Venture Capital and Angel FinancingFor Universidad Adolfo Ibañez John C. Edmunds February 1, 2006
Starting a New Business in the United States• The founders develop a business plan.• Then they create a corporation.• They do not try to keep 51% of the shares.• They do not plan on keeping the company and passing it to their children.• Many founders are “serial entrepreneurs” which means they start one new business after another.
Starting a New Business in the United States, 2• Many times the founders fail in their first attempt.• Some also fail in their second attempt.• The bankruptcy law in the United States is intentionally designed to allow founders a second or a third chance.
Starting a New Business in the United States, 3• A person who has tried to start a business and failed is still a respected member of the community. He or she is not stigmatized for life and can still be successful later in another new business or in some other career.
Angel Financing in the United States• After the founders of a new business have sold some shares in their company to family and friends, they sometimes find an “angel investor.”• An angel is a rich person who helps the new company in its very early stage.• The angel invests money and also offers advice.
Angel Financing in the United States, 2• The angel usually invests an amount in the $50,000 - $250,000 range and usually gets around 20% of the shares of the new company.• The angel tries to help the new company achieve enough growth to attract the attention of other investors.
Stages of Venture Financing1. Friends, Family and Fools2. Angel Financing3. Early Stage Venture Capital Financing4. Additional Round(s) of Venture Capital Financing5. Initial Public Offering of Shares OR Sale of the Entire Company to a Bigger Company
Venture Capital Financing in the United States• There are many venture capital firms in the United States.• A large number of them are around here – in Boston or on Route 128 (also known as the Silicon Necklace).• Most venture capital firms are small. They have a small number of officers.
Venture Capital Financing in the United States, 2• The typical venture capital firm raises an amount of money in the $100 million - $500 million range. The money is put in by “backers” who agree to leave the money in the hands of the venture capitalists for eight years.• After eight years the fund is liquidated. The “backers” recover their investment and their profit if the investments have been successful.
Venture Capital Financing in the United States, 3• Most venture capital firms raise money from backers more than once. They start a second fund after two or three years, and then a third one.• Venture capital firms can be so successful that they attract more capital than they can invest. This happened in 1999-2000 and might be happening now.
Venture Capital Financing in the United States, 4• The rate of return that backers have earned from their investments in venture capital has been HIGH and VIOLENTLY CYCLICAL.• This has been true for the entire history of venture capital in the United States.
Obtaining Venture Capital Financing in the United States• The founders of the new company try to “pitch” their company to venture capitalists.• When they get a chance to make their presentation to a venture capital firm, they try to communicate how good their idea is and how successful their company will be.
Obtaining Venture CapitalFinancing in the United States, 2• If the key decision makers at the venture capital firm are interested, the negotiations begin.• The founders of the new business try to get as much money as they need, while giving up as few shares as possible.
Obtaining Venture CapitalFinancing in the United States, 3• The founders typically give the venture capitalist 20% - 40% of the shares in exchange for $2 million to $5 million.• The terms depend on how promising the company is, how good the management team is, and how many other venture capital firms are likely to be interested in financing the company.
Obtaining Venture CapitalFinancing in the United States, 4• The founders try to give the venture capitalist as few shares as possible because later the company might need to seek a second round of venture capital financing, or a third round.• There have been successful companies that obtained as many as seven rounds of financing from venture capitalists.
Liquidity Events• After the new company has been operating for a couple of years, the venture capitalists want to recover their investment and their profit.• The opportunity comes when the new company makes an initial public offering of common stock. (IPO)
Liquidity Events, 2• The IPO is the glamour moment in the life of a U.S. entrepreneur.• The new company hires an investment bank to sell some of the shares, usually 15% or 20% of the total, to the public.• The founders and the investment bankers do a “road show” to sell the shares that are being offered.
Liquidity Events, 3• The shares that are offered to the public in the IPO come from three sources – some come from the VCs, some come from the founders, and some are newly issued shares.• That is so that the VCs recover their cash and some of their profit, the founders get rich, and the company gets some cash to finance its growth.
Liquidity Events, 4• The shares of the new company are listed on the NASDAQ and the price of the shares sometimes rises very rapidly.• The investment bankers set the initial offering price of the shares and also try to maintain an orderly market in the shares for a few months.
Liquidity Events, 5• Sometimes the market price of the new company’s shares rises to an extreme level on the first day of trading.• This happened often during the period 1998-2000.• The Google IPO (2004) used an auction process to limit the frenzy. Huge opening- day price rises are now much less frequent.
Liquidity Events, 6• In reality, not very many new companies make an initial public offering of shares. Instead a big company buys them before they “go public”.• The venture capital firms make huge profits whenever there is a liquidity event.• They need the big profits to compensate for the (many) failures.
Venture Capital in Chile• Hay, pero no hay.• For the past few years, my Chilean friends have been VERY pessimistic about the possibility of obtaining venture capital financing in Chile.• They tell me that the chances were better in 1996 than in 2006. There is some hope for 2007.
