Cache Creek Partners’ Venture Capital Primer has been used by McGraw-Hill’s Online Learning Center in support of its textbook Principles of Corporate Finance, Sixth Edition (Brealey & Myers); by Harvard University in support of KSG PED-328 Community Financial Institutions and Microfinance in Theory and Practice and by other notable colleges and universities.
What is venture capital?
Venture capital is capital invested or available for investment in the ownership element of a new enterprise. While there may also exist a preferred return or debt component, the defining characteristic is that the capital investor retains some equity in the venture.
There are several types or stages of venture financing typically referred to as:
1. Seed
2. Start-Up
3. Second Stage
4. Third Stage
5. Mezzanine
6. Initial Public Offering (IPO)
What is seed money?
Seed money, seed capital or seed financing is venture capital used to finance the early development of a new product or service concept. Generally, it is usually the most expensive in terms of equity concessions since there is no guarantee that the product or service under development will ever make it to the stage of a workable prototype much less a viable commercial enterprise.
What is start-up capital?
Start-up capital usually refers to venture funding sufficient to generate initial sales and profits. Our view is that if an initial private placement, distributed on the basis of a viable three-to-five-year plan to reach fundamentals sufficient to undertake a successful public offering, is fully subscribed, there should be no need for second and third-stage equity offerings. This is advantageous to both the founders, management team and first-stage investors in that neither suffer any subsequent dilution prior to the firm’s initial public offering (IPO).
Why would these later stages be necessary?
In the event that the firm’s initial private offering does not prove sufficient, the company may need to resort to additional debt or equity placements to raise more capital. This may become necessary due to management’s failure to utilize properly its initial financial resources or it may result from unforeseen changes in the company’s operating environment or from many other factors. If a follow-on-stage offering is used to fund an expansion that enables a company to later conduct a public offering, it is sometimes referred to as a mezzanine financing. In all later-stage financings you can be sure of one thing, management’s equity will almost certainly be reduced, drastically so in many cases. We’ve seen common share “cram downs” as bad as 60-to-one.
Is there a way to avoid later-stage financings?
The probabilities that later-stage private offerings will be necessary can be reduced by stating your total funding requirements up front and raising adequate reserve capital. Properly presented, investors should prefer this approach because it charts the most direct course towards the twin goals of profitability and liquidity.
Does that mean it’s best to ask for as much money as you think you can get?
We don’t believe so. We feel it is important to have a well-thought-out three-to-five-year financial plan and to balance the need for contingent reserves against the need to provide adequate return on investment. We believe that most investors want to see that management has both (i) requested sufficient capital to create a viable enterprise capable of effecting a successful IPO within a reasonable time frame and (ii) has a plan to utilize such capital in an efficient, cost-effective manner. Therefore, we believe it is wise to base a new venture’s financial projections and private offering plan on adequate and substantial, but not excessive, capital reserves.
What is an “IPO”?
IPO is the frequently-used abbreviation for initial public offering. Many venture investors think of it as “payday”. That’s because, if successful, an initial public offering will create a viable market for the company’s stock and provide its founders and early-stage investors with a cash return on their investment and, eventually, liquidity for their remaining shares.
Further, since liquidity is an intrinsically valuable investment component, the market will usually assign it some level of premium. At least part of a publicly-traded company’s market cap can be thought of as a liquidity premium as investors will pay more for a security which can be quickly and easily converted into cash than for an investment which offers a similar risk/reward profile but will require time and effort to liquidate.
What if I am seeking venture funding during a downturn in the stock or IPO market?
In the past few years, the IPO market has fluctuated between irrationally euphoric and virtually non-existent. Fortunately, since it is impossible to predict market conditions for more than a few months out, venture capitalists generally do not factor in the current state of the IPO market when considering new investments in start-ups.
“It is very hard to invest in anticipation of a market cycle. The companies we fund now are going to be going public two, three, four, five years from now. We have no idea what the [IPO] markets are going to be like at that point, so we might as well not worry about it,”
says Robert Nelson, Co-Founder and Managing Director of ARCH Venture Partners.
What is a “price/earnings ratio”?
A price/earnings ratio, or P:E, is a mathematical articulation of the relationship of a company’s earnings to its market capitalization as expressed as a fraction with the current share price as the numerator and the current after-tax earnings per share as the denominator.
For example, a company with a total of 10 million shares issued and outstanding, after-tax earnings of $5 million and currently trading for $6.00 a share would be said to have a price/earnings ratio (or multiple) of twelve-to-one (or simply 12). Notice if you multiply your earnings per share ($0.50) by 12 you get $6.00.
It’s important to realize that a stock’s P:E is not arbitrary; the board can’t declare it. The price/earnings ratio is determined by the market and is influenced by many factors including investors’ expectations of future earnings, the company’s book value and other fundamentals and all those factors which affect the public securities markets as a whole such as interest rates, inflation, unemployment, Federal Reserve policy, etc.
