Euromoney Institutional Investor PLC

Changing the Game of Venture Capital: Expert Insights

Author(s): Tanaha Hairston
Source: The Journal of Private Equity, Vol. 16, No. 3 (SUMMER 2013), pp. 57-68
Published by: Euromoney Institutional Investor PLC
Stable URL: https://www.jstor.org/stable/43503776
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Tanaha Hairston
is Thunderbird Angel Net-
work Director at Thun-
derbird School of Global
Management in Scottsdale,
AZ.
tanaha.hairston@global.t-bird.
edu
Summer 2013 The Journal of Private Equity 57
Changing the Game of Venture
Capital: Expert Insights
Tanaha Hairston
has provided funding to a great number of
cited the significant down- the most successful start-ups of the past 30
sizing of venture capital, yet years. Based on market capitalization, VC has
Many the sizing cited future industry thethe future
of venture
of venturesigcapiniftialcant of venture analysts capital, down- capital have yet funded 4 of the current 20 largest companies
does not need to remain grim. An analysis Apple, Cisco, Microsoft, and Google. During
of the framework and operating principles of the 2008 recession there were employment
venture capital reveals areas of improvement losses across the nation, but these unemploy
that, if made, wil minimize the effects of ment numbers were smaller within venture-
negative external economic forces. Examina- backed companies. From 2008 to 2010, as the
tion of the historical impact of venture capital U.S. non-governmental job rate fell 2.6%,
and the factors precipitating the downsizing venture-backed company employment fell
of the venture capital market reveals opportu- only by 2.0%. According to the National
nities for a resilient venture firm less affected Venture Capital Association (NVCA) 2012
by market forces and able to deliver optimal Yearbook, VC investments increased 23%
returns on investments. from $23.3 billion in 2010 to $28.7 billion
The research is presented within thein 2011. Venture-backed companies in the
context of the four venture capital phases. United States represent 11% of all U.S. total
These four phases are: investment screening, jobs at 12.1 million. Venture commitments in
selection, monitoring, and exit. The pur-2012 were $20.1 billion dollars to 183 funds.
pose of this article is to present best practice Also in 2012, a total of $26.7 billon
research and alternate strategies for ventureventure dollars was invested in 3,143 com-
firms to consider. The basis for the adjust-panies. The leading industry was the software
ments is suggested through primary research industry with 31% of the total venture-
interviews of experienced venture investors backed revenue being invested in technology.
and supplemented by secondary research. More than 50% of the major industry sec-
tor's growth was due to venture capital. In
IMPACT OF VENTURE CAPITAL the software industry, VC-backed companies
created 734,000 jobs, 90% of industry jobs
Analysts, business leaders, and poli- backing $226.5 million of revenues.
created,
ticians have cited venture capitalVC's
(VC)backed
as 72% of the semiconductor and
an important factor behind the economic industry jobs, which was $234.4
electronics
million
growth in the United States. Venture of revenues, creating 620,000 jobs.
capital
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Exhibit 1
Venture Capital Under Management - Summary Statistics

No. of VC Firms in Existence 358 1,089 841

No. of VC Funds in Existence 616 2.119 1269
No. of Principals 4,996 14,541 5,887
No. of FirstUme VC Funds Raised 13 25 43
No. of VC Funds Raising Money This Year 78 176 162
VC Capital Raised This Year (SB) 4.9 15.7 20.1
VC Capital Under Management ($B) 28.7 272.1 199.2
Avg VC Capital Under Mgt per Firm ($M) 80.2 249.9 236.9
Avg VC Fund Size to Date ($M) 39.1 94.4 110.6
Avg VC Fund Size Raised This Year ($M) 62.8 89.2 124.1
Largest VC Fund Raised to Date ($M)

Source: NVCA [2013]

Exhibit 2
Inflation-Adjusted U.S. VC Capital Raised

$-140 - ^ """•NW
$132 ^

H 2000-2011: (88%)
$120 - ■

$100 - H >s.

S80 $73 ■

$60 - H H 2006-2011: (57%)

H H $48

„7 ||ll
■■■■■
■■■ $22 ■ ■ ■ fjļ
$14 $16 ■ ■ ■ ■ ■ $13 m ■ ■ ■
HHHHHHH$5 ■HHHHHHbH

¿ř ^ N<# ^ <{& <f§^ <{& efļP (fļP e^ ef^

Source: Thomson One as of November 9, 2011.

