Tuesday, March 28, 2006

Don't Hate me because I'm a Venture Capitalist

It's no secret that entrepreneurs don't enjoy the fund-raising process. Managers always feel like they understand their business as well as it can be understood and get frustrated with the amount of time it takes the `smart money' to get it. Managers are afraid that the venture firm was never really interested in the first place and instead were planning on backing a competitor. Managers believe that the terms are bad, the valuation is low, and that the VC shouldn't make so much money if it is really the manager that did all the work. Sometimes, managers even believe that the VC is out to steal the company, replace the management, and take the best ideas public without the manager's involvement and make millions or billions of dollars. Is it true? Maybe- but probably not.

There are lots of fair criticisms leveled at the VC industry from `too little money chasing too few deals' to `Venture firms' individual portfolio needs or preferences can keep a manager from growing his business the way that he wants to'. But is it an evil plot? no it is not.

Venture Capitalists have raised $10's or $100's of millions of dollars from large institutions that are interested in delivering pension benefits to their retired employees. They do not want to be in a situation where they fail to deliver those benefits, so they are not interested in taking on large amounts of risk. However, they do expect a premium return based on their willingness to tie up their money for a long period of time (10 years) and for investing in smaller or less liquid securities. How does risk management then play in?

First, the pension managers will diversify their own portfolios so that `illiquid assets' are not too big a percentage of their funds (so if the asset class fails they have other assets that might pick up the slack); next they put the venture firms that they invest in through a rigorous due diligence process that takes months (and sometimes years). Finally they put in place some degree of restrictions on what types of deals the firms they invest in can do.

Once the money arrives at the doors of the venture firm, one of two broad strategies will generally be applied. The first is to manage risk through diversification. This type of firm generally believes that it is virtually impossible to know which companies will be winners and losers on day one. As such, they have a simple set of rules that dictate that every investment that they make has the possibility of generating a 10-20x return. By taking this approach, only a certain type of idea (the big idea) gets through the gates, and only a certain valuation gets approved (low) because otherwise the upside isn't enough to get that type of multiple. Using this model a portfolio might have 20-30 companies, and the VC may be hoping for 5-10 winners, knowing that there will probably be at least 10 washouts. However, if those 5-10 actually generate 10x-20x return, then the portfolio as a whole will meet the return objectives of their investors and the VC firm stays in business. Why does a manager/entrepreneur even consider such an approach (they are going to pay me very little for a really big idea)- because the idea is only big if they have capital to attack it, and the big VC firms have all the capital that the entrepreneur can use. In addition, VC's often have industry relationships with past portfolio companies or otherwise that can help the growth process along.

The other way of managing risk at the VC level, is vigorous due diligence. This type of VC wants to truly understand every aspect of the business (whether management views those elements as relevant or not), the financial model, the customers and the strategy. What are the key assumptions, the market sizes, and track record of management. Why? because if they really understand it, they will pay higher valuations and expect a lower overall return. Does management like the due diligence process- absolutely not. Does management like the higher valuation and more favorable terms- absolutely. Our firm, Pharos Capital, tends toward the latter approach but certainly there are successful firms in both categories.

On the topic of VC's spending time on a company just for competitive purposes, or wasting management time when they are not really interested- I am personally not familiar with cases like that. VC's stay sufficiently busy that wasting their own time never really makes sense. There is always another deal out there to try to track down.

Make no mistake- you won't like every VC that you come across. The industry definitely attracts type A personalities. However, for every professional that is in the business because he thinks he can make a lot of money, there is a professional who truly enjoys the business building process and helping small companies succeed. The VC industry is a necessary part of the US economy, which is far and away the most dynamic and entrepreneurial in the world- as such, reserve judgment or at least, don't hate me because I'm a VC.

For the counter position to my piece, an interesting article is at: http://www.paulgraham.com/venturecapital.html

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