As I have been asked to explain the venture capital business more frequently as of late, I thought it would work better if I just put some thoughts down in writing.  These questions are beyond the basic “what is venture capital” inquiries, and instead are focused more on what working in the VC world is like. 

First, let me say that I am not a venture capitalist; I just help run a firm that invests private equity capital in early stage (read ‘venture’) start-up companies.  Ok, so I guess that technically is VC, but I don’t claim to be an experienced VC veteran and I certainly am not involved in the business like most of the sector’s people are.  Personally, I prefer the public equities market, but I’ll save my personal comparisons of likes/dislikes between private and public equity for a later post.  If you want to learn more about our family’s private equity investments, visit the Coker Capital Partners website at www.cokercapital.com.

With that said, I got to thinking about how VC is best explained and I came up with three main traits of a VC professional, which I call the “Three Pillars of VC.”  Why do I call it the Three Pillars?  Because there are three points and it sounds cool.  Moving on …

What makes a venture capitalist?  I believe the three main characteristics of VC’s (both individuals and firms) are:  1) access to capital; 2) relationships and resources; 3) business/management/industry expertise and/or entrepreneurial experience. 

There is nothing really exceptional about becoming a venture capitalist.  A wealthy individual who provides some of their capital to start-up companies is a VC.  A firm managing billions of dollars in institutional funds investing in any stage of a start-up is a VC.  It’s a fairly large continuum of players.  People become VC’s in a variety of ways and the typical players come from a variety of backgrounds.  We’ll get to that shortly. 

The first and most basic component to being a venture investor is having money to invest.  Whether you are investing family money, money from previous business experience, or institutional funds raised on the capital markets, if you don’t have the capital, then clearly you won’t get very far.  It seems like every day I see entrepreneurs that have a start-up with a Board of Directors made up of friends or close advisors who I am sure have great advice from time to time; however, these folks have no real stake in the game, so to speak.  You gotta have capital.

The second thing is relationships.  Assuming having capital is the most basic requirement for investing and it really goes without saying, relationships and contacts in the marketplace are really the things that make good VC’s exceptional.  I would say this is the most important thing for a VC, again, besides the obvious need for money.  The VC business is based on relationships and resources within a variety of marketplaces that can ultimately be leveraged at a time that poses the greatest benefit.  The reasons your large VC firms can be so successful is because they leverage their contacts and networks when they need it most, ultimately gaining the competitive edge for their portfolio companies over the other players in the market. 

The last Pillar is important; however, it falls a good ways behind the first two.  The best way to explain these characteristics is to look at the typical demographic make-up of VC’s in today’s market.  Your typical venture investor is made up of either former corporate finance types (i.e., people that come from mid to large cap banks, etc) or serial entrepreneurs.  The most common VC, especially at the big firms, are either traditional MBA’s or more technical minded engineer/science types.  Actually, it is becoming commonplace to see more VC’s with both technical and business training. 

If you spend five minutes within the VC world, you will find that it seems like everyone comes from either Harvard Business School or Stanford Graduate School of Business, and those that come from the latter often have engineering or other technical training.  In the life sciences space, where we primarily focus, you also see a number of scientists that have come up from turning academic research into commercialized products, thus turning into entrepreneurs and in some cases doing this over and over again.  In reality, everyone in the VC world does not fall under these descriptions; however, it is definitely common. 

With that said, the last Pillar is centered around the idea that VC’s have to bring something to firms’ tables, other than cash, if their investments are going to pay off.  It is common to see wealthy individuals place personal capital in a variety of investments, yet they bring nothing else to the table, due to a lack of experience or industry knowledge or whatever.  The Three Pillars really address what good VC’s must bring to the table in efforts to make firms successful.  In today’s competitive environment, cash is not enough.  Further, relationships alone will only get you so far.  It is the trifecta of characteristics that help make deals successful.   

What is the primary investment strategy?  This is an easy one:  high risk, high returns based on volume of quality deals sourced in any number of ways.  The VC investment objective is actually the simplest thing of the whole discussion.  Let’s take a basic example as an illustration.  Say you have a VC firm that raises $250 million for a fund.  This probably seems like a lot of money for a fund; however, in today’s environment, it would likely be on the lower end.  It is relatively simple to raise capital for professionally managed funds if you know the right people.  We’re not talking about going to friends, family and general contacts and asking for personal investments.  Most true venture funds are funded with institutional capital, typically coming from financial intermediaries, asset management firms, private equity firms, pension funds corporations, and even hedge funds and other alternative investment vehicles.  Investing in venture funds is now just a diversification strategy for larger institutional funds. 