It is the potential for a private company to attain sufficient fundamentals to allow for a successful public offering, and, hence, a much higher price/earnings ratio (than for a privately-held firm), which provides a return attractive enough to warrant the risk usually associated with venture capital investing. And to a certain extent, industries which historically command higher price/earnings ratios should, on margin, be more attractive to astute venture investors.
Aren’t founders’ shares and private placement stock subject to restrictions on transfer? If so, how then do the founders and early-stage investors cash out?
Shares issued under private offering exemptions are subject to restrictions on transfer imposed by the Securities and Exchange Commission (SEC) Rule 144. Such stock is often referred to as legend stock, restricted securities or 144 stock and may not be sold immediately following the firm’s IPO. This protects IPO investors from a drastic drop in share price due to a sudden increase in supply and allows for the development of a healthy aftermarket.
There is a simple and fair way for founders and early investors to cash in at least some of their holdings and this involves the registration of a portion of their shares (and the sale thereof) in the firm’s initial public offering. As long as management continues to retain most of their holdings, the company’s underwriters (brokerage firms contracted to market the company’s stock to the public) and IPO investors will generally not view this as a bail out. Many entrepreneurial companies allow early-stage investors, and even founders, to register (and sell off) up to about 20 percent of their holdings in the IPO. Further, after one year, the SEC will generally allow limited sales of restricted securities and unlimited sales after two years.
Note: This is not intended as a complete discussion of Rule 144 but is given to demonstrate one method investors and founders may use to cash out.
What if the underwriters do think management is bailing out?
If management seeks to sell too many of its shares in the IPO, the company’s underwriters may balk. Naturally, they will be concerned that investors will shy away from the offering, interpreting this sell off as an indication that management is not thrilled by the company’s future prospects. The underwriters may demand other concessions (such as higher discounts) or they may conclude that the offering is not viable. Provided that the IPO is not premature, that is, it is based on sound economic fundamentals, a balance can usually be struck – and a do-able deal negotiated – which satisfies underwriters and IPO investors, results in a favorable market capitalization, a solid aftermarket and also puts significant cash into the pockets of the founders, managers and early-stage investors.
Who invests in start-ups?
Venture investors include:
1. Institutional venture capital funds typically organized as limited partnerships.
2. Corporations seeking to gain access to new technologies and/or markets.
3. Corporations seeking venture opportunities strictly to enhance return on equity.
4. Wealthy individuals who either specialize or have a percentage of their portfolio in venture capital investments.
5. Entrepreneurial business owners and corporate managers.
Says John H. Martinson, president of the National Venture Capital Association,
“The success of the venture industry is now attracting record amounts of growth capital from other sources such as corporate venturing programs. This expands the sources of growth funding available for entrepreneurs.
“While all venture investors can be assumed to fancy a profitable opportunity, secondary motivational factors, as well as corporate cultures, vary amongst the groups cited above.
To quote Prime Computer founder and prominent venture investor John Poduska,
“I do angel deals for some of the same reasons I support the ballet. Take one look at me and you’ll know I’m not a ballet dancer, but I like being part of something that’s worthwhile.”
On the other hand Corporate Venturing News reports that,
“Over 80 percent of corporate venture capital groups are investing primarily for strategic return.”
Hence, the strategies taken with respect to soliciting financial assistance from various investors may differ significantly. Part of what contributes to a successful private offering is the credibility gained by approaching prospective investors in a fashion with which they are comfortable and most likely to interpret as professional.
Through industry analysis, research, personal contact and experience, Cache Creek has developed a proprietary database of active, pre-qualified, accredited venture capital investors. These include both private and institutional investors who are interested in financing start-up ventures. Some may specialize in a particular area such as medical or high-tech ventures. Others may be open to virtually any promising opportunity.
The common denominators are:
1. They have or control substantial financial resources liquid and available for venture capital investments.
2. They actively investigate, review and invest in start-up ventures; they are not merely LBO funds masquerading as venture capitalists.
3. They have an established business relationship with Cache Creek Partners, its general partner, or other affiliate, sufficient to determine that they are sophisticated and qualified investors interested in exploring various types of venture opportunities.
Aren’t there securities laws concerning investor solicitations?
Yes, there are both state and federal securities laws regulating many aspects of private offerings which specify both civil and criminal sanctions for violators. Further, these laws vary from state to state and many statutes are subject to fairly complex legal interpretations. Potential problem areas include: prohibitions on general solicitation and public advertising; investor suitability and sophistication standards; sufficiency of previously-established business relationships; and form, accuracy and completeness of investment-inducing disclosures.
Don’t you have to register your offering with the SEC?
Federal law requires that an offering of securities be registered unless a specific exemption from registration is available. If no such exemption is available, a company seeking to offer its securities for sale must first register them with the Securities and Exchange Commission pursuant to the Securities Act of 1933. Such an issuer must complete a specified registration statement (such as a Form S-1) and obtain SEC clearance on its adequacy before offering its securities. The company must also satisfy the securities regulations (“blue sky laws”) of each and every state in which it intends to offer its securities.
