Venture Capital

The Traditional Venture Capital Fund

Most venture capital funds are set up as independent limited partnerships. This includes well-known coastal names like Kleiner Perkins and Highland Capital, as well as regional up-and-comers such as Renaissance Venture Capital Fund. The venture capital firm acts as the general partner (GP) with third-party institutions investing the bulk of the capital to the fund, filling the role of limited partner (LP). During the fundraising phase that every venture firm goes through in building a new fund, the GP seeks out investment commitments from accredited investors. The VC firm distributes a private placement memorandum (PPM) or prospectus to potential LPs, and might expect to raise the necessary capital over the course of the ensuing six to 12 months.

Funds generally raise anywhere from $10 million to several billion dollars from their limited partners. According to the National Venture Capital Association (NVCA), more than 50 percent of investments in venture capital come from institutional pension funds, with the balance coming from endowments, foundations, insurance companies, banks, affluent individuals, and other entities who seek to diversify their portfolio with an investment in risk capital. It is the GP’s job to invest this capital in privately held, high-growth companies. In order to make these investments, the venture firm has to “call in” its LPs’ commitments through tranches or “capital calls.” Venture firms have synchronized these calls (sometimes also called “takedowns” or “paid-in capital”) to their funding cycles, allowing funds to be available on an as-needed basis.

A partnership agreement sets forth the relationship between the GP (the VC firm) and their LPs (investors). The returns of the venture capital fund are distributed back to the LPs as dictated by the partnership agreement, but naturally lean toward the later years of the fund. The reason for the preponderance of partnerships, as opposed to corporations, is the security that partnerships give venture capitalists to make long-term decisions. Once an agreement is signed and the capital commitments are made, the LPs are generally stuck with this group of venture professionals for the duration of the partnership (VC funds are generally organized as 10-year partnerships, but, in recent years, have expanded to more than 10 years). For the duration of the partnership, the institutional investors cannot remove their capital from the fund at will. Liquidity is realized when a viable exit option becomes available.

Liquidity Options

Both IPOs and M&A transactions are credible exit strategies. A liquidity event can take several forms, including a cash deal, stock, or both. Capital or shares of stock are then distributed back to investors according to the partnership agreement, unlike a mutual fund where invested cash can be withdrawn at any time. As a result however, the arrangement allows venture capitalists to act as a relatively reliable pool of risk capital. Plus, VC firms will rarely “go bankrupt.” If unsuccessful, they are more likely to be wound down over time without the ability to raise an additional fund.

For example, a typical 10–year venture capital fund may cash flow something like this:

• Year one to four: Initial portfolio company investments are made
• Years three through seven: Follow-on investments are made into the portfolio companies
• Years three through 10: The investments are exited/liquidated.

Not unlike a mutual fund, a venture capital firm may manage several individual funds at any given time. The individual funds are distinct entities with their own set of limited partners, although LPs do sometimes overlap across funds. As one might imagine, this creates a pile of issues that we will not try to go into here (if you really want to know how the story of VC partnership ends, both Josh Lerner and Joe Bartlett have leading books on the subject).

Distributions and Carried Interest

Typically, venture capital fund profits are distributed as follows: 80 percent to the LPs and 20 percent (carried interest) to the general partner after the limited partners have recovered their initial investment. There are as many variations on carry, distribution, and similar terms as there are firms. The terms are ultimately established through negotiations on a case-by-case basis.

Management Fees

The general partner (VC firm) charges a fee for its role as portfolio manager. This management fee covers the fund’s costs such as rent, salaries, and keeping the lights on. The fee is usually 1 to 2.5 percent of the assets, or committed capital. The actual percentage can vary based on fund size, the partners’ prior investment history, etc. Although the management fee is often paid quarterly over the life of the fund, it is not uncommon for it to diminish over time (toward the end of the fund’s life-cycle). Why is all this important? Because at the end of the day, this is how you get paid. That 20 percent of carry is split amongst the employees of the firm at the discretion of the managing or general partners.

Finance Industry Affiliate VC Programs

Some venture firms are born as the affiliate or subsidiary offspring of an investment/commercial bank or insurance company (e.g., Goldman Sachs' GS Growth). Depending on these funds’ reasons for being, they make investments on behalf of the parent firm’s partners, management, or wealthy clients. Others bring in outside limited partners, and run their funds no differently than any other venture capital general partnership.

Corporate Venture Capital Programs

Corporate venture capital programs typically begin as subsidiaries or affiliates of large non-financial corporations such as Intel, GE Capital, Microsoft, and Merck. Most of these subsidiaries have a charter or mission statement which calls for making direct investments that are of “strategic” value to the parent corporation. The dynamics of how investment opportunities are found and deals get done differ from firm to firm. However, since many of these companies are publicly held, there is often a two-pronged approach to deal sourcing. The perfect corporate venture investment is one where the corporation’s business unit (depending on the industry/space/etc.) champions the deal. This makes sense, since with every signed term sheet the corporation concludes a Memorandum of Understanding (MOU) spelling out what both the startup and the corporation itself will contribute as future partners in this relationship. As the strategic component to the investment, the business unit will be intimately involved with the portfolio company after the deal is done. If this turns out not to be the case, all of the highly touted strategic value is likely lost.

