operating guidelines for effective venture capital funds
TRANSCRIPT
Operating Guidelines for Effective Venture Capital Funds Management By: Terry Dorsey Date: 1979 Abstract: Extending Liles' work in the development of an effective "enabling strategy," the author has formulated a set of 20 operating guidelines for effective venture capital funds management. The guidelines presented in this paper are the result of a detailed study of 368 venture capital investments which were analyzed along three critical investment parameters. These parameters are: (1) the capital requirements of investee ventures, (2) investment liquidity, and (3) the riskiness of venture capital investing. In addition, the characteristics of investments in "start-up" and "later-round" situations are compared. Keywords: venture capital; funds management; finance Institute for Constructive Capitalism Technical Series no. 3
IC² Institute, The University of Texas at Austin http://ic2.utexas.edu
lRREE OPEA'ITING GUIDELINES
FOR EFFECTIVE VENrURE 01PITAL FUNDS MANAGEMENr
c
By Terry Dorsey
TECHN CAL SERIES The Institute forConstructive Capitalism
The University of Texas at Austin
1
OPERATING GUIDELINES
FOR EFFECTIVE
VENTURE CAPITAL FUNDS MANAGEMENT
by
Terry Dorsey*
*Terry Dorsey is a financial consultant with the Chase Information Group, a subsidiary of the Chase Manhattan Bank, and holds a Ph.D. in the management of technology from the University of Texas at Austin.
@Business School Foundation 1979
ABSTRACT
Extending Li les 1 work in the development of an effective 11enabl ing
strategy, 11 the author has formulated a set of 20 operating guidelines for
effective venture capital funds management. The guidelines presented in
this paper are the result of a detailed study of 368 venture capital in
vestments which were analyzed along three critical investment parameters.
These parameters are: (1) the capital requirements of investee ventures,
(2) investment liquidity, and (3) the riskiness of venture capital i nvest
ing. In addition, the characteristics of investments in 11 start-up11 and
11 Jater-round11 situations are compared.
Although articles on venture capital -- William M. Bulkeley and
Lindley B. Richert 1 s "Venture Capital Is Plentiful Once More ... 11 in the
Wall Street Journal and Nick Galluccio's 11 Comeback for the Dream Merchants 11
in Forbes to cite two recent examples -- are becoming more numerous, these
pieces are generally anecdotal and offer little concrete assistance to
funds managers. The operating guidelines presented here are designed
specifically to enable these managers to better understand the venture
capital process and manage venture capital funds more effectively.
OPERATING GUIDELINES FOR EFFECTIVE VENTURE CAPITAL FUNDS MANAGEMENT
INTRODUCT~ON
Based on findings of a study of 368 venture capital investments, this
paper presents guidelines for the development of an effective "enabling
1 strategy•• for venture capital funds management. Patrick R. Liles, a noted
analyst of venture capital, has described the importance of an effective
enabling strategy to the venture capital firm:
In these firms where the major portion of the firm's resources is devoted to activities which require many years before allocated resources produce significant returns, and where there are great uncertainties about the magnitude and timing of these returns, successful execution of the tasks of the firm over the short and medium term cannot produce the resources needed to : sustain the firm's activities. Nor can they provide an attractive return to investors until the long-term payoffs from the strategy have been realized. This is normally the case for any venture capital firm. Under these conditions, the firm's poor record during the early years makes it difficult for management to obtain additional resources or to justify to investors that the remaining resources should be expended to continue with the original strategy.
In such situations, a sound approach to the future of the enterprise must include some means for obtaining resources for continuing investments and for current expenses. It must also include provisions for consistency and continuity in the firm's activities as operations are carried out and evaluated over an appropriate period. This part of a firm's activities--its enabling strategy--can be defined as the establishing and maintaining of conditions which permit an enterprise to pursue its long-term goals and activities.2
The need for an effective enabling strategy carries implications for
many facets of venture capital funds management. The strategy discussed in
this paper has been developed from an examination of three critical invest
ment characteristics: 1) the capital requirements of investee ventures,
2) investment liquidity, and 3) the riskiness of venture capital investing.
In addition, the characteristics of investments in 11 start-up1.1 and 11 later-
round' ' venture situations are compared.
DATA COLLECT ION ON 368 VENTURES
Data from which the operating guidelines have been distilled were
drawn from a report prepared by The Diebold Group, Inc., for the National
Science Foundation. That report "evaluates alternative investment
guarantee programs open to the Government•• to encourage venture capital
investment. 3 While the Diebold study contains a great deal of data and
analysis, its primary mission is a cost/benefit evaluation of such an
investment guarantee program. Thus despite inclusion of substantial
relevant data, its analysis is directed toward very different questions
than those addressed here. Indeed, the Diebold study notes, 11A very large
amount of data and computations have been included in this report, to
possibly form a foundation for additional studies that might logically
develop from the findings •114
The Diebold data were collected in six stages. During the first three
stages, data were collected on characteristics of 140 venture capital firms.
2
Then personal interviews with representatives of 77 venture capital firms
were conducted to obtain data on 368 11 typical 11 ventures which they had
financed. 5 This fourth stage of data collection entailed obtaining
information on the amount and date of finance of each venture, sales of
ventures still in business in 1973, and the date of liquidation and life
sales of ventures that had terminated. These ventures are considered
sufficiently representative to permit reliable analysis and conclusions
conducive to a better understanding of the overall venture capital
11picture. 11 Data on "successful " ventures were gathered during the fifth
and sixth stages of the study. "Successfu I 11 ventures were considered to
be "those companies that have been in operation longer than the five year
guarantee period or which have every indication that they will (continue in
operation for a minimum of five years) -- either through corporate profit
6 tax payments or from sales growth. 11
Additionally, detailed statistics on 79 firms were developed for the
seven years subsequent to their receiving venture capital financing.
These firms were 11generally either publicly owned or quite. successfully
operated--and thus represented possibly a more attractive picture than the
majority of the successf u 1 companies surveyed . 117 These firms are referred
to in this study as "highly successful" ventures. Data were thus collected
on three categories of venture capital investee firms:
Investee Firms
Highly Successful Successful Liquidations Tota l
3
Number
79 229 60
368
Summary statistics for these three groups of investments are given in
Table I.
Mean
Maximum
Minimum
N
TABLE I
SUMMARY STATISTICS OF INVESTMENTS IN HIGHLY SUCCESSFUL, SUCCESSFUL AND LIQUIDATED VENTURES
Highly Successful Successful Liquidated
Ventures Ventures Ventures
$ .838 mi 11 ion $ .562 mi 11 ion $ .416 mi 1 lion
6.000 mi 11 ion 5.000 mi 11 ion 1. 500 mi 11 ion
.050 mi 11 ion .015 mi 11 ion . 025 mi 11 ion
79 229 60
OPERATING GUIDELINES FOR THE FUNDS MANAGER
Capital Requirements of Investee Ventures
Operating Guideline 1: There are minima l capital requirements which a venture capital organization must meet before it can realistically expect to finance new ventures effectively.
As might be expected, these capital requirements derive from a
number of considerations. One of the key elements is the amount of
capital which an organization must likely provide to a successful new
venture .