Fortunately, both federal and most state’s securities laws provide exemptions from registration in specified circumstances. It is important to note, however, that a securities offering is never exempt from the anti-fraud provisions of the 1933 Act. Further, exemption from federal registration does not necessarily result in a corresponding state exemption nor is an exemption obtained in one state necessarily available in every state in which an issuer may wish to offer and sell its securities.
Though often thought of as a “mini-public offering”, private offerings differ from registered public offerings in the following ways:
1. Private offerings are generally less time-consuming and expensive in terms of legal, accounting, development and offering costs.
2. Disclosure requirements vary but are generally less extensive for a private offering.
3. Reporting requirements under the 1933 Act and certain other obligations of public companies are not triggered under a private offering.
4. Limits are imposed on the number and qualifications of investors allowed to purchase privately-placed shares and, in certain instances, on the amount which may be raised.
5. Market capitalizations will generally be less for a private offering due to constraints on the number of purchasers and restrictions on resales.
6. The publicity that results from a public offering, and the public image that accrues to a reporting company, will not be obtained in a private offering.
Today, the most commonly-used exemptions from federal registration requirements are the private placement and limited offering exemptions provided by the 1933 Act as modified by the Small Business Investment Incentive Act of 1980 and SEC Regulation D adopted on March 3, 1982.
According to SEC Release No. 6389, at 84,907, Regulation D is designed “to simplify and clarify existing exemptions, to expand their availability, and to achieve uniformity between federal and state exemptions in order to facilitate capital formation consistent with the protection of investors.”
Regulation D consists of six Rules, i.e., 501 through 506, which became effective on April 15, 1982 and two, 507 and 508, which became effective April 19, 1989. These rules set forth the conditions attached to Regulation D exemptions. Rules 501 through 503 define the uniform terms and conditions; Rules 504 through 506 describe the three specific transactional exemptions; and Rules 507 and 508 modify the previous Rules and address the consequences of an issuer’s failure to comply with the terms, conditions and requirements of Regulation D.
The most commonly-used exemptions from registration in the state of California are provided under Corporations Code Sections 25102(f) and 25102(h). In general, such offerings are restricted to an unlimited number of “excluded”, and a maximum of 35 “non-excluded”, investors who must be, nonetheless, sophisticated enough to evaluate the merits of the offering as well as financially-able to risk the loss of their entire investment.
Such prospective investors may not be contacted via public advertisement or general solicitations and must receive disclosure documents sufficient to satisfy the anti-fraud provisions of the 1933 Act. An application for permit under 25102(n) requires further restrictions on investor qualifications but allows for certain types of advertisements which would otherwise be illegal.
Employment of experienced securities counsel is an essential prerequisite to the successful placement of a private offering of equity securities; however, prior registration with the SEC is not always necessary in order to raise capital.
Note: This is not intended as a thorough or sufficient discussion of all aspects of securities law as related to limited offerings and private placements.
How much money is available for investment in venture capital situations?
During a six year run beginning with 1995, the venture capital industry witnessed an unprecedented expansion of resources and activity with a record of over $105 billion invested in 2000. From the second quarter of 2000 to the first quarter of 2003, the trend was negative but the total amount invested still exceeded $100 billion over the “down years” of 2001 through 2004.
Total Annual U.S. Venture Fund Investments
1995: $8,015,000,000
1996: $11,342,000,000
1997: $15,005,000,000
1998: $21,473,000,000
1999: $54,847,000,000
2000: $105,105,000,000
2001: $40,952,000,000
2002: $22,177,000,000
2003: $19,620,000,000
2004: $23,209,000,000
2005: $23,524,000,000
2006: $29,514,000,000
2007: $31,952,000,000
2008: $29,949,000,000
2009: $20,265,000,000
2010: $23,360,000,000
2011: $29,710,000,000
2012: $27,323,000,000
2013: $29,365,000,000
2014: $48,300,000,000
2015: $78,900,000,000
2016: $69,100,000,000
2017: $84,000,000,000
2018: $131,000,000,000
2019: $136,500,000,000
2020: $156,200,000,000
2021: $329,900,000,000
2022: $240,930,000,000
Source: National Venture Capital Association
Click here for graph of historical VC activity.
Click here for graph of current VC activity by region.
Despite of all the difficulties associated with an economy in recession, a stock market in decline, continued fallout from the dot-com fiasco and the attacks on the World Trade Center, U.S.-based venture fund investments exceed $40 billion during 2001 and $22 billion in 2002, at the time, ranking these years the third and fourth largest in history in terms of total dollars invested.
The year 2003 marked turnarounds in the economy, the stock market and venture capital funding. Venture capital activity hit its lowest level in five years (approximately $4.1 billion) during the first quarter of 2003 but, thereafter, the trend reversed and the year ended with $5.4 billion invested in the fourth quarter.
After three consecutive years of decline, venture capital investment increased 12 percent in 2004 with $23.2 billion invested in 3,228 deals and continued on course in 2005 with $23.5 billion invested in 3,293 deals and in 2006 with $29.5 billion in 3,882 deals.