58 Changing the Game of Venture Capital: Expert Insights Summer 2013

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 In regards to the number of deals, 2012 shows the the next peak." This phenomenon that Ga
highest percentage of seed- and early-stage deals since thaler is referring to is what some investo
at least 1985 (51.8% of total deals). the "Patterson cycle," which is a hypothesi
Venture capital provides opportunities for entre- venture capitalist, Arthur Patterson, who s
preneurs to bring their technologies to fruition, stim- investment cycles have eight years of grow
ulates job creation, and results in revenue growth in by six years of retrenchment. According to P
particular industries. Venture capital is vital to the current period began in 2006 and ends in 2
growth of the economy and our country. ously discussed, venture capital returns in
two decades have undergone volatility.
VENTURE CAPITAL IN A RECESSION The process of obtaining capital com
from private and/or institutional investor
As with any industry, venture capital experiences
a much slower pace than in 2000. A record
good and bad markets. The VC industry is not $70without
billion was raised in 1999 and 2000. The current
controversy. Some experts believe that the VCinvestment
model is pace is $15 billion to $20 billion, so the
in need of repair and the VC industry needs to shrink.
ability to raise money is weak. Decreased fundraising
Venture capital returns in the previous two decades
means a lack of funds to pour into new start-up invest-
have demonstrated tremendous volatility, which makes
ments. Fundraising decreased because limited partners
it difficult to manage risk. This volatility is were
reflected
not experiencing the returns that they had received
in the capital raised as well as returns on investments
during 2000, when the venture returns were at a peak.
in venture. In 2006 and 2007, the business market showed signs
Exhibit 2 illustrates that the amount of venture of improvement and during times of recession, when
capital raised during the 2006-2011 period has declined jobless rates are higher more individuals pursue entre-
57%. Venture investor Gary Morgenthaler says, "Since preneurial opportunities.
our firm was founded in 1968 we have seen two market The amount of venture capital invested follows
cycles since the late 1960s. There are peaks and val- trends similar to the amount of fundraising. A steep
leys in the venture business. The first was in 1969, then decline following the year 2000 is followed by relatively
1983, and 1999. Because it takes 13 to 15 years to move stable increase in invested amounts from 2004 to 2007
among cycles - quite possibly we are four years from with a slight decrease demonstrated from 2007 to 2009.

Exhibit 3
All Venture Capital Investing

100 " ■■Unvested " 6'°°°

Source: Thomson One data through December 31, 2011.

Summer 2013 The Journal of Private Equity 59

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 In the Incredible Shrinking Venture Capital , Browning As we have discussed, similar to any
said, "there was decline of Venture Capital in the first ture capital experiences good and bad m
quarter of 2009 in the US." The decrease was reflected ture capital industry is experiencing th
in the science industries. US venture capital investment in the market, not incompetence of the
decreased by 40% in life science, 46% in biotechnology, ists. Venture Capitalist Jock Holliman
and 84% in green technologies. The Kauffman Founda- capital is a very cyclical business. The la
tion reports that VC has generated poor returns for more excellent early rates of returns in the
than 10 years. Also, VC has not substantially outper- 1997. The amount of money is declin
formed the public stock market since the late 1990s. The rapidly as the number of VC firms. In
vast majority of funds, 62 out of 100, failed to exceed 1,700 operational VCs; by 2015, that
public market returns. The NVCA has released current between 350 and 400 funds. Massive attrition of VC
data demonstrating the VC industry is in a recession. funds is occurring in the smaller regional fund market."
For the full year 2012, VC funds invested declined 10% When VC is in a recession does it affect all the venture
to $26.5 billion and the number of VC deals completed capital funds equally?
declined by 6%. The Cambridge Associates Benchmark Report
There are various reasons for the overall decline indicates a clear performance gap of both upper and
in venture funding. There was a tremendous amount of lower VC quartile performers measured by internal rate
fundraising that occurred in the previous decade, which of return (IRR). During the VC peak years of 1999-
translated to more venture investments. With increased 2001, this gap was substantial, with differences of 10%-
investments, VC firms are unable to obtain acquisi- 30% in IRR. This leads us to the question: What are the
tions or merge the companies they had invested in. The top-performing venture capital firms doing that allow
decline of the stock market has affected investors' abili- them to experience higher returns? Is there a difference
ties to provide funding to grow their companies and as in methodology for decision making in screening new
a result they are not focused on discussing new invest- deal opportunities? Although many agree that venture
ments. Instead, they are concentrating on preserving and capital is in a down cycle, venture capitalist Howard
sustaining the investments they currently have in place. Lindzon, of Lindzon Capital Partners, says, "It [VC] is

Exhibit 4
The Performance Gap between Top- and Bottom-Quartile Funds

100

so r'
Ä J
60 ' -
/ '
Ä I 40 *

^"

-40 -

1981 1986 1991 1996 2001 2006

Vintage Year

-Upper Quartile IRR - - Lower Quartile IRR

Source: Cambridge Associates, 2010 Benchmark Report.

60 Changing the Game of Venture Capital: Expert Insights Summer 2013

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not in a recession, the sizes are changing into smaller vation in order to map the market of participant firms,
webs of funds. There are global funds starting. It is just their market strategies, market position, and then we
evolving. It is more important and vibrant. Some [VC identify who we believe will be the leader and develop
firms] are doing space or clean technology - there is relationships with these leaders." Jock Holliman enjoys
no more of the typical VC semiconductor fund." Inde- deal flow referred from investment banks, accounting
pendent of the viewpoint of the VC, a vast majority of firms, angel groups, or, the best in his opinion, other VC
firms have been affected negatively by the economy; funds. In order to improve the quality of deal flow, VC
therefore, agility and adaptability are important for the firms should implement pro-active origination strate-
"next generation" VC firms. gies such as:
The VC process is broken down into four cat- 1. Build a specialized origination program with dedi-
egories: screening, selecting, monitoring, and exiting cated sourcing teams. Some VC firms may not
investment activities. Each of these categories has utilize students to assist in the deal origination
improvements that can be made to allow the VC firm program. Therefore, investors can set criteria for
to perform more effectively, independent of economic deal selection based on the firm's guiding invest-
fluctuations.
ment thesis and then empower students to discover
potential investment opportunities.
SCREENING THE INVESTMENT
2. Create opportunities, don't wait for opportuni-
ties - funds can use a proactive approach that will
In the United States, about 5% of proposals sub-
allow them to co-create companies such as part-
mitted to venture capital firms are financed. Selecting
nering with "deal executives" or syndication to
firms that promise high future profits is a challenge for
source opportunities in the executives focus area.
VC investors. Even if the firm has a history of selecting
3. Utilize
successful ventures, it can still be difficult to signals to look for targeted investments such
identify
as gleaning private company information online
the next great opportunity. There are two strategies
for seeking deal opportunities in a VC group - and noting site traffic increases.
passive
or pro-active. Many firms follow a passive
4. deal flowon social media strategies. Investors
Capitalize
strategy. have found that openly discussing their investment
Passive deal flow is when a VC receives deal oppor- thesis increases the perception of their abilities
tunities through the Internet, online databases, net- and builds trust. Social media also increases brand
working events, advertising, and other industry events. recognition, expands deal referral networks, and
VCs utilizing this strategy use a hierarchical screening drives traffic to the website, and ultimately leads
process, in which the initial screening is done at the to increased deal flow. Venture capitalist Howard
junior level and the investment decisions and negotia- Lindzon uses social media, such as Twitter, to
tions are done at a senior level. The directors screen obtain deal flow.
applications through the online platform and send out
5. Use a customer relationship management system
deal alert opportunities for the investors to review, or
(CRMS) tool to manage ideal clients. This com-
they may write an investment memorandum that sum-
puter software system allows a VC firm to track
marizes the opportunity.
interactions, collect data, and measure the perfor-
Pro-active deal origination has set criteria for deal
mance of the VC prospects.
selection based on the VC s guiding investment thesis to
generate increased returns on investment. According to
SELECTING THE INVESTMENT
the best practices of venture capital/private equity (VC/
PE) firms, those firms that employ a proactive origi-
Traditionally, venture capital was considered
nation strategy experience consistently higher returns,
be an art and not a science. Venture capitalists spe
because of increased quantity of deal flow and increased
great deal of time sourcing, screening, and selecting
relevance of the investment opportunities. VC Gary
opportunities because there are very few decisions
Morgenthaler notes, "Across 400 investments in over
45 years we look at specific sectors for disruptive inno-

