• Most entrepreneurs are capital constrained so they seek external
funding for their projects.
• Entrepreneurial firms with limited collateral (i.e., tangible assets),
negative earnings, and large degree of uncertainty about their future
have very limited access to external funding.
• Lack of outside funding hampers growth of new businesses in many
countries around the world.
Potential funding sources
1) Bootstrap (owner equity) – insufficient when the firm grows above
a certain threshold
2) Angel investors (wealthy individuals) – limited due diligence, less
thorough in their negotiations since reputational concerns are less
important, don’t actively monitor their investments
3) Banks – Reluctant to lend to firms that burn cash and offer little or
no collateral. Also, entrepreneurial firms value flexibility and thus are
not very fond of bank loan covenants.
4) Corporations – a way for corporations to beat their competitors
What is a VC fund?
1. is a financial intermediary, collecting money from investors and
invests the money into companies on behalf of the investors
2. invests only in private companies. (Question: What is a private firm?)
3. actively monitors and helps the management of the portfolio firms
(Question: How do VCs help their portfolio firms?)
4. mainly focuses on maximizing financial return by exiting through a sale
or an initial public offering (IPO). (Question: So, what are the necessary
conditions for the development of the VC sector in a country?)
5. invests to fund internal growth of companies, rather than helping firms
grow through acquisitions.
• VC firms are organized as small organizations, averaging about ten professionals.
• VC firms might have multiple VC funds organized as limited partnerships with
limited life (typically 10 years).
• General partners (GPs) of the VC fund raise money from investors referred to as
limited partners (LPs). GPs are like the managers of a corporation and LPs are like
• LPs include institutional investors such as pension funds, university endowments,
foundations (most loyal), large corporations, and fund-of-funds.
• LPs promise GPs to provide a certain amount of capital (committed capital) and
when GPs need the funds they do capital calls, drawdowns, or takedowns.
• During the first 5 years of the fund (investment period) GPs make investments and
during the remaining 5 years they try to exit investments and return profits to LPs.
Prominent VC-backed companies
• Microsoft, Google, Intel, Apple, FedEx, Sun Microsystems, Compaq
• Some of these investments resulted in incredibly high returns for VC
“During 1978 and 1979, for example, slightly more than S3.5 million in venture
capital was invested in Apple Computer. When Apple went public in December
1980, the approximate value of the venture capitalists’ investment was $271
million, and the total market capitalization of Apple’s equity exceeded $1.4
• There are also big disappointments though. What the VC funds are
doing is to try to find the next Microsoft, Google, Apple, which might
help offset the losses associated with 100 other investments.
What do VCs do?
Screen hundreds of possible investment and identify a handful of
projects/firms that merit a preliminary offer
Submit a preliminary offer on a term sheet (includes proposed
valuation, cash flow and control right allocation)
If the preliminary offer is accepted, conduct an extensive due
diligence by analyzing all aspects of the company.
Based on findings in the due diligence, negotiate the final terms of
to be included in a formal set of contracts; and closing.
Board meetings, recruiting, regular advice
IPOs (most profitable exits) or sale to strategic buyers
The investment process of a
typical VC fund
Screening (vague) 100 to 1,000 firms
Preliminary due diligence 10 firms
Term sheet 3 firms
Final due diligence 2 firms
Closing 1 firm
• Takes a big chunk of the VC’s time:
– Search through proprietary private firm databases
– Deal flow from repeat entrepreneurs
– Referrals from industry contacts
– Direct contact by entrepreneurs
• Reputable VCs have easier time identifying better companies
because of their big networks and entrepreneur's willingness to work
• Most investments are screened using a business plan prepared by
the entrepreneur. Two major areas of focus in screening:
– Does this venture have a large and addressable market? (market test)
– Does the current management have capabilities to make this business work?
• Main focus: Possibility of exit with an IPO within 5 year with a
valuation of several hundred million dollars
• The market for the firm’s products should be big enough
– A company developing a drug to treat breast cancer is likely to have a bigger
market than a company developing a drug for a disease with only 1,000 sufferers
• Barriers to entry should not be too high in the firm’s market
– A company that developed a new operating system for PCs does not have much
chance against Microsoft.
• Sometimes, there is no established market for the firm’s products
and services (e.g., eBay, Netscape, Yahoo). In such cases, spotting
potential winners is more of an art than science.
• Ability and personality of the entrepreneur and the synergy of the
management team is examined
• Repeat entrepreneurs with track records are the easiest to evaluate
• An often spoken mantra in VC conferences is that: “I would rather invest
in strong management with an average business plan than in average management
with a strong business plan”. Do you think this makes sense?
• Pitch meeting: The meeting of VC with company management
– Management test
• For firms that successfully pass the pitch meeting, the next step is
preliminary due diligence
– If other VCs are also interested in the firm, preliminary due diligence is short
– Due diligence is on management, market, customers, products, technology,
competition, projections, partners, burn rate of cash, legal issues etc.
• If the results of the preliminary due diligence is positive, the VC
prepares a term sheet that includes a preliminary offer.
VC Investments by stage
• Early stages:
Seed: Small amount of capital is provided to the entrepreneur to prove a
concept and qualify for start-up capital (no business plan or management
Start-up: Financing provided to complete development and fund initial
marketing efforts (business plan and management in place, ready to start
marketing products after completing development).
