604989 the Venture Capital Cycle

8/7/2019 604989 the Venture Capital Cycle

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CONFIDENTIAL

This report is solely for the use of client personnel. No part of it may becirculated, quoted, or reproduced for distribution outside the clientorganization without prior written approval from McKinsey & Company.This material was used by McKinsey & Company during an oralpresentation; it is not a complete record of the discussion.

Adil Haque ± SVA

Feb 2001

The Venture Capital Cycle

Fund-raising

Investing

Exiting



1

PURPOSE OF DOCUMENT

� The purpose of this document is to provide background and insight into theventure capital cycle by identifying and highlighting key areas of interest andimportance to McKinsey CSTs dealing with Venture Capital firms or their portfolio companies

� Primary content for this document is derived from The Venture Capital Cycle,authored by Paul Gompers and Josh Lerner, with additional insight includedfrom other sources



2

AGENDA Focus of section

Introduction to theVentureCapital cycle

Fundraising Investing Exiting

Brief overview Brief overviewBrief overview

VC partnership structure Investment staging

Effect of market conditionson decision to go public

VC compensation Investment management

VC share distribution

VC structure implications Investment syndication VC backed offeringsperformance

Effect of reputation ondecision to go public



3

� Several misconceptions about the nature and role of VCs exist:

± VCs add little value to young firms aside from money

± VCs unwind their holdings on young firms

� The document functions as a primer on the VC cycle (i.e., fundraising, investing, and exiting) by drawing out commonthemes across the cycle:

± VCs typically focus and concentrate on industries with a great deal of uncertainty, where large information asymmetry existsbetween entrepreneurs and investors

± VC process should be viewed as a cycle rather than a discrete event. This cycle includes:

· Raising of fund,

· Investing proceeds,

· Monitoring investment,

· Adding value as required to firms,

· Exiting successful deals,· Returning capital to investors,

· Raising a second fund, and so on . . .

± VCs are slow to adjust to a change in supply of capital or demand for financing because their funds make long-runilliquid investments

INTRODUCTION TO THE VENTURE CAPITAL CYCLE

Common misconceptions about VCs exist with limited knowledge around theventure cycle



4

� VC is a relatively young industry that has continued to evolve with the changing times

± Initially started in 1946 by MIT, HBS Professors and local business leaders looking to capitalize on post WWII technologies

± First VC limited partnership started in 1958 by Draper, Gaither, and Anderson, but, at this point most of industry was closed-end funds, small business investment companies, and federally guaranteed risk pools

± Fund flow into industry escalated post-1979 amendment to ³prudent man´ rule allowing pension funds to invest money inhigh-risk VC investments*

± 1980s led to investment advisor (³gatekeepers´) entering market to advise institutional investors about VC investments

± Late 1980s led to lower returns on venture funds through over-investment in certain industries and market entry byinexperienced VCs

± Departure of inexperienced VCs and robust IPO market led to higher returns in 1990s

± Over time the limited partnership structure became the dominant organizational form for a VC, increasing from 40% in 1980 tonearly 80% in 1994 due to favorable operating structure shifting power from limited to general partners

� VC industry compensation for the most part has remained constant and relatively simple to understand. There is an annualfixed fee (1.5-3% of capital invested or assets under management), plus variable compensation derived from fund profits(usually about 20%)

� VC industry focus has remained geographic and industry-centric with most capital being deployed in CA, and MA in the hightechnology and medical/pharma sector*

INTRODUCTION TO THE VENTURE CAPITAL CYCLE ