How Venture Capitalists Work Out The Financial Odds

Every business has equity financing. Initially it is money that entrepreneurs put into their ventures to launch them. Some entrepreneurs augment their personal capital with money invested by family and friends. A few expand the equity in their business by selling shares to wealthy individuals, business angels. And a tiny elite group of high potentials raise equity capital from formal venture capital companies.

Of the 2 million or so ventures started annually in the US, about 95 per cent get all their equity funding from the founding entrepreneurs and their immediate family and friends. No more than 5 per cent get funding from angels and less than .05 per cent from formal venture capitalists.

 

The most sophisticated private equity investors are professional venture capitalists. By examining how they evaluate, value and finance entrepreneurial companies we can learn a lot about the process of private equity investing. Granted, this is a group of sophisticated investors but they set the standards for good practice when it comes to equity investments in private companies.

Entrepreneurial folklore says professional venture capitalists do not invest in a company until their rising greed overcomes their declining fear. In other words they do not put money into a company until they are convinced there is a reasonable probability the potential financial returns measure up to the risks.

As a rule of thumb, this means they expect to get a return of between five and 10 times their initial investment in about five to seven years. In an ideal case the company will grow rapidly and float an initial public offering of its shares within five years of the first venture capital investment.

Common shares are the riskiest equity none more so than shares in a young, private company. Besides, the fact that common shareholders stand last in line to be paid when a company fails, investment in a private company lacks liquidity because there is no public stock market where the shares can be readily traded. But there are many other risks to contend with.

Consider the example of Apple Computer. Founder Steve Jobs first approached a professional venture capitalist in the autumn of 1976. The company was then selling Apple I microcomputers. The total market for these machines was minuscule and no company had a commercially viable product. What is more, Jobs and partner Stephan Wozniak were college drop-outs with modest work experience.

The venture capitalist rejected them because they were neophyte entrepreneurs without significant management experience, on top of which they were offering an introductory product in an embryonic market.

On his suggestion they approached Armas Mike Markkula, a semi-retired Intel veteran, who made an angel investment in Apple and brought much-needed management savvy. The company introduced the Apple II in 1977.

Next year, when Apple sales were about $10 million a year the first professional venture capital was invested. By then the infant

microcomputer industry, propelled by the VisiCalc spread sheet, had made a breakthrough and microcomputers were being used for business applications.

When venture capital was invested in Apple, the management, market and technological risks, although still high, were much lower than they had been 18 months earlier and were outweighed by the potential financial returns. How do venture capitalists evaluate those risks and what kind of returns do they expect from the companies?

First and foremost, venture capitalists invest only in companies with first-class entrepreneurial leaders in markets that are big enough for a companys sales to grow to at least $ 50 million with pre-tax profit of 20 per cent within five years.

Experience shows a company like that will be able to go public, or be bought by a larger company, and will return five to 10 times the venture capitalists original investment. A tenfold return in five years yields an annual rate of return of 58 per cent and a fivefold yields 39 per cent, which are within the range of satisfactory risk-adjusted returns.

Next, venture capitalists hedge their bets by providing the finance in stages. Suppose an early-stage company says it requires $ 5 million of equity financing before it will be able to go public. If a venture capital group decides to invest it will usually split the financing into two rounds, of say $2.5 million each.

Provided the company meets its projected sales and profit milestone with the first $2.5 million, the venture capitalist will almost certainly want to invest the second $ 2.5 million. Typically, if the first round is sold at $ 1 per share, the second round will be about $ 3 per share. Hence, with two rounds of financing, the company sells only 3,333,333 shares (2.5 million plus 833,333) to raise $5 million rather than 5 million if it had raised all the financing in one round.

However, if the company falls hopelessly short of its milestone, the venture capitalist will probably not invest any more money and in the worst case will be prepared to write off the first $2.5 million. So by making the investment in stages, the venture capitalist hedges its risk and the company, provided it meets its projections, reduces the number of shares it sells.

In the real world, it is likely that the venture capitalist would syndicate the deal with two other venture groups. Venture capitalists also manage their total financial risk by investing in a portfolio of different companies.

Finally, venture capitalists reduce their financial risk by purchasing convertible preferred shares, which give them specific rights and preferences compared with holders of ordinary shares. The final investment agreement can run to 200 or more pages, but the key

provisions are summarised in a term sheet of a few pages.

Those provisions protect the venture capitalists investment whether the business goes well or badly. The venture capitalists have rights to convert preferred shares to common shares, dividend rights, redemption rights, registration rights, protection from ownership dilution in a recapitalisation, rights to maintain pro rata ownership in future rounds of private financing, and rights to approve the issue of any equity security, liquidation of the company and the acquisition of or investment in another company.

They also have ways of controlling the company through ownership of equity and seats on the board of directors. If they hold 51 per cent of the common shares, they have outright voting control. Although they initially might not have a majority of the board seats, they have the right to appoint a majority of the board of directors if specified negative events happen.