Venture Capital in Chile, 2• Let’s discuss why people like you have had such difficulty obtaining venture capital financing in Chile.• The size of the venture capital sector in Chile is, in proportional terms, about the same size as the venture capital sector in the United States.
Venture Capital in Chile, 3• In Chile, venture capital funds have cash, but they do not place it.• Instead the venture capitalists sit in their offices and reject the proposals they receive.• Is that true? My Chilean friends think so.• If that is true, why is it true?
The Conventional Explanation• For 15 years I have been hearing an explanation why venture capital funds in Chile have been such a disappointment.• The explanation has never convinced me but is has always convinced my Chilean friends.
The Conventional Explanation, 2• Chileans are self-critical. Chilean venture capitalists say that they proposal they see are not worthy of financing.• The Chilean economy is small, but is it REALLY too small to support new companies???
My Objection to the Conventional Explanation• The conventional explanation assumes that Chile, as a country, suffers from some disadvantages that are impossible to overcome.• It assumes that a business that starts in Chile, or operates entirely in Chile, can never be very exciting or valuable.
My Objection, 2• I ask my Chilean friends if it is really necessary for Chileans to go to Silicon Valley or to Boston in order to have a good idea.• Many of them think that Chileans become more creative after they leave Chile.
My Explanation for the Lack of Venture Capital Financing in Chile• Venture capitalists make mistakes.• Two thirds of the ventures they finance fail.• The key question is how much profit venture capitalists make on the investments that succeed.
My Explanation, 2• In Chile, the venture capitalists were criticized for the mistakes they make in the Nineties.• The venture capitalists had some successful investments.• But on those successful investments they didn’t make big enough profits.
My Explanation, 3• The biggest profit I heard about was an investment where the venture capitalist made a return equal to six times the investment.• That is not a big enough return to compensate for the failures.
My Explanation, 4• The result has been that the rate of return on venture capital investments in Chile has been too low to compensate for the risk.• This fact has made Chilean venture capitalists look bad.
My Explanation, 5• Chile’s capital markets were not set up to finance new ventures.• The law allowing venture capital funds to be created was passed in 1989, BUT the other needed changes in the DESIGN of the capital markets did not come until a decade later.
My Explanation, 6• During the Nineties there was no market for initial public offerings of common stock in Chile.• La Ley de OPAS (1999) changed the treatment of minority shareholders.• La Ley de Multifondos (2002) is what finally reactivated the Chilean stock market.
My Explanation, 7• In 2004 and 2005 there were several initial public offerings in Chile.• Two of these were oversubscribed in the ratio of 17 to 1.• The Chilean stock market is now functioning better.
My Explanation, 8• The Bolsa Emergente IPOs in the years 2004-2006 have not been Compañías Emergentes. The IPOs have been done by companies that are already mature, like Ripley, and also one semi-bankrupt football club (Colo Colo).
My Explanation, 9• The Chilean venture capital funds are still being ultra-cautious because there STILL has not been an initial public offering of common shares from a company that obtained venture capital financing.
My Explanation, 10• The venture capital sector in Chile needs a BIG success, something like Google.• A Chilean venture capitalist needs to make a HUGE return, at least 100 for 1.• Then the Chilean venture capital sector will become very vibrant and will give financing to all of you.
Future Prospects for Venture Capital in Chile 2007 -• The government assigned US$ 200 million to CORFO in November 2006.• The Initial Public Offerings via the Bolsa Emergente are continuing in 2007.• Soon there will be an IPO in Chile by a company that received venture capital financing.
Future Prospects, 2• Chile has fallen behind Brazil in IPO financing.• Brazil, via the Novo Mercado, has done MANY more IPOs than Chile since 2004.• Chile will take steps to catch up with Brazil in the key area of financing new businesses.
Conclusion• In the U.S., the culture, the legal system, AND the financial system are all very friendly to entrepreneurs.• Venture capital firms are profitable and sometimes very profitable.• Many young people with ideas get financing.
Conclusion, 2• In the U.S., there are periods of time when every start-up company gets financing, including the ones that so bad they should not get financing.• The U.S. is in a period of time like that now.• The next boom here has already started.
Conclusion, 3• In Chile, there have been venture capital funds since 1990. Many start-up companies have received financing.• The venture capital funds have performed poorly, especially since 1997.• The Ley de Multifondos and the Ley de Ahorro Previsional have revived the demand of initial public offerings.
Conclusion, 4• The preconditions are in place for venture capital in Chile to enter a phase of rapid growth.• There have been several encouraging signs that key people in Chile now consider that venture capital is a priority.• One more thing is needed: a big success.
Conclusion, 5• Capital will not flow to new businesses in Chile until there is a BIG success• In which the venture capitalist obtains a return of 100 to 1 on the initial investment.• This can happen soon in Chile because the initial public offering market has revived.