Operating Guideline 2: More successful investment situations require larger amounts of investment capital than the ones which fail. Average investment sizes for the three classes of investments were $838,000 for 11 highly successful 11
, $562,000 for 11 successful 11 and $416,000 for liquidated ventures.
4
FIGURE 1
AVERAGE INVESTMENT SfZES IN HIGHLY SUCCESSFUL, SUCCESSFUL, AND LIQUIDATED VENTURES
1000
Investment Size (Thousands of Do 11 ars)
Boo
600
400
200
-
-
_,
-
-
$836,ooo
n=79
Highly Successful
$562,000
n=229
$416,000 ..
n=60
Successful Liquidations
Due to the way in which data on investment size were collected -- e.g.,
investment firms rather than investee ventures provided such data -- it is
necessary to infer that the data pertain to investments made by individual
investors rather than to total venture funds placed in investee firms, or
by syndicates of venture capital organizations.
In order to better interpret the importance of this find~ng for the
development of an effective enabling strategy, it is useful to examine the
5
size of individual investments in successful ventures. It is evident from
an evaluation of the frequency distributions presented in Table II that
while most investments were $499,000 or less, some very large investments
in successful and highly successful ventures tended to substantially in-
crease the average size of these types of investments.
Size of Investment
$ 0-99K
I00-249K
250-499K
500-749K
750-999K I000-1249K
1250-1499K
1500K +
TABLE 11
FREQUENCY DISTRIBUTIONS OF INVESTMENTS IN HIGHLY SUCCESSFUL, SUCCESSFUL, AND LIQUIDATED VENTURES
Total Substantial Investments Successes Successes # % # % # %
24 6.50 2 2.53 14 6.09
92 24.93 6 7.59 65 28.26
108 29.27 24 30.38 70 30.43
61 16.53 19 24.05 33 14. 35
21 5.69 6 7.59 12 5.22
22 5.96 5 6.33 17 7.39
8 2. 17 1 1.27 3 1.30
32 8.94 16 20.25 15 6.55
Liqu i dat i ens # %
8 13.33
21 25.00
14 23.33
9 15.00
3 5.00
- 0
4 6.67 1 1.67
Total 368 79 229 7o
$ 0-499K 224 60.70 32 40.51 149 65.07 43 71. 77
500-999K 82 22.22 25 31 .65 45 19.65 12 20.00
IOOOK + 62 17.07 22 27.85 35 15.28 5 8.33
6
It now becomes useful to evaluate the relevance of the finding that
successful investments are, on the whole, larger than unsuccessful ones.
To begin with, it is inappropriate to infer that the converse is also true.
That is, that large investments are more successful than smaller ones. No
cause and effect relationship has been implied nor should any be inferred.
Operating Guideline 3: While most initial venture capital investments are $500,000 or less, those ventures which become successful frequently require subsequent and significant infusions of additional venture capital.
Those ventures whi ch fal l upon hard times rarel y receive subsequent
financing before liquidation and the average size of investment in liqui-
dation and the average size of investment in liquidated ventures remains
relatively low.
The relevance of this finding for the venture capital portfolio
manager may also be stated in terms of investment policy:
Operating Guideline 4: The capital needs of successful portfolio ventures subsequent to initial financing imply (a) the need for a reserve fund to further support successful ventures within the venture capital organization and (b) the venture capital portfolio should avoid.becoming fully invested.
It is also possible to estimate the appropriate size of such a reserve
fund as a proportion of total venture capital funds available. First, it
is necessary to estimate an average initial investment amount. This figure
is inferred by the writer to be approximately $416,000, the average size of
investment in liquidated ventures. This amount is chosen because subsequent
7
funding of liquidated ventures is probably infrequent.
Operating Guideline 5: $416,000 represents a typical average initial investment size for both successful and unsuccessful ventures.
Next, it becomes necessary to estimate the proportion of total funds
which will be requ i red subsequent to initial investment. In the sample of
368 investments which were examined, a total of $153.09 million went to
initial investments -- assuming an average initial investment of $416,000
(368 investments x $416,000 per investment= $153.09 million). However,
total investment in the 368 ventures was $219.7 million. Thus it appears
that approximate ly $66.61 million or 30.32% of total capital was invested
subsequent to initial investment. This pattern suggests a minimum pro-
portion of inital investable venture capital funds which should be held
in reserve for subsequent funding of successful ventures.
Operating Guideline 6: Venture capital portfolio management should avoid investing more than 70% of its total capital in the initial financing of investee ventures. Conservative investment practice would dictate that no more than 50% or 60% of total capital go to initial investments.
Guideline 7 thus becomes apparent:
Operating Guideline 7: A reserve of 40% to 50% of an investing organi zation's total capital should be set aside for subsequent support of successful ventures.
Whil e i t is beyond the scope of this paper to estimate the most
appropriate rate at whi ch such ventures should be funded, it is useful to
8
point out the probable effect of coupling a policy of maintaining a 40-50
percent reserve fund with a conservative policy of funding new deals rela-
tively slowly. For example, a strategy of investing no more than 20
percent of a fund's total capital in new and previously-funded portfolio
ventures during a twelve month period would (1) necessarily prevent the
fund from becoming totally invested for at least five years; (2) permit
management of the fund to better di st i ngu i sh its 11wi nners 11 from its 11 losers 11
since most liquidations occur within two years of initial funding;8
(3)
permit funds management to concentrate on the development and support of
its more successful investees; and (4) permit funds management to devote
a greater proportion of its total capital to emerging winners by investing
additional capital in subsequent financing and thus to have a greater pro-
portion of capital invested in successful, rather than unsuccessful,
ventures. Moreover, if management sought an investment strategy to obtain
investment liquidity within five years of investment, the fund might have
some capital for reinvestment beginning about the sixth year without the
need to look to external sources for additional capital. It consequently
becomes useful to state:
Operating Guideline 8: New deals should be funded at a relatively slow rate.
Support for this guideline is provided by Liles (discussed more ex-
tensively later in the paper) when he states that a well-known venture
capital firm concluded that its most frequent error had been to fund new
ventures too quickly.
9
Investment Liquidity
Before addressing the issue of venture capital investment liquidity,
it is first useful to investigate the termination of successful venture
capital investments via investee ventures• public stock offerings. Speci-
fically the following two issues are addressed:
.What proportion of venture capital is invested in firms which achieve a requisite size to 11go publ id 1 within five years of investment?
.What are the capital requirements for investment in firms which can 11go public11 within five years of investment?
Three factors dictated the use of 1973 sales data of venture capital
investments made in 1969 for this analysis. First, data for the Diebold
study were collected in 1973. Second, the greatest number of investments
were made in 1969. Third, the median time between incorporation and the
public offerings of 28 technical firms which went public in 1968 was 62
months. 9
It is impossible to state a universal, unchanging criterion whereby
one may evaluate the ability of an investee venture to go public. Besides
being determined by such characteristics of the firm as sales, profit-
ability, and the firm's respective industry, the ability of a firm to go
public is also shaped by the presence and viability of a market for new
security issues. That market has been especially volatile in recent years,
as illustrated in Table II I.
