Venture Capital Funds and Their Portfolios

Venture Capital Funds and Their Portfolios

The development of the venture capital industry, spearheaded by the venture capital funds, was and still is central and essential to the development of technology companies. The prolific and developing world of technology would probably not have reached such a high and advanced stage of development, in which entrepreneurs and companies literally change the world economy, without venture capital funds.

The uniqueness of venture capital funds as the most natural and suitable partners for startups stems from the fact that they usually have no extraneous interests which can clash with the company's interest: The main interest of the venture capital fund is that the company in which it invests will develop in the quickest and best manner into as valuable a company as possible. As such, the venture capital fund is the ideal partner of entrepreneurs in building up the company. While many if not most private investors have no extraneous interests either, their strengths and the assistance they can offer emerging companies are usually considerably inferior to those which venture capital funds can offer.

This is not to underestimate the importance of introducing other partners to the company such as strategic partners and large companies in the field, whose assistance in building up the company, including its marketing facilities and credibility in the market, is very important. However, it should be kept in mind that in contrast to venture capital funds, strategic entities have other interests which may at times not coincide with those of the company. Therefore, their involvement as partners should be conducted with caution.

The natural partnership between venture capital funds and entrepreneurial firms has created an integrated world in which the two industries are interlaced and mutually dependent: To be successful, funds need a wide variety and large number of promising startups; startups, in their turn, need experienced financing partners who have connections in the market, are ready to take chances, and whose interests overlap those of the company.

The Added Value of Venture Capital Funds

A good venture capital fund is not only a source of financing for a startup, but is also a financial partner with connections in the capital market and experience in building up companies. The added value of venture capital funds is expressed mainly by having the funds' partner-managers serve on the boards of directors of portfolio companies, as well as by the ongoing consulting to and guidance of such companies. A good venture capital fund can assist its portfolio companies in the following aspects:

  • Money— First and foremost, a venture capital fund offers high-risk money which it is prepared to invest in companies in which it believes in consideration for a percentage of their equity. This investment is made without additional guarantees aside from the companies' resources (which are limited) in a very well-informed and sophisticated manner which has evolved over the years. This readiness should not be slighted; most financiers are deterred by such risky investments, even in euphoric times such as the years 1999–2000.

  • Financial backing— Good funds do not abandon their portfolio firms in times of crisis, but rather tend to support them until additional resources may be engaged, even when the process takes longer than expected. This is true as long as they believe in the company, its entrepreneurs and managers, and in their ability to pull through the rough times and recover from them. For instance, after the crisis in the capital market started in 2000, many funds continued investing considerable amounts of money in their portfolio companies, even though their original plans were to solicit financing from the public or by private placements. Companies which are not backed by funds with strong financial resources are less likely to survive in times of crisis on the capital markets.

  • Credibility— The introduction of a substantial fund into a startup requires the company to manage its affairs properly and to keep them in good order. Moreover, other investors and entities seeking cooperation usually like to see a substantial venture capital fund in the company, since such presence affirms the propriety and high standards of the company and its entrepreneurs. The existence of a reputable fund among the main investors in a company also facilitates the recruitment of senior employees for the company, since potential workers are favorably impressed by the fact that the company has passed the fund's screening mechanisms and can rely on the fund's know-how, experience, and connections.

  • Connections in the financial community— Successful venture capital funds are well-connected in the financial community, both with other venture capital funds and in the broader community which includes, among others, investment banks. These connections are highly beneficial for the company's future investment rounds. Funds tend to work with one another, and a company referred by an esteemed fund stands a better chance of securing an investment from the fund to which it was referred. Furthermore, in later stages, the presence of funds and other institutional investors among a company's investors provides the company with additional support which facilitates the raising of capital from the public and, consequently, engaging underwriters for the offering.

  • Strategic connections— The managers of venture capital funds are usually well-connected in the business world, either directly or through their acquaintance with their own investors. Connections in the industry can significantly facilitate a company's securing of strategic alliances, as well as business deals. This issue is particularly important when the company's clientele are not end consumers, but rather the business community itself. In such cases, fund managers help to open doors to potential customers and tie deals with the investors in the fund and the companies which its managers know, as well as promote investments by various strategic investors.

  • Considerable assistance in recruiting top management— An excellent management is crucial for leading a company on the road to success. Leading venture capital funds have reserves of and connections with managers who possess the potential to manage different companies, and the funds help to bring them to the company. Fund managers may also assist in screening and interviewing candidates. Furthermore, as mentioned above, senior executives prefer to see a leading venture capital fund as a partner in the company because such partnership indicates that serious outsiders have invested money in the company (i.e., the risk is lower than the risk involved in anonymous ventures) and guarantees that the company has stable financial backing, at least initially.

  • Managerial and operating know-how and experience— Throughout the development of a venture, particularly in its early stages, the managerial know-how and experience with which the managers of a good fund are equipped are important. At times, fund managers are former entrepreneurs or people who managed companies before becoming venture capital fund managers. In addition, fund managers have accumulated experience in investing in and guiding many companies, and have therefore confronted various managerial situations and mistakes which are characteristics of new companies. Such prior experience enables them to give timely warnings of incorrect developments and choices and to propose practical solutions.

  • Assistance in forming the business model— Many companies start out by developing a product for a particular market, but later decide to change direction. Experienced fund managers can also assist companies in identifying other markets in which their existing technological potential can be applied. The identification of applications which are not in the focus of the entrepreneurs' initial business plan does not necessarily involve the use of more advanced technologies.