During calendar year 2007, U.S. venture capital funds invested a total of nearly $32 billion in 4,227 deals, an increase of 16 percent over 2006 levels and the highest total dollar amount since 2001.
Even with the financial turmoil precipitated by the Fannie Mae and Freddie Mac fueled sub-prime mortgage fiasco of 2008, total U.S. venture capital activity still totaled nearly $30 billion for the year.
Following the election of the least market liberal president in U.S. history, venture capital activity plummeted to $20.3 billion in 2009, a 32 percent decline from 2008 and the lowest annual total since 1997.
Although a discouraging two-year period saw an overtly anti-capitalist executive branch coupled with one party control of both chambers of Congress, neither cap and trade nor union card check nor a single payer healthcare system materialized.
Investors responded to this less than worse case scenario with a 15 percent increase in venture capital activity. Funds invested in 2010 totaled $23.4 billion, on par with the post-Internet bubble slump of 2002 to 2005.
With the November 2010 election of the most Republican-dominated House of Representatives since 1946, the pace of VC activity accelerated. Total investments for 2011 exceeded $29.7 billion, very near the levels seen prior to the 2008 election. With over $27.3 billion invested in 2012 and $29.4 billion in 2013, the pace of the venture capital market, about $30 billion in total annual activity, resumes to a level very similar to that of the period of 2006 through 2008.
Institutional venture capital investments continued to surge into and throughout 2014 totaling $48.3 billion for the year, an increase of 61 percent over 2013.
In 2015, total investments surged to $78.9 billion followed by another robust year in 2016 during which approximately 550 funds invested a total of $69.1 billion.
The uptrend resumed in 2017 as US-based VC investments topped $84 billion and then again in 2018 when total investments exceeded $131 billion, the highest total ever, eclipsing even the $105 billion invested during the Internet boom year of 2000.
The surging flow of venture capital into US startups continued with new records set in 2019 ($136 billion) and 2020 ($156 billion) and then more than doubled in 2021 ($330 billion).
Venture capitalists invested a total of $241 billion into US startups in 2022, a sharp decline from 2021 but the second most active year in history nonetheless.
Today’s entrepreneurs are still blessed with the greatest Venture Capital Gold Rush in history.
Cache Creek believes that entrepreneurs should focus like a laser on VCs for the same reason that Willie Sutton ‘focused’ on banks, “Because that’s where the money is.”
Our conclusions:
1. If you seek to launch a start-up venture and you are not prepared to solicit capital from institutional venture capital funds, you are ignoring at least 96 percent of the start-up capital market.
2. Further, the remaining three to four percent is scattered out among literally tens of thousands of much smaller and more difficult to locate players whereas institutional venture capital is concentrated in about 547 funds. Venture capital funds may have a particular and somewhat peculiar way of doing business but the alternative is like searching for a needle in a hay field.
3. Although there is no such thing as an easy venture capital deal, availability of capital is not the problem. In terms of dollars invested on an annual basis, the VC industry is now more than ten times as robust as it was in 1996, a year that saw the successful launches of Alexa, Ask Jeeves, Expedia, Lucent Technologies, Stamps.com and Travelocity. The challenge lies in developing a credible and attractive offering and then selling the deal on terms that make sense for both money and management.
Wouldn’t I have a better chance going after so-called angels rather than VCs?
A lot of entrepreneurs are intimidated by VCs and think they are going to have an easier time pitching their deal to so-called angels. The reality is that, for a number of reasons, angels are much more difficult to locate, identify and work with.
Angels are playing with scarred money. Their number one worry is that they are going to lose their money. Their due diligence process can literally take forever. For every angel who actually brings himself to pull the trigger on a deal, there are at least 20 who are never going to write a check – but love being fawned over while they play the role of big-shot-mentor-investor. We call these guys “guru-wannabes”.
Even if you are dealing with a real angel, one that actually does have dollars he or she is willing to put at risk, the odds are overwhelming that they don’t have the resources to play Venture Roulette like a real VC.
A VC fund manager knows he or she only has to hit on one-out-of-ten deals to keep their total portfolio’s internal rate of return north of 30 percent – and, hence, keep those managers in the Venture Roulette game. VCs are more worried about missing out on that one-out-of-ten homerun rather than losing any one bet. That doesn’t mean they are going to get sloppy on their due diligence. It just means that the purpose of their process is to actually get to the point of placing a bet – not prolonging the dance indefinitely for the sake of reaping an ego-driven, non-financial payout.
Angels want to risk as little money as possible and still get a major if not lion share of your upside. VCs want clarity. They want the deal to succeed (or fail) as soon as possible. They are ready to throw down whatever it takes to give you and them a fair chance to cash in on the opportunity you have convinced them is worth pursuing.
Further, VCs figure an 80-percent internal rate of return on a $12 million deal beats a 90-percent internal rate of return on a $1 million deal and they factor in that it takes as much time and aggravation to babysit a $12 million deal as a $1 million deal. It’s a completely different mindset.