Business units of publicly held companies need to deliver the numbers every quarter, so the investments they source reflect an effort to tackle current pains. On the other hand, venture groups like Intel Capital have historically also had hard core techies on the deal team, who have the breathing room to look out at 12–18 months. They search for “cool” technologies, without being fettered by either practical current application or connection to their core business. Either way, strategic value is king.

Although it is extremely difficult to quantify said value, the objective of this investment strategy can be to fill an R&D role (buy vs. build), penetrate new markets, or help sell more core products. While a few of the more experienced corporate investors have a good handle on the balance between strategic value and financial return, this has been a trouble spot and point of contention with less seasoned corporate venture teams. The bias toward strategic investing has the potential to create confusion, poorly aligned goals, and disincentives within/between the venture team, management, and corporate shareholders. The most probable ensuing conflicts from this and other corporate investment issues include:

1) Public for-profit corporations prioritizing strategic value in venture investments, without sufficient focus on ROI (return on investment).

While there is much to be said for strategic value, the point—the only point—is to make money. It is not always possible however, to calculate how an investment in a start-up today will impact a company’s bottom line on a recurring basis three years from now. Yet as a public company, Oracle’s management must answer to shareholders once every quarter. So, unless the dollars invested can be demonstrably proven to either move more product or in some other way increase net income, ROI must play a more central role within corporate venture programs.

2) Companies sometimes compartmentalize their corporate venture groups.

For example, one multibillion dollar Silicon Valley corporation launched its venture program by dividing responsibilities between sourcing investments, negotiating deals, and managing the investment portfolio. This structure lends itself to lack of ownership or accountability by any one team. The sourcing group looks for the “gee-whiz” gizmo factor, with little regard for business model or financials. The deal team then has to complete enough diligence to decide whether this investment should go forward. If the decision is “no,” then the team faces an uphill battle and the political repercussions of trying to kill the deal. Worse yet, portfolio start-ups are forced to work with someone new every several weeks throughout the deal negotiation and funding process.

3) Board seats are a serious liability.

Board members are held accountable when their company stumbles. To avoid this conflict, publicly held firms should only accept board observer status. This gives corporate investors a window into portfolio companies on a month-to-month basis, without exposing the parent corporation to litigation and undue liability.

Some corporate investors do place a strong emphasis on financial returns, and may even function purely as financial investors capitalizing on the technology, know-how, reputation, and access to capital of the parent. Players in this realm include Dell Technologies Capital and NGP Capital. While somewhat controversial, these programs can produce some of the most enviable returns in the industry, and successful programs are often spun off as separate venture funds.

Other Venture Capital Structures

Venture capital firms can be effective with structures other than the ones outlined above. Limited Liability Corporations (LLCs) such as Granite Ventures LLC in San Francisco are an alternative form of structuring a fund, but for our purposes, these function in a similar manner as limited partnerships. The venture capital firm MVC Capital Inc. (NYSE: MVC) is an example of a closed-end publicly traded venture fund. 180 Degree Capital Corp. (NASDAQ: TURN) is also a publicly held venture capital firm, operating as a Business Development Company (“BDC”) under the Investment Company Act of 1940.

Smaller Alternatives

The National Venture Capital Association outlines other organizations, including government-affiliated investment programs that help start-up companies either through state, local, or federal programs. One increasingly popular vehicle is the Small Business Investment Company (SBIC) program administered by the Small Business Administration (SBA), through which a venture firm supplements its own pool of funds with federal money at a ratio of up to two government dollars to every dollar raised via limited partners (with a cap of $175 million). A typical SBIC loan ranges from $250,000 to $10 million. Meanwhile, the SBA only requires a limited return on their investment. While SBIC funds create more paperwork and bureaucracy for the general partnership, they can be a good deal for the limited partners. Between the inflated power of their leveraged investment and limited ROI upside for the SBA, LPs in an SBIC have a good thing going during the good economic times. Don’t forget however, that returns are based on timing. SBA funds require interest payments, and the GP might have to pay 6 to 7 percent when only making 10 to 12 percent annually.

Despite the endless maturations for organizing venture capital firms, atypical structures should set off a red flag for the applicant. “Why are they not a fund?” is the first question that a job-seeker should ask herself. While many alternative methods of organization have merit, a prospective applicant should be comfortable that the firm in question has sufficient unencumbered capital and is not just trying to look as if it does.