The venture capital cycle and the history of entrepreneurial financing

Seminar Paper 2010 35 Pages

Business economics - Investment and Finance



Table of Abbreviations

Table of Figures


1. Introduction

2. Venture capital and the venture capital cycle
2.1. Raising funds
2.2. Selecting investments
2.2.1. Patterns in venture capital investing
2.2.2. Screening & Due diligence
2.3. Sophisticated contracting
2.4. Development of the portfolio companies
2.5. Divestment of the portfolio and distribution of the returns

3. Contradictions between venture capital theory and “real life”
3.1. The .com bubble and the financial crisis
3.2. Exiting investments in China

4. The historical evolution of funding entrepreneurial ventures
4.1. Timmons model of the entrepreneurial process
4.2. Historical overview based on Perez’ technological revolutions model
4.3. Apple - An example of a venture capital-backed company

5. A glance into the crystal ball - the future of venture capital



Table of Abbreviations

illustration not visible in this excerpt

Table of Figures

Figure 1: The venture capital cycle

Figure 2: The six financing stages for entrepreneurial ventures

Figure 3: Timmons model of the entrepreneurial process


The venture capital industry operates in a cyclical business model, called the ven- ture capital cycle. A venture capital firm sets up venture capital funds that pro- ceed through the stages of (1) fundraising, (2) selecting of investments, (3) con- tracting, (4) development of the portfolio companies and (5) the divestment of the investments and the distribution of the returns to the investors. It shows that the business model opposes challenges for both the investors that put money in the fund as well as for the entrepreneurial ventures in which the fund invests.

“Reality” reveals that the venture capital cycle does not always work properly. In particular the burst of the .com bubble and the financial crisis have triggered imbalance in the cycle. It also shows that distractions from theory occur in countries with less developed capital markets like China.

An analysis of the history of entrepreneurial funding in the framework of Tim- mons model of the entrepreneurial process and Perez model of technological revolutions shows, that the financial instruments used to fund ventures have adapted to the needs of each revolutionary industry cluster and its specific char- acteristics and needs. The ‘modern’ venture capital constitutes the fitting finan- cial instrument for the latest revolution, namely the ICT revolution. Most of the major players in the IT sectors such as Apple were backed by VC and an in depth look at Apple shows the influence of VC on the development of the company.

It will be interesting to see if the venture capital industry is able to adapt in a way that it can also fuel the next upcoming revolution, in whatever sector it may evolve, or if a completely new financial instrument will emerge.

1. Introduction

Already the financing of Christopher Columbus’ expeditions by the Spanish mon- archy can be seen as venture capital (VC) funding and probably as one of the most profitable ever (Kaiser and Westarp 2010, 6). Apparently, VC funding has a long history although the term ‘venture capital’ was probably coined by Arthur Rock only in 1965.1 Today it shows that a VC-backed company has a significantly higher chance (80%) of surviving five years than the population of all start-ups. Therefore venture capitalists (VCs) must have the ability to pick the right compa- nies and/or to add significant value to their investments (Bygrave 2010, 11).

This paper aims at explaining how VCs work and how the funding of entrepre- neurs has evolved over time. Hence, the remainder of the paper is organized as follows. Chapter 2 analyzes the different phases of the venture capital (invest- ment) cycle and highlights challenges for investors and entrepreneurs in the dif- ferent phases. Chapter 3 presents two examples of contradictions between the venture capital cycle theory and reality - in particular the situation after the .com burst and the financial crisis and the exiting options for VC funds in China. Chap- ter 4 applies Timmons model of the entrepreneurial process and Perez’ model of technological revolutions as frameworks to show how different industry clusters have evolved with different types of funding and to present one in depth exam- ple of a VC backed company, namely Apple. Chapter 5 will give an outlook on the future of venture capital and funding entrepreneurial ventures.

2. Venture capital and the venture capital cycle Metrick (2007, 3-6) defines VC by five characteristics:

(1) The venture capitalist acts as a financial intermediary, collecting funds from investors and investing the money in the portfolio companies.
(2) The VC invests in private companies, not traded on a public exchange.
(3) VCs are active investors, monitoring and advising their investments.
(4) The goal of a VC is to maximize the return at the exit by selling the com- pany or through an initial public offering (IPO).
(5) The VC funding is used to fuel internal growth in the portfolio company and not to grow through M&A.2

VC has established a transmission channel for private capital into industry sec- tors that have no direct access to public capital markets due to their lack in tan- gible collateral, information asymmetries and huge uncertainty about their de- velopment (Cressy 2006, 364; Gompers and Lerner 2004, 157-158; Alternative Investment Expert Group 2006, 14).3 Simon Barnes, a VC puts it: “we simply pro- vide the R&D budget for companies that would not ordinarily have one” (Tidd and Bessant 2009, 446). Indeed, VC-backed firms show significantly higher patent rates than other start-ups / early stage firms (Gompers and Lerner 2004, 306). A VC firm operates by setting up VC funds that constitute independent entities managed by the firms’ VCs (see Exhibit 3) (Kaiser and Westarp 2010, 12). These funds follow a cyclical development coined the ‘venture capital cycle’ by Gom- pers and Lerner (2004, 3; 2001, 152):

illustration not visible in this excerpt

Figure 1: The venture capital cycle

Source: Own depiction based on Gompers and Lerner (2004) and Jung-Senssfelder (2006, 11). For the phase descriptions see Gebhardt (2008, 72), Reid (2000, 73) and Silviera and Wright (2007, 1).

