VENTURE CAPITAL vs. venture capital

(nineteenth in a series)

By Frank Demmler

The words, “venture capital,” are used quite frequently in discussions of entrepreneurial finance, but to different people, they mean different things. It is essential that the first-time entrepreneur knows the differences and uses the term correctly.

“VENTURE CAPITAL” is professionally managed investment capital targeted for new and emerging companies in which investments have the potential to yield extraordinary returns.

“venture capital” is a generic term that the man-in-the-street uses to describe all forms of private equity that might be invested, on some basis, in privately held, smaller firms. Quite often, the person using this term is referring to angel, or individual, investors.

The first-time entrepreneur should only use this phrase to refer to VENTURE CAPITAL, the professionally managed money. To do otherwise is likely to cause confusion, and has the potential to be viewed as a lack of sophistication, which could reflect poorly on you and your business.

Professional Venture Capital

Right now, you may be thinking that I’m splitting hairs. “What’s the big deal?”

A recurring theme throughout this series of articles has been to encourage you to make the most efficient use of your time as possible. In fund raising, that means only pursue sources that are viable providers of capital to you. The corollary to that is that you need to understand the investment objectives of the investors you approach and make sure that the investment you pitch to them is something in which they are interested.

For you to do this with regard to VENTURE CAPITAL, you need to understand what makes them tick. I hope to provide you with some of that insight in today’s column.

Let’s look at a typical activity sequence for a professional venture capital firm. (To my VC friends, I apologize in advance for this oversimplification).

1. Create a ten-year limited partnership with the venture capital firm the general partner.
2. Raise money from investors. [Yes, just like you, a venture capitalist is an entrepreneur who needs to raise money.]
3. Invest the capital in opportunities that meet its investment criteria, AND pass the internal approval process.
4. Work with the portfolio companies to help them build value and move them toward an attractive exit.
5. Achieve exits when possible and distribute the proceeds to its investors.
6. Do it all again.

Pretty simple, huh? No big deal. Let’s look at these steps in greater detail.

Limited partnership

One of the key things you need to appreciate is that the money you seek from a venture capitalist will be coming from an entity that has a ten-year life. You need to know the vintage year (the year it started) of the fund from which you are seeking investment. If the fund is in its eighth year, then it is probably not making any new investments, particularly in early stage companies.

In fact, most funds try to make the majority of their investments and commitments in the first three or four years. The combination of investments, commitments, and reserves (investment capital held back for use with existing portfolio companies under a variety of circumstances) is likely to leave the fund with very limited “dry powder” for new investments.

This also why the professional venture capitalist is raising a new fund when the current fund is only a few years old (Step 6, above).

Raise money from investors

Just like you, the venture capitalist has to convince investors to invest in its fund.

If it’s a first-time fund, it is extremely difficult to convince investors to take that risk (just like first-time entrepreneurs).

If it’s a second, third, or fourth fund, past performance will have a major impact on whether the existing investors will invest additional capital in future funds managed by that particular venture capitalist. Furthermore, investors who have not invested in the prior funds are likely going to want to see that many of the existing investors invest in the new fund.

Who are these investors? According to the National Venture Capital Association, the investors into venture capital limited partnerships break down as follow:

Pension Funds 42.0 %

Financial Institutions & Insurance 26.0 %

Endowments & Foundations 21.0 %

Individuals & Families 9.0 %

Corporations (as LPs) 2.0 %

All of these are professionally managed sources of capital themselves for which venture capital is an asset class, often limited to less than 5%. Their investment in any limited partnership is likely to be tens of millions of dollars. Such investment decisions are not made lightly.

Investment criteria

Each venture capital fund has its own investment criteria. Some of the likely elements are: size of initial investment; total investment opportunity, including follow on investments (most funds can not commit more that 10% of the fund’s committed capital to any one deal); industry; stage; and geography.

Don’t expect them to deviate from their criteria because yours is such a great deal. For an example, a $500 million venture capital fund is not going to make $1 million investments. They need to put more money to work in any given deal to make it worth their time.

Approval process

All funds have an internal approval process for making investment decisions. Just because a partner endorses an investment in your company doesn’t mean that his partners will agree. Many funds require a unanimous approval of all partners.

Your challenge, then, is to make the partner with whom you are working your aggressive champion within his partnership. When he makes an investment recommendation, he is putting his credibility and ego on the line. You have to convince him that it’s worth the personal & professional risk to do so.

Build Value & Exit

This is the normal, everyday blocking and tackling that a venture capitalist does to provide his value added. These activities consume a very large portion of a venture capitalist’s time.

If you consider an investor’s assistance “meddling,” venture capital is not for you.

Do it again

For venture capital to be a professional career, a venture capitalist must be able to raise a series of venture capital funds. As noted before, this requires that a significant number of the investors in the existing fund participate in the next fund. Only by layering funds of different vintages on top of one another can a venture capital firm sustain itself.

You need to understand this and be able to make the case that an investment in your company will assist the venture capitalist in those efforts.

Advice to entrepreneurs

1. “Venture capital” refers to professionally managed investment capital.

2. Use the phrase, “venture capital” correctly.

3. Don’t expect venture capitalists to deviate from their investment criteria because yours is such a great deal.

4. You need to make the partner with whom you are working your passionate champion within his venture capital partnership.

5. If you consider an investor’s assistance “meddling,” venture capital is not for you.

6. You are selling an investment opportunity to a venture capitalist. Make sure that you select the firms to approach based upon their investment criteria. Make sure you demonstrate to them how you will satisfy (exceed) their investment objectives, thereby contributing to their success as a venture capitalist, and their ability to raise additional funds.

7. Build a network of mentors, advisors, professionals, and entrepreneurs who have “been there and done that,” particularly in your market space. They already have the battle scars.

As a first-time entrepreneur, you need to master the vocabulary of your chosen pursuit. If you desire and/or require venture capital investment, then make sure you understand things from their side of the table.

Frank Demmler (fd0n@andrew.cmu.edu) is Adjunct Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at Carnegie Mellon University. (http://web.gsia.cmu.edu/display_faculty.aspx?id=168)