Sources of Capital: Private Equity and Venture Capital Funds

Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser et al

Private Equity

Private equity is a term used to broadly group funds and investment companies that provide capital on a negotiated basis generally to private businesses. This category of firms is a superset that includes venture capital, buyout-also called leveraged buyout (LBO)-and mezzanine and expansion funds. The industry expertise, amount invested, transaction structure preference, and return expectations vary according to the mission of each. Additional information about the fund types mentioned is provided hereafter in this handbook.

Over the past decade, private equity has developed into a major asset class, providing significant risk/reward benefits to institutional investors' portfolios. During the 1980s, the industry was still considered a niche sector, with less than $10 billion in capital invested annually. However, since 1990 over $730 billion has been committed to private equity funds, with over $340 billion committed in the past three years alone. Top-quartile managers have realized a net internal rate of return (IRR) in excess of 17 percent over the past 12-year period of economic cycles. 1

Private equity is an alternative asset in which many institutional investors in the United States allocate on average 7.5 percent of their total portfolios. 2 About 50 percent of the private equity in the United States is provided by public and private pension funds, with the balance from endowments, foundations, insurance companies, banks, individuals, and other entities who seek to diversify their portfolios with this investment class. 3

Private equity firms act as the intermediary between institutional investors and the entrepreneurial and portfolio companies (issuers). In addition, there are publicly traded investment companies that play the same role between public investors and the same issuer market. Their investments are sometimes augmented by angel and corporate investors. Issuers include the following types of companies:

  • Expansion.
  • Change in capital structure (recapitalization).
  • Change in ownership.
  • Public companies:

  • Going private.
  • Leveraged buyouts.
  • Financial distress.
  • Special situations.
  • Private investment in public equities (PIPE).

Figure 5.9 provides a perspective of the private equity landscape and the players.

You will find that the types of firms and the types of investments they make are not clearly delineated. Some venture funds invest in the same rounds of financing alongside buyout funds that provide expansion and growth capital. It seems a bit confusing because the terms in the private equity business are not used consistently among firms. Some firms will only take a controlling interest while others will make minority investments. The actual deal structure varies greatly based on the experience and preferences of the general partners of each of these types of firms.

In some instances, private equity firms take a controlling interest in the target investment, with minority stakes left to management and prior company stockholders, some of whom may have been involved in creating the company or developing the company to the stage where the acquisition or investment became attractive.


In other situations the private equity firms leverage their buyouts by pooling bank and other financial institution debt in a financial package that could include convertible subordinate debt and tranches of unsecured financing.

Some private equity firms deal only in a specific business field where they have a strong expertise, while others seek opportunities in diverse industries.

Many private equity firms have staffs with strong management skills, although they seldom take a day-to-day operating role in the firms they acquire or in which they invest. Their staffs are accustomed to consulting and guiding company executives in how to achieve growth and profitability that will increase firm value during the holding period. The support staff could be organized as a management consulting arm of the firm, and it may charge fees to portfolio companies.

In the past, private equity firms typically purchased a private company, spruced it up, and then took it public or sold it to another operating company, hopefully at a profit. Today, more private equity firms are passing portfolio companies among themselves. Such deals, where investment firms are on both sides of a transaction, used to be relatively rare. In 2001, for instance, there were only $2.5 billion worth of such deals, according to Dealogic, which tracks merger-and-acquisition activity. In contrast, there were almost $41 billion worth in the first seven months of 2004. 4

Venture Capital

Venture capital (VC) is probably one of the most misused financing terms, attempting to lump many perceived private investors and investment types into one category. In reality, very few companies receive funding from venture capitalists-not because they do not have good companies, but primarily because they do not fit the funding model. One venture capitalist commented that his firm received hundreds of business plans a month, reviewing only a few of them and investing in maybe one, and this was a large fund. This ratio of plan acceptance to plans submitted is common.

Venture capital is primarily invested in young companies with significant growth potential. Industry focus is usually technology or life sciences, though large investments have been made in recent years in e-businesses and certain types of service companies such as outsourcing. Investments tracked by the MoneyTree Survey 5 are grouped into the following segments:

  • Software.
  • Biotechnology.
  • Telecommunications.
  • Networking and equipment.
  • Medical devices and equipment.
  • Semiconductors.
  • Computers and peripherals.
  • Information technology services.
  • Financial services.
  • Industrial/energy.
  • Business products and services.
  • Consumer products and services.
  • Media and entertainment.
  • Electronics/instrumentation.
  • Retailing/distribution.
  • Health-care services.
  • Other.

Industry Overview

Data and information in this section is current as of July 27, 2004, and provided by PricewaterhouseCoopers, Thomson Venture Economics, and the National Venture Capital Association MoneyTree Survey. None of the parties can warrant the ultimate validity of the data. Results are updated periodically. All data is subject to change at any time.

This section is intended to provide an overview and current perspective of the VC industry, and to set the stage for the balance of the discussion surrounding venture capital.

The steady upward trend in venture capital continued in the second quarter of 2004 with investments of $5.6 billion going into 761 companies. (See Table 5.6.) This compares to $5.0 billion invested in the first quarter of 2004 and $5.4 billion in the fourth quarter of 2003. Over the past two years, quarterly investing has drifted upward at a deliberate pace, ranging from $4.3 billion to this quarter's high of $5.6 billion.

The life sciences sector (biotechnology and medical devices together) continued to dominate other industries as it has for the past eight consecutive quarters. Investments in the sector totaled $1.4 billion, or 25 percent of all venture capital. Proportionately, life sciences investing remained near historical highs.

The software industry held on to the top slot in the second quarter of 2004 as the largest industry category. Software companies garnered $1.2 billion going into 212 companies; both figures were comfortably above the prior quarter. The decline abated in the networking industry with 44 companies getting $459 million in mostly follow-on rounds. The telecommunications industry did not fare as well, with a decline from Q1 2004 to $518 million going to 59 companies in Q2 2004, again mostly in follow-on rounds.


As shown in Table 5.7, a total of 229 companies in the early stage of development were funded in Q2 2004, the highest number since Q2 2002. Proportionately, they accounted for 30 percent of all companies, the highest percentage since Q1 2001. And early stage companies captured $1.2 billion or 21 percent of all venture capital in the period, well above recent quarters. Average funding per company of $5.1 million exceeded the $4.6 million average over the prior four quarters.

Expansion stage companies, which typically account for the largest total dollars and number of deals, increased slightly as well. Expansion stage funding was $2.8 billion in Q2 2004, or 50 percent of all investing, compared to $2.6 billion and 51 percent in Q1 2004. Average funding per company at $8.1 million exceeded the $7.5 million average over the prior four quarters. Later stage funding was flat. Investments in Q2 2004 were $1.6 billion, or 28 percent of all investing versus $1.6 billion and 31 percent of all investing last quarter.

Companies receiving their first round of venture capital rebounded in Q2 2004 to their highest level in two years. (See Table 5.8.) A total of $1.2 billion or 21 percent of all venture capital went to these companies, compared to $981 million and 19 percent of fundings in Q1 2004. In terms of number of companies, 208 first-timers accounted for 27 percent of all companies receiving financings in the second quarter, up from 172 and 25 percent of all companies in the previous quarter. Average funding per company was essentially flat at $5.6 million, reflecting continued emphasis on capital efficiency.

Additionally, companies receiving their second/third-time investments also charted an upward course with a 13.8 percent uptick in deals and 19.9 percent more dollars invested in the second quarter than in the first quarter.

The most active venture investors in the United States closed five or more deals each in Q2 2004. (See Table 5.9.) Of the more than 2,100 transactions reported in Q2 2004, the most active firms accounted for 744, or 35 percent of all investments. The top 13 firms accounted for almost 8 percent of the deals completed in the quarter. New Enterprise Associates topped the list with a total of 24 deals, while U.S. Venture Partners came in second having made 16 investments during the quarter. Morgenthaler Ventures, Draper Fisher Jurvetson, and Polaris Venture Partners were also among the most active investors in the second quarter, reporting 14 or more deals each.





Finally, as shown in Table 5.10, Silicon Valley and the Northeast areas continue to see the majority of the venture investment in terms of deals and dollars.

Value-Added Investors

The base content of this section is adapted from "Note on Venture Capital Portfolio Management," 2003, by Professors Colin Blaydon and Fred Wainwright, Tuck School of Business at Dartmouth, and Andrew Waldeck. The authors gratefully acknowledge the support of the Tuck Center for Private Equity and Entrepreneurship. Copyright© Trustees of Dartmouth College. All rights reserved.

VCs have two very powerful mechanisms to effect change in a portfolio company. VCs can replace management (with board approval) or force the sale of a company (by refusing to invest additional capital). Both of these measures, while effective, are quite drastic. There are a number of other ways that VCs impact the operations of portfolio companies.


Generally all VC firms will provide the following assistance to portfolio companies:

Financing or Exit Transactions VC firms by nature have unique insight into the current trends in the private equity markets. In addition to providing market insight, VC firms will often make introductions for portfolio companies to other VC firms when looking for a lead investor for another round of financing. Most venture firms also have relationships with commercial banks which can be used when portfolio companies require debt financing. Finally, venture firms also have strong relationships with leading investment banks and are highly active in the selection of the banking syndicate and throughout the IPO process.

Strategic Advice All firms can utilize their extensive experience as investors in, and in some cases operators of, similar businesses to provide strategic advice to growing companies

Team Building/Recruiting Most firms take some role in helping to recruit and build out the senior management team. Many firms focus a great deal of their energy on evaluating management teams and making additions or changes where appropriate-including recruiting and interviewing prospective new hires. Some firms, such as Bessemer, have even expanded to include formal executive search and recruitment departments, focused solely on placing world-class talent into their portfolio companies.

Leveraging Contacts All VCs have extensive contacts within their respective industry segments. VCs leverage these contacts for a number of purposes, including negotiating transactions on behalf of portfolio companies or sourcing exit transactions. Portfolio companies can also leverage these contacts directly to assist in new business development, sales support, and gathering market intelligence. In addition, leveraging contacts also includes resource sharing within the portfolio. Accell Partners, Battery Ventures, Crosspoint Venture Partners, and many others as well actively encourage interaction among portfolio company management teams.

Crisis Management Start-ups from time to time may experience times of crisis, such as the loss of a major customer or senior member of management, a cash crunch, or a major design or development issue. During these times, VCs will utilize any and all available resources, in rare cases acting as interim management, in order to protect or save their investment.

Venture Funding Process

Referring to our baseline financing process flow chart in Figure 1.1, the process to obtain venture funding encompasses steps 1 through 9. Key to raising venture capital is matching your deal to investor criteria. Secondly, there needs to be a compelling story for a company that solves a real problem, addressing a "painkiller to a painful area" versus "vitamins to make you feel better." 6 Said in another way, there must be a market need for a "must have" versus a "nice to have" product, service, or solution. The following list cites criteria that the target business and team need to possess to be a candidate for venture funding.7 Obviously not all businesses fit every item, but most are required:

  • Quality management for the stage of the venture. Show how you are building a qualified team, advisory board, and board of directors.
  • Product addresses a key aspect of the customer's business.
  • Customer is targetable and accessible.
  • There is a market beyond early adopters. The literal majority of entrepreneurs perform inadequate market research. Instead they try one of the following two approaches: (1) "The market is there!" (I guess that means "Take our word for it." We won't.) or (2) "We're part of the $220 billion electronics industry. If we get just 0.01 percent of it, we'll be a $22 million company." While the arithmetic may seem sound, this argument is so intellectually offensive that it leads to the immediate conclusion that the team's whole fabric is shallow and rhetorical. Scientific market research is almost never easy, but almost always possible. VCs look for a team that has segmented the overall market to isolate their specific opportunity, anchors their claims to solid, third party observations, and can focus on the specific target.8 Know the size of the markets and who are the largest players, their share of market, growth trends of industry versus players, what are the biggest issues facing the industry. How does your company fit? Be prepared to address concerns about the industry.
  • Customer is willing to change with defined purchasing processes.
  • Understand the selling process. Who are the decision makers? Are other parties critical to the decision process? What is the lead time to sell? Will it be a relationship or commodity sale? Be able to articulate a detailed benefits analysis to the customer.
  • Can understand/leverage corporate partners.
  • Can understand and articulate necessary milestones in the go-forward plan
  • Have a workable business model with above-average margins. Explain the detailed financial model.
  • Have a clear understanding of competitive/alternative landscape and trends. A cavalier dismissal of this threat, manifested in the oft-heard phrase "We have no competition," is a near-certain predictor of performance shellshock later on. Many VCs insist that the business plans seriously reviewed contain a competitive matrix-for instance, a comparison by relevant features of the product/service versus all other logical purchase alternatives.9
  • Have exclusive access to defined products, processes, or intellectual property.
  • Have an investment/funding strategy (including an exit strategy).
  • Have an unfair competitive advantage.
  • Foreseeable that the investment can have a 10 times return in 5 to 10 years.
  • Use a model for strategic planning; the model should reflect vision and market execution. The strategic plan must have milestones and metrics to measure those milestones. Outline the risks to your plan and explain why you can navigate.

An alternate view is to define what criteria will get the target company removed from or filtered out of the process quickly. We highlight a few issues:10

  • Lack of alignment of values with partner.
  • Management clearly lacks the background (for instance, no one has prior related success).
  • Me-too business (for instance, "only needs 1 percent market share").
  • Large capital requirement/too long to market.
  • Business plan and business model are lacking.
  • The plan is for a product, not a business.
  • Unrealistic funding/investment strategy.
  • Underestimating the competitive response.
  • Does not understand the selling process for the product/service.
  • Lacks ring of truth.

Following is a list of additional elements that venture capitalists mention as key investment criteria, shown in descending order of importance.11 Couple the two preceding lists and these key elements, and you have a solid filter or test for determining the probability of obtaining venture funding:

  • Management capable of a sustained intense effort.
  • Management thoroughly familiar with the market.
  • Management with demonstrated leadership.
  • Management that can evaluate and react to risk well.
  • Investment exit exists.
  • Significant market growth.
  • Management with a track record relevant to the venture.
  • Management that can articulate the venture well (can tell the "compelling story").

Be Prepared!

Assuming that you are able to pass the criteria described and prepared to address the topics mentioned, you can expect to engage in a process with a venture fund that resembles the one shown in the diagram in Figure 5.10. Given the significant number of unsolicited business plans submitted to venture capitalists, most firms are best accessed through their network of trusted advisers and resources. This network includes lawyers, accountants, venture partners, investment bankers, and consultants who are routinely engaged by the target venture firm. If these are not the same advisers to your company, you may need to be prepared to switch. Whether or not in writing, there is usually an implied agreement that if they introduce you and help you obtain financing then you will begin to use their services.

As you may have observed, raising venture capital is not a scientific process. In fact it is fairly subjective. VCs like to travel in packs. It has often been said that if you can attract one VC with serious interest, others follow. The way to attract a crowd is to have the interested VC firm set up meetings with other VC firms after declaring its interest. The company is building the syndicate for the lead VC firm. VCs prefer not to invest alone; they desire the deep pockets of a partner and they want the assurance of another investor's eyes and brains. If you have approached a number of firms and everyone is turning you down or dragging their feet, you have to assess whether the deal is financeable in its present form. A deal can get shopworn; investors often talk among themselves and can kill interest in a deal if there is any structural flaw in management or the business plan. So you have to ask yourself constantly, "Do I have the proper management? Is the team deep enough?" Remember VCs do not fall in love with technology or products but rather management. Founders and technical inventors are not generally suitable to be CEOs.


The fund-raising process can be frustrating and time-consuming. In fact, it slows corporate progress while management seeks financing. The most debilitating aspect is that the VC decision-making process is a prolonged event. If you get a quick no, it is because you do not fit their investment criteria. Rarely is there a quick yes. If there is initial interest, the partner will begin the investment process of performing exhaustive due diligence on the proposed management team and business model. There will be many meetings with industry leaders, friends of the firm, and your team. Management must simultaneously keep pushing forward with planned activities to build the business. Responding to due diligence requests makes you better at explaining the deal and answering concerns. Over the financing process, you will become more articulate, better focused, and armed to answer real or perceived concerns.

Be persistent. Give short- and long-term milestones. Tell the VCs when you make those milestones even if they were lukewarm on the investment; maintain a flow of communication. How an investment is perceived changes as circumstances change. Certain events can lead to financings- technology breakthrough, scientific community sponsorship, a reputable angel investor, a large sale, industry partners, and changes in the conditions affecting public markets. Entrepreneurs receive accolades from VCs for persistence. There is nothing wrong with repackaging the deal with answers to old concerns.

When a venture fund rejects your company for funding, it is not the end. You need to capitalize on the reasons for turning down the investment, and assess whether the concerns are valid and whether the issues can be addressed. Shopping puts your deal in front of more eyes and "beauty is in the eye of the beholder." Thus it is critical to shop but be aware of how the investors are viewing your deal. Are you hearing the same objections? Are you changing your presentation to address concerns from earlier meetings?

The Meetings

As mentioned, there will be a series of meetings with you and your team to position the company and to provide investors with support for your claims, the experiences and perspective of management, the chemistry among the team, and the underlying assumptions being made. These meetings should be two-way communications in which you are also able to better understand and assess your potential partners. In steps 3 and 4 there are a number of reference, customer, and management checks to validate backgrounds and test assumptions. As the process nears the point where a decision is made to invest, a case for or against is going to emerge, such as:

1. Strong technical team.


1. Doubtful CEO.

2. Chance to lead the market.

2. Big chance for slippage.

3. High upside.

3. Too much capital required

4. Weak investor group. . .12

The more introspective you and your team can be, and develop real alternatives or solutions to the "BUT" side of this equation, the greater chance you will have for passing through the filter and obtaining the investment sought. More importantly, you will likely have a stronger company and will have increased the chances for success.

As mentioned, having a realistic and clear funding strategy is important. Understanding the typical venture model will help determine if you are a candidate and have the appetite for venture capital investors. Funds are usually deployed in various stages, typically named: "seed, series A through series D," and so on. The stages are also referred to as "first round," "second round," and so on. Follow-on funding may be characterized as mezzanine or bridge round, usually completed 6 to 12 months prior to an initial public offering. Each stage is intended to take place at a point in the life of the company where the value has significantly increased with a target step-up in valuation over the prior round valuation. Following the burst of the Internet bubble, many companies have seen follow-on round valuations decrease; this is referred to as a down round. When a down round occurs, prior investments are usually significantly diluted.

Figure 5.11 illustrates the building of value through milestones with staged investments. Generally, the amount of money invested in a round increases as the stages progress. Seed investments range from a nominal investment to about a million dollars. Preseed investment is typically monies provided by friends, family, founders, and an angel investor; occasionally a venture fund will provide the seed round. Depending on the size of this start-up capital, some companies skip the seed round and accept an initial investment from a venture capitalist (or a syndicate of venture capitalists) as their A round, which varies in size from $1 million to $5 million. In the biotechnology and semiconductor industries, the initial rounds may be much larger. Obviously, there are exceptions to all of these generalizations. Average investments by round are illustrated in Figure 5.12.


The exit strategies are reasonably direct: Either take the company public or sell to a strategic acquirer. As a fallback, a company may be merged with another and better positioned for one of the prior exits mentioned. Other potentially less favorable exit alternatives include sale of the portfolio company to another investment firm, sale back to management, or liquidation.

Selecting a Venture Capitalist

Just as the quality of management in the target is important, so is the quality of the venture investor important to the success of the target company. We encourage you to explore and understand the background of the venture investors that you choose. If you choose to pursue venture funding, consider that the partners in the venture firm will become co-workers.

Table 5.11 compares the pros and cons of venture investment partners.


The Venture Capital Business Model

Understanding the business model and economics behind the venture firm may help you better understand the motives and actions of the VCs you partner with. We highlight some of the key facets of the VC model:

  • Young VCs tend to look at markets and data.
  • Experienced VCs tend to look at people.
  • A typical fund:
  • Invests in 10 to 15 companies.
  • Expects one company to "return the fund" or generate enough gains to repay the entire amount of the fund back to the limited partners.
  • Expects one to four companies to fail.
  • Expects the rest of the companies to have minimal to reasonable returns.
  • Has a life of 10 years.
  • Leverages expertise in certain areas by investing in a portfolio of companies in an industry.
  • Invests in stages, based on milestone completion.
  • VC investments:
    • Are structured to return 10 times their investment in five years.
    • Hold for three to seven years; average is about four years.
    • Expected returns depend on stage of the company; vary from 25 to 70 percent annually.
    • Must have a minimum projected portfolio company market cap of $100 million.
    • Historically have achieved overall multiples of 7 X for an IPO, 2 X for a sale, and .1 to .2 X for a liquidation.


The content is this section is largely based on "Understanding Valuation: A Venture Investor's Perspective," by A. Dana Callow Jr., managing general partner, and Michael Larsen, senior associate, life sciences, both of Boston Millennia Partners.

At the core of every venture capital financing is a mutually accepted valuation of the company by investor and entrepreneur. A valuation reflects both the entrepreneur's determination of the acceptable amount of ownership that may be given in return for the venture firm's capital and expertise, and the venture investor's determination of the risks and rewards of the investment. This dynamic is often misunderstood-and with harmful consequences. Understanding valuation from the venture investor's perspective is crucial. Realizing how valuations are determined and adjusted throughout the life of the company is critical to the investor-entrepreneur relationship and the ultimate success of the company.

