1. What are venture capital firms? And what characteristics do they seek in
A venture capital firm is a specific type of financial intermediary that has a unique
organizational structure and a specific market niche. Venture capital firms tend to seek
out young companies with the potential for rapid and substantial growth and companies
that require a substantial amount of capital investment to finance growth. Venture capital
fills the gap between early-stage private investment by the entrepreneur, their friends and
business angels, and the established-company market for public capital or private
corporate acquisition. Venture capital firms provide both financing and managerial help.
2. Institutional investors, such as endowments, pensions, and insurance
companies provide a significant fraction of investment capital to venture
capital funds. What factors contribute to their choice to make such
Venture investing is a long-term proposition that exposes the investor to illiquidity. Until
the investment is harvested, by IPO or other means, there is no convenient means to
achieve liquidity. Because institutional investors have long-term investment horizons and
large portfolios of more liquid assets, the lack of liquidity is not as significant a problem
as for other types of investors. Also, institutions fit the profile of investors who can be
trusted to contribute capital on schedule and who are not very sensitive to the timing of
distributions. As a result, compared to other investors, institutions view venture capital
investing as more attractive relative to alternatives.
3. “Managing a fund with multiple closings gives rise to opportunism.” True,
false, or uncertain? Explain.
Multiple closings may enable investors to get into the fund at different times, existing
investors would not want new investors to buy into existing successes at low prices, and
prospective investors would not want to buy into existing failures at high prices.
4. Why does the prospect of multiple closings increase the importance of an
accurate valuation of the fund’s existing portfolio?
The concern is with opportunism, where an earlier-stage investor may try to take
advantage of later-stage investors, and vice versa. Hence, to abate these problems,
ownership claims need to be based on accurate valuations. Alternatively, the fund
manager can try to address potential opportunism by segregating existing and new
investment by forming separate venture funds for each.
5. Provide examples of how venture capitalists can add value to new ventures.
Do you think they add enough value to justify their compensation? Explain.
Venture capitalists are able to add value to cover their compensation by competing to find
the best ventures and those that can benefit from their involvement, and by negotiating
deals that adequately compensate investors, while preserving the incentive of the
entrepreneur. They also try to time fund creation to correspond to periods of the greatest
opportunity. Later, they try to add value by making good decisions about follow-on
investments, by monitoring the portfolio companies as an aid to making informed
decisions about the investment, and by assisting the venture’s managers in a variety of
ways. Ultimately, they try to find harvesting opportunities that create the most value for
6. “The compensation structure of the general partner in a venture capital fund
can affect the kinds of ventures the general partner may seek, as well as the
deal structure.” Explain.
General partner compensation usually includes a management fee and 20 to 30 percent of
the capital appreciation of the portfolio. The financial claim of the general partner has
characteristics of a call option: a limited downside and a significant upside. A venture
with a reasonably high expected return, but limited upside potential, is unlikely to be a
prospect for venture capital, even if downside risk is small. Other things being equal,
such a venture does not offer potential for the general partner to benefit significantly by
sharing in the capital appreciation. The attractiveness of the investment to the general
partner also depends on the terms of the financial contract. A high-risk venture that is
structured to create financial claims that offers safe but modest returns to investors is
unlikely to attract venture capital funds. On the other hand, a low-risk venture can receive
venture capital funding if the structure of the financial claims offers substantial upside
potential by shifting project risk to the investor.
7. How might the interests of the general partner in a venture capital fund
diverge from those of the limited partner?
The general partner receives the carried interest from the fund and generally receives
only management fees if the fund does not do well. A manager who is concerned about
the fee may make investments partly to increase management fees, even if the potential
of an investment is not great. Because the carried interest is like a call option (with only
upside risk) the fund manager may want to structure investments so that the upside
potential is very great, even if doing so reduces the expected return from the investment.
In addition, managers may be able to select investments that go into the fund versus those
in which the manager invests personally, so there is a potential for self-dealing. There
are other ways that the interests can be in conflict. Generally, the investment agreements
include efforts to control the conflicts.
