Chap 12 Solutions

Chapter 12: Professional Venture Capital

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Chapter 12 PROFESSIONAL VENTURE CAPITAL

DISCUSSION QUESTIONS AND ANSWERS 1. What is a professional venture capitalist? How does this occupation differ from that of an angel investor? A professional venture capitalist is one who invests not only his own money but also other capital from other investors while an angel investor is a wealthy individual who invests just his own money. 2. Briefly describe how professional venture capital got started after World War II. See section 12.1 for details. Professional venture capital, as we know it today did not exist before World War II. A group of people including Georges Doriot and Ralph Flanders believed that WWII technologies could be commercialized and joined to form the first professional venture capital fund called American Research and Development (ARD) in 1946. 3. What was the early role of the Small Business Administration (SBA) in fostering venture investing? The SBA initially helped small businesses get government contracts and then moved into guaranteeing small business loans. The SBICs chartered by the SBA became the primary structure for professional venture capital very quickly after their inception. 4. Describe the development of professional venture investing in the 1960s, 1970s, and early 1980s. After the overheated SBIC market, private venture capital partnerships became the predominant form for organizing a professional venture capital fund. This structure remains the dominant form. The growth of VC investing came along with technology investing in minicomputers and microcomputers. 5. What has happened to professional venture investing since the mid-1990s? Much of the growth in VC investing during the second-half of the 1990s was associated with internet technology’s phenomenal boom and crash in the late 1990s. See Figure 12.1 for historical levels of VC investment. 6. What are the components or stages in the professional venture investing cycle from inception to funding?

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(1) Determine (Next) Fund Objectives and Policies; (2) Organize New Fund (usually partnership; (3) Solicit Investments in New Fund; (4) Obtain Commitments for Series of Capital Calls. 7. What are the components or stages in the professional venture investing cycle after funds have been raised until closure? (5) Conduct Due Diligence and Actively Invest; (6) Arrange Harvest or Liquidation; (7) Distribute Cash and Securities Proceeds (as available). 8. Who are the major suppliers of venture capital by type and size of commitment? Refer to Figure 12.4 which shows Suppliers of Venture Capital as determined by Bloomberg in 2014. Major suppliers are: (1) Public Pension Funds = 20%; (2) Endowments and Foundations = 17%; (3) Financial and Insurance = 14%; (4) Family Offices = 14%; (5) Funds of Funds = 13% [Note: Figure 12.4 incorrectly shows the Funds of Funds at 33% instead of the correct 13%.]; and (6) Other (including professionally managed venture capital) = 22%. 9. What is meant by the terms (a) capital call, (b) deal flow, and (c) venture investing due diligence? (a) capital call: when the venture fund calls upon the investors to deliver their investment funds; (b) deal flow: flow of business plans and term sheets involved in the venture capital investing process; (c) due diligence: process of ascertaining the validity of a business plan. 10. What is meant by the terms (a) lead investor, (b) SLOR, and (c) term sheet? (a) lead investor: venture investors taking the lead for a group (syndicate) of other venture investors; (b) SLOR: standard letter of rejection; (c) term sheet: summary of the investment terms and conditions accompanying an investment. 11. Why should entrepreneurs care what pressures venture capitalists face in carrying out their professional money management (intermediation) function? Entrepreneurs should care about the outside pressures because venture capitalists have time frames and financial goals to reach in order to satisfy their investors. Receiving more capital from venture capitalists depends on meeting their timing and financial goals. 12. Why do venture capitalists make quick decisions on the infeasibility of some business plans? When a business plan is not quickly determined to be infeasible, what happens next and why?

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Venture capitalists screen a large number of business plans in any given year. Due to limited staffing and their receiving many plans that fall outside of their field for investing, VCs learn to make quick and decisive scans at the initial screening stage. Typically the VC screening process looks for reasons not to fund a venture. Assuming that the venture passes this initial screen, it is then subjected to additional screening and the beginning of the due diligence phase. 13. What should be the goal of the financial projections in a business plan submitted to a venture capitalist? The goal of financial plans submitted to a VC is to provide evidence that the business plan has, to the extent possible, been reflected in a timeline and set of financial events. The financial projections provide initial estimates of important screening criteria like capital needs, time to market (first revenues) and prospects for profitability. The absence of financial projections can signal that the entrepreneurial team has not given sufficient thought to the true viability of the business plan. 14. Is the compensation paid to venture capitalists (e.g. 2% management fee and 20% carried interest) reasonable? What are a fund’s investors buying with this compensation? While the determination of reasonableness of VC compensation is somewhat subjective, there is widespread evidence that VCs services are valuable and sought after. The investors pay the venture capitalists a portion of their earnings in order to give them incentive to make sure they invest in worthy ventures. 15. Why are venture capital funds typically organized as limited partnerships? In particular, why are they private firms instead of public firms? VC funds are typically private in part due to their ability to avoid registration with the SEC. The limited partnership structure provides limited liability for their investors who are typically “accredited.” The publicly-traded form for venture capital funds has not met with as much success possibly due to the difficulty of creating an understanding in the general public that venture investments are of indefinite length and involve a high probability of complete loss. 16. What can be learned from the SBA’s creation and the Internal Revenue Service’s subsidy of venture investing through SBICs? Typically tax subsidies attract investors. The SBIC structure subsidizes capital costs for SBIC investors and at least historically may have contributed to funding ventures past the point where they would have been funded were it not for the subsidy. Whether this additional investment provided a net social benefit remains to be seen. 17. Discuss why it is important to have an exit event for each investment held by a venture investment fund.

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An exit event for each investment is necessary to bring a venture capital fund to closure. The VCs must arrange for the liquidation or harvest of each investment and distribute cash and securities proceeds to investors. When a venture fund’s last  investment reaches the exit event and all the proceeds have been distributed, the firm  calculates the return achieved for investors over the entire life of the fund. Venture  capitalists will if necessary make adjustments in strategy, organization, or marketing  necessary to launch the next fund. Thus, the professional venture investing cycle  continues. 18. From the Headlines – Tabula: Describe the role venture capitalists played in the founding and expansion of Tabula. Comment on possible reasons for the involvement of multiple VC firms. Answers will vary: Tabula was founded with venture capital and has completed multiple VC-backed investment rounds to support its development and expansion. The involvement of multiple VCs can arise from diversification motives of the VC investors, limitations on the abilities of early-stage VC investors to bankroll a long development cycle prior to revenue and profit, and a desire to engage the resources available from multiple VC firms, among other things.