In addition, the term sheet places significant requirements on the companys management and employees. These include: issuing timely annual audited financial statements and monthly or quarterly unaudited statements, non-compete agreements, key person life insurance and a stock vesting agreement that any employee who leaves prematurely has to sell a portion of his or her shares back to the company at their nominal price.

It will also include an agreement that while the company is private an employee cannot sell shares to a third party without first offering them to the preferred shareholders, a limitation on the stock option pool and limits on managers salaries.

Due diligence, financial prudence and legal agreements notwithstanding, it is

impossible to eliminate the risk inherent in equity investing.

In general, investments in younger companies are riskier than those in older ones because they have shorter track records and investments in them have to be held longer. Hence, venture capitalists classify companies according to their stage of development.

A seed-stage company is little more than a concept; a start-up company is already in business and developing a prototype but has not sold it in significant commercial quantities; a first-stage company has developed and market-tested a product and needs capital to start full-scale production.

Second-stage, third-stage and mezzanine financing fuels growing companies; and bridge financing may be needed to support a company while it is between rounds of financing often while it waits to go public.

The younger a company, the greater the risk and the higher the expected return. The expected annual return declines from about 80 per cent for seed-stage financing to about 30 per cent for a third-stage financing (see Figure 1).

The expected returns, combined with the valuation of a company, determines the price per share a venture capitalist will be willing to pay to buy its equity. Since venture capital is invested in growing companies, the venture capitalist wants to know what the companys value is likely to be when it wants to sell its investment and realise a capital gain.

It estimates the valuation of the company at a future date then discounts it back to its present value. (Valuation will be covered in detail in Part 4.)

Here is a simplified illustration of the most commonly used method.

A one-year-old company is seeking $2 million of start-up financing. Its projections show it will have earnings (net income) of $5 million five years hence. The venture capital group believes the company could launch an initial public offering in five years and the price to earnings (p/e) ratio will be 20. Thus, the future total valuation of the company will be $100 million (20 x $5 million).

The venture capitalist wants a 60 per cent rate of return so the companys present value is $9.54 million $100,000,000/ (1.6)5. Hence, for an investment of $2 million, the venture capital group needs 21 per cent ($2/$9.54)x 100 of the companys equity to achieve a 60 per cent return.

There are huge uncertainties in that calculation. The earnings are only projections and even if the company achieves its projections in five years it might not be able to go public if the market for initial public offerings is weak.

And who can foresee what the p/e ratio will be five years in the future? Figure 2 shows

how the percentage ownership required to yield a 60 per cent return on a $2 million investment varies with the future valuation of a company and the holding period. It contains some simple messages for entrepreneurs seeking venture capital.

First, they should think big enough when making their projections because the greater the future valuation of the company, the less equity they will have to sell to raise their venture capital.

Second, they should propose an early public offering because the shorter the expected holding period for the investment, the less equity they will need to sell.

Third, they should grow their companies as big as possible before raising venture capital because the longer they wait, the lower the required rate of return and the shorter the holding time to harvest the investment.

In this example, if the company were a first-stage instead of a start-up investment, the required rate of return would be 50 per cent instead of 60 per cent and it might be ready to go public in four years instead of five. Hence, the company would need to sell only 10 per cent of its equity instead of 21 per cent.

Target annual returns that can go as high as 80 per cent seem to be outrageously exorbitant to new entrepreneurs. But they have to bear in mind that returns from the good investments have to compensate for losses on the bad.

In a successful venture capital portfolio, out of every 10 investments, two will make or exceed the target rate of return, two will be total write-offs and the remaining six will range from the walking dead where the companies never get big enough for a significant harvest to the walking wounded that need refinancing if they are to survive.

The average annual returns on venture capital since the birth of the professional industry in 1946 have been, at best, in the mid-teens, which suggests that this industry is not making excessive returns on risk-adjusted basis. Indeed, some financial observers might argue that the returns are not adequate compensation for the risk involved.

Without doubt, private equity is the most expensive type of capital for entrepreneurs. What is more, when it comes from sophisticated investors, such as professional venture capitalists, it has numerous covenants and restrictions. When things go badly wrong, venture capitalists exercise their rights and intervene in managing the company, often removing one or more of the founding entrepreneurs. It is those situations that lead to the derogatory term

vulture capitalist.However, when things go well, everyone wins. Entrepreneurs receive the capital that enables them to

grow their companies faster; venture

capitalists receive a return commensurate with the risks they take; and society

benefits from exciting new products and high-quality jobs.

What is more, the best venture capitalists such as Arthur Rock, John Doerr, and Ben Rosen bring much more than money to the deal. They bring the wisdom earned by advising and observing entrepreneurs in whom they invested to build tiny

companies such as Apple, Sun Microsystems, Netscape, Lotus and Compaq into industry giants. n

William D Bygrave is the Frederic C Hamilton Professor for Free Enterprise and director of the Center for Entrepreneurial Studies at Babson College, Wellesley, Massachusetts, visiting professor at Insead, France, and special professor at the University of Nottingham, UK. He teaches and researches entrepreneurship, especially financing of start-up and growing ventures.