These are all important distinctions – and they all break in favor of the VC over the angel – but they all pale in significance to the number one difference: The 1,300 or so decision-makers that call the shots at the 550 or so U.S.-based VC funds active in early-stage investing control more than 96 percent of all the dollars that will actually be invested in startups.
In 2014, U.S.-based VC funds invested a total of $48.3 billion in start-ups. According to the 2014 Halo Report issued by Angel Resource Institute, Silicon Valley Bank and CB Insights, US angel investments totaled $1.65 billion while Crowdnetic reports a total of $218 million in equity crowdfunding in 2014.
Thus, US-based venture capital funds contributed over 96 percent with angels (3.29 percent) and crowdfunding (0.43 percent) combined less than four percent of all dollars invested in start-ups in 2014.
If you are trying to launch a startup, our view is that you should make as much progress as you can with your own money and that of so-called “friends, fools and family”. But as soon as you can put your ideas into a coherent professional format, you should go straight after the mother lode of startup funding: managing general partners of VC funds.
But don’t VCs only invest in deals that are already profitable?
Venture capital deals are done at various stages of development including pre-revenue, pre-minimum viable product and even pre-prototype.
Envision your deal as falling somewhere along a continuum that starts with a business concept scribbled on the back of an envelope and ends with a fast-growing company that is setting the world on fire with sales and profits. In between these two extremes are a nearly infinite number of developmental milestones. Venture capital deals are done at all points on this continuum.
Somewhere, there is a threshold at which multiple funds will be willing to invest in your enterprise. It might be at one extreme or the other or (more likely) somewhere in between. There is no way to know at which such point your venture will attract investors until you put it on the radar of all the funds that are active in your space and, if need be, keep it there and keep making progress until somebody gets it.
But don’t VCs only invest in CEOs with a history of successful exits?
From the venture capitalists’ point-of-view, it would be truly wonderful if every startup came with a seasoned CEO who had done it all before. That situation, however, is extremely rare because the guy or gal who has achieved such a level of success now has his or her own money to work with. They don’t need any help capitalizing their new venture. So don’t let the fact that you’re not Larry Ellison deter you from accessing institutional venture capital. Mr. Ellison is not your competition.
Every venture capitalist is looking for the same three things:
1. A competitive advantage;
2. In a market large enough to support a liquidity event;
3. A leader who can execute and make it happen.
Let’s assume you have a competitive advantage in a market big enough to be meaningful. How would anybody know if you are the sort of guy or gal that can make something happen?
The best way to demonstrate your ability to execute is to show the world what you can do with little or no money, with smoke and mirrors. If you can turn a profit, that’s fantastic. Most of the time, however, you don’t even need to do that. Product development that has gone a long way without burning a lot of cash can also be impressive. Investors figure, if you can do something with little or no money, just add cash and you’ll do a lot more.
You don’t need to convince VCs that your new venture is a slam dunk. Venture capitalists are risk takers. They are not looking for a guarantee that your project is going to successful. You’ve got a pretty good chance at cutting a deal the moment a managing general partner starts to think you just might be successful.
What type of return do venture investors require?
Venture investing is a high-risk, high-return proposition.
“Venture capitalists want to hit home runs with their investments,”
says David J. Blumberg, managing director of Blumberg Capital.
Entrepreneurs always seem to underestimate the high level of risk associated with even the most promising and well-planned endeavor. Frequently, investors find themselves in an adversarial position with management, even when the venture succeeds, because the entrepreneurs forget the risks taken, focus only on the current results and begrudge the investors their profits.
Entrepreneurs also forget that not all of a venture investor’s projects are going to be successful; therefore, the successful enterprise must not only provide a sufficient return to warrant the risk of that investment, it must also provide a return sufficient to cover the investor’s inevitable losses in other deals.
For most start-up situations, investors are going to want at least a six-to-one return in three years or approximately 90 percent compounded annually. This can rarely be achieved based on cash flow alone, especially assuming the investor has taken a minority equity position.
However, if management has a well-thought-out business plan including a strategy to take the company public, it’s possible to project, and deliver, such a return based on the liquidity premium obtained from the establishment of a viable public market for the company’s stock.
What types of returns are possible?
Kleiner Perkins Caufield & Byers, a San Francisco-based venture fund which backed Genentech in 1976, got an 800-to-one return on its money when the company went public in 1981.
Janet Axelrod was a secretary employed by a tiny computer software company. Offered stock in the company, she invested $4,000 because some other employees were doing so. The name of the firm? Lotus Development Corporation. The eventual value of her shares? $9 Million.
One reason why start-up ventures have become a sort of new American dream is that capital appreciation deals give management and investors alike the opportunity to amass multi-million dollar fortunes without paying enormous income taxes. Since you only pay tax on your stock when you convert it to cash (by selling it), the majority of your increase in net worth comes tax free.