10
Month
January February March April May June July August September October November December
Total
Year
1974 1973 1972 1971 1970 1969 1968
TABLE 111
NEW SECURITIES ISSUES. 1968-1974
1974 1973
Number Dollars Number Do 11 ars of Issues Underwritten of Issues Underwritten
(mi 11 ions) (mi 11 ions)
1 $ .8 33 $ 69.8 2 3.4 23 48. 1 4 7.6 20 39.9 0 0 9 17.0 0 0 9 17.2 0 0 0 0 0 0 3 2.3 2 4.3 0 0 0 0 1 2.6 0 0 1 1. 3 0 0 0 0 0 0 2 7. 1
9 16. 1 101 205.3
Totals for Past Seven Years
Number of Issues
9 1 01 409 248 198 698 358
Dollars Underwritten (Mi 11 ions)
$ 16. l 205.3 896.0 550.9 375.0
1,336.9 745.3
SOURCE: Venture Capital. January 1975, pp. 1-2.
NOTE: Above data represents firm underwritings for all companies with a net worth under $5 million. Issues of over $5 million were not included nor were Regulation A or best effort underwritings. The above data were compiled through the efforts of Greater Washington Investors and S. M. Rube l & Associates.
11
Despite the near absence of new issues in 1974 and early 1975,
there have been several new issues by smaller firms since late 1975.
Therefore, the characteristics of those firms which have gone public since
that time are used in this study to derive an appropriate criterion by
which to evaluate the ability of similar new numbers to go public. Table
IV contains information from the New Issues Barometer of Venture Capital.
This barometer contains information about securities issues of two ca te-
gories of firms, those having a net worth less than $5 million with
issues prior to March 1976 and firms of net worth less than $10 million
having issues subsequent to March 1976. lO The average annual sales of
these firms are $26.322 million. This discussion suggests an initial
operating guideline regarding investment liquidity. The criterion used
by this paper to assess the ability of new ventures to 11go public" is that
such ventures must attain annual sales of $20 million or mo re within 5
years of initial investment.
Table V provides data about the successful and highly successful in
vestments made in 1969. Specifically listed are the size of investment,
the prior year sales if the investment was not in a start-up situation,
and the 1973 sales. If the investment is in a second-round situation,
1973 sales are given both net of prior year sales and including prior year
sales. (Table VI summarize~ Tables V (A) and V (B).)
12
Cardiac Pacemakers, Inc. Waters Associates
SBE, Inc. Pathcom, Inc. Manufacturing Data Systems, Inc. Chemlneer, Inc.
Cray Research, Inc . 0Jta~<>int, Inc. Microdata Huring Food Groups Syco1·. Inc. McLpath, Inc. Executive Industries, Inc. Al lied Lelsm·e Industries, Inc. Conununications Industries, Inc.
Dynascan Corp. Four Phase Systems
Date of Offering
11/75 11/75
l/76 1/76
2/76 2176
3/76 2/76 2/76 3/76 3/76 4176 4/76
4/76
5/76
5/76 6/76
TABLE IV
CHARACTERISTICS OF SMALL FIRMS HAVING SECURITIES ISSUES BETWEEN NOVEMBER 1975 AND JUNE 1976
Host Recent Yearly Sales
(rai 11 ions of dollars)
8.419 17.269
14.332 52.194
11. 530 25.970
.085 46.890 15.9114 60.010 54.829 14. 796 29 . 606
4 . 889
18.816
48.605 50.150
Most Recent Yearly
Earnings (millions of
dollars) (net of taxes)
1.440 1. 8110
1.227 5 . 315
1.194 1 . 014
( . 88 7) 4.567 1.118 1.585 6.408 1.558 1. 6 31.
( . 223)
1.494
5.156 2.655
Earnings/ For Fiscal Sales Year
17.10% 10.65%
8.56% 10.18%
10. 367. 3.90%
(1043.537.) 9.747. 7.01% 2.64%
11. 69% 10 . 53'1.
5.52%
( 4.567.)
7.947.
10.61% 5.29%
Ending
12131/75 12/31/75
10/31/75 12/31/75
8/31 /75 10/31175
12/31/75 7131/75 8/31/75 1/31/76
12131/75 9/30175 9/30/75
10/31/75
12/31/75
12/31/75 12/31/75
Description of Firm
mfg implantable heart pacemakers mfg liquid chromatography instruments and related products mfg citizens band radios mfg citizens band radios
programming services for machine tools mfg equipment to process and handle fluids mfg research computers mfg small computer systems mfg mini computers process & distribute meat products mfg intelligent terminals independent clinical laboratory mfg recreational vehicles
mfg speciality amusement games
mfg peripheral equipment for communications systems mfg citizens band radios mfg data processing equipment
TABLE V-12-Continued
Date of Most Recent Most Recent Earnings/ Offering Yearly Yearly Sales
Sales Earnings (millions of (mi 11 ions of
dollars) dollars) (net for taxes)
Advent Corp. 6/76 16. 724 (2.973) ( 17.787.) Shared Medical Systems 6/76 22.563 2. 778 12.31%
United States Surgical Corporation 6/76 12.822 .889 6.937.
Total 525.443 37.789 7.197.* Average 26.322 1. 889 7 .187.*k
SOURCE: New Issues Barometer of Venture Capital, December 1975-July 1976 .
*37.789 • 7.197. of 525.443 . **1.889 • 7.187. of 28.332.
For Fiscal Description of Firm Year
Ending
3/29/75 mfg high fidelity equipment 12/31/75 provides data processing services to
hospitals
12/31/75 mfg automatic suturing devices
TABLE V (A)
HIGHLY SUCCESSFUL VENTURES FUNDED IN 1969
Type of 1968 Sales I 1973 Sales: Second-
Firm Size of Situation Round ~ituations ID Invest- Start- I Second- (Second-Round i When 1968 Sales
Number ment* up Round Situations*) j 1973 Sales* Are Included*
7 1.580 x I 11.200 12 .227 x 11.300 13 .225 x 4.000 17 . 735 x .803 3.650 4.453 20 .500 x 2.680 8.520 11. 200 21 .575 x 56.500 25 . 270 x 12. 700 53 .825 x 5.020 64 1.970 x .675 6.330 7.005 65 .400 x 31.100 72 1. 700 x 5.600 89 .330 x 1.000 8.280 9.280
121 1. 950 x 18.700 226 .380 x 2.800 233 1. 750 x 52.800 239 .891 x 19.200 256 2.000 x .380 27.000 27.380 255 .306 x 13.000 267 .350 x 2.500 282 .558 x 2.360 284 .958 x 9.250 294 .500 x 3.000 12.800 13.100 295 2.000 x 11. 200 313 .700 x 2.000 328 .600 x 2.020 3.940 5.960 332 .250 x 10.100 334 .250 x 2.590 342 . 719 x .672 29.700 30. 372 345 .260 x 2.590 350 1.210 x 16.000
*Millions of dollars.