Summer 2013 The Journal of Private Equity 61

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have greater consequences for a firm than the decision
of whether or not to acquire another business.
The primary goal for a venture capitalist is to
make a wise decision based on the investment oppor-
tunities available. The definition of a wise investment
is an investment in a firm that generates a substantially
high rate of return. Today, the equity market gener-
team to execute the business model. Therefore,
the role of a VC firm is to work with manage-
ment to refine the product market strategy and
possibly to upgrade the management team, if nec-
essary. If you do not have the core of something
that is world class, then there is a low probability
of success.

ates 5%-8% returns, therefore, VC as a much riskier

As the personal interviews demonstrate, there
asset class should generate 15% and higher. When inves-
are varied levels of value placed on the different fac-
tors manage a fund, they are scrutinous regarding their
tors - management, product, market, and finance - in
investments so that they are able to generate a high
analyzing an investment deal. Also, there are tools to
return. On average, if 200 proposals are submitted toassess
a these factors, and each factor has models to aid in
venture capital firm, 20 will advance through the initial
its measurement. Porter's models are used for analyzing
screening process. Out of these 20, approximately 5-10
industries and help to assess product and market compo-
are funded per year. European Venture Capital Associa-
nents. These models provide a framework for analyzing
tion Secretary General Dorte Hoppner says, "If venture
suppliers, buyers, competitors, and possible new entrants.
capitalists are good and experienced they understand that
To assess financial factors, basic accounting models and
all their portfolio companies will not be top performers,
business valuation models are available (Higgins [1995]).
but they expect that some will be top performers."
These models rely on assessing the value of an enterprise
Most VC firms have an investment process in
through making forecasts and calculations about future
which a partner responsible for the investment writes cash flows.
up an investment analysis describing the investment.
In the past, however, there was a facet of valua-
Some are brief 2-page documents, while others are 20
tion that is often overlooked that significantly affects
pages. In analyzing an investment, VCs have varying the firm's return on investment. This is a valuation of
levels of preferences within the four primary factors that
human capital or the management of a firm. There are
are assessed: management, market, product, or finance.
no models that exist in this field for assessing human
Executive Director of Inter- Asia Venture Management
capital that answer to the question: Does the manage-
Lewis Rutherfurd places utmost importance on mar-
ment team have the knowledge and skills to build a
keting because, he says, all his firm's "deals have failed
successful firm in order to generate a substantial return
because of marketing. The deals haven't failed on com- on investment?
petition or the people, they have failed because their
people can't sell the product." Venture investor Alan
Baratz says, "The business model defines how successful
Human Capital Valuation
you can ultimately be with the ideal management team,
Human capital valuation consists of making pro-
and the people determine how much of that value you
jections regarding future behaviors that human capital
will actually achieve. There are times when a below par
is likely to perform and then assessing the present value
manager team in a stellar area will do better than a good
of that future stream of behaviors. Business valuations
team with a below average product."
use past financial performance as a guide in making esti-
Venture capitalist Jock Holliman says his firm's
mates of future performance. Human capital valuations
focus is the large market, in order to build successful
may use past behaviors as a guide in making estimates of
companies. His firm is not opposed to seeking the man-
future behaviors. An accurate human capital valuation
agement team for a certain opportunity. Venture investor
is expected to help contribute to the accuracy of the
Steve Larsen says, "You can always replace a team, but
business valuation and therefore help venture capitalists
you cannot replace a great market." Gary Morgenthalermake better investment decisions.
echoes Steve's comments by saying,
In a classic study of 102 venture capital firms,
A market opportunity exists because of changes in MacMillan, Siegel, and Narasimha [1985] identified the
the business model, and it takes the management top two criteria that venture capitalists consider when

62 Changing the Game of Venture Capital: Expert Insights Summer 2013

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making an investment decision pertaining to human
capital. These two elements are 1) the entrepreneur's
ability to sustain intense effort (cited by 64% of the
respondents), and 2) the entrepreneur's familiarity with
the market targeted by the venture (62%). The first
element is a "motivation" dimension of human capital.
demonstrated. In contrast, work sample formats do not
measure past behaviors; they measure present behaviors
in a sort of "audition" format. These interactions are also
called "hypothetical" or "situational" interviews and
measure responses to hypothetical questions about what
a candidate "would do" in certain situations.

