Sources of Capitalfor Entrepreneurial Firms

Harry J. Sapienza, PhD.University of Minnesota

Ozyegin University, July 25, 2012

25 Years of StudyingVenture Capitalists and Entrepreneurs• How do VCs create, manage a portfolio of

investments? What influences success?• What roles do Investors play? How similar/

different are these around the world?• When do investors add more than money?• When do entrepreneurs learn from investors?• When do investors learn from entrepreneurs?• What are causes and effects of conflict?• How do investors make “gut” level judgments?

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Studies/ data collected over time• VC Roles, VC-Entrepreneur conflict, valuation of investors, U.S.• Roles, valuation of investors, UK, France, Belgium• Roles of investors, Asia• Target returns U.S., Europe, Asia• Information exchange, fairness, U.S.• “Ideal” contracts and role of trust, U.S.• Syndication, reputation, involvement, U.S., Europe• Learning by Investors, U.S.• Decisions to Terminate or Exit at a Loss, U.S.• Innovation and “Angel” Investor roles, U.S., Europe• Business models and investors, Europe• Entrepreneurs use of Story and investor evaluations, U.S.• Signals of Competence and Integrity and Investor evaluations

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Outline of Today’s Topics• (Outside) Sources of a Venture’s lifeblood• “Appropriateness” of Sources• Goals and Types of Entrepreneurs• Tapping into venture capital– often an uneasy

marriage: Formal and Informal Venture Capital• Formal (Institutional) VC• Comparison of formal VC and informal VC• Research Reflections on VC-E Relationships

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

• The typical entrepreneur does not want to grow his business to extremely large proportions

• However, even modest startups often need more money to get going than is available

• This is where lending or investing starts…A necessary evil?

Ozyegin University, July 25, 2012

New Venture Money:A Messy Proposition

Introduction Fund Sources Formal VC Informal VC Reflections

Typical Sources of Funds • Own savings/ earnings• 3F’s: Family, Friends, other Fools• Customer advances, Supplier Credit• Bank Loans• Government loans, grants, etc.• Private individuals (“Angels”)• Angel syndicates• Private Venture Capital, (Gov’t Venture Capital)• Corporate Venture Capital

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

How Stage or “Burn Rate” affectsAppropriateness of Sources

• Development and pre-sales• Early sales• Growth• (Somewhat) Steady state

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

How Growth Goals (or lack of)Affect Appropriateness of Sources

• Most funding sources do not necessarily care whether you seek to grow rapidly or not.

• For institutional venture capital, rapid growth in the period following investment is critical

• For most business angels growth will be important but need not be as dramatic

• For corporate venture capital, growth is good but technology or customer space may suffice

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Preferences for Control Versus Return

• ‘Passion’ about the venture may take several forms– e.g., – passion to build the best technology, – to solve an important or personal problem– to create something for the family– to create an organization one can run well

• From an equity point of view the key is, how important is it to maintain control?

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Serial vs. First time or one time Entrepreneurs

• “Serial” entrepreneurs, ones who have created several successful ventures, are very attractive to equity investors. Why?

• An untested, first time entrepreneur is risky• The team of founders may be most critical;

Yet, there must be a leader

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Single versus Multiple-founder Firms

• The later the stage, the more important to have a complete team

• Some investors like to have a hand in filling out the team, but generally speaking a team of top-notch people is very positive--attracting great talent is a sign of value, charisma--having no redundant or useless parts is a sign of

the organizational and business judgment of the leader

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Informal and Formal Investors

• Much more is known about private, institutional venture capital firms (VCFs), though private individual investors (business Angels) have been around as long commerce has existed

• We begin with formal venture capital, then compare what is known about business angel investing and how it has learned from formal VCFs

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

VCF Structure in U.S.• VCFs are organized as general partnerships,

typically 3-10 partners and a staff that works on information gathering, communication, etc.

• At any point in time, the VCF will have several “funds” to manage, each with a limited life, typically of 10 years, maturing at various times

• Limited partners “own” the funds VCFs manage, and limit their liability by leaving fund management to the VCFs

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

The Formal Venture Capital Cycle• Raising a Fund from Limited Partners– Track record of General Partner VCs– Investment climate and money availability

• Screening Criteria for potential investments• Due diligence• Deal negotiation• Portfolio management (next cycle begins here)• Exits and fund termination

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Pre-Investment Activities• Establishing a 10 year limited partnership;

conditions and terms (typically management fee, “carry,” restrictions on the general partners’ decisions and activities– no direct say in management of investees)

• Raising a fund• Searching for a pool of viable investments• Investigating only the top prospects• Negotiating 1st round of investment, investment

rights

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Criteria for Venture Selection

• Quality of Top Management Team, Lead Entrepreneur

• Market Size, Competitiveness, Growth Potential

• Viable Exit Routes• Significant barrier to Duplication

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Valuation and Negotiation

• Use of Selection Criteria• Setting ‘pre-money’ valuation is a backwards

process• Setting terms to – protect right to participate in success, – minimize damage (to extent possible) in failure

• Negotiate information rights, board seats, future equity fund raising, hiring

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Once the First Money Is In• Typically, monthly reports are sent to investors,

focusing on progress on “milestones”• Board meetings may be bi-monthly or quarterly,

with frequency highest at earliest stage• Boards most often around 5 people: VCFs having

2 or 3 seats, 1 expert outsider, 1 or 2 managers• Money is put into the venture in “rounds” and

“tranches”– serving several purposes

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Good Times and Bad

• Investors expect most of the ventures to be disappointing-- most returns come from few

• The difficulty is determining whether to keep the venture on life-support, or terminate

• Rough times are common; decision is not trivial. Investors vary in incentive to continue

• When things are going well, the toughest decision may be about leadership transition

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Exits

• Happy exits:– In some cases, management buyback,– Most commonly, acquisition or trade sale– Highly desirable (in most ways) to investors, is the

initial public offering

• Not-so-happy exits:– Liquidation or buyback

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Goal Differences AmongInvestors

• Often the greatest conflict regarding the fate of ventures has to do with the circumstances of the investors. Things that may cause these differences include:– Differential liquidation rights– Inability to participate in further equity rounds– Differences in time horizons or needs for cash

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

The Rise of Sophisticated Angels

• Long history of ‘Private’ Investors• Angel Investing is “venture capital-equity investments

made by private individuals, directly in unquoted companies in which they have no family connection...”