15
TABLE V (B)
SUCCESSFUL VENTURES FUNDED IN 1969
Type of 1973 Sales: Second-Firm Size of Situation 1968 Sales Round Situations
ID Invest- Start- Second- (Second-Round When 1968 Sales Number ment* up Round Situations)* 1973 Sales:id Are Included*
6 .050 x 1.400 37 .700 x 20.000 38 .250 x 2.500 47 .500 x 3.000 70 .600 x .100 87 .500 x 1.000 97 .636 x 9.000
107 1.000 x 5.000 111 .050 x 3.000 116 .465 x 7.933 135 .750 x 10.000 136 .250 x .100 166 .200 x 16.000 183 .152 x 3.600 195 1.000 x .700 200 .275 x .003 207 .060 x 2.000 209 .600 x 1.800 9.500 11.300 210 .400 x 56.500 216 l.100 x 5.000 221 l. 000 x .500 228 .140 x 1.500 229 .200 x .500 l.500 2.000 236 .500 x 4.000 242 .224 x 6.000 243 l. 500 x l.600 6.000 7.600 258 .500 x 2.000 18.000 20.000 261 .750 x 15.000 269 .100 x .600 273 .280 x 2.100 281 .450 x .100 l.000 l.100 285 .200 x 2.000 13.000 15.000 296 1.500 x 5.000 297 .800 x 5.000 325 .250 x 8.000 343 .200 x .500 347 .800 x 17.000 348 .400 x 2.000 353 .250 x 4.000 362 .500 x 5.000 363 .015 x .100 364 .050 x 1.000 365 .365 x .250
*Million·s of dollars.
16
Number of In-
TABLE VI
1973 SALES OF 73 HIGHLY SUCCESSFUL AND SUCCESSFUL VENTURES FUNDED IN 1969
Number of Ventures with 1973 Sales~~ of
Type of vest- 0- $5,000,000 $10,000,000 $20,000,000 $50,000,000 Venture men ts $4,999,999 -9,999,999 -19,999,999 -49,999,999 or more
Success- 24 10 6 2 1 ful 43 56% 23% 14% 5% 2%
Highly success- 8 6 11 3 2 ful 30 27% 20% 36% 10% 7%
Aggre- 32 16 17 5 3 gate 73 43% 22% 23% 7% 4%
*For investments in second-round situations, 1973 sales i nclude prior year (1968) sales.
The infarmatto~ presented in Table VI becomes useful in a discussion
of terminating successful venture capital investments via investee firms•
11going public. 11 The sales data for the three types of ventures suggest
certain mechanisms whereby venture capital firms can liquidate their in-
vestments. Using the criterion that a venture must achieve $20 million in
sales before it can go public referring to Table VI , one realizes that
only 8 of the 73 successful and highly successful ventures funded in 1969
met or exceeded that sales level by 1973. Referring to the information in
Table VII, one recognizes further that approximately $7.044 million of
the total $45.48 million invested in 73 successful and highly successful
ventures in 1969 was invested in ventures which had achieved 1973 sales of
$20 million or more.
17
Firm ID
Highly Successfu 1
21
65
233
256
342
Successful
37
210
258
Total
Average
TABLE VI I
VENTURES FUNDED IN 1969 AND ACHIEVING 1973 SALES OF $20 MILLION OR MORE
Amount of Investment*
.575
.400
1.750
2.000
.719
.700
.400
.500
7.044
.881
1973 Sales*
56,500
31 • 1 00
52.800
27.380
30.372
20.000
56.600
20.000
294.852
36.857
*Milli ons of dollars; 1973 sales for second-round situations include 1968 sales.
It i s now possible to estimate the proportion of total venture capital
invested in those firms which are likely to go public within five years
after investment. In addition to those successful and highly successful
ventures funded in 1969, there were 22 investments totaling $10.507
mill ion i n unsuccessful ventures. Thus, of the $55.987 million invested
18
in 95 ventures in 1969, only 12.6% was in highly successful and successful
ventures. These 12.6% were the ventures most likely to go public and per-
mit investment termination within five years. 18.8% of total funds
was invested in ventures which were eventually liquidated, and the balance
was invested in firms which probably had not attained a requisite size for
going public. Finally, of those ventures funded in 1969 which had
achieved $20 million in sales by 1973, the average size of investment was
very substantial: approximately $881,000.
Accordingly, it becomes possible to identify another two guidelines
for the funds manager.
Operating Guideline 9: Approximately 12.6% of all invested venture capital flows to firms which eventually achieve a size sufficient to have public stock offerings. The average size of these investments was found to be approximately $881,000.
Adding 12.6% to the 15% of capital estimated later in this paper to be
lost in liquidations of unsuccessful investments and in the sale of
marginally successful ventures leaves the portfolio funds manager with
72.4% of total capital in illiquid investments: 100% - (12.6% + 15%)=72.4%.
Operating Guideline 10: Approximately 72.4% of venture capital is invested in highly illiquid situations .
Besides a public offering, the only other apparent external mechanism
for realizing liquidity from an equity investment is the sale of that
investment position to a firm desiring to merge with or to acquire that
venture. It is obviously crucial to recognize the importance of an invest-
19
ment strategy whereby a capital venture fund can terminate its successful
investments which do not achieve sufficient size to have public offerings.
Thus the need to structure investments for termination prior to initial
funding is critical to the success of the funds manager.
An in-depth analysis of mechan i sms for structuring investments--their
re l ative feasibility, merits, and disadvantages--is beyond the scope of
this paper, and would serve as an excellent basis for future research.
However four mechanisms for structuring the initial investment to ensure
eventual termination will be discussed briefly: (1) specialized debt
instruments; (2) guarantee of bank loans; (3) ESOTs; and (4) repurchase
of investment positions by investee firms out of retained earnings or cash
flow sheltered by accelerated depreciation.
Debt Instruments
Bes i des providing eventual liquidity, dept instruments also have the
advantage of providing regular interest payments to help pay operating
costs for management of the venture fund. Another advantage of using
combined debt-equity investments occurs when the investor receives an
equity position or options to purchase equity in exchange for the invest
ment of debt. It must be noted that there are two ways to rea 1 i ze a
positive return from a venture capital investment. First, and most obvi
ously, the value of the equity portion of the investment may increase.
Second, and Jess obviously, the cost basis of the investment may decrease,
20
as when the debt portion is repaid, while the value of the equity portion
of the investment remains constant or even (hopefully) increases. The end
result is that the investor has created a valuable equity position with
a cost basis of O.
The use of debt instruments as venture capital mechanisms would at
first seem to have the effects of (1) increasing debt/equity ratios and
--according to much financial theory--the riskiness of new ventures; and
(2) of limiting the ability of investors to participate in the profit-
ability of investee ventures.
The use of warrants with subordinated (possibly convertible) debt
would not affect the risk exposure to senior debt holders and would pro-
vide the capital venture with a mechanism eventually to terminate its
capital commitment. The warrants, if exercised, would of course pe rmi t
participation in profits.
While subordinated convertible debt instruments mi ght not actually
increase the risk exposure of senior debt holders, it is not known whether
the presence of those instruments affects ventures• ability to obtain
senior debt from banks and other financial institutions. Such ability
would seem to depend on whether those institutions perceive the subordi-
nated instruments as 11 near-equity 11 or whether they are perceived more as
debt instruments. Work to determine attitudes toward such instruments
would consequently seem to form a useful basis for future research.
Operating Guideline 11: One mechanism available to the portfolio funds manager for ensuring termination of a venture is the use of debt as an investment vehicle.