Valuation methodologies differ by the stage of investment and the availability of quantitative and qualitative data. However, the basic language and components of venture capital valuation are universal, simple, and should be well understood before you engage in a discussion of valuation with a venture capital investor. We will explain how venture investors consider, construct, and justify valuations of early stage companies, and will offer perspective on the dynamic role of valuation throughout the life of a company.

The Basic Math

Any private equity deal will focus on the premoney valuation of the company. This is the estimated or notional value of the company as it stands prior to any purchase of equity. Determining the premoney valuation of the company, combined with the amount of capital accepted by the company, determines the amount of equity ownership sold in exchange for capital. The resulting valuation after the investment of capital is called the postmoney valuation. For example, in a company with a premoney value of $5 million, a $5 million investment would buy a 50 percent ownership stake in the company.

Premoney Valuation + Invested Capital = Postmoney Valuation

Price per Share = Premoney Valuation/Premoney Shares

It is important not to focus just on the valuation negotiation. Just as important as the negotiation of the premoney valuation is the entrepreneur's decision as to the amount of capital to accept, which is predicated on how efficiently the company will use capital.

Methodology-Differentiating Data

Early stage investing is far from an exact science. Early stage companies are often comprised of little more than an entrepreneur with an idea. Valuations at the seed stage are generally driven by factors that by their nature are subjective. These include appraisals of the CEO and management team, novelty of the value proposition, evaluation of intellectual property, expected time to market, expected path to profitability, estimated capital needs and burn rate, syndicate risk, sector volatility, and deal structure. In postseed investing, intermediate data points such as events demonstrating proof of principle and product validation will factor strongly in valuation determinations. As a company matures to a revenue stage, more quantifiable data is produced in the form of operating statistics and performance indicators. Actual results allow investors to more accurately model quarterly and annual revenue, EBITDA, cash burn, pipeline close rates, backlog, bookings, and enterprise valuation.

Table 5.12 may be oversimplified (and should not be considered as a guide to minimum valuation levels) but it does indicate the valuation trend line of a typical investment as the company matures. Risk varies inversely with the quality and quantity of data. The high degree of uncertainty inherent in seed and early stage investments translates into low premoney valuations. Failure rates of start-up companies are high, so investors must be compensated for placing their capital at such risk. Conversely, late stage and mezzanine investors have the benefit of predictive financial models that help to mitigate risk. They pay for the reduced risk with higher premoney valuations, allowing for less upside.

Venture investors see hundreds, if not thousands, of business plans each year. Every plan includes an attractive budget and aggressive growth plan. Forecasts, as illustrated in Figure 5.13, claim to be predicated on conservative assumptions including minimal market penetration, product pricing, and gross margin. Regardless of how they are constructed, these forecasts are almost always overly optimistic in their assumptions. A venture investor will "scrub the numbers," rationalize assumptions, and run sensitivities based on varying degrees of execution, competitive pricing pressure, seasonality, and the like. The resulting rationalized forecast may represent only a fraction of the original plan. Figure 5.14 illustrates a rationalized forecast.



Discounting from the original forecast may reveal significantly greater capital requirements than first expected. As an entrepreneur, it is in your best interest to understand the short- and long-term capital requirements of your company. These capital requirements will provide the underpinning of your company's long-term financing strategy. How much must be raised now? When will the next financing be needed? What significant milestones will be accomplished during that time? An understanding of the long-term financing strategy is crucial. A seasoned entrepreneur works with investors to develop a financing strategy based on building value from one financing to the next and understanding how value will be measured.



Figure 5.15 illustrates a staged financing strategy. Building a company requires time and cash.

  • Seed financing. The seed financing will provide the capital needed to support salaries for founders/management, R&D, technology proof of- concept, prototype development and testing, and so on. Sources of capital may include personal funds, friends, family, and angel investors. Capital raised is limited due to its diluting impact at minimal valuations. The goal here is to assemble a talented team, achieve development milestones, proof of concept, and anything else that will enable you to attract investors for your next financing.
  • Series A financing. Typically the series A is the company's first institutional financing-led by one or more venture investors. Valuation of this round will reflect progress made with seed capital, the quality of the management team, and other qualitative components. Generally, a series A financing will purchase a 25 percent to 50 percent ownership stake. Typical goals of this financing are to finalize product development for information technology companies, hire top talent, achieve value-creating milestones, further validate product, expand business development efforts, and attract investor interest in the next financing (at an increased valuation).
  • Series B financing. The series B is usually a larger financing than the series A. At this point, we can assume for information technology companies that development is complete and technology risk removed. Early revenue streams may be taking shape. Valuation is gauged on a blend of subjective and objective data-human capital, technical assets, intellectual property, milestones achieved thus far, comparable company valuations, rationalized revenue forecasts. Goals of this financing may include operational development, scaleup, further product development, revenue traction and value creation for the next round of financing.
  • Series C financing. The series C may be a later stage financing designed to strengthen the balance sheet, provide operating capital to expand the company operations, finance an acquisition, develop further products, or prepare the company for exit via IPO or acquisition. The company often has predictable revenue, backlog, and EBITDA at this point, providing outside investors with a breadth of hard data points to justify valuation. Valuation metrics, such as multiples of revenue and EBITDA, from comparable public companies can be compiled and discounted to approximate value.