The second element is a type of knowledge or skill. Smart [1999b] suggests examples of past-oriented
Venture investor Howard Lindzon supports this data in questions: "Let's talk about your first job. What were
his interview: some high points and specific accomplishments? Tell
me about a time in that job in which you organized
The people are everything, and therefore I try
and planned a project. How many hours did you work
to find resilient entrepreneurs because good
per week on average in your first job?" Indeed, Hough
businesses come down to the vision, culture,
[1984] found that past-focused questions aimed at uncov-
motivation, and skills of the entrepreneur. The
ering a candidate's accomplishment record were highly
characteristics of the great ones are great at living
predictive of future performance. An accomplishment
their idea and are great at recruiting their team.
record is simply a record of a candidate's past accom-
In a study of 52 entrepreneurial firms in New plishments that are relevant to the job for which he or
England, Stuart and Abetti [1990] found that human she is interviewing. The underlying notion is that the
capital was a stronger predictor of venture performance best predictor of future performance is past performance.
than factors related to the product or service of the Work samples measure what a person "can do."
new venture. The research uncovered the presence of Past-oriented interviews measure what a person "does
an entrepreneur with prior senior management experi- do." As hypothesized, the past-oriented interview
ence in new ventures was the best predictor of financial appears to be more closely associated with the accu-
performance of the new venture. racy of human capital valuation than the work sample
Numerous prominent deals of the 1980s were done method. Work samples can be thought of measuring
with casual due diligence, which resulted in acquisitions "best behavior." This method relies on the assumption
that produced sobering results. Therefore, buyers in the that a person's best behavior is predictive of how they
1990s require more extensive hard knowledge about will actually perform on the job. However, findings
their acquisition targets. There are many reasons there is of this study suggest that past behavior is a better pre-
a need for an expanded due diligence framework. Most dictor of future behavior than best behavior. Therefore
are because, now more than ever, VCs are scrutinized this article suggests conducting past-oriented interview
for their ROIs. Investors will now look for returns to be techniques in order increase the chances of assessing the
higher than they can receive from investing in the equity most important criteria in determining the success of a
market. The expanded due diligence framework includes firm, the management team.
valuation of human capital and examining intangible as
well as tangible assets. In the past, traditional due dili- Effective Intellectual Property Due Diligence
gence was simply focused on tangible assets.
Many scholars agree that the human capital is a A second component that is often overlooked
very important - if not the most important - determi- during the screening process is intellectual property
nant of new venture performance. Some researchers sug- due diligence. In discovering the overall valuation of
gest that human capital is important but maybe is not the business, the value of the operating firm is added
the most important factor. The issue that is not clear is to the value of the intellectual property and informa-
how to accurately assess the human capital of a venture tion technology. According to The Economist , as much as
prior to making an investment decision. One solution three-quarters of the value of US publicly traded com-
is utilizing a past-oriented interview format (Smart panies come from intangible assets. Intangible assets are
[1998]), which asks ^questions about actual experiences intellectual property, patents, trade secrets, and domain
and behaviors. Questions in a past-oriented interview names. An example of why effective IP due diligence is
measure behaviors that a person or group has actually