Other early-stage: Used to increase valuation and size. While seed and
start-up funds are often from angel investors, this is from VCs.
• Mid-stage or expansion:
At this stage, the firm has an operating business and tries to expand.
• Late stages:
Generic late stage: Stable growth and positive operating cash flows
Bridge/Mezzanine: Funding provided within 6 months to 1 year of going
public. Funds to be repaid out of IPO proceeds.
VC investment share by stage
VC investments by industry
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
Valuation approaches (2)
3. Venture capital (or comparable firms) methodology
• Back out the valuation of your company using the ratio (e.g., P/E)
for a comparable publicly traded firm
• Suppose a publicly traded firm that is almost identical to the firm
you are trying to value has a P/E ratio of 20.
• If the company that you are trying to value has earnings
$0.50/share, the value of each share of this company is
approximately $10 (=20 x $0.5)
4. Capital cash flow approach
• Similar to APV, the only difference is you discount tax shields with
required return on assets rather than required return on debt.
Which method to use?
• For young firms with great deal of uncertainty about future cash flows,
use the venture capital approach.
• When valuing a later stage firms, if you want a DCF-based valuation
estimate, whether you should use the WACC or APV approach depends on
your assumptions about future debt levels:
– If you assume that the firm has a constant debt ratio target, use
WACC because APV is computationally difficult
– If you assume that the firm has a constant dollar debt amount target,
you cannot use WACC, you must use APV
VC partnerships and legal issues
• VCs are organized as limited partnerships. Tax advantages:
Not subject to double taxation like corporations; income is taxed at the LP level.
Gain or loss on the assets of the fund are not recognized as taxable income until
the assets are sold.
• Conditions to be considered a limited partnership for tax purposes:
(1) Pre-specified date of termination for the fund
(2) The transfer of limited partnership units is restricted
(3) Withdrawal from the partnership before the termination date is prohibited.
(4) Limited partners cannot participate in the active management of a fund if their
liability is to be limited to the amount of their commitment. (Note, however, that
LPs typical vote on key issues such as amendment of the partnership
agreement, extension of the fund’s life, removal of a GP etc.)
• While LPs have limited liability, GPs have unlimited liability (they can
lose more than they invest): Not critical because VCs don’t use
• 1% of the capital commitment comes from the GPs. Why?
• The contracts share certain characteristics, notably:
(1) staging the commitment of capital and preserving the option to
(2) using compensation systems directly linked to value creation,
(3) preserving ways to force management to distribute investment
• These elements of the contracts address three fundamental
(1) the sorting problem: how to select the best venture capital
organizations and the best entrepreneurial ventures,
(2) the agency problem: how to minimize the present value of agency
(3) the operating-cost problem: how to minimize the present value of
operating costs, including taxes.
The nature of incentive conflicts
between VCs and entrepreneurs
• Some projects have high personal returns for the entrepreneur but
low expected payoffs for shareholders.
A biotechnology firm founder may choose to invest in a certain type of
research that brings him great recognition in the scientific community
but provides lower returns for the VC.
Because entrepreneurs stake in the firm is like a call option, they might
choose highly volatile business strategies, such as taking a product to
the market while additional tests are warranted.
• Entrepreneurs like control, so they will avoid liquidating even
negative NPV projects.
• The incentive conflicts are more severe and so funding duration is
shorter for high growth and R&D intensive firms as well as firms with
fewer tangible assets.
VC investment contracts (1)
1. Virtually all private investments are structured as convertible
preferred with redemption features and often include warrants
to acquire additional shares.
The convertible preferred allows private investors to have a priority claim while
sharing in the upside.
This structure can increase the size of the cash flow pie by controlling agency
problems and reducing information asymmetries.
1. Virtually all venture investments involve staged commitments.
Staged commitments add value by creating an option to abandon
(a put option).
Staged commitments also give the venture capitalist the option to revalue and
expand their investment at future dates.
1. Most private investment provide for some form of investor control
that is often tied to the performance of the venture.
Staged capital infusions
• Rather than giving the entrepreneur all the money up front, VCs
provide funding at discrete stages over time. At the end of each
stage, prospects of the firm are reevaluated. If the VC discovers
some negative information he has the option to abandon the project.
• Staged capital infusion keeps the entrepreneur on a “short leash”
and reduces his incentives to use the firm’s capital for his personal
benefit and at the expense of the VCs.
• As the potential conflict of interest between the entrepreneur and
the VC increases, the duration of funding decreases and the
frequency of reevaluations increases.
• Most venture contracts defined triggers for cash flows, voting, and
other control rights. In general the better the performance the less
• Corporate control mechanisms.
– Private investors typically get at least a few board seats.
– Voting control is based on the percentage ownership: Often times a particular
issue votes as a block (even though there may be a number of individual
– Control is often tied to targets… i.e. sales or operating targets when reached
increase entrepreneurial control.
Other ways to control
• VCs may discipline entrepreneurs or managers by firing them
(remember VCs often take controlling stakes and board
memberships in the firms that they invest):
Right to repurchase shares from departing managers from below market price
Vesting schedules limit the number of shares employees can get if they leave
• Managers are compensated mostly with stock options, which
increases incentives to maximize firm value. This might of course
also provide incentives to increase risk, so close monitoring is
• Active involvement in management of the firm
• Should you invest in the jockey or the horse?