Even when you sell your stock, your income from such sale (capital gains) is generally taxed at a much lower rate than other so-called ordinary income. The tax laws are somewhat volatile in this area – so you never know for sure what the tax rate is going to be three to five years out – but the current federal rate for assets held over one year is 15 to 23.8 percent depending on the marginal tax bracket. Ordinary income may be taxed up to 39.6 percent.
Thus, at the top of the Forbes 400 you’ll find mostly entrepreneurs and astute investors who have accumulated their fortunes through the capital appreciation of equity assets. Relational Investors’ Ralph Whitworth sums up the potential for outstanding returns in venture capital with the following comment,
“It only takes one.”
What else do investors expect?
Venture investors are likely to concentrate their attention on three areas:
1. The proposed product or service.
2. The potential market.
3. The management team.
While all three need to be satisfactory, you’ll hear different investors say they emphasize one area or the other. Many are product or technology-oriented. Others are more fascinated by vast, emerging or protectable niche markets. Probably most would say that management is the most important factor.
Stan Fung of Zero Stage Capital claims,
“Ninety-five percent of a company’s success is determined by its team anyway, not a unique product idea.”
Some even comment that what they really invest in is the entrepreneur – not the deal.
Our view is that all three aspects are vitally important and that emphasizing one over the other is a nonproductive exercise. However, we believe it’s not unproductive to recognize that many investors are biased such that they may be more heavily influenced by one of these three elements. Discerning a particular investor’s hot button may enable one to present the deal in a more persuasive manner.
As to the mindset of a successful venture capitalist, consider these insights from Fred Alder.
Adler’s Laws of Venture Capital
1. The probability of a company succeeding is inversely proportional to the amount of publicity it receives before launching its first product.
2. An investor’s ability to talk about his/her winners is an order of magnitude greater than the ability to remember the losers.
3. If you don’t think you have a problem, you have a big problem.
4. Happiness is positive cash flow.
5. The probability of a company’s success is inverse to the size of the President’s office.
6. The longer the pitch deck the shorter the odds of success.
7. There is no such thing as an over-financed company.
8. Founders who worry about voting control usually have nothing worth controlling.
9. There is no limit to what one can do or where one can go, if they don’t mind who gets the credit.
How important is the offering circular?
The offering circular, also referred to as the private placement memorandum, consists essentially of the issuer’s business plan, financial projections, a thorough discussion of the risks inherent and all other disclosures necessary and sufficient for an investor to make a fully-informed and intelligent investment decision. Not only is it critical in terms of compliance with securities laws and limiting future liability and possible lawsuits from disgruntled investors, much of an offering’s initial credibility will be created (or destroyed) by the content of the private placement memorandum. To quote Edwin Goodman, general partner of Hambro International Investment Fund,
“A business plan and business proposal will never make you successful but [poorly done] it can screw you badly.”
In his now-classic, best-selling work, In Search of Excellence, author/lecturer Tom Peters offers,
“The most valuable and successful companies will be those that add value to information.”
We believe that to be an accurate description of Cache Creek’s involvement in the private offering development, solicitation and negotiation process.
What are the most important elements of the offering circular?
David Pierce, CEO of Pierce Investments, offers the following as essential questions to be answered in any offering circular:
1. What is unique about this company or project? Investors do not necessarily need to find a unique product but one with growth potential that sets it apart from other industry members or from other proposals received.
2. What does the company do? The prospective investor wants to be able to understand the company’s product and services and the operations of the company.
3. How does the company plan to attain profitability? This area should discuss the market and competition as well an analysis of areas such as revenue and profit margins.
4. What benefit will be derived from a capital infusion? In other words, how will the proceeds of the proposed financing be utilized and what results benefiting the investor will be achieved. This should translate into increased revenues and profits and an excellent return on investment.
5. Is management capable of implementing the business plan? Many investors consider this the most important element of a business plan. An investor must be comfortable with the experience and abilities of the management team. Many investors believe that an outstanding management team can, many times overcome other plan deficiencies.
6. Do the financial projections make sense? Over optimistic projections reflects on management’s judgment. Projections can be aggressive but must be within the realm of the real business world.
7. Is there an exit strategy for the investor? If the business has the potential to: (i) merge, be acquired or go public; (ii) obtain an attractive price/earnings ratio and, hence, (iii) provide investors with both liquidity and an outstanding return on investment, investors have a compelling economic incentive to further their due diligence. If not, there really isn’t much point in studying the deal.
Given that you have a good business concept, a potentially lucrative market and a competent management team, we believe the two most important elements of the offering circular are:
1. Competitive advantage(s); and
2. Pro forma financial projections.
The first element, your competitive advantage, is what sets you apart from your competitors and (hopefully) makes you unique in the marketplace. It may be, or incorporate, a proprietary technology, software, marketing device or other intellectual property. It may include a specific benefit, or menu of benefits, which your product or service provides which cannot be elsewhere easily obtained. It may be a process or technology which enables you to produce a product or provide a service which others cannot easily match. In any event, your competitive advantage is the fundamental strength of your venture which you will seek to exploit, develop and maximize.