Figure 5.16 demonstrates the typical relationship between the postmoney valuation as determined in a venture investment and the intrinsic market valuation of the enterprise that might be realized in a sale of the company. The implied premoney valuations of the seed and series A investments exceed the market valuations at the time of those investments. This early value premium is the result of qualitative data employed in the early stage valuation methodology. The venture investor is valuing the intangibles of the idea and human capital. Moving forward to the series B financing, premoney valuations fall in relation to market value. Interim valuations are generally below market value; this affords investors a risk premium in valuation to compensate for the illiquid nature of private equity.

Applying Perspective

The preceding example illustrates the stepped function of valuation. Each financing is designed to provide capital for value-creating objectives. Assuming objectives are accomplished and value is created, financing continues at a higher valuation commensurate with the progress made and risk mitigated. However, problems can and will arise during this time that may adversely affect valuation. When a financing cannot be raised at a step-up in valuation, investors may structure a flat round or a down round in which valuation is reduced.


A down round can result from premature capital shortages from overspending, failure to achieve value-creating milestones, or suboptimal operating performance. Overpricing of a prior financing or softening capital markets may also play a role. Down rounds are undesirable-they undermine management and investor confidence. They also bring unwanted write-downs to venture investors' portfolios. However, many companies have built success stories despite going through a down round.

The valuation of a company at a discrete point in time is subject to a certain range of interpretation. Most seasoned venture investors will value a company within a 10 to 15 percent range of comparably staged portfolio companies if they have exhausted all quantitative and qualitative data available. Given the consistency that is generally seen in the market, the key factor in choosing one VC over another should rarely be based in valuation.

In the long term, interim valuations will factor only modestly in the realization and distribution of proceeds upon exit. Investors will keep management incentivized. Remember to take the long view. Avoid arbitrary step-ups in valuation. Plan for the next financing and make sure there is ample justification for a step-up in valuation if milestones are achieved. In the end, the minutiae of valuation will matter very little. Valuation can make a good investment more attractive, but it will not salvage a poor one. A company will usually receive several financings before an exit is realized. Building value is the shared objective of entrepreneur and investor. A mutual understanding between investor and entrepreneur of the risks and rewards driving a valuation is crucial to starting a relationship on equal ground.

Other Contributing Factors in Valuation

Outside of the milestone-based measures, other factors contribute to the price paid by the VC for new shares:13

  • Condition of public and private financial markets.
  • Strength of management for the milestone stage.
  • Terms and conditions of the round.
  • Trends in the venture market.
  • Strategic significance of the company's product.

Many times, the terms and conditions of the investment are far more important than the actual price agreed upon. The investment should be evaluated based on a combination of elements of the deal structure14 - broadly, valuation, terms and conditions, and the planned exit:

  • Valuation.
  • Amount and timing of the investment.
  • Form of the investment.
  • Board compensation.
  • Vesting of management's ownership.
  • Additional management members.
  • Conversion rights.
  • Preemptive rights of the investors.
  • Employment agreements.
  • Proprietary rights of the company.
  • Exit strategy.
  • Lockup rights.

Partner Interaction with Portfolio Companies

The base content of the section is adapted from "Note on Venture Capital Portfolio Management," 2003, by Professors Colin Blaydon and Fred Wainwright, Tuck School of Business at Dartmouth, and Andrew Waldeck. The authors gratefully acknowledge the support of the Tuck Center for Private Equity and Entrepreneurship. Copyright© Trustees of Dartmouth College. All rights reserved.

As the founders or management of a venture-backed company, you can expect the partner of the lead venture capital firm to interact in a number of ways to provide input and collect information to monitor their investment.

Board Representation When venture firms invest in a private company, most receive one and sometimes two seats on the company's board of directors. Board members have a fiduciary responsibility to ensure that the company is being managed in the best interests of all of its shareholders. Board members receive regular updates on how the business is performing and the key strategic issues that it faces. Members are expected to attend regular board meetings, which can occur monthly for early stage companies or quarterly for later stage companies. Prior to each board meeting, each member receives a detailed board package, which is a collection of materials intended to be an all-inclusive update and review of the business. In addition to current financials, board packages typically contain a written update on progress in the business as well as a detailed explanation of the key issues being discussed at that particular board meeting (such as compensation plans, hiring of key managers, etc.).

Investor Information Provisions VCs and all other investors have information rights that are detailed in the shareholders' rights agreement, which is agreed to prior to the closing of a financing. Through these information provisions, investors typically are entitled to receive interim financial statements (which can be either monthly or quarterly), annual budgets or forecasts, and completed audited financial statements. Many VCs will request additional information to be included along with these interim financial statements, which help track the company's progress in achieving certain agreed-to milestones (such as number of customers or number of employees). In an effort to keep all investors better informed, private companies are now also including written business summaries with interim financial statements. These updates would cover any important business developments, such as additions to the management team, major new customer wins, or loss of a key customer. Using the last as an example, a realistic assessment should be presented indicating how to acquire customers to offset the sales volume loss. If no near-term offsetting sales gains are achievable, then management would present a fallback alternative downsizing plan showing commensurate expense reductions. Other alternatives would need to be prepared and presented with a recommendation for board discussion and approval.

Additional Informal Communication VCs will regularly call, e-mail, and visit many of their respective CEOs and other senior managers. Some VCs expect to communicate with 80 percent to 90 percent of their portfolio companies at least once a week. Investors use these opportunities to ask additional questions or to receive additional management insights. In addition, these situations also present management with a chance to ask questions, seek guidance, and get feedback from investors as well. Many investors believe casual and informal communication with management often provides the most meaningful insights into business or management performance.