Back to our example firm, though, this $250mm fund will typically be a Limited Partnership (LP) and the VC firm serves as the General Partner, while the investors are Limited Partners.  Not complicated.  Once the capital is raised, the managers start sourcing deals (actually all of this is happening continuously). 

Assuming you possess the Three Pillars, the key to making a fund’s capital work for you boils down to one thing:  deal flow.  Your pipeline must have access to the best new companies, products and entrepreneurs in the market, or more importantly, not yet in the market.  This is much more difficult that it sounds, because not only do the VC’s have to source the deals, but they then have to find the diamond in the rough, and they have to do it before other crafty VC’s do it.  It’s all about access and timing at that point.

Other than that, though, the investment strategy is very simple.  The managers will put the $250mm to work in let’s just say an average of $5mm investments.  This means they will do a total of 50 deals for the fund in efforts to allocate all of the capital. 

With an exit strategy of either an acquisition or IPO, you assume a 10-15% (many times higher, but also lower) success rate of your portfolio companies.  Let’s just say 10% of your portfolio companies make it to a successful IPO priced in the $2.5 billion range.  Investing $5 million in the company, you probably came in at a series A and you could have retained about 10% equity ownership in the company after being dilluted from subsequent rounds of financing.  Ultimately, you own roughly 10% of five companies that have a market cap of greater than $2.5 billion and are priced as much when hitting the public capital markets.  That turns out to be pretty nice returns on your original $250 million worth of capital.  What happens to the other companies you’ve been spending all that time with for the past few years.  Nothing.  They’re an afterthought. 

Now, this obviously is a very basic example and it is typically much less simple; however, you get the gist.  The process is always much more complicated, but the illustration shows how the investment strategy, in its purest form, really is not complicated to understand. 

One of the key negatives to this process that is easy to overlook is that the process itself can take ten or more years.  Ideally, a VC wants a 5 year (or less) window on a company.  In reality, though, these are very long term investments that require a lot of TLC every step of the way. 

Which leads us into the other point that is often misunderstood.  When entering a deal, it isn’t as though the investor writes the check and starts preparing to ring the opening bell at the NASDAQ stock exchange.  First, the VC’s want to play a very active role in their investments.  The idea of monitoring does not escape venture capitalists in the least.  The most common way to do this is through Board of Directors involvement.  The VC will always want at least one board seat and more often they want to control the board completely. 

The most effective method for insuring their returns is for the VC to take over fifty percent stake in the portfolio company.  This means they can control the entrepreneurs and make sure their getting the biggest kick out of the returns when that acquirer comes a knocking. 

Again, let me clarify that not all VC’s come in and take over every company in which they invest.  A lot of people do not like VC’s solely because they see these investors as wanting to come into a company and take over the entrepreneurs’ dreams like they’re Pharoahs calling for the collection of the first born children.  It is true that many VC’s expect a lot from the companies in which they invest; however, when you’re pumping $5 mm of fresh cash into a company that had a pre-money valuation of $3 mm, you have the right to ask for 51% equity and control of the Board.  Now, if you come in during a series A financing with a relatively medium amount, you may take 40% of the company and 60% voting power, all of which will be dilluted when a new VC firm comes in during a series B and places $20 mm of capital. 

The question entrepreneurs must ask themselves is can I do this without venture capital?  If the answer is yes (and they’re okay with the amount of time, costs, etc it will take), then they shouldn’t give anything up to VC’s.  Conversely, if an entrepreneur looks at their product/idea/company and says “wow, I really hate to give up control of my company that I’ve been working hard to develop, but owning 10% of a $5 billion company in 5 years sounds nicer than owning 80% of a $1 million company in ten years,” then Mr/Mrs Entrepreneur has their answer. 

Overall, this material is nothing new and it certainly isn’t anything complex.  It’s just my “VC 101″ explanation for when people ask what venture capital really means.  In the future, I will address some different issues related to VC, because there are so many variables to consider when discussing this sector of the economy. 

There’s a lot of buzz within the industry about the fact that VC is kind of the “hippee” son of corporate finance.  The picture of investors and entrepreneurs conducting meetings at coffee shops off Sand Hill Road in Menlo Park seems very far removed from the suit and tie powerlunch off Wall Street.  Indeed, I would say most of you VC’s – even your most experienced and well educated ones – could not tell you what the S&P 500 looks like on any given day or what the price of oil is currently at (unless they’re in the energy business, of course).  However, venture stage funding is critical to the future of our capital markets.  Without it, we probably wouldn’t have the Microsofts, Googles, Yahoos, Intels, Apples, etc of the world creating hundreds of billions of dollars in value for shareholders on the public capital markets.  Heck, without venture capital, we likely would not have seen the technology revolution that brought us cool blogs like this one!  More to come soon …