The second element, your pro forma financial projection, not only describes in detail how you will seek to exploit, develop and maximize your competitive advantage, it also gives a prospective investor some direct indication of your management strategy and skills. If you can’t manage cash flow on paper, you’re not likely to do too well with the real thing either.
Since the pro forma financial projections contain the financial details of your business concept, many investors will peruse your projections before reading your business plan. Hence, that famous first impression is frequently garnered from your pro forma financial projections. Finally, a motivated investor is almost certain to, at some point, begin to ask very specific questions regarding your plan and your projections. Entrepreneurs, especially CEOs, need to know these numbers “backwards and forwards” and be able to field questions in a relaxed and confident manner. Deferring such inquiries to your CPA – or even your CFO – is one way to lose investor confidence… and blow a deal.
How do you determine the offering price per share and the equity percentage offered?
The offering price per share and the equity percentage offered are based on the anticipated achievement of certain income and profitability projections and the need to provide sufficient compensation to investors to thus induce them to assume the financial risks of the enterprise. As mentioned, most venture investors will want to have a reasonable expectation of a minimum 90 percent compounded annual return which works out to about six times their money back in three years.
For example, if a new enterprise (i) requires $20 million in venture capital, (ii) has a realistic goal of $100 million in sales in its third year, (iii) projects third-year after-tax of profits of $12 million, (iv) can reasonably expect to receive a price/earnings multiple of 22 and (v) can convince investors that their pro forma financial forecasts are attainable and reasonably conservative and that the company has a good chance of either being taken public, cashed out or acquired by another company within three years, investors may be induced to purchase 50 percent of the company for $20 million, satisfied that, if the company reaches its objectives, their stock would be worth about $143 million and, hence, they will have achieved a 92 percent compounded annual return.
One very important consideration is: Can sufficient funds be raised using this valuation method and still leave management in control of the company? Generally, we agree with multi-billionaire venture investor H. Ross Perot,
“The builders must have control.”
Are we guaranteed to get our offering price?
No. Venture investors are usually savvy and frequently ruthless. They know you are anxious to get started. They know you have probably experienced some degree of prior frustration. Even though your offering may be fairly and attractively-priced, they will still want to get the best deal they can.
If you appear to have only one prospect, they may be tempted to play hardball. Ever wonder why so many venture firms advise entrepreneurs not to “shop” their deal? Limiting your prospects to a few well-chosen firms seems, to us, to be a strategy which works in favor of those few firms… and against the entrepreneur. Conversely, we believe issuers need to cast a wide net, and get the best possible supply and demand fundamentals, before sitting down to negotiate a close.
Frankly, it can be more than a little intimidating to sit across a desk from an internationally-renown, self-made billionaire (who’s listed near the top of the Forbes 400) and hear him say, “Well, we would like to participate… provided we can agree on the valuation.” If you start to jump out of your shoes, you’re very likely to invite a low-ball offer. There is really no way to sugar coat it. The bottom line is – it’s basically a poker game and the stakes are high.
Luis Villalobos, of the Tech Coast Angels, says the object of entrepreneurial management should be “to end up with four to five percent of a successful enterprise”. We agree with the successful enterprise part but believe that management’s equity goal should be more like 50 to 60 percent. Ultimately, there are no guarantees in venture capital but we maintain that management retention of majority ownership is a worthwhile and attainable objective.
What are the odds that a given venture will be successful?
The statistic most often cited in the literature (which feels about right but which we know of no way to verify with absolute certainty) is that only one-in-500 business plans achieves institutional funding and of those, only one out of 10 makes it to a successful liquidity event. So if those ratios are accurate and you consider your project “average”, your odds of achieving an IPO or other successful liquidity event are about one in 5,000. Obviously, no one considers their project “average” or there would be no successful VC-backed IPOs because no one would ever set out to overcome such daunting odds and there would be no VC-backed startups.
John Kennedy was fond of noting that, “Victory has a thousand fathers but defeat is an orphan.” Sometimes this is paraphrased as, “Success has a thousand fathers but defeat is an orphan.” When structuring any high-risk, high-reward undertaking, it’s highly advisable to include some sort of clearly-stated acknowledgement that the risks associated with the venture are substantial and that each participant has evaluated and assumed those risks independently of the other parties. Otherwise, unless your venture runs the gauntlet all the way to a successful exit, you are almost certain to end up with partners and/or investors accusing other each other of inducing their participation by overstating (or even “over-implying”) the ultimate odds of success of a given venture or offering at the outset or some other critical juncture.
How do investors feel about working with financial intermediaries?
Walter Lipper, author, venture investor, former Chairman of Venture Magazine and a member of the New York Stock Exchange and New York Futures Exchange, writes in Financing and Investing in Private Companies,
“It must be pointed out that the presence of a reputable financial intermediary or investment banker can add enormously to the credibility of a proposal. Such an investment banker’s reputation is on the line, and he is probably assuming some legal liability in making the offer, notwithstanding claims to the contrary… The use of intermediaries is an accepted part of business. Successful entrepreneurs have almost always used intermediaries successfully.”