Summer 2013 The Journal of Private Equity 63

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important is the Volkswagen 1998 acquisitions of Roll In addition to raising funds, VCs spend
Royce. Volkswagen neglected to confirm intellectual shaping and recruiting the management team, b
property asset ownership before buying Rolls Royce do not want to be involved in the daily details
and Bentley from Vickers. Even though Volkswagen portfolio companies. Research validates that the
paid more than 700 million for the cars, design, and tion allocated by venture capital firms to their p
manufacturing, Volkswagen could not use the Rolls companies' impacts their performance. There ar
Royce name on their new line of luxury cars. BMW motivations for involvement in the firm. The first is to
purchased the Rolls Royce trademarks from the actual monitor their portfolio investment. Because VCs are
owner - Rolls Royce PLC, an aircraft company - for 65 rarely involved with the daily operations of the venture,
million and ended up with all of the Rolls Royce. This separation of ownership and control leaves them reliant
example demonstrates how important IP is to a business on the chief executive officer to maximize the value
deal, and the importance of IP due diligence. The first of the VC's investment. Sometimes, the interests of the
step in IP due diligence is to describe and prioritize venture capitalist and the CEO may not be aligned,
assets. What is the value of the IP now and in the future? which may result in the CEO focusing on the pursuit
Second, a complete listing of all intellectual assets should of private interests and other opportunistic behavior.
be obtained. This includes patent, trademark, and trade One of the concerns of a venture capitalist is that entre-
secret tables. Third, confirm asset ownership, including, preneurs with private information and large private
verifying that ownership is with the seller, track history benefits will not want to liquidate their project even if
of listed inventors to see if chain of title is without a gap, they know the firm has a negative net present value for
noting encumbrances, and confirming paid fees. Also, the shareholders. Also, monitoring the firm reduces the
ensure the IP doesn't face threats of third-party claims asymmetric information between the firm and the VC.
for infringement of IP. Thus, according to Valuation of Venture capitalist Howard Lindzon says his motivation
Intellectual Property and Intangible Assets by Smith and Parr, for monitoring his portfolio companies is that he has
the total value of an intellectual property is based on investors that rely on him to generate high returns so he
three components: needs to stay in touch with companies to see how they
1. Current and expected applications of the intellec- are doing. Up front, he communicates with entrepre-
tual property neurs how to use him and thus the entrepreneurs com-
municate with him. Venture capitalist Louis Rutherford
2. Logical extensions of the intellectual property
says the entrepreneurs that he has invested in need help
3. Speculative extensions of the intellectual property. and they know it.
The second motivation for allocating attention to
The Handbook of Business Valuation and Intellectual
the investment is the value of the VC's assistance. VCs
Property by Reilly and Schweihs states: "The income
invest not only financial resources but also their own
approach to intellectual property measures the present
value of the economic benefit or the economic loss to time, experience, managerial expertise, and connections
in order to build a successful and profitable firm. The
the owner over the intellectual property's expected
VC's ability to locate a promising company is impor-
remaining useful life."
tant, but it is also necessary that they add value through
the daily business operations. Daily operations include
MONITORING THE INVESTMENT
such issues as operational, strategy, human resources, or
finance challenges. Other value-adding responsibilities
The reality is that, venture capitalists spend the
may include setting up the boards and serving on them,
majority of their time fundraising because the revenue
designing human resource policies and stock-based com-
model of a venture capital firm supports pay for fund-
pensation schemes, meeting with customers and sup-
raising instead of return on investment. VCs typically
pliers, replacing and hiring key managers, and providing
are paid a 2% management fee on committed capital and
consulting as well as active involvement in strategic deci-
a 20% profit-sharing structure. Thus, VCs are compen-
sions. Therefore, VCs should consider how many port-
sated for raising larger funds.
folio companies they can manage while adding value.
If the number of companies managed exceeds the capa-

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bility of the firm then the VC's value-adding activities clinical trials or regulatory results, and at each phase they
become too fragmented. Investors can utilize syndica- give the entrepreneur additional money. Their goal is
tion as a mechanism to avoid resource constraints. to weed out non-performers early. They either miss or
As suggested by theoretical analysts venture capitalscore, and if they miss then they will not continue to
firms should contract and structure their investments receive investment.