21
Loan Guarantees
While the venture fund does incur a contingent liability in the amount
of the loan, that liability will diminish over time and eventually disappear
as the venture repays the loan. Assuming the loan is repaid, the invest
ment fund would have an equity position in the venture without actually
having capital invested.
The policy of guaranteeing loans to new ventures in return for equity
positions has several unique characteristics. First, it is not necessary
to have a cash pool to undertake such underwritings. What is actually
required is a relatively liquid, low-risk asset base such as a portfolio
of high-grade bonds. The main requirements of such an asset base are
that it be convertible to cash in case the venture defaults on the loan
and that it be suitable collateral to the institution making the loan.
Once again, discussion of the most suitable assets as well as the pro
pensity of financial institutions to make loans collateralized in this
manner is beyond the scope of this article. However, both would seem
excellent bases for subsequent research.
The guarantee of loans to new ventures has another unique charac
teristic worthy of mention. Such an operating policy would permit many
institutions having very large, low-risk asset bases to serve essentially
the same function as venture capital funds with controlled risk exposure
to themselves. For example, if a financial institution such as an in
surance company having a high-grade municipal bond portfolio of $1.5
22
\. I
billion chose to underwrite banks loans to new ventures using only 2% of
its portfolio as collateral, it could guarantee up to $30 million in
loans to new ventures. A $30 million venture capital fund would be a
very large one. Of the 140 venture capital firms surveyed in the Diebold
study, only seven reported having portfolios of $30 million or more.
In addition, the cost and risk to the institution in this example
would certainly seem acceptable. Were a professional staff set up to work
with and select ventures whose loans would be guaranteed--a staff serving
the same functions as that of a typical venture capital organization--and
if the annual cost of maintaining this staff were five percent of the value
of the loans which could be guaranteed, the cost to the financial insti-
tution would be approximately $1.5 million per year. The total cost for
such a staff for five years would be about $7.5 million. Moreover, if 15%
of the $30 million were lost through 11making good 11 on guaranteed loans
which went into default, the total estimated loss would be $4.5 million .
Hence the total cost for a five-year investment program would be approxi -
mately $12 million or about .8 percent of the $1.5 billion portfolio. The
average yearly cost to the financial institution would be approximately
. 16 percent of its total portfolio.
Fina,lly, the syndication of funds from several large institutions
would also seem feasible. The potential for assisting new ventures in the
procurement of risk capital is significant: a syndication of three in-
stitutions each having portfolios of $1.5 billion and each pledging 2% of
their portfolios to serve as collateral for loans could guarantee up to
23
$90 million in funding for new ventures. The identification of specific
institutions and of wealthly individuals with suitable asset bases and the
propensity of those institutions to engage in such activity are once again
beyond the scope of this article, but would be most useful as bases of
subsequent research. The following quideline serves to summarize the pro-
ceeding discussion.
Operating Guideline 12:
ESOTs
Operating Guideline 13:
Another policy for ensuring the termination of an investment is through the guarantee of loans to new ventures in return for an equity position in those ventures.
A third operating guideline to facilitate in~
vestment termination is through the use of Employee Stock Option Trusts (ESOTs).
Under such trusts, employers may allocate up to 15% of their eligible
payroll to purchase company stock at fair market value for employees.
Such allocations are tax deductible as business expenses. To provide
termination of a venture capital equity investment, the cash contributions
to the ESOT would be used to purchase the equity position over time at its
(hopefully appreciated) fair market value. While the use of ESOTs to
terminate investment commitments is certainly feasible, it must be noted
that its desirability for such an application is not clear.
First, the venture must have a substantial payroll, large enough that
15% of it is adequate to repurchase the investment within an acceptable
24
time frame. Second, the corporation must either have profits in the year
when the ESOT is established or it must have recent profits upon which it
paid income taxes. Whil e an analysis of the desirability of the ESOT as
a mechanism to terminate investments has not been conducted, it could
serve as a basis for valuable future research. Furthermore, such research
is certainly feasible since the Diebold study contains payroll data for
the 79 highly successful firms studied in-depth. Yearly payroll data for
these firms for the first seven years subsequent to investment is included
by the Diebold group.
REPURCHASE OF INVESTMENT POS ITIONS
Operating Guideline 14: The repurchase of a venture capital commitment by the investee venture represents a fourth mechanism for terminating an investment.
This managerial alternative includes the repayment of a debt instr-
ment (discussed earlier) or the repurchase of equity at its fair value for
treasury stock.
The ability of a venture to repay its investors is a direct function
of its sales, cash flow, and earnings. An examination of the sales per-
formance of 209 highl y successful, successful, and unsuccessful ventures
reveals that for each dollar of investment the ventures generated approxi -
mately $31.82 in sales during the first five years subsequent to initial
investment. 11 It should also be noted that if approximately 3.14% of
those sales were allocated to repayment of venture capital investors,
25
those investors' commitments could be repaid at cost within five years of
initial investment. Since these calculations also include investments in
unsuccessful ventures, capital invested in such investments could also be
repaid within five years by approximately 3.14% of the more successful
ventures' sales. Moreover since sales figures for later round investments
are net of the sales level produced in the year prior to initial invest-
ment, only 3.14% of sales increases after initial investment would be re-
quired for repayment of investors' commitments in such situations.
New ventures are generally thought to be more needy of additional
capital than capable of generating excess cash for repayment of investors.
Additional capital is generally needed for working capital, plant and
equipment, and other uses associated with growth. Thus, despite rapid
sales growth, these ventures might be hard pressed to devote even 3.14%
of sales to repayment of investors. However, a 3.14% increase in product
price would permit repayment if the additional revenue were channe led
directly to a fund for repayment of investors rather than used for payment
of expenses or financing of growth. New ventures might well be very cap-
able of increasing product prices slightly with relative impunity. Venture
capital investors can be expected to seek ventures capable of generating
entrepreneurial profits, that is, profits which significantly exceed the
profitability of more established firms. The following quote graphically
illustrates the point:
Although ... Arthur Rock (a co-founder of Davis & Rock, a very successful venture capital partnership} denied any real concern with "too deep psychology," it is clear that his financial success arises from a singleness of
26
concentration symbolized in a reiterated formula which, for the listener, takes on a granitic solidity: 11 1 back a man who I am really convinced wants to make money, and who somehow has demonstrated that he has the ability to make money. 11
••• Rock nearly stutters as he relates a story of one fellow he sent away.
The fellow had what Rock considered to be a great idea for making a device for which there was a big and definite need, and the fellow had sold, evidently without difficulty, some prototype. Rock was definitely interested. 11How, 11 he asked the fellow, had he ''arrived at the sales price7 11 Logical answer: He had added his costs and then added on a fair margin.