Hambro International Investment Fund’s Edwin Goodman adds,
“Usually [good deals] come in through other venture capitalists or through intermediaries that we respect, so we have some confidence that it is a quality deal before we begin the process. Very few deals are done that come in absolutely cold from the entrepreneur with no introduction.”
And from Space Center Ventures’ Paul Knapp comes this,
“We are inundated with business plans; the only sure way for your project to attract our attention is for someone we respect to refer it to us.”
It should be noted, however, that, once introduced to a deal, many investors believe they can get entrepreneurs to agree to better terms if they can get them away from their financial partners, advisors and attorneys. All the more reason, we believe, why you should be well represented at all meetings.
What constitutes a credible intermediary?
Venture capital investors are far more likely to spend their time and resources investigating a deal that has already been pre-screened by someone who has demonstrated previous success in picking winners.
Most entrepreneurs will, at some point, be approached by someone who will offer to help them secure financing for their project. This can be a treacherous area for entrepreneurs for there are many individuals who claim to have experience, expertise and/or existing relationships in this space but who, in fact, bring no value to the situation whatsoever. Some of these may be individuals whose intentions are good but who have yet to establish any level of credibility within the VC community. Some are just outright frauds.
Fortunately, the Internet has made it much easier to qualify and sort through these intermediary candidates.
Cache Creek Partners recommends the following five step test.
1. All credible intermediaries should have a website that is visible and accessible to the public (including securities regulators) at all times, i.e., not password protected.
2. Such visible and accessible website should also identify a physical address (not a Post Office box) for their place of business.
3. Their website should also list the names of the owners, partners or principals of the organization.
4. The professional resumes of all such principals should identify specific posts previously held at specific companies, e.g., “he has previously served as CFO for The Gospel.com” rather than nebulous statements such “he has 25 years experience in finance”.
5. Their website should also list specific portfolio companies, e.g., “Accuray, Inc.”, rather than “a software developer”, at least some of which should have made it all the way from a successful raise through a successful launch and onto a successful IPO or other liquidity event.
If a potential intermediary is lacking any of these five elements, our experience has always been negative and, accordingly, we would advise that you are well served to move on before wasting your time or, worse yet, getting entangled in a bad deal.
Additionally, if you run the names of the principals of your intermediary candidate on search engines such as Google or Yahoo, their resumes should show up on at least some of their portfolio company web sites as it is common for such individuals to hold board seats (either past or current) at these companies.
Finally, whenever anyone guarantees a successful outcome or otherwise downplays the difficulties of raising venture capital, they’re almost certainly not for real.
Does Cache Creek seek to be involved in day-to-day management?
No. We are desirous of maintaining a presence on the board of directors for the purposes of representing minority interests, keeping ourselves informed and to avail the company of our latest research and networking capabilities. We may be able to introduce entrepreneurs to inventory financing sources, manufacturers, distributors, attorneys, accountants and/or other subcontractors, vendors or professionals who may positively impact the venture. But, we absolutely do not seek to micro manage any enterprise and feel most strongly that managerial meddling is rarely successful.
What does Cache Creek look for in management?
Cache Creek recognizes that an academic analysis of a business plan is one thing while its implementation is another. That is why we generally like to see some practical business experience somewhere on the management team. We put a lot of faith in managers with intimate knowledge of bottom-line accountability, i.e., entrepreneurs who have operated a successful business without the infrastructure of a large organization.
On the other hand, a lot of institutional investors come from academic and/or corporate backgrounds and, likewise, are impressed with similar credentials. Thus, ideally, we would like to see a diverse mix of entrepreneurial talent with a variety of ages and experience represented including intelligent managers from academic, small business, military and/or corporate backgrounds.
What types of ventures does Cache Creek view as most attractive?
Change, whether technological, demographic or regulatory, seems to create opportunity. Inexpensive personal computers and the emergence of the Internet have spawned innumerable venture opportunities in hardware, software and services. The aging of the populations of the developed countries of the world has produced opportunities in healthcare, housing, leisure and recreation. Regulatory changes have generated opportunities in banking, telecommunications, import/export and utilities. Several funds have been chartered with mandates to invest specifically and exclusively in one or more of these areas.
Cache Creek recognizes these niches as potentially very profitable and would be delighted to participate in any venture which services any one of them effectively. However, we also believe it to be a mistake to become too narrow-minded when evaluating potential investment opportunities. There is already far too much “me-too-ism” in the venture capital community. We at least like to believe that we would be receptive to an original or unusual business model – or even a common and rather ordinary concept with a new twist or unique competitive advantage.
We also place a high value on the passion and enthusiasm which certain entrepreneurs bring to a project. Any venture is sure to have its breakthroughs and its setbacks. Keeping the entire team focused, involved and upbeat throughout the inevitable ups and downs of the start-up process goes a long way toward achieving a successful result.