CEO Ventures Entrepreneur Resources . . .

How Do Venture Capitalists Select Investments?

Full content credits to Catharine Merigold

Expensive!

Cheap!

Co

st o

f C

apit

al

Stage of CompanySeed MatureSelfFF&FEmployerSBA, SBIRBanks - PG

Banks - ABStrategic Investors

Venture Capital& Incubators

Venture Lending

Early Late

PrivateEquity /

Mezzanine

Sources & Costs of Capital

Venture Makes Sense for Very Few Companies

• MOST successful companies are NOT funded by venture

• Venture Capital ONLY makes sense for very few companies

• My own advice: If there is any way to build a business without venture capital, you should

• Venture capitalists are not risk-takers, they are risk managers

1st M: Money

• How a VC “selects” investments is a function of:

1) “Whose” money they are investing;

2) What other rates of returns are available to those who invest in the fund (LPs) from other investment vehicles

3) The stage of company they invest in

Where do VCs Get Their Money?

59%

4%11%

7%

11% 8%

Pension Funds

Foreign Investors

Foundations

Families &Institutions

Banks & Insurance

Corporations

Commitment Sources to US VC Funds

The Entire Fund Has To Return Higher Than Other “Less Risky” Investments

• Consistently a higher rate of return than other investments

• An “alternative” asset class

0%

50%

100%

150%

200%

250%

1 yr 3 yr 5 yr 10 yr

Early-Seed

Balanced

Late-Stage

All Venture

Rat

e o

f R

etu

rn

Time Horizon

Venture Returns by Type, Q1 ‘00

If Fund to Return 30%, Avg. Investment Must Return More Depending on Number of Losers

40%

30%

20%

8% 2%

losses

1-2x

2-5x

5-10x

10x+

“Typical “ Early-stage Venture Portfolio Returns

The Lesson: An Early-Stage Portfolio

Return is Determined by 2-3 Winners

Multiple percentage # of investmentstotal investment total returnlosses 40% 10 33,000,000$ -$ 1-2 x return 24% 6 21,000,000$ 29,400,000$ 2-5 x return 20% 5 20,000,000$ 60,000,000$ 5-10x 8% 2 11,000,000$ 82,500,000$ 10x + 8% 2 11,000,000$ 165,000,000$

100% 25 96,000,000$ 336,900,000$

Venture Fund Portfolio Model

Assume fund = $ 100,000,000 Assume investments = 25Lemons ripen early

How Much Does Venture Capital Cost?

Risk – Return Continuum

Seed 1st Prof2nd-3rd Rounds

EmergingGrowth

Lever.Buyout

Age of Company 0 0-1 yr 1-3 yr 3-5 yr 10-50 yr

Product Stage Idea Proto 1st Gen 2nd, 3rd gen Mature

Sales Growth Rate 0% explosive 100% 25-50% 10-15%

Profits losses losses losses/BE profit stable profit

Captial Needs $250k-$1M $2-$10 M $10-$40 M $5-30M $5-$50M

Return Expectations Mult of Inv 15-20x 10-12x 8x 6x 3x IRR 70%+

2nd M: Market

• “Big” market

• Ability for rapid growth up to a substantial sales level

• The opportunity to deploy significant capital

–For example, some funds want to invest $10-20 million over the life of a company to create an “impact” investment

Market Part 1: Market Size

• Market for the product/service should be more than $1B or small & growing rapidly

• Why? Need for Exit

– Remember, VCs get their money from someone else, and have to close out all investments in 10 years

• A large share of a small market, even with profitability, means:

• No one will pay a premium in an M&A situation

• Can’t go public because growth limited

Market Part 2: Rapid Growth

• Ability for rapid growth up to a substantial sales level

– $50M+ in 4 years

– Why? Rate of Return

• Therefore, VCs look for:

– A company that solves a significant market “pain”

– Sustainable competitive advantage

• This means many good businesses are not fundable because they either cannot grow quickly enough or are not scalable – e.g.retail, many service-businesses

Market Part 3: Ability to Deploy Capital

• No matter what the rate of return, VCs will typically NOT invest if a company needs less than $5 million in capital

• Why? Fund Size and Rate of Return

• If a Fund has $300 million to invest, it would take 30 “home runs” of 10x return on a $1 million investment just to return the fund

3rd M: Management

• VC mantra - management, management, management

• At the end of the day (unless an irrational market lifts all boats), it is management that is responsible for success

• Depending on the particular VC, they may look for:

– “Recycled” entrepreneurs

– Domain expertise

– “Sticky” entrepreneurs

– “Real” entrepreneurs

Value Creation in Business and Product

Value

Tech/Prod

Business

alpha

Beta

Patent

Idea

PoC

Sr.Team

Customers Partner

s

Sticky Bus Plan

RevRamp

Ship

• Management risk

• Market risk

• Sales risk

• Technology risk

• Business strategy risk

• Financing risk

To Maximize Funding Potential and Valuation – Minimize Risk Vectors

Finding the Right VC

• Choosing the right VC firm as your “partner” is important

• Look for help beyond capital

– Industry expertise in your area

– Good track record

– Reputation for working well with entrepreneurs

• Make sure the VC’s expectations on growth strategy, future fundraising, and investment time horizon are the same as yours

How Do VCs Choose Investments?

• Recap: The 3 M’s

–Money

–Market

–Management

Full content credits to Catharine Merigold