After the closing of a fund, the cycle renews itself when the next fund is raised (Gompers and Lerner 2004, 3).

The different phases will be explored further in the following paragraphs.

2.1. Raising funds

In the setup phase of an VC fund the VC raises funds from outside investors, typically institutional investors such as banks, pension funds, insurance companies or the government (Cressy 2006, 361; De Clercq et al. 2006, 91).4 VC funds show a typical pattern of characteristics:

(1) The monetary size of the fund is fixed up front (Cressy 2006, 361). The size of a fund varies with the strategy and reputation of the VC firm, but a typically range is $100 million to $500 million (De Clercq et al. 2006).
(2) The fund has a fixed maturity date - usually after ten years with possible ex- tensions of one to four years (Allen and Song 2002, 5; Kaiser and Westarp 2010, 12; Geranio 2004, 56).
(3) The fund is organized as a limited partnership with limited liability for the outside investors that are not involved in specific investment decisions and unlimited liability for the VCs that manage the fund (Cressy 2006, 360; De Clercq et al. 2006, 91).
(4) Investors can’t withdraw from the fund before maturity and the partnership in the fund is not, or at least not easily, tradable (Allen and Song 2002, 5).
(5) The contract involves covenants that restrict the actions of the VC during the fund’s lifetime (Berg-Utby 2007, 8). Examples for covenants are restrictions on the size of one investment, on the usage of debt, on the reinvestment of profits, on classes of assets to invest in and/or prohibitions against invest- ments in certain industries (Lerner, Hardymon and Leamon 2005, 66-69; Kaplan and Warren 2010, 191-193; Gompers and Lerner 2004, 73-77).
(6) The VC fund does not hold a pool of capital, therefore capital is provided ‘just in time’ if the VC ‘calls for capital’ (EVCA 2010a, 19; Haislip 2010, 69).

In the fundraising phase, the VC uses a private placement memorandum - a for- malized, legal version of a pitch presentation for the fund, outlining the basic features, such as investment strategy, fund size or size of investments to attract potential investors (Christofidis and Debande 2001, 11-12; Haislip 2010, 69).

The limited partnerships also show a typical two component compensation scheme for the VCs (Allen and Song 2002, 5; Kaiser and Westarp 2010, 13).5 The first component is a fixed management fee, usually around 2.5% of the net asset value of the fund (Metrick 2007, 29-31). The second component is a carried in- terest on the fund’s return - around 20% (EVCA 2010a, 19). Often, there is a downside threshold for the carried interest, meaning that the carried interest is only paid if e.g. an 8% annual return is achieved (Metrick 2007, 34-35).

The relationship between investors (principals) and VCs (agents) constitutes an agency relationship (Cressy 2006, 360). The VCs have information advantages and share the downside risk of the investments only to a very limited extend. As the investors are not able to influence the regular operation of the fund, moral hazard might occur and VCs might extract private benefits rather than to work in the best interest of the investors (Geranio 2004, 55-56; Kaiser and Westarp 2010,

5). Therefore the major challenge for investors is to mitigate the information asymmetries and to align the interests of the VCs. Several mechanisms are used to approach these challenges:

- Contractual covenants limit the scope of action and therefore mitigate the asymmetric information problems (Gompers and Lerner 2001, 154).

- The carried interest feature in the compensation scheme lets the VC par- ticipate in the funds’ returns thereby incentivizing him to aim for the highest possible return (Gompers and Lerner 2004, 24,114).6

- The definite maturity of the fund gives investors the possibility to sanc- tion the VC firm by not investing in future funds (Berg-Utby 2007, 8-9).7

- The investor has to monitor the actions of the VC to ensure that the contracts are met. The investors have a right to be informed about the progress of the fund (Kaiser and Westarp 2010, 5).

The next paragraph will analyze how VCs select their investments after the fundraising is completed.