• It fills the gap between founders, family and friends and institutional venture capital funds

• substantially larger than formal VCF market -- in terms of amount invested in businesses at their start-up -- and in terms of the number of such deals made in early stages

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Ozyegin University, July 25, 2012

Key Aspects of Business Angel Investing

• Unlike family/ friends, “arms length” relationships• Unlike VCs, BAs are investing their own money• BAs typically cannot get the same equity per $/TL as VCFs • Significant barriers to linking BAs and entrepreneurs• Estimated

– 3x to 5x the money; – 40x the number of deals

• Countries, regional authorities, entrepreneurs, and BAs have all tried to increase connections

Introduction Fund Sources Formal VC Informal VC Reflections

Portrait of a ‘Typical’ U.S. Business Angel (circa 2000)

• Age 47-54 years old• Sex Male• Annual family income ~$100,000• Net worth ~$2 million• Experience Extensive, some entrepreneurial• Education Bachelor’s; half with advanced• Number of investments 2 every three years• Investment rate in 8% of deals• Average amount invested $60,000• Preferred stage Startup 56%; Earlier 24%• Co-investment Formerly alone, now syndicating • Control 56% have minority voting position

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Ozyegin University, July 25, 2012

Business Angels Around the World

• Evidence suggests that the profile of business angels is similar around the world

• Typical investment in ‘chunks’ of – $10,000– $25,000– $50,000* mode– $100,000– $250,000

• BA investing recent trends– More sophistication in diligence, terms, negotiations– More syndication

Introduction Fund Sources Formal VC Informal VC Reflections

Ozyegin University, July 25, 2012

Angel vs. VC Characteristics and Practice

• VCs have more investing experience• BAs have more startup management experience• VCs have wider, more consistent access to new deal flow• VCs ‘share’ flow more• BAs conduct less due diligence• BAs use less routinized valuationQuote from Angel: “...I rely less on the numbers, but more on the subjective

impression of the entrepreneur--it has to feel right and I have to believe in it. I don't have to be analytical, I can go on instinct unlike the venture capitalist. I don't have to rationalise my investment decision to a boss at the end of the day"

Introduction Fund Sources Formal VC Informal VC Reflections

Ozyegin University, July 25, 2012

Investment Motivations of Angels

Angels rate making money highest, but two other motivations are also important:

Realize financial gain 4.09 rating out of 5Play role in entrepreneurial process 3.68 rating out of 5Have fun, achieve satisfaction 3.68 rating out of 5

“...I feel this is a fantastically exciting sport!” Angel quote

Van Osnabrugge, 1999*

Introduction Fund Sources Formal VC Informal VC Reflections

Ozyegin University, July 25, 2012

Sampling of Top Investment Criteria for Angels Comparison with VCs

1. Enthusiasm of entrepreneur 4.692. Trustworthiness of entrepreneur 3. Sales potential4. Expertise of entrepreneur 4.335. Likes entrepreneur upon meeting6. Growth potential of market7. Quality of product 4.158. Investor involvement possible9. Able to reach break even without more funding10. Low initial expenses 3.4411. Is local12. Investor understands business/industry13. Good potential exit routes 3.12

Above scale is of importance of criterion from 1= not important, 3= somewhat important, and 5= extremely important

Introduction Fund Sources Formal VC Informal VC Reflections

Ozyegin University, July 25, 2012

Significant Differences in Angels’ and VCs’ Criteria

• In comparison to VCs, Angels– rely less on the expected financial return criterion– are more concerned with cost containment criteria– focus less on entrepreneur’s track record & expertise– are more concerned the venture is nearby– are more insistent on being operationally involved– are more interested when own strengths fill venture gaps– rely less on the business plan – are less concerned that a clear exit path exists

Introduction Fund Sources Formal VC Informal VC Reflections

Recent Experience as Angel Investor

• “Bands of Angels” becoming common• Sophistication / professionalism of practice

increasing, but still much “solo flying,” and still much room for personal motives

• Loose organization like herding cats• Dedication, risk-taking on individual level

varies widely• What I like…

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Reflections from Research, Practice• Quality of relationship is very important in rough

times– times are rough more often than not• Process favors those with greater stack of money• The closer the relationship the more conflict, but

also more satisfaction (all else equal)• A venturing ‘community’ tends to develop in

areas with great activity; reputation is critical• ‘Gut feel’ and group process play big roles • Entrepreneurs are optimists, investors are

pessimists

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Advice to Entrepreneurs• Seek appropriate sources of funding• Understand yourself– is control of the creation

more important than wealth realization? • If you do take VC, do your own due diligence• Understand that investors’ want to get out

with as much as they can as soon as they can• Keep the investor informed throughout the

relationship; honesty and openness lead to better terms, more leeway

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections

Conclusion

• I have found this process to be a fascinating blend of the personal and the impersonal

• It is about making good, well-considered decisions in the face of tremendous uncertainty: persistence, determination, and risk-taking with reason

• It is also very much about people. This should be not be forgotten.

Ozyegin University, July 25, 2012

Introduction Fund Sources Formal VC Informal VC Reflections