We sometimes think of the stock market purely in terms of demand. A stock is demanded or it is not, and subsequently, its price goes up or down accordingly - but that is not all there is to it. Of course in any economic market, there are always two factors: demand and supply.
Supply for stocks as a whole increases when new shares come into the market through initial public offerings (IPO), and supply decreases when private equity buyout firms take publicly traded companies private. This article will take a look at one of the more important forces influencing the supply equation - venture capital (VC).
The Private Equity Supply Chain
"Private equity" is a catch-all term that includes the earliest stages of investing - often when a company consists of little more than its founders and an idea - right through to the large buyout firms that raise equity and debt financing to take public companies private. Within this supply chain, VC firms occupy a position along a continuum such as that represented in the diagram below.
The earlier in the life cycle, the less structured the investment process. Many entrepreneurs try to hold out for as long as they can with their own capital or support from family and friends. In the absence of enough capital to go it entirely alone, entrepreneurs may seek affiliation with incubator firms, organizations that will provide some basic infrastructure such as office space, technology, administrative support and perhaps some early stage capital as well. Incubators are frequently associated with educational institutions located in prominent high-tech centers like Silicon Valley and Austin, Texas. For example, the Austin Technology Incubator, affiliated with the IC2 Institute of the University of Texas, Austin, has incubated companies that have in total raised more than $750 million, and have directly and indirectly created a total of 10,000 new jobs, according to the organization's website.
In between the later-stage VC funding and seed financing is an indeterminate early stage, or what participants sometimes refer to as a "funding gap." This gap exists because established VC firms tend to want to invest a minimum of several million dollars per deal. A typical startup with, say, $250,000 in seed capital may need an additional $500,000 or $1 million for early stage development. Unfortunately, this low funding requirement excludes these companies from most VC firms. This is a critical time for the company: often, this is a time when it needs to develop a prototype technology, obtain intellectual property rights, conduct discovery and testing (e.g. in the case of a biotechnology startup) and establish commercial viability for product or service offerings. Early-stage VC firms and angel investors play an important role in this stage. Angels are wealthy individuals, often retired VC partners or corporate executives with a particular knowledge of or enthusiasm for a particular technology or sector.
As a startup company collects early-stage investors, it develops a more corporate structure. Frequently, the investors will play an active role as members of an advisory board, board of directors or other governance structure and may also use their own networks for marketing and other strategic initiatives.
From "A" Round to Exit
Assuming the funding gap is overcome, the fledgling company will then be qualified enough to approach most VCs. The heart of the VC process is a trajectory from the point when a company has proven its early stage viability to exit - a liquidity event such as an IPO or acquisition in which the VC investors cash out all or a significant part of their interests. Although it varies, VCs participating in this stage are usually looking to exit in a three - to seven-year time frame. VCs call this period the "alphabet rounds" because successive funding rounds are termed Series A, Series B and so on. It is not unusual to have a few alphabet rounds before the liquidity event occurs.
The market for VC funding is highly competitive. A VC may look at several hundred opportunities before selecting a single one. The VC tends to be quite choosy regarding companies because they tend to play a much more active role in the investee companies than, for example, portfolio managers do with the publicly traded stocks in their portfolios. The VC has to make an estimate of the viability of an often unproven technology, its potential for success in the commercial marketplace, the quality and strength of the management team and competitive threats from larger established companies in the market. In exchange for assuming these risks, the VC sets very high expectations for target returns.
Investment usually takes place through a pooled investment structure such as a limited partnership (LP) or limited liability company (LLC). The investment may be in the form of common stock, convertible preferred stock or another security providing equity ownership rights to the investors. One of the first things a VC does is place a pre-money value on the investment. This represents what the investors consider the company to be worth before they step in. For example, a VC firm establishes a pre-money value of $7 million and the company's current shareholders agree to proceed with a transaction on that basis. The VCs agree to invest $3 million in new capital. Thus, the post-money value of the company is $10 million and the VCs have a 30% ownership interest.
Figuring Out Terms and Conditions
VC investors negotiate an extensive set of terms and conditions upon which they will make the deal. Common terms include seats on the company's board of directors, anti-dilution provisions, debt ceilings, limits on transferability of shares and lock-up arrangements for key management team members. VCs closely monitor their investments and are voracious consumers of information about the industry sectors in which their investee companies seek to compete. It is not unusual for members of a VC deal team to involve themselves in strategy meetings, marketing and other corporate events.
The most common routes for exit are through IPO or mergers and acquisitions (M&A). Somewhat contrary to popular belief, IPOs represent a significant minority of liquidity events. IPOs depend on a number of factors, including the stock market's appetite for new issues. Even in 1999, at the height of the dotcom bubble, IPOs accounted for only $17.8 billion of VC exits as compared to $36.5 billion through M&A. In 2006, IPOs represented $5.1 billion of exits and M&A accounted for $16.7 billion. Predictably, the volume of exit activity has a close correlation to the amount of new VC investment. In 2000, U.S. venture investment reached an all-time high of $106.8 billion. That had fallen to $19.9 billion by 2003 amid the wreckage caused by the tech bubble's bursting. However, nearly a decade after in 2011, combined exit activity rose to $53.2 billion with the rise if new startups.
VC Goes Global
Venture capital has traditionally been a highly-localized business. For a time, it was common for VCs (in the mega centers of San Jose, Austin or Boston) to travel no more than 30 miles to visit a prospective investee company. This has begun to change with the increasingly global nature of the business. Although the U.S. still leads world volume by a considerable margin, there is a pace of robust activity in global VC hotspots such as Munich, Tel Aviv, Bangalore and Kuala Lumpur. The development of an active market and investment process for early stage companies in other countries has started to put pressure on U.S. VCs to look beyond than their own back yards, not only for prospective investments but for cost-effective partners, suppliers and buyers for their existing portfolios.
Investing in VC - Risks and Considerations
The risk factors associated with a VC investment are considerably higher than those for more established companies trading on public securities exchanges. In addition to the fundamental requirement of being a very high net worth investor with the capacity (and the propensity) to take on the liquidity and other risks of private investments, you need to have access to a VC fund to participate in the institutional financing rounds. VCs typically raise funds for their deals through private placement offerings and furnish potential investors with a memorandum outlining, among other things, the firm's strategy, target market, risk factors, deal team members and pipeline of potential deals. The most common structure is a limited partnership where the VC firm acts as the general partner and private investors are the limited partners. The traditional cost structure for a venture capital partnership is a 2% management fee and 20% performance fee or "cost of carry" - the percentage of profits earned by the general partner with the remainder distributed to the limited partners.
The Bottom Line
Regardless of how well the market for technology stocks is doing at any point, venture capital is a very important piece of our financial system. Models that have worked for many years in the U.S. are now being replicated in global markets and changing the shape of the industry. VC investing is different from investing in liquid, publicly traded securities. However, many public companies once existed as VC investments, so knowing how this market works is a useful piece of knowledge about many companies.