11Well, 11 the money man exclaims in a voice peaked with exasperation, 11you know there's no point in discussing anything further with this guy. If he's going to judge what's a fair margin, he just doesn't have the instincts to make money. 11 12
Thus it is quite possible that successful investee ventures might be
capable of repaying investors from revenue, either through generation of
entrepreneurial profits or by increasing product prices 3-4%. Note that
while either would probably permit the repayment of investments within
about five years, only the cost basis would be repaid without commitment of
additional revenue to provide investors with a profit. However, if the
investment were structured such that (1) the 3-4% of revenue pledged to
investors were a royalty which would end when investors had received an
amount equal to their original investment, and (2) the investors retained
an equity position after repayment; then the investors would in effect
decrease their cost basis in the venture to zero, but would retain an
equity position in the venture. Furthermore, it is possible that careful
structuring might permit such payments to be tax deductibile. If they
27
were tax deductible, then net after-tax profit margins would decrease only
about 1.57% (given no price incre~se and a 50% tax rate); if product prices
were increased to yield royalty, after-tax profits would be unchanged.
The Riskiness of Venture Capital Investing
A critical determinant of venture capital profitability is the amount
of capital lost through marginally successful or liquidated ventures. In
order to examine the risk component of venture capital profitability the
following questions are analyzed:
What proportion of total venture capital funds is invested in unsuccessful situations?
What proportion of total venture capital funds is lost through investment in unsuccessful situations?
Of $219.72 million invested in the 368 individual ventures examined
in the Diebold study, $66.19 million or 30.12% of total capital was invest-
ed in 79 substantially successful ventures, 21.47% of the total number.
Additionally, $128.59 million or 56.15% was invested in 229 successful
ventures. The remainder, $24.94 million, was invested in 60 ventures
which were liquidated; the total amount lost due to liquidation was $23.72
million.
Although 60 ventures, 16.30% of the total number, were eventually
liquidated, only 11.35% of total capital was invested in these ventures.
(Recall the earlier finding that average investments in successful ventures
are larger than investments in unsuccessful situations.)
28
Operating Guideline 15: Based on the analysis of 368 ventures, it appears that 11.35% of total capital was invested in liquidated ventures and 10.79% of total capital was lost in liquidations.
One factor might tend to offset this estimate of capital lost through
liquidations: it is possible that some of the ventures termed successful
or highly successful failed and were liquidated subsequent to data
collection in 1973. However, the number of cases in which this might be
true is considered very small. Most ventures which fail are liquidated an
average of 2.6 years after they receive initial funding. Figure II relates
the timing of the 60 liquidations examined by the Diebold study and sug-
gests the following guideline:
Operating Guideline 16: Liquidations of ventures usually occur within two years of initial investment.
Fl GURE 11
TIMING OF 60 VENTURE CAPITAL FAILURES
30
20
Number of Failures 10
0 2 3 4 5
Time (years after initial investments)
SOURCE: The Diebold Group, Inc., Final Report-Phase Three Venture Capital Investment Guarantee Study, prepared for the National Science Foundation, December 1974, p. 7.
29
Thus most of the ventures funded prior to and during the last year
of da~a collection (1973) which would eventually fail would most probably
have done so in 1974 or 1975. An examination of the data on liquidations
reveals that two failed during 1974. It appears that some follow-up data
collection occurred to include ventures liquidated during 1974. Conse-
quently, only ventures liquidated during 1975 are omitted from the esti-
mates presented in Operating Guideline 15. The short time period between
initial investment and liquidation, coupled with data on liquidations
during 1974 suggest that few, if any, of the 308 remaining successful and
highly successful investments were liquidated. Thus it appears appro-
priate to leave the estimate of capital losses through liquidation un-
changed.
However, the funds manager must also be of the following consideration.
Operating Guideline 17: It is unlikely that liquidations account for the totality of loss in venture capital investing.
Some firms which meet the criterion of success--remaining in business
at least five years subsequent to initial investment--are undoubtedly only
marginally successful as business ventures and as venture capital invest-
ments. Indeed, their sale may result in a loss to the investment organ]-
zation.
Therefore, in attempting to determine actual capital losses, it is
necessary to estimate the amount of capital lost on technically successful
ventures--that is, on ventures which remain in business at least five years
subsequent to investment but whose sale result in a lost of capital. In
30
its examination of 140 venture capital organizations, the Diebold study
reported the following responses to the respective queries:
Average (proportion) of investments that were satisfactory
Average (proportion) of investments liquidated or sold at loss
Average % of loss on such investments
Average (proportion) still held but expected to be sold at a loss
65.4%
19.3%
57.9%
10.4%
Before analysis using these data can be conducted, a number of caveats
must be pointed out; caveats which make such analysis difficult.
First, these figures are simple, unweighted averages of data reported
by venture capital organizations. Second, an examination of the question-
naire used to collect these data reveals that they relate to number of
investments, not amounts of capital. Any efforts to estimate capital
losses from these data must necessarily assume that all investments,
successful and unsuccessful, are the same size. Earlier this was shown to
be unrealistic. The finding that successful investments require more
capital than unsuccessful investments implies that an estimate of capital
losses using the above data will be higher than if better data had been
utilized. However, such an estimate can nevertheless be made.
If the 10.4% expected to be sold at a loss resulted in an average
loss of 57.9% upon termination, the overall loss would be approximately
17.2% ( (10.4% + 19.3%) x .579). Moreover, if the additional 4.9% of in-
vestments unaccounted for ( 100~ - (65.4% + 19.3% + 10.4%) = 4.9%) were
31
all sold at an average loss of 57.9%, the overa ll loss would be approxi-
mately 20.0% (17.2% + (4.9% x .579) ) .
Operating Guideline 18: Analysis of the data yields the conclusion that approximately 17.2% to 20% of invested capital is lost to marginally successful and liquidated ventures, assuming that all investments are the same size. Although it is not possible to compensate for the smaller size of unsuccessful investments, it seems that about 14% to 17% of invested capital is lost to ventures which are sold at a partial loss or which fail completely.
The investment of venture capital has been termed 11 high-risk11 by
numerous writers in the field. This writer has been frankly surprised
that the estimated loss is only 14-17% of total invested capital. However,
since (1) the adjusted estimate was made from two separate sources and
types of data and (2) each separate estimate seemed slightly biased in the
direction which was to be expected, the analys i s leads to the conclusion
that the adjusted estimate should be accepted. Support for this adjusted
estimate of capital loss is supplied by Liles. In his examination of the
histories of two venture capital firms, American Research and Development
(ARD) Corporation and Boston Capital Corporation (BCC), Liles determined
that their respective losses over time were 11.3% and 18.0% of total funds
invested. 13 Both loss rates are certainly compatible with the 14-17%
estimate of losses calculated in this paper.
Liles has suggested that one important measure of venture capital
performance should be the amount of invested capital which is lost.
11This dimension of performance--few losses while maintainihg upside op-
32
portunities--implies that measures and evaluations of venture capital per•
formance should include means for assessing how well management succeeded
in keeping losses down in addition to how well they kept the opportunity
open, and possibly achieved, substantial gains. 1114
Speaking of the importance assigned to losses by ARD, General Georges
Poriot is said to have remarked, "It hurts my conscience because these
losses come out of (equity) capital. Losses are always net. 111 5
The need for venture capital funds management to minimize losses on
invested capital as part of its enabling strategy is especially important
in the case of leveraged funds such as Small Business Investment
Corporation (SBICs). To illustrate, the impact of ~ifferent Joss rates
on two fully invested venture capital funds--identical in all respects
except for capital structure--wil1 be examined. As illustrated in Table
VI I I, Fund A consists of 100% equity capital and Fund B has a 2:1 debt/
equity ratio--a capital structure which would approximate that of a large,
fully-leveraged SBIC. Both funds are analyed under two sets of circum-
stances: (1) Scenario I, in which the loss rate is 11.3% of invested
capital, the rate achieved by American Research and Development: and (2)
Scenario II, in which the loss rate is identical to that of Boston Capital
Corporation--18%.
