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12.9 Venture Capital Funds and Venture Capitalists

Venture capital fundsProfessionally managed funds that provide high-potential start-ups with funds in exchange for management fees and equity or shares of stock in the start-up. are professionally managed funds that provide high-potential start-ups with funds in exchange for management fees and equity or shares of stock in the start-up. Venture capitalists (VCs) invest between $1 and $20 million in a start-up, but it can vary. The venture capital funds are themselves funded by wealthy investors. The venture capital funds sometimes charge about 2–4% per year as a management fee. In addition, they charge 20–25% return (sometimes more) on their investment over the course of 5 years. So if a start-up borrows $5 million from the venture fund, then they may have to pay $100,000 in management fees per year (at 2%) and then pay out approximately $13.3 million in 5 years (at 20%) for the return on the VCs investment. The management fee is a kind of coaching or consulting fee. A typical fund can have 15–20 ventures with about half-generating returns. Only a few of the businesses are hits and the hits subsidize the failures and the marginally successful ventures.

Potential Problems with Venture Capital

There has been much criticism in the engineering community in reference to venture capital funds stifling innovation.Stuck and Weingarten (2005). Some of it is related to investing in start-ups with superstar management and some of this is related to the tendency of VCs to pursue incremental innovations where there are lower levels of risk. VCs are not interested in technology; they are interested in adding a business to their portfolio that has a good chance of generating above-average returns. They know that some start-ups will fail, and they rely on their knowledge and expertise and portfolio diversification to deliver a few successful start-ups. The point is that it is hard for the new entrepreneur to make a splash because there are no previous splash patterns. Start-ups with little experience usually rely on the founder’s money, family and friends, and a variety of other approaches to run the company (see http://brainz.org/startup-funding/ for an excellent overview of nonventure-capital fund sources). There are many opportunities to raise funds outside of professionally managed money and indeed that give the company’s founder a degree of control and flexibility that may exceed the benefits of securing funds that reduce flexibility and control and are accompanied by very high interest rates.

Importance of Market Potential to VCs

VCs are interested in firms that have the potential to acquire substantial market share in large markets.Sahlman (1997). They want to know whether the market is large, whether it is growing rapidly, and whether the start-up can capture some of that growth. They also want to know whether the business is scalable. A scalable business modelA business can shrink or grow very quickly with minor changes in the cost structure (variable costs and fixed costs). means that the business can shrink or grow very quickly with minor changes in the cost structure. In the best situation, growth should not increase variable costs and fixed costs (perhaps even decrease variable costs). Ideally, growth should not incur large fluctuations in business processes as new customers are added. Remember, however, that scalable growth is usually scalable within a relatively narrow range.

The potential investors will also want to know whether the start-up can acquire customers and keep them. They will also be interested in the market forecast. Savvy investors will question market forecasts that indicate that the firm will garner either 1% or 10% of the market. The 10% share of the market usually means that the market is relatively small and the start-up needs 10% to break even. The 1% usually means that the market is huge and the start-up will be lucky to acquire even 1%. Market forecasts need to be based on realistic assumptions, rather than based on what makes for easy spreadsheet construction. There should be a strong rationale why the start-up will acquire 10% of the market the first year and increase that share by 20% in subsequent years.

Guy Kawasaki has several good ideas for developing market forecasts. His first idea is to develop a forecast from the bottom-up. In this approach, the start-up would try and identify the number of sales outlets and then estimate how many items might be sold at each outlet. Another example would consist of looking at the number of sales contacts each week for each salesperson and then estimate the percentage that will be successful. This approach, admittedly, also relies on percentages and, in some ways, is also seat-of-the-pants as is the 10% solution. The important point in developing forecasts is to examine and test assumptions and to constantly refine the forecasts.