2.2. Selecting investments

2.2.1. Patterns in venture capital investing

VC funds invest in high-potential (often disruptive) technology companies - therefore VC is always high-risk / high-return capital (Byers and Dorf 2008, 429- 431; Silviera and Wright 2007, 2). The companies are characterized by a high de- gree of uncertainty, an intangible asset base and information asymmetries (Allen and Song 2002, 17; Gompers and Lerner 2004, 199).8 To compensate for the high risk, VCs typically require an expected annual rate of return of 30-60% over the investment horizon, depending on the investment stage (Dollinger 2003, 230).9 The golden rule of investment ‘buy low, sell high’ transfers to ‘buy very low, sell very high’ for a VC given the extreme risk profile of the investments (Tidd and Bessant 2009). The typical size of a VC investment in a firm is $10 million to $20 million (Byers and Dorf 2008, 429). Therefore, VC is described as “narrow but deep” (Braunerhjelm and Parker 2010, 4), as few entrepreneurs get funded but those are backed with huge amounts of money.10

Staging of investments

Typically, the funding of a company involves several stages (Cressy 2006, 371). At each stage, the company is given enough capital to proceed to the next stage (Allen and Song 2002, 6; Cressy 2006, 371). To receive the funding for the next stage, companies have to achieve certain milestones such as securing important contracts, hiring crucial management members or setting up a working proto- type (Pearce 2010, 42; Byers and Dorf 2008, 430).11 This approach constitutes the most important control mechanism for VCs, keeping the entrepreneurs on a “tight leash” (Kaiser and Westarp 2010, 61; Gompers and Lerner 2004, 161,171). The mechanism enables the VC to abandon the project or to renegotiate the terms in later stages thereby maximizing the option value of the investment, as a correct continuation decision is ensured (Byers and Dorf 2008, 429; Stern and Chew 2003, 273; Allen and Song 2002, 6).12 Barnes says: “Venture Capitalists pro- vide a rigorous and ongoing selection process for the innovation process holding the companies they back to strict targets and deadlines - there is no hiding place” (Tidd and Bessant 2009, 447).13 A company typically proceeds through 6 stages:

Figure 2: The six financing stages for entrepreneurial ventures

illustration not visible in this excerpt

Source: Ross, Westerfield and Jaffe (2010, 644-645; originally: Bruno and Tyebjee 1985, 65-66) and Kaplan and Warren (2010, 197).

A VC fund is usually involved from the start-up or from the first-round financing (Byers and Dorf 2008, 429; De Clercq et al. 2006, 93).14 Seed money is mostly provided by business angels, family and the entrepreneur’s own funds (Byers and Dorf 2008, 430).


1 See http://www.bookrags.com/biography/arthur-rock/ for the biography of Arthur Rock.

2 Gompers and Lerner (2004, 17) define VC in a broader sense as ” dedicated pools of capital that focus on equity or equity-linked investments in privately held, high growth companies”. This paper will use the more specific definition by Metrick (2007).

3 Exhibit 1 shows how this business model differs from those of business angels and corporate venture capital (CVC). This paper will not further explore business angels and CVC but concen- trate on independent VC. See MacMillan et al. (2008) for an overview on CVC.

4 Exhibit 5 shows the allocation of funds raised on the different players for 2007-2008. It shows that there is no stable division between the different sources. Note that in the US also Universities invest heavily in VC funds (Cressy 2006, 361).

5 Note that, nevertheless we find a typical scheme of VC compensation, Gompers and Lerner (2004) show that a lot of differences in the details of the compensation exist. They have de- veloped two theoretical models - the learning model and the signaling model to explain the differences in compensation based on missing information and information asymmetries with regard to the VCs performance (Gompers and Lerner 2004, 94-97). Empirically they find evi- dence for the learning model, meaning that both the investors and the VCs cannot evaluate the ability of the venture capitals before his first fund (Gompers and Lerner 2004, 91-126).

6 Note that this can trigger excessive risk taking as the carried interest marks a call option on the fund value, increasing in value with volatility (Lerner, Hardymon and Leamon 2005, 66- 67).

7 Emphasizing the importance of this mechanism, it shows that the performance of VCs shows strong persistence, implying that the performance is based on skill and not on luck (Kaiser and Westarp 2010, 27,57). A logical result is, that is shows that a venture capitalist that underper- formed in his last fund has severe problems in raising capital for his next fund, as he is likely to underperform there as well (Gompers and Lerner 2004, 62).

8 In 2006, the most important Investment sectors for VCs were Software, Biotechnology, Medi- cal devices and Telecommunications (MacMillan et al. 2008, 5).

9 See Exhibit 4 for the required rates of return for the different investment stages.

10 Note that VCs often form syndicates with other VC firms to fund specific projects or compa- nies. This practice is beyond the scope of this paper and will not be discussed further. See Fer- rary (2010) and (Cressy 2006, 368-370) for an overview on the syndication of V investments.

11 See Byers and Dorf (2008, 430) for further examples on milestones.

12 Bergemann, Hege and Peng (2008) have shown theoretically and empirically that the staging of investments helps VCs to create a clearer picture of the success probability of the entre- preneur that the VC is not able to draw in the first investment round. Therefore the staging gives the VC the possibility to adjust the investment path according to the latest information.

13 Gebhardt (2008, 72,84-85) emphasizes that the capital constraint set by raising funds only once and covenants that prohibit to take on debt are especially valuable when it comes to the continuation decision as the decision is thereby often even delegated to a new venture capi- talist with no biased incentives to continue the project.

14 See Exhibit 2 for an overview about issues for the VC associated with the involvment in different phases.


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Venture Capital Venture Capital Cycle Finance

Title: The venture capital cycle and the history of entrepreneurial financing