8. Contractually, how might the interests of the general partner be more closely
aligned with those of the limited partners?
Interests are aligned when both types of partners (general and limited) participate in the
venture success but are protected against losses if the venture performs poorly.
Convertible stock, for example, offers some downside protection, and still preserves the
potential for significant gain. Other structures, involving staging of investment or put
options for the investor, can have similar effects.
9. Identify economics reasons for why convertible equity is commonly used in
venture capital financing.
There is a burgeoning literature regarding the use of convertible securities in new venture
contracting. Among the (non-mutually-exclusive) reasons offered for convertible
securities are: tax considerations, testing the beliefs of the entrepreneur, and improving
the alignment of incentives between managers and investors.
10. What are some of the measures that the venture investors use to address the
general partner incentive to take excessive risk?
The investor may have agreement that limit the amount of fund investment in a single
venture and restrict the ability of the general partner to add leverage by borrowing.
11. What are some of the measures that the venture capital investors use to
address the concern that the general partner may favor an existing fund over
a new fund that the general partner is forming?
A fund contracts may give limited partners the right to review the general partner’s
investment decisions. Sometimes limited partners serve on the fund’s investment
committee. The agreement may prevent the general partner from investing in a new fund
in the portfolio companies of the existing fund. Or the agreement may require that, if the
general partner wants to make follow-on investments in portfolio companies of its other
funds, it may do so only as a co-investor, along with another first-time investor in the
12. Why do you think venture capital funds are organized as limited
partnerships instead of closed-end mutual funds?
The limited partnership structure enables the fund to raise capital from all investors at the
same time (or at a few discrete closings), and enables the general partner to match the
timing of capital raising and investing in ventures. The requirement that the fund be
liquidated after several years subjects the general partner to the discipline of the market,
because, unless the fund is successful, the general partner will have trouble raising capital
for the next fund. In addition, limited partnerships can offer tax advantages that closed-
end funds cannot. The fact that closed-end funds are open to small investors is a
drawback for limited partnerships, but does not appear to be critically important to fund
13. Describe the contractual structure of a typical venture capital fund.
Funds are organized as limited partnerships, where the general partner is responsible for
management. Limited partners provide most of the financial capital (usually around 99
percent). The general partner provides the other one percent. In exchange, the limited
partners generally receive their return of principal first. After that, they normally receive
80 percent of capital appreciation. The general partner receives and annual management
fee of around 2.5 to 3 percent of capital under management, and receives 20 percent of
the capital appreciation as a carried interest.
14. How does using capital calls enable a venture capital fund to earn a higher
rate of return for the limited partners?
By only calling on limited partners to provide capital when the fund manager is ready to
invest in opportunities, the fund’s rate of return is measured from the point of the capital
call to the point when the capital is returned to investors. Thus, the fund return is not
depressed by holding capital in abeyance in a low-return, liquid form, while waiting for
investment opportunities to be identified. Additionally, the manager does not feel
pressure to invest capital in sub-optimal opportunities.
15. Why is it valuable for the passive investors in a venture capital fund to have
Venture capital funds operate best when they match the timing of capital calls with
investment opportunities. However, the fund must be able to rely on the limited partners
to deliver the capital when they are called upon to do so. Failure to provide capital when
requested to do so can harm other limited partners. Litigation to force an investor to
honor a capital commitment is unrealistic for a variety for reasons. Thus, reputations are
important to the venture capitalist.
16. What are the advantages of a venture capital fund having a finite life?
The finite life enables the fund to allocate proceeds with less concern about favoring
some investors over others, subjects the fund manager to greater market discipline,
enables the market to downsize more efficiently, when investment opportunities decline,
and in some cases enables the fund manager to negotiate harvests of investments more
efficiently. There are also some disadvantages, such as the possibility that the fund will
need to harvest some of its investments too soon.