Mastering Private Equity. Prahl Michael

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For VC funds to achieve their fund-level target return,27 low-performing and failed investments must be offset by at least one or two highly successful – and highly visible – investee companies that generate a return of 10 times (10×), 100 times (100×) or more on the VC’s invested capital. These “home runs” often return 100 % or more of a single fund’s committed capital and determine the success of an entire fund. This tail-heavy, feast-or-famine return profile underscores both the riskiness of VC investing and the significant risk appetite required from limited partners (LPs) to include VC funds in their private equity (PE) programs.28

      The high risk of VC investments has a distinct impact on venture capitalists’ investment decisions and their portfolio management style. Reflecting on the risk of failure, VCs require high deal-level target returns when exploring the next investment: a 40−80 % target internal rate of return is not unusual and feeds directly into the valuation and equity stake underpinning the investment.29 VC funds typically invest in more companies per fund than growth or buyout funds to increase the chances of a “home run” and to diversify their risk. The larger number of portfolio companies and the high rate of failure require VCs to make tough decisions and (potentially) write off underperforming investments quickly to focus their time and resources on the most promising companies. Entrepreneurs are well advised to be aware of these dynamics before presenting their business plans to a VC fund.

      The risk−return dynamics of VC investing are a concern for its investors. While limited partners remain intrigued by the industry’s well-publicized winners and its fabled returns, a landmark report by the Kauffman Foundation published in 201230 raised doubts on the return contributions from venture to an institutional portfolio, implying that the risks may outweigh the strategy’s return and that LPs make decisions based on “seductive narratives like vintage year and quartile performance.” It suggested that the LP investment process may be broken, and that LPs have themselves “created the conditions for the chronic misallocation of capital.”

      FUNDING IN STAGES: VC funding is raised via discrete rounds of investments. Each round will fund a start-up’s operations for a specific period of time and enable the company to reach a predefined operating milestone.

      Deploying funding in stages allows a VC fund to assess the progress of the company against milestones and allocate follow-on capital to the best performing companies in its portfolio. By spreading its capital out, the fund can invest in more companies thereby “buying an option” in more potential blockbusters. It also enables individual VC firms to specialize in a specific phase of company development, from early stage to late stage, and offer stage-appropriate expertise.

      Successful VC-backed companies are typically funded through progressively larger rounds of preferred equity.31 Each subsequent VC investor will look for positive momentum (as proof of the company’s value proposition) and for signs of successful execution. The preferred shareholding structure establishes a hierarchy of claims on future proceeds in the event of an exit…or liquidation.

      In each financing round, entrepreneurs and existing investors give up a share of their equity in exchange for additional capital, with the percentage largely depending on the amount to be raised and the new investor’s return expectations, which take into account the company’s riskiness and its forecasted value at exit.

      In the case of a successful start-up, raising capital step by step allows an entrepreneur to benefit from progressively higher valuations and give up less equity per dollar raised as the business matures.

      START-UP DEVELOPMENT

       VENTURE CAPITAL TARGETS

      A start-up will navigate several stages of development before reaching profitability and a steady state of operation. Along the way, the company draws capital and expertise from different types of investors in the VC ecosystem. While each start-up follows a unique path, three distinct stages of development can be defined: proof-of-concept, commercialization, and scaling up. It should be noted that the vast majority of start-ups will never reach this final phase of accelerated growth.

Exhibit 2.2 highlights the type of investment required at the respective stage to successfully grow and scale a business.

Exhibit 2.2 Start-up Development and Funding

      PROOF-OF-CONCEPT: Companies at this stage have little or no track record and only a concept of a product, technology or service. Small amounts of funding are required to conduct product feasibility studies, define relevant markets, formulate a business plan, and develop a prototype. Once the product or service is developed, engaging with and securing a user base to show that the idea has the potential to translate into a successful long-term business is a critical step to achieving proof-of-concept and attracting further funding; it also shows that the founding team has the ability to execute. During the proof-of-concept stage, company development is funded by seed investment often provided by the entrepreneur, friends and family, business angels or seed-stage VC investors.

      COMMERCIALIZATION: After a company’s value proposition has been validated by a group of core customers the focus shifts to translating the idea into an operating business and growing the top line. Companies at this stage of development focus on refining the product or service offering, expanding the sales and marketing functions, filling out missing capabilities in the core management team, and targeting large-scale customer acquisitions. They start to generate revenue but are far from cash flow positive; building up operations naturally increases operating cost, which combined with the initial working capital and capital expenditure needed in a growing business results in a high burn rate. In many cases, funding raised from VCs to drive commercialization are the first injections of institutional capital.

      SCALING UP: This stage is all about expansion and market penetration. By now, companies are typically growing exponentially and are on their way to profit or even operating cash flow breakeven. However, profits generated from operations are reinvested in the company and may need to be supplemented by additional VC funding to meet market demand. In addition to rapidly growing a start-up’s core offering, funding is needed to expand product and service offerings to differentiate the company from competitors and to balance product-specific sales fluctuations. Mid- and late-stage VC investors, along with growth equity funds, are the main investors at this stage.

      Box 2.1

      VENTURE CAPITAL REMAINS US FOCUSED

Geographic location is crucial for VC as an asset class, given the importance of networks when growing early-stage companies. The deepest, most “developed” VC ecosystems can be found in the United States – Silicon Valley in particular – but other geographies such as China, India, Europe and Israel have seen active clusters emerging. Successful VC communities not only have complementary funding vehicles that support early-stage growth with angel investors, crowdfunding platforms, corporate venture capital, and government funding vehicles, but provide ready access to follow-on rounds and serve as magnets to attract the talent needed to scale quickly. Exhibit 2.3 shows the total amount of venture capital invested by geography over three consecutive five-year periods starting in 2001.

Exhibit 2.3 Global VC Investment by Geography

      Source: Preqin

      THE VENTURE CAPITAL INVESTMENT PROCESS

      

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