Company Performance Monitoring

The base content of this section is adapted from "Note on Venture Capital Portfolio Management," 2003, developed by Andy Waldeck (Tuck 2004) under the supervision of Adjunct Professor Fred Wainwright and Professor Colin Blaydon of the Tuck School of Business at Dartmouth College, Center for Private Equity and Entrepreneurship.

In general, the information venture firms choose to focus on to monitor their performance is largely determined by the stage and sector of each company. For example, for a prerevenue biotech investment, a VC will want to track expenses and be updated on the status of the regulatory approval process. An investor in that same company at a later stage may track the sales pipeline (i.e., future revenue), expenses, and progress on future R&D efforts. Listed in Table 5.13 are examples of the type of information that VCs would focus on depending on stage.

Managing a Venture-Dominated Board

Caution: The following section may get you excited, especially if you are a VC. These paragraphs are not intended to criticize, but to provide the reader a perspective from entrepreneurs.

Leading or managing the board of a venture-backed company has dynamics that are not found in other companies. In discussing this topic, company management may benefit from understanding the psyche of a venture capitalist. We believe that the following four quotes from venture capitalists provide insight into how they may view the world. As with any generalization, there are exceptions.

Quote #1: "We cannot pick our winners." Imagine playing a game each year at the Christmas party where each venture partner tries to pick their most successful companies (meaning those that will be successfully exited) in the coming year, and they discover after years of play they cannot. Companies that may appear to being doing well from an operations or a technology development viewpoint today may encounter significant problems later in the corporate development process. This reality creates a healthy amount of skepticism and self-doubt. We believe every venture capitalist has a nagging fear the investment will not prove out and that he or she will be held responsible for poor judgment by his or her partners. Notwithstanding, the VC wants to believe the investment will prove successful for all the reasons that justified the investment. This is the root of the paranoia: "I believe in this investment but I'm not sure." As we will discuss, upon being presented with unforeseen or uncontrollable variables, some venture capitalists have a tendency to react emotionally and protectively, which can result in biased decisions.


Quote #2: "My experience is that often winners are decided by the stars and moon aligning." What this means is there is a bit of luck associated with determining a winner. Several venture portfolios lived and died exclusively on the dot-com industry. Successful venture firms exited early and initiated option strategies to protect fluctuating stock prices and lock in profits. It is all about market timing. You have to ask where those successful companies are today. Many have been liquidated because they were built without credible operating strategies. Were the successful VCs smart or lucky? Think of biotech companies. When do you know you have a winner? It could take as much as a 10-year development cycle with results really concrete only after conducting blind phase III trials. Great science and management teams have fallen to a drug candidate's unexpected side effects, the inability to prove statistically significant end points and, in certain cases, regulatory politics. Were the venture capitalists in successful biotechs smart, or did they invest in a portfolio of companies that yielded successes?

To give further examples, think of the long adoption curve for the telephone, television, and computer. Great products and solutions are often slow to be adopted, particularly if there is a perceived satisfactory existing method or product. People are not change friendly; most people resist learning new things until they have to. For venture capitalists and management, it generally takes longer for investments to mature than is anticipated. Patience requires a strong belief in management and products.

The other big unknown is the stock market. For years, it seemed the IPO market got hot for companies within specific industries and drove valuations up significantly. Market timing for a specific industry is unpredictable, but what is predictable is that when the market rotates to a particular industry sector there is a window to successfully finance, exit, or consolidate. Management has to have the company ready to take advantage of such market opportunities; finance, merge, exit when the market is available because that is where the highest valuation will occur. Venture-backed companies that are not ready may never see another up cycle. Venture-backed management fails when it believes there will be greater value later and does nothing to exit during a bull market.

Quote #3: "For us, it is all about putting the right fannies in the right seats to build a team. If any entrepreneur asks me what to do, I know I'm in the wrong investment." If there is an element of luck, or certain uncontrollable industry or market variables, to building corporate value and successfully exit, then there has to be an emphasis on hiring management and, more specifically, building a team. Venture capitalists usually do not operate and they need managers who can navigate through icebergs. In the back of a venture capitalist's mind, he or she is always assessing the management because it is all about building confidence. Most companies, to use a NASCAR phrase, will "hit the wall" (encounter difficult obstacles) at some point and there is potential for serious damage to investment returns. This is particularly true with technology development companies, early stage companies, or novel technologies trying to develop new markets. Consequently, there will be a crossroad where VC investors will doubt their management decisions. Precisely when the going gets tough, less experienced venture capital firms will be the first to complain, raise doubts about strategy and direction, and ask unanswerable questions requiring soothsaying managerial talents. From a manager's perspective, it is incumbent to build a team to instill calm through managerial confidence in a shared strategic vision.

Make sure your team has consistent interaction with the VCs at board meetings, present well-rehearsed presentations on their areas of expertise, and relay a consistent strategy. VCs should not look to a manager, but rather to a team of managers and gain confidence in the team as a whole versus the individual. Never ask a venture capitalist to develop strategy; the VC's inquisitive, and sometimes aggressive, questioning is often to test management's commitment and confidence in their own strategy. Is the team considering known and unforeseen variables? Imagine if the venture capitalist always knew when the entrepreneur was steering through icebergs!

Quote #4: "Returns come from diversifying risk through a portfolio of companies. You have to place multiple bets to find winners." When an entrepreneur reads and understands these four quotes, we believe he or she will better understand the venture capital perspective. "One venture board member used to arrive for meetings and immediately ask to find an earlier flight back. The first priority was always telling us how busy he was and his travel itinerary." Many investors see an investment as just part of a larger portfolio and view board meetings as quarterly updates. They want the big picture: "Are we on plan? What has changed? How are we adjusting to the changes? What effect does this have on our short-term and long-term plans/results?"