33
Initial Capital Structure
Equity Capital Debt Capital
Total Capital
Initial Debt/Equity Ratio Interest Rate on Debt Capital Annual Debt Service Requirements
Scenario I
Loss Rate on Invested Capital Amount of Loss Capital Structure after
Realization of Losses Equity Capital Debt Capital
Total Debt/Equity Ratio Loss of Equity Capital Required Return on Remaining
Capital to Meet Annual Debt Service
Scenario 11
Loss Rate on Invested Capital Amount of Loss Capital Structure after
Realization of Losses Equity Capital Debt Capital
Total Debt/Equity Ratio Loss of Equity Capital Required Return on Remaining
Capital to Meet Annual Debt Service
TABLE VI 11
Fund A
$6,000,000 0
$6,000,000
0
11.3% $ 678,ooo
5,322,000 0
$5,322,000 0
11. 3%
0
18.0% $1,080,000
$4,920,000 0
$4,920,000 0
18%
0
Fund B
$2,000,000 4,000,000
$6,000,000
2: 1 10%
$ 400,000
11.3% $ 678,000
1,322,000 4,000,000
$5,322,000 3. 026: 1
33.9%
7.52%
18.0% $1,080,000
$ 920,000 4,000,000
$4,920,000 4. 348: 1
54%
8.13%
Under Scenario I, equity holders in Fund A experience a loss of 11.3%
of capital while owners of equity in Fund Blose 33.9% of their orginial
34
investment. The occurrence of Scenario I I will result in an equity loss
of 18.0% to owners of Fund A and a loss of 54.0% for equity investors in
Fund B. Under either scenario, the equity investors in Fund B may event-
ually benefit from the effect of ·leveraging if the portfolio of invest-
ments becomes profitable. However, during the interim period from the
time when losses are realized usually within two years of investment until
the realization of gains (probably 5-10 years), the fund will be charac-
ter ized by (1) a very thin equity cushion, specifically a debt/equity
ratio of 3.026:1 (Scenario 1) or 4.348:1 (Scenario I I); and (2) the con-
tinuous requirement to earn 7.5ZJ{. (Scenario I) or 8.13% (Scenario I I) on
remaining invested capital to serve annual debt obligations. The following
operating guideline consequently assumes importance for the portfolio funds
manager:
Operating Guideline 19: While the minimization of losses on invested capital should be an integral component of the enabling strategy of the venture capital fund independent of capital structure, its importance increases significantly with the amount of leveraging used to capitalize the fund.
Management Efforts to Minimize Losses
It next seems appropriate to suggest actions which funds management
might pursue in order to minimize losses. Three categories of actions are
addressed: (1) the orientation and role of the venture capital staff;
(2) the rate at which new investments are made; and (3) the holding per-
35
iod of investments.
Lile's study of ARD and BCC reveals that management of both firms had
originally planned to offer substantial amounts of management assistance
to portfolio companies. However, the rate at which each firm funded new
situations soon resulted in their respective professional staffs' being
faced with substantially different sets of problems to manage. Table IX
compares relevant data about ARD and BCC.
TABLE IX
ARD BCC
Date of Initial Capitalization
Amount of Initial Paid in Capital
Approximate Proportion of Initial
August 1946
$3.4 million
September 1960
$20.6 million
Cap i ta 1 Invested During In i ti a 1 18 Months of Operation
Number of Situations Funded During Initial 18 Months of Operation
Number of Situations Funded During Initial 30 Months of Operation
41% 50%
8 23
33
Loss Experience-% of Invested Funds
11
11. 3% (1946-1971)
18. 0% ( 1960-1970)
Li Jes describes the difference in managerial orientation which re-
sulted from the different rates of funding new ventures:
ARD's staff concentrated its efforts largely on management assistance to portfolio companies with problems ... keeping successful investments and working with problem portfolio companies instead of getting rid of them meant that little turnover of capital was achieved from early sales of portfolio holdings. At the same time however working with companies helped produce a record of performance that showed modest early gains and few realized losses.
36
In a review of the firm's activities through May of 1963, the Boston Capital concluded that the company 1 s most frequent error had been to give money to its affiliates 'too much and too fast•.16
Boston Capital's early plunge into many investment situations soon produced more problems than the staff could adequately handle through management assistance. Consequently, the major effort was shifted from portfolio company assistance to the sale or merger of portfolio companies. As a result, Boston Capital's performance showed a number of early realized losses, but with this approach, the overall situation was improved, and several investments eventually produced sizable gains.17
Because ARD funded new situations more slowly, its professional staff
was better able to work with problem situations which occurred in portfolio
companies. Moreover, the smaller number of portfolio companies enabled the
staff at ARD to work with its problem companies rather than selling them
at a loss. While this management approach probably increased the average
investment holding period, it also seems to have contributed to a lower
loss rate.
Start-Up vs. Second-Round Investment Situations
It is useful for funds management to understand the relative charac-
teristics of investments in start-up, as opposed to second-round, situ-
ations. Therefore this section addresses the following issues:
What are the relative investment requirements for start-up and
second-round situations?
37
• What is the relative riskiness of start-up and second-round invest-
ment situations?
Table X contains summary data on the 368 investments examined in this
study. Of the $219.72 million invested, $150.701 million or 68.59% of
total capital was invested in 272 start-up situations. The average invest-
ment was approximately $554,000. In contrast, $69.019 million was invested
in 96 later-round investments, indicating an average Investment of $719,000.
Table X may also be used to compare the riskiness--the proportion of total
invested capital which is lost--of start-up and later-round investments.
TABLE X
COMPARISON OF INVESTMENTS IN START-UP AND LATER ROUND SITUATIONS
Number of Investments
Total Amount of Investments*
Number of Liquidations
Amount Invested in Liquidations*
Amount Lost in Liquidations*
Average Size of Investment*
Proportion of Investment Made in Liquidations
Proportion of Capital Invested in Liquidations
Proportion of Capital Lost through Liquidations
*Millions of dollars
Start-Up Situations
272
$150.701
49
$ 18.943
$ 18.078
$ .554
18.01%
12.57%
11. 99%
Later Round
Situations
96
$ 69.019
11
$ 5.996
$ 5.641
$ .719
11.46%
8.69%
8.17%
While 11.99% of total capital was lost to liquidated statt-up
ventures, only 8.17% of total capital invested in later-round situations
was lost in liquidations. Furthermore, the proport ion of total ventures
which eventually were liquidated were 18.01% and 11.46% for start-up and
for later-round situations respectively. Thus, the final operating guide-
line formulated for the funds manager is as follows.