    An example of this is the well-known story of Hotmail, the company now owned by Microsoft and one of the largest providers of free e-mail in the world (in fact, Hotmail was one of the first to offer this product). The company was bought by Microsoft for the large amount of approximately $400 million, although the company's original business model did not include any material element of revenues from users. Nor did the company receive any significant amount of venture capital financing. Originally, the company focused on creating a site for developers in the Java programming language, and many funds which saw the company's business plan and its managers turned it down immediately. Help came to the company from one of the leading funds in the United States, Draper, Fisher, Jurvetson (DFJ). It was actually the free e-mail service, which the company had created as a service for their users, which excited the managers of the fund. This supplementary service became the cornerstone of the company's action plan and was the main reason for the fund's investment. The company reached more than 10,000,000 users before it was acquired by Microsoft for more than $400 million.

  • Constructing a balanced and contributing board of directors— The board of directors is involved in strategic and material decisions and complements the company's management team with its experience. The fund leading the financial round will usually appoint at least one representative to the board of directors and may also help in recruiting talented and experienced persons to the board to the company's advisory board. It is hard to overrate the importance of an advisory board staffed with reputable and well-connected persons. A company's success depends to a large extent on its ability to build a network of investors, customers, and other companies in the field.

In conclusion, having venture capital funds join a startup is a considerable event in the company's life, which testifies that it has achieved a certain degree of maturity, and the more prominent the fund in the market (in its size, connections, financial abilities, understanding and level of management), the more significant will be the event to the company.

The Means by Which Venture Capital Funds Oversee Their Investments

As investors, venture capital uses various supervision mechanisms to ensure that their investments in their portfolio companies will yield the highest return possible. The need for different supervision tools results from the uncertainties which face any investor in a company, but particularly investors in early stage companies. These result from information gaps between the company and the investor and from the "agency problem" which exists between principals (in this case, the shareholders), and their representative agents (in this case, the company's management). The "agency problem" is driven by the fact that a manager who is not the full owner of an enterprise may act without proper supervision to maximize his own benefit by engaging in activities which promote his wealth, rather than the investors benefits. For example, if he or she chooses only high-risk projects, the investors are the ones who bear the full financial risk of the project's failure. If the project succeeds, however, the manager shares the rewards. Due to such potential conflicts of interest, the readiness of investors to finance the company is reduced, and consequently the investments are also smaller or, alternatively, are made according to a lower valuation, since investors require a premium for the risk involved in the representative's opportunistic behavior. Therefore, both the manager and the investor would rather have the manager supervised, which would reduce the investors' uncertainty and therefore raise the level of their comfort with the investment.

We will now review the main monitoring tools used by funds to reduce the cost of uncertainty and to alleviate information asymmetries with managers (for a discussion of the legal aspects of the control mechanisms, see the section on the main issues in investment agreements).

  • Investing in several rounds— The first main tool used to reduce the risk and increase the ability to control a company is investing in stages. An investment in a startup is usually made in several rounds, not all at once. This is the most effective tool for reducing the investor's risk, as well as the strongest means of control which an investor can exercise over his portfolio companies. By investing in stages, the investor can re-examine the investment, and he is not committed to any additional investment unless the company meets the targets determined as a condition for the continuation of the investment. Naturally, the closer are the investment rounds to each other, the more effective is this means of control, but it also reduces the managers' freedom of action in a manner which could prejudice the company's current activities and impose too heavy a burden of control on the investors. Venture capital investors take the cost of such control into account and ensure that the investment stages are determined in accordance with the need to re-examine the company's progress. This is one of the reasons why investment rounds are larger and less frequent when the R&D stage is lengthy, since the probability that any considerable change will occur in the short term is low. However, if the business environment in which the company operates is dynamic and fast-moving, then a constant evaluation of the company is crucial to ensure that the company is indeed on the track which will yield the returns hoped for by the investors in the previous round.

  • Syndication Venture capital funds tend to enter investment rounds together with other investors. Syndication enables venture capital funds to hedge risks by investing smaller amounts of money in many companies. In follow-up financial rounds, this also enables each fund participating in the round to signal its commitment to the firm. Typically, a lead firm is responsible for monitoring the due diligence and investment contracts, but it is commonly one of the new investors in the round. This also provides an efficient manner to reduce duplicative due diligence costs.

  • Ongoing control— From the venture capital funds' point of view, the cost of control by investing in stages is high, since the examination of the investment requires resources, which could otherwise have been spent identifying and examining new potential investments. In addition, if the financing rounds are frequent, they may entail burdensome transaction costs. Consequently, between rounds, the leading investor in the latest round monitors the company constantly, and the other investors receive reports from him and from the company. Such control includes, among other things, representation on the board of directors, the receipt of current reports and financial statements, and the right to veto certain decisions (for a further discussion, see the section on the main issues in investment agreements).

  • Compensation of entrepreneurs and managers— Compensation methods which are based on options and on performance assessments contribute to the alignment of interests of the investors and the managers (see the section on the methods of employee compensation). Long vesting periods, as well as various stipulations in the investment contracts with respect to continued employment with the company, ensure that the managers will remain with the company and will dedicate all of their energy to it.

  • Geographic preference— Venture capital funds enjoy broad representation on the boards of directors of their portfolio companies in particular, in its early stages, and are often also involved in the daily management of the company. When a company is undergoing a crisis, additional representatives of the venture capital fund join the board of directors, and there is a tendency to replace managers. Such managerial involvement by venture capital funds, and the vast time-resources it requires, explain the preference exhibited by funds to invest and exercise managerial involvement in companies which are in geographic proximity to their offices. Indeed, it has been documented that the probability that a venture capital fund will appoint a representative to the board of directors of a company declines with the increase in distance between the fund and the company.