Board meetings must be controlled and informative, provide full disclosure, contain the right amount of detail to demonstrate strong knowledge, and end with strong optimism and assurance to investors of the possibility of strong returns. Meetings should generally not last more than two to two and a half hours.

We emphasize the need for full disclosure and integrity; investors have to be aware of all the downside possibilities, and you must immediately notify them of any material problems. With that said, however, your primary focus must be on the upside. We believe that companies can succeed because they are willed to succeed by management but only if they have the time to succeed. Time is associated with investment and investor confidence. Pessimistic leaders fall by the wayside because they do not provide vision, and thus provide no leadership. When encountering adversity, use creativity to reach your goal a different way. Markets will change, and you have to adapt your strategy accordingly. That is why they back you. Come off the wall, assess the damage, and get back in the race. VCs want gamers; they know obstacles will arise.

As mentioned, understanding the venture capitalist's viewpoint is critical to managing the board. Remember the venture capitalist is sitting on numerous boards and reviewing multiple deals, and gleans lots of knowledge tidbits from many sources. He may have or had investments in your industry and like to recite their experiences. Be sensitive to those experiences even if not relevant to your company. This represents his point of reference and he does not want to repeat a mistake.

A problem for many entrepreneurs is that venture capitalists are generalists, and are not operational. They do not want to make your decisions but they will be inquisitive about everything. I have found that entrepreneurs often fall into the trap of trying to discuss and decide corporate strategy with their venture partners. Mistakenly, they assume the venture capitalist actually wants to be a part of the decision process. What the venture capitalist seeks is the comfort that you believe in your strategy and can support your position when cross-examined. If the entrepreneur actually asks for advice, venture capitalists immediately assume they may have the wrong person. Venture capitalists are like a large lake on a windy day when no whitecaps appear. It is because the water's not deep. Venture capitalists cannot take deep dives. Entrepreneurs must.

VCs sit on at least three boards. Coupled with ongoing investment diligence, it is difficult to give any one company but so much mind share. Thus, start off each meeting with your strategic goals and how you are progressing toward them. Do not assume your venture board remembers the problems from a quarter ago; do not assume they read your board package! Review issues in light of the larger strategy. Talk about issues and potential solutions, and always relate them to the investment opportunity, a profitable exit. Each meeting, begin with the vision, deal straightforwardly with issues and obstacles, address how to solve these concerns, and end with selling the vision again.

Entrepreneurs will be judged on their ability to build teams, handle problems, and stay focused on attaining corporate goals. Remember everything takes longer than projected or expected. Venture capitalists are prepared for this. In today's environment, they are prepared to put two to four times their initial investment into a deal that is progressing and demonstrating results. As an entrepreneur CEO, never let the company become cash constrained; start initiating fund-raising months before conservative projections show cash shortfalls. Never, never, never surprise venture investors with calls for capital! This is why we were so adamant previously when we stated that entrepreneurs had to take advantage of bull markets for financing purposes. Rarely has anyone ever written articles about being overcapitalized.

Here are six keys for success in VC-backed company board meetings:

  1. Instill investor confidence in the management team.
  2. Communicate belief in the corporate vision in the face of adversity.
  3. Stay focused on the big picture and progressing toward goals and exits.
  4. Understand that venture capitalists do not want to be a part of the operating decision process.
  5. Understand that a company is just another investment requiring returns.
  6. Surround yourself with people smarter than you are.


In today's environment VCs are seeking proven managers who have already grown a company and shown their prowess. This makes it difficult for the entrepreneur with ideas but little experience to raise venture capital. VCs are looking at expansion and later stage deals with favor. In general they would rather back a more mature deal where they can exit in two to three years than a start-up with a more traditional funding cycle.15 The implications are that early stage deals are tough to get done, and this increases the need and demand for quality angel investors.

Lastly, VCs are seeking the efficient use and deployment of invested funds. This concept of capital efficiency is in the vein of returning to industry basics as seen in the early 1990s. Unlike the period during the Internet bubble, today VCs prefer to invest more traditional amounts in tranches that will cap the total investment in a company at $20 million to $30 million. This means that a company can foreseeably go from seed round through its final VC round using no more than $20 million to $30 million and be a viable ongoing business; obviously there are exceptions such as the biotechnology industry. VCs who invest in technology companies that create software are seeking offshore suppliers and partners to stretch their investment dollars.



3 "The Venture Capital Industry: An Overview,"

4 Henry Sender and Dennis K. Berman, "For Sale: Again and Again and . . . ," Wall Street Journal, September 4, 2004, p. C1.

5 The MoneyTree Survey by PricewaterhouseCoopers, Thomson Venture Economics, and the National Venture Capital Association, www.pwcmoney

6 Robert S. Winter, "Venture Funding Process and Valuation," 1997, Slide 4.

7 Winter, Slide 6.

8 Frederick J. Beste III, "The Twelve (Almost) Sure-Fire Secrets to Entrepreneurial Success," Mid-Atlantic Venture Funds, LP.

9 Ibid.

10 Winter, Slide 7.

11 Winter, Slide 8.

12 Winter, Slide 11.

13 Winter, Slide 17.

14 Winter, Slide 18.

15 Interview with Andrew G. Burch

The above material is adapted from The Handbook of Financing Growth: Strategies and Capital Structure by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser. Copyright ©2005.This material is used by permission of John Wiley & Sons, Inc.