Operating Guideline 20: Approximately 11.99% of total capital invested in start-up situations and 8.17% in second-round situations was found to be lost in liquidations. (However, this does not take into account losses from marginally successful ventures sold at loss. )
Thus, it would appear that assertions made in the literature--that
start-up investments are smaller than later-round investments and that
start-up investments are riskier than later-round investments--were shown
to be true for our data.
While the losses due to liquidations of 11.99% and 8.17% may seem
inconsistent with the earlier estimate that 14-27% of venture capital is
lost through unprofitable investments, the fact that the latter range of
14-17% is adjusted for losses due to the sale of marginally profitable in-
vestments suggests that the estimates of 11.99% and 8.17% shou·Td be in-
creased. However, the conclusion that start-up situations are riskier than
later-round situations remains unaltered.
39
SUMMARY
This paper has sought to build on Liles' work in the development of
an effective "enabling strategy" for venture capital funds management by
formulating a set of operating guidelines for the portfolio manager.
These operating guidelines are designed to assist the funds manager in
making venture capital investment decisions.
The management guidelines developed to effect the three investment
parameters examined in this paper are summarized below.
INVESTMENT PARAMETER
Capital Requirements of Investee Ventures
OPERATING GUIDELINE
1. There are minimal capital requirements which a venture capital organization must meet before it can realistically expect to finance new ventures effectively.
2. More successful investment situations require larger amounts of investment capital than ones which fail. Average investment sizes for the three classes of investments were $838,000 for 11highly successfu 1, 11 $562, 000 for 11successful, 11 and $416,000 for liquidated ventures.
3. While most initial venture capital investments are $500,000 or less, those ventures which become successful frequently require subsequent and significant infusions of additional venture capital.
4. The capital needs of successful portfolio ventures subsequent to initial financing imply (a) the need for a reserve fund to further support successful ventures within
40
INVESTMENT PARAMETER
Investment Liquidity
OPERATING GUIDELINE
the venture capital organization, and (b) the venture capital portfolio should avoid becoming fully invested.
5. $416,000 likely represents a typical average initial investment size for both successful and unsuccessful ventures.
6. Venture capital portfolio management should avoid investing more than 70% of its total capital in the initial financing of investee ventures. Conservative investment practice would dictate that no more than 50% to 60% of total capital go in initial investments .
7. A reserve of 40% to 50% of an investing organization's total capital should be set aside for subsequent support of successful ventures.
8. New deals should be funded at a relatively slow rate.
9. Approximately 12.6% of all invested venture capital flows to firms which eventually achieve a size sufficient to have public stock offerings. The average size of these investments has been found to be approximately $881,000.
10. Approximately 72.4% of venture capital is invested in highly il liquid situations.
11. One mechanism available to the portfolio funds manager for ensuring termination of a venture is the use of debt as an investment vehicle.
41
INVESTMENT PARAMETER
Investment Liquidity
The Riskiness of Venture Capital Investing
OPERATING GUIDEL INE
12. Another policy for ensuring the termination of an investment is through the guarantee of loans to new ventures in return for an equity position in those ventures.
13. A third operating guideline to facilitate investment termination is through the use of Employee Stock Option Trusts (ESOTs).
14. The repurchase of a venture capital commitment by the investee venture represents a fourth mechanism for terminating an investment.
15. Based on this analysis of 368 ventures, it appears that 11.35% of total capital was invested in liquidated ventures and 10.79% of total capital was lost in liquidations.
16. Liquidations of ventures usually occur within two years of initial investment.
17. It is unlikely that liquidations account for the totality of loss in venture capital investing.
18. Analysis of the data yields the conclusion that approximately 17.2% to 20% of invested capital is lost to marginally successful and liquidated ventures, assuming that all investments are the same size. Although it is not possible to compensate for the smaller size of unsuccessful investments, it seems likely that such compensation would lead to the estimate that about 14% to 17% of invested capital is lost to
42
INVESTMENT PARAMETER
The Riskiness of Venture Capital Investing
OPERATING GUIDELINE
ventures which are sold at a partial loss or which fail completely.
19. While the minimization of losses on invested capital should be an integral component of the enabling strategy of the venture capital fund independent of capital structure, its importance increases significantly with the amount of leveraging used to capitalize the fund.
20. Approximately 11.99% of total capital invested in start-up situations and 8.17% second-round situations was found to be lost in liquidations. (However, this does not take into account losses from marginally successful ventures sold at a loss.)
In making investment decisions, the venture capitalist must integrate
a number of financial variables. They include portfolio objectives, the
costs of servicing the investment, the risk premium required to compensate
for capital losses from unprofitable investments, and the holding period
required for the investment. Ina comparison paper, these variables are
integrated into a consistent managerial methodology for the venture capital
funds management process: portfolio selection, operation, and control.
The writer hopes that combining this managerial methodology with the
operating quidelines herein will lead to a better understanding of the
venture capital process and, ultimately, to more effective and professional
venture capital funds management.
43
ENDNOTES
1Research findings are reported in their entirety in 11The Measurement and Assessment of Capital Requirements, Investment Liquidity and Risk for the Management of Venture Capital Funds, 11 a doctoral dissertation by Terry Dorsey at The University of Texas at Austin.
2Patrick R. Liles, Sustaining the Venture Capital Firm (Cambridge, Massachusetts: Management Analysis Center, 1977), 1-2.
3Diebold Group, Inc., Final Report Phase Three Venture Capital Investment Guarantee Study (National Science Foundation, December 1974), 6.
4Diebold Group, Final Report, 6.
5Although data on 371 investments were collected three investments had to be deleted from analysis for lack or inconsistency of data.
6Diebold Group, Final Report, 23.
7Diebold Group, Final Report, 24.
8Diebold Group, Final Report, 7.
9charles River Associates, 11Small Technology-Based Firms as Investment Opportunities11 (US Department of Commerce: Experimental Technology Investment Program at the National Bureau of Standards, 1975), 12.
lOThe maximum size of firm included in the New Issue Barometer has been increased from a net worth of $5 million to a net worth of $10 million. This shift suggests that capital requirements for successful new ventures have increased.
11 Terry Dorsey, 11The Measurement and Assessment of Capital Requirements, Investment Liquidity and Risk for the Management of Venture Capital Funds 11 (Ph.D. Dissertation, The University of Texas at Austin, 1977), 149.
12Nilo Lindgreu, 11 Signposts on the Trail of Venture Capital, 11
Innovation, 4 (1969), 49.
l3Liles, Sustaining the Venture Capital Firm, 150.
14L. l S . . h V C . l F. 150 1 es, usta1n1ng t e enture ap1ta 1rm, .
44
1511The Go 1 den Touch of American Research and Deve 1 opmen t , 11 Dunn's Review (November 1968), 43.
16L. 1 S . . h V C . 1 F. 119 1 es, usta1n1ng t e enture ap1ta 1rm, •
17Liles, Sustaining the Venture Capital Firm, 146.
45
BIBLIOGRAPHY
Charles River Associates. 11Small Technology-Based Firms as Investment Opportunities. 11 Prepared for the Experimental Technology Incentive Program at the National Bureau of Standards, US Department of Commerce, 1975.
Diebold Group, Inc., Final Report Phase Three Venture Capital Investment Guarantee Study. Prepared for the National Science Foundation, December 1974.
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