based on the performance of the entrepreneur. As long

as the entrepreneur performs well, she would retain VC Syndication
control of the company, however if she does not, the
VC would retain control. This strategy would allocate Syndication is when one or more VC firms origi-
cash flow rights, control rights, liquidation rights, andnate the deal and then take the lead role in working
employment terms. with the portfolio company. Traditionally, VCs do not
In addition to financial resources, VCs invest theirsyndicate frequently. However, there are many benefits
own expertise, managerial skills, time, and connections of syndication. The first benefit is the future recipro-
in nurturing a company to profitability. The future suc- cation of investment opportunities. A second benefit
cess of the VC firm arises from a unique ability to spotis the VC is better able to screen the investment by
talent and an excellent opportunity, but also to add value leveraging the location- or industry-specific expertise of
to the operating of the company. Unlike the traditionalother firms. Syndications assist in diffusing information
VC strategy of betting on a company's future prospects, across industry boundaries and allow VCs to diversify
it is the assistance from an experienced and connectedtheir portfolios. Gary Morgenthaler says, "Syndication
individual with a reputation for success that brings value. is used to manage risk and value. In all 400 investments,
There are two useful strategies that assist in monitoring it is the practice to bring multiple partners in an invest-
the investment: staging the capital infusion and VCment over time. Syndication within a given round has
syndication. occurred in over half of our investments."

Staging Capital Infusion EXITING THE INVESTMENT

Research shows that the staging of capital infu-
sion allows venture capitalist to gather information to
monitor the progress of firms and maintain the option
to periodically abandon projects. Staging capital infu-
sion is similar to debt in highly leveraged transactions
because it keeps the owner on a tight leash and reduces
the potential of losses from bad decisions. Apple com-
puter, which received three rounds of staged financing,
shows how VCs used staged financing to evaluate its
progress. In the first round, VCs invested $518,000 in
January of 1978 at a price of $0.09 a share. By the second
round, in September 1978, the company was doing well
so the VCs committed an addition $704,000 at a price
of $0.28 per share, which reflected the progress of the
firm. A final VC investment of $2,331,000 was made
in December 1980 at $0.97 per share. Each stage, the
increasing price per share and the growing investment
reflected the transition from uncertainty to certainty of
Apple's future prospects.
VC Jock Holliman funds to milestones. His firm
identifies a series of milestones that are usually tied to
Venture capitalists own their profit over time whe
some of the companies in their portfolio are sold
the public market for an initial public offering (IP
through another exit vehicle for more than the in
value of the firm. The goal of VC firms is to liqui
their ownership in the invested company. There are
tiple different ways to exit a company; most comm
the IPO, which offers a 96% positive return. The se
most common is merger and acquisition, which off
59% positive return.
In an IPO, VC firms distribute the shares they h
in the IPO companies to the limited partners. VC fi
begin to distribute the shares when the lockup agr
ment between the underwriters and the insiders exp
The majority of the VC funds exit the portfolio c
panies within two years after the IPO. Because VC
undergone a recession over the past decade, IPOs h
decreased significantly. An acquisition is the sec
best solution and is not enough to sustain the vent
model. There is a third option for venture capital
is not normally considered. The third option is

Summer2013 The Journal of Private Equity 65

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lizing secondary markets to sell the individual owner- Venture capital returns suggest VC is in a down
ship interest in private start-up or VC funds. Secondary cycle and external economic forces have had a nega-
markets operate at the individual investment level rather tive impact on venture capital. It is possible to mini-
than the start-up level. Investors have varying liquidity mize the risks associated with investing in early-stage,
requirements, and an individual-investor option offers high-growth-potential start-up companies and generate
exit to those who need it - whether this is the VC whose higher returns. First, VCs can incorporate best practices
fund is about to expire and must return capital or the of VC/PE firms in selecting the investment. Second,
serial entrepreneur that desires to begin another ven- they can adequately screen the investment, using both
ture. The benefits to the secondary buyers is that they tools and models for each component of valuing an
will have a new exit clock, discounted purchase prices, opportunity, specifically incorporating the under-uti-
and an opportunity to invest in an asset class that was lized tools of valuing human capital. Third, firms should
not originally available to them. This is not a foreign actively monitor the investment using expertise of the
concept. There is a secondary market that is emerging firm and incorporating staging and syndication. Finally,
for stock in private companies and limited partnership they would analyze alternative exit strategies as a tool
interests in venture capital funds. to ensure better returns on investment. By incorporate
VC Gary Morgenthaler states, "There is a new these principles, VCs will minimize the negative effects
secondary market arising that provides liquidity and of the investing environment.
market momentum. The public market is buying shares
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