on your experience, what issues would a company that wants to collect information on the tech world using social media encounter?” If they like what they see and hear from their visit and from their calls to people like me, they will report back to the partners with a specific recommendation. At the next partners meeting, they may be asked to get even more information, told not to proceed any further, or the partners may vote to give the senior partner permission to draft a Term Sheet for an amount of money the partnership would be willing to invest at a specific valuation.

  The Term Sheet outlines the proposed terms of a potential investment the VC firm might make in the company. It is not a binding offer; it is a basis for further discussion and negotiation. Even after the Term Sheet is agreed on, it is still subject to negotiations over dozens of details, conducted between the lawyers for the company and the VC firm, as well as an additional investigation (called due diligence) into the company, its products, its finances, its top employees, as well as the company’s customers, potential customers, partners, and suppliers. Assuming all this additional investigation and negotiation turns out satisfactorily for both parties, then a thick set of documents is signed by all parties, and money is handed over to the startup.

  In debating whether to make an offer to invest (“deliver a Term Sheet”), the partnership considers if they should make a bet. No matter how much research and due diligence a VC firm does on any given entrepreneur and startup, they cannot tell if the company will be successful enough to make the investment worthwhile—a dilemma which necessitates the complex debates about how well the firm thinks they understand the risks relative to how much wealth might be created. They also debate how much to invest and what percentage ownership of the new company they want. The partners will then discuss what restrictions and constraints they will place on the entrepreneur: how much they will let him or her invest without asking permission, whom he can unilaterally hire, whether he can sign a lease, the size of the order he can place with his suppliers, or how large a contract he can sign. For some of these decisions the entrepreneur will be required to get the permission of the Board of Directors; for other decisions, the venture capital firm may reserve veto rights.

  After an investment is made, the senior partner who worked on the deal is assigned responsibility for the investment and must report on the progress of the company at partners meetings. Such updates are typically the second item on the agenda of these meetings. The updates include a summary of the company’s latest financial results, but more importantly, from the partners’ point of view, they also include an assessment of what could be done to “help” the company do better and become more valuable. The discussion about how to help a company takes on a different tone depending on whether it’s an early-stage or growth-stage VC. Partners at early-stage VCs will discuss whether they think the original premise for the company is still valid based upon the latest information they received on product testing or customer reaction. Their discussion centers around the changes they think management should make: “The prototype they sent to IBM for qualification failed testing, I think we need to insist they hire an experienced quality engineer to get better control over their supply chain.”

  If you’re listening to a partners meeting at a growth-stage VC, you might hear more comments about the quality of the leadership than about the product—comments along the lines of, “The company is falling behind on their plans to introduce their improved product. I don’t think the head of engineering really understands the magnitude of the challenge—he doesn’t have the experience to manage a team of fifteen engineers. The CEO is too easy on him because he’s not a software guy and is not confident in pressing for change. I think we need to insist that John (the CEO) start a search for a new VP of engineering, and if he resists then we need to think about replacing him.”

  You might also hear a senior partner at a growth-stage VC firm start another discussion along these lines: “My company is doing well but could be doing better. I am worried that their major competitor just got funded with another $50 million. They could start taking our clients away by offering rebates, which could slow our growth rate. I have talked to the CEO about my concerns but she thinks that her better customer service will make such a competitive attack a waste of money. I think this shows overconfidence and a lack of vision. I have privately discussed this with the other investors on the board and they’re equally concerned. I haven’t broached the subject of replacing the CEO with them but I plan to do that this week. I’m sensitive to how traumatic that change could be, but keeping her as CEO could mean the difference between the company being worth only $50 million rather than being worth $1 billion.”

  Because growth-stage VCs invest only in already fast-growing (but perhaps not yet profitable) companies, their focus is on how well the company’s leadership team is growing the business. They’re not focused as much as early-stage VCs on the viability of the product. It’s when early-stage VCs bring in the bigger, growth-stage VC firms that the founder’s job becomes at risk. Research has shown that the more successful a venture-backed startup, the more likely the venture capital firm is to try to replace the founder.

  Near the end of this part of the agenda, the partners focus on investments that they are close to “exiting”—by selling the company or taking it public. The partners all want updates on where the firm’s portfolio companies stand relative to the “process” of offering a company for sale, or of creating a structure and environment where a company’s stock can be sold on public markets. They want to know from one another, “Where are you on choosing your investment banker?” “When will the pitch book (or prospectus, in case of an IPO) be done?” “Are they going to beat their numbers this quarter relative to the baseline projections used for our valuations?”

  The partners are all focused on doing whatever they can to maximize the money they receive from selling or IPO-ing their portfolio of companies. Without successful exits, VC firms cannot survive, junior partners cannot get promoted, and senior partners can’t make the big money they aspire to. The subject of exits therefore gets a great deal of their attention. Venture capital partners feel anxious when there are none to discuss.

  After the partners debate how to best position the companies they plan to sell or IPO, VC firms move on to discuss fundraising. Almost all venture capital firms operate as a collection of ten-year partnerships. Each ten-year partnership controlled by the venture capital firm represents an independent business that has been created with the sole purpose of buying shares in startups and other private businesses. The partners in a venture capital firm are the “general” partners of these legal partnerships and get paid by all the other investors in the fund (investors are legally “limited” partners, i.e. silent partners) to invest the partnership’s funds in such a way that before ten years has elapsed, each investor gets back much more money.

  Of the money invested in the partnership, the VC partners are usually allowed to spend 2 percent each year on their own salaries and expenses, sometimes reduced to 1.5 percent after five years. So over the ten-year life of the partnership, the venture capital partners spend 18 to 20 percent of the original
investment to pay, support, and house themselves, and only around 80 percent of the limited partners’ original investment is used to invest in startups and other private companies. On top of the salaries and expense reimbursements paid by the investors, VC partners are also paid a bonus of 20 percent of all the profits made by the partnership. This can be a considerable sum of money for a successful venture partner. This compensation plan is known as the “two-and-twenty” model, and it generally applies to the functioning of venture capital firms, as well as to private equity and hedge funds.

  The formula for how venture capitalists are compensated has significant implications for entrepreneurs who seek to score venture capital funding. It drives VCs to look for entrepreneurs who want to do something big, who want to “shoot for the moon.” Very roughly, if a venture partnership has been given $100 million by its limited partners to invest over ten years—a small fund by today’s standards—then it will look to invest in companies where it thinks a $5 to $7 million investment on their part can grow to be worth $50 to $70 million in five years or so. A $100 million VC fund gets $2 million a year to pay salaries and rent a nice office, as well as to pay for expert opinions, sundry legal fees (the startups themselves often agree to reimburse VCs for all or part of their legal fees), limited partners meetings, and dinners with other VCs. That translates into a fund this size having only a couple of partners, some supporting analysts, a couple of personal assistants, and a receptionist. A firm with staffing like that has the bandwidth to invest its $80 million (after 18 to 20 percent of the initial $100 million is allocated to expenses) in maybe fifteen companies. When divided up, this yields a target investment of $5 to $7 million per company.

  Since most companies any VC invests in do not achieve their long-term goals despite the significant up-front analysis and due diligence, the firm needs their companies that do succeed to succeed big. In shooting for 10X returns with individual companies, the VC firm actually aspires to return to their investors about three times their original investment when the partnership dissolves in ten years. 3X equates to slightly less than a 12 percent compound annual return—a decent return for an investor who parts with their money for ten years with no guarantees.[8] 3X is what a VC firm needs to actually return to be considered “in the game.”

  The implication of hundred million dollar VC firms looking to make 15 investments in the range of 5 to 7 million, each investment with the potential of being worth 10X what they invested, is that hundred million dollar VC firms only want to invest in companies that are going to be worth in excess of $100 million dollars in a few years time (very roughly, the VC will own only a portion of the company, so they will want their fraction of ownership to be worth $50 to $70 million). Unless an entrepreneur has a credible plan to create a business that can be quickly sold for $100 million, he’s unlikely to find venture capital backing from even a small, early-stage VC firm.

  Today’s most famous VCs manage funds with at least a billion dollars to invest, meaning their targets are ten times the numbers associated with a $100 million fund. That is why today’s brand name venture capitalists are interested in businesses that can grow to be worth over a billion dollars very quickly. Venture capital only makes sense for entrepreneurs aspiring to build big companies quickly, hence the adage, “Shoot for the moon and use other people’s money.”

  Even though each partnership has ten years to operate, VC partners are on an almost constant fundraising treadmill. Almost all VC partnerships are structured so that the general partners can invest funds only in “new” companies in the first five years, with the requirement that the second five years be focused on optimizing the performance of the companies in which the partnership originally invested. The mantra is, “Five years of planting seeds, five years of harvesting.” So if a VC firm isn’t raising a new fund within three years of the launch of their last fund (experienced partners expect fundraising to take at least a year and a half), they will find themselves at the end of year five with no money for planting seeds—making them no longer a player. Fundraising strategy and results are therefore discussions that occur consistently in the partner meetings of the most successful VC firms, usually at the end.

  As you might imagine, how a group of partners goes about balancing all these different factors relative to the companies they invest in can get complicated. Virtually no startup performs as the partnership expected when they make their initial investment. A few will do better than anticipated, but the overwhelming majority of startups stumble or hit some unanticipated constraint. While most of the companies with venture capital investments will ultimately make a profit, their unspectacular profitability and unimpressive growth make these companies difficult to sell. Every decision about how to increase the value of the companies they own can have a huge impact on the careers and pocketbooks of VC partners.

  The truth is that the majority of venture capital funds fail to return to their investors more cash than was originally invested a decade or more before. VCs are secretive about their returns. The venture capital trade association sometimes discusses numbers that point to average returns for their industry in the 14 percent range, but these numbers are not tied to the actual cash returned to the investors. The Kauffman Foundation, a large non-profit dedicated to fostering entrepreneurship, even wrote a white paper about the disappointing endowment returns they received from their own limited partner VC investments. These reported financial returns include estimates of the value a VC firm feels it will eventually receive for their shares in all the companies that remain unsold. Investors often receive only a fraction of the estimated value of “zombies”—slow-growth, marginally profitable enterprises that continue to operate and are hard to sell. And once the VC does manage to sell them, it often takes years for the checks to show up in investors’ mailboxes.[9] In reality, at the end of ten years, most venture capital firms return less than a compounded 13 percent ROI. After deducting the fees and bonuses paid to the general partners, many more VCs do much worse. Few venture capitalists make the large returns they dream about, and most VCs raise money only once, going out of business when their first fund winds down a dozen or more years after being launched.

  Venture capitalists are high-risk entrepreneurs themselves. That makes the few consistently successful VCs great partners for the high-risk entrepreneurs that they invest in. These VCs understand how to identify, prioritize, and control risk, and ultimately how to reduce and eliminate risk in businesses.

  We need to be clear here, because all VCs invest in businesses and not entrepreneurs, no matter what they say. The shares the VCs own represent ownership of the company and not of the entrepreneur. Early-stage VC investors do care about the teams they invest in. They feel the momentum and passion behind an idea will likely dissipate if they fire whomever leads product development, so they are just as likely to shut down a company as they are to find new leadership. Once a company gains traction and has accepted money from growth-stage VCs, the entrepreneur will be fired if and when the VC feels the company could do better without him or her.[10] It is the share price of the companies they have invested in that determines the priorities of all successful VCs. Entrepreneurs are strictly a VC’s means to achieve their desired end.

  The data on venture capital investment surprises most people. As of 2015, there were 718 active venture capital firms in the United States. Only 238 of these firms invest in early-stage startups; the rest invest almost exclusively in companies that already have established customers and products but may not yet be profitable. The number of entrepreneurs and their companies that received venture capital in 2015 to help fund their initial product development was 147. This number has been dropping for five years straight and is at a twenty-year low. And this is at a time when interest in high-risk entrepreneurship is close to or at an all-time high. We do not know how many entrepreneurs aspire to use outside funding from strangers to help get their product launched, but the number certainly exceeds 100,000. Clearly, only a t
iny fraction of these entrepreneurs will ever succeed as high-risk entrepreneurs.

  From 1995 through 2015, VCs have invested in a total of 28,516 companies, an average of 1,358 new companies per year. In 2015, VCs invested in 1,444 companies that had not yet received any VC funds, a number that has changed little in the past twenty years. Venture capital is not a high-growth business—but it is volatile. This is not so surprising if we look at what has happened to those 28,516 companies that have received VC money since 1995. Over that time, slightly more than 2000 VC-backed companies have gone public on US stock exchanges. (Some of these companies may have received their first VC investment before 1995, so this number over-counts the number of IPOs of companies who received investments from 1995 onwards). Another 7,535 VC-backed companies were sold or merged with other companies during this same period. A little over a quarter of these mergers or sales were at a loss. Again, these numbers somewhat over-count the exact quantity of post-1995 VC investments that resulted in a sale of the company. That leaves at least 19,000 VC-backed companies, two-thirds of the twenty-year total, either remaining in VC portfolios or shutting down. The fact that VCs have invested in slightly less than 13,000 companies in the past ten years (the aspirational maximum of the time a VC targets for owning shares in any given company) implies that from 1995 and 2005 approximately 6,000 companies backed by VCs were shut down—more than 38 percent of the total funded during that time. The numbers also imply that many VC-backed companies take over ten years to exit.