Venture Capital - where does it fit in?

Recently, I had the pleasure (take that with a grain of salt) of discussing, with several colleagues, the pros and cons of taking venture capital investment. Everyone seems to have an opinion. I have seen articles published that VCs are the unsung heroes of modern American capitalism. I have seen others that vulture capital would be a better term.  Interesting how the world shifts.

Until the 1980s or even early 1990s, pretty much no one outside of the business knew what venture capital was, how it worked, or where to get it. Then came the Internet boom. Of course, numerous VC-backed firms had had successful exits long before that, making some VCs and founders quite wealthy, but the scale and speed of the Internet boom in the 1980s brought it very much to the public eye. Add some VCs driving their Lamborghinis (plural) around town, and suddenly everyone wanted to be VC-backed, if not an actual VC.

In 2000-2001, the whole thing crashed. Then, everyone believed VCs were terrible, money-losing, and would make you lose your business to boot. Then came social media, the whole concept of "eyeballs" actually began to make money with online advertising, and VCs had a big comeback.

In the 2007-08 recession, it all seems to have turned around.

The real question is: who are VCs, and are they good or bad for your business?  

In true engineering fashion, the answer is, "it depends."

The VC Business Model

Let's look at the VC business model, and then we will have a better understanding as to how they fit in. Venture capitalists are a niche of private equity. They are in the business of taking other people's money, usually large institutional funds like Calpers or Duke University endowment but sometimes very wealthy individuals, and investing it on their behalf to earn outsized returns. The value the VC brings to the investor is their supposed ability to filter among the thousands, millions of potential early-stage private investments, determine which mix of business plan and team is most likely to be successful, and put money into the firm in exchange for equity.

The VC - and by extension the investors - get their money back when the "exit" occurs. The exit is a liquidity event, something that allows the investor to turn their privately held illiquid stock in the firm into a liquid form, usually cash.  There are normally two kinds of exits:

1. IPO: The Initial Public Offering. The firm lists itself on a public stock market - historically in the US this has been the Nasdaq for tech ventures, although others have listed on the NYSE, while others overseas list on the Deutsche Neuer Markt, the London Exchange, etc. -   and the investors can now sell their stock to the public. This exit has been in severe decline in the last decade. This is primarily due to two main factors: litigation, by which public companies and their directors and officers personally are sued for a decline in the stock price; and regulation, particularly the Sarbanes-Oxley act, and its notorious section 404, which dramatically increased the regulatory burden of being a public company. In response, most new firms have avoided the IPO as their stated exit. Others have chosen to list overseas to avoid the double-squeeze of US litigation and regulation.
2. Acquisition: The firm is acquired by an existing firm, for some mix of cash from the acquirer's reserves and stock of the acquirer, which is likely already publicly traded and is thus liquid.

In other terms, the VC puts its money into the firm, fully expecting that at some point hence, normally 5-7 years, it will receive many multiples of it back in a liquid form. The VC will do everything necessary and within its power to move the firm towards that exit.

Of course, most new ventures fail, many within 1-2 years. The riskier the venture, the larger the market, the greater the probability of failure. To compensate, the VC must invest in lots of firms. So, the VC makes an assumption. For every 10 firms: 7 will fail, 2 will be going concerns but not worth very much (by the VC's standards), and 1 will be a star. Thus, to make sure that the one star really does shine, and make up for all of the rest, the star must be worth $1BN, and thus must be in a $1BN market.

Result: It is in the VC's interest to drive every firm in its portfolio to get as big as fast as possible. It doesn't want successful firms; it wants hugely valuable firms. If that means that all 10 firms take outsize risks, so be it. One will succeed, and that is all it needs.

The VC's Compensation

In general, the VC is compensated with two elements:

1. Management Fee: Each year, a certain percentage of the money committed to the VC is paid out to the VC's firm as a management fee. In the VC world, it is normally 2%. Thus, if the VC has raised a $10MM fund, he can expect to receive $200,000 per year as a management fee, which covers everything from legal expenses to accounting to office space to salaries. It is easy to see that a small 3-partner VC firm requires a lot of money under management just to get by. 
2. Upside: When the VC returns money to its investors, it shares in the upside. Sometimes it is after a certain minimum return, sometimes it is before or after the management fee, but the general rule of thumb is to share in the upside. Thus, if a $100MM fund returns $130MM, the VC takes $6MM and the investors take $24MM, ignoring the effects of minimum return, management fees, etc. It is important to note that the VC does not share in the downside. Thus, if the $100MM fund loses money and ends up at $80MM, the investors take the entire $20MM loss.

This management fee plus upside model is very common in private equity, of which VC is a small niche, and is almost non-existent outside of it. In general, most US regulation disallows upside sharing for publicly available investment vehicles, e.g. mutual funds. This structure is normally expressed as "management fee / upside." Thus, the VC model is normally described as 2/20.       

The Founder's Model 

The founder of the firm, on the other hand, is putting all of his or her life's energy into this one firm. He wants this firm to succeed, and may be willing to take fewer risks than an investor. He may or may not be satisfied with a $20MM valuation, whereas the VC wants a $1BN or higher valuation. The founder cannot diversify away his risk the way the VC can.

So What is the VC

The VC is a businessman, like any other. He is usually financially savvy, often strategically savvy, and infrequently but sometimes understands operations and execution. It is also usually a he, not a she, for reasons that I do not fully understand. It is unlikely to be any form of discrimination; many of these VCs hire high-powered extremely capable women to run their companies, like Meg Whitman of eBay, Carol Bartz of Autodesk (now at Yahoo) and many others.

The VC has his or her own interests and needs. His model is built around certain assumptions about diversification, risks, size and speed, and he has certain expectations. There is nothing wrong or right, good or bad, with his model and interests. It just is, however, the model the VC has chosen.

When to Take VC Money

By this point, the answer should be fairly straightforward: take VC money when the founder's interests and the VC's interests align. If the two do not align, then chances are strong there will be a nasty falling-out at some point in the future. Charles de Gaulle was famous for saying, "countries have no friends, only interests." The same should be said for VCs.

The overwhelming majority of new business ventures that are founded start off as, and intend to grow as, small businesses. Of the rest, many have a maximum intended growth of a few $MM to a few tens of $MM over many years. A few, a very few, are intended to be game-changers: Google, Amazon, Intel, the kinds of companies that change the face of an industry, if not the world.

If you are building a company that intended to change an industry or the entire world, and in order to succeed you must get very big, reasonably fast, and are thus willing to take very big risks, go for the platinum ring, then VCs are the right vehicle for you. Even if you get funding, 70% of the time you will fail, 20% you will sort of hang on, but the last 10% will be home runs. 

On the other hand, if you are looking to build a successful small or midsize business, intending to grow a decent market share and have solid revenues and profits, but do not want to risk the whole thing on a single throw of the dice - go for the brass ring or silver ring, rather than the platinum - then VC is not for you. There are plenty of other sources of capital - angels, friends and family, banks, SBA, the list goes on - that are much better suited. If you approach the VC, and especially if you take their money, you are doing a disservice to everyone: your investors, your friends, your employees, your customers, your VCs and most especially yourself. Fortunately, many VCs are very sharp, some of the smartest people I have met (but not all) are VC partners, and they will winnow out the ones that do not suit their model. But sometimes they will see one that can fit their model very well, even if the founder does not. It is in their interest to find and invest in these companies. If you do not want that growth, risk, size and relationship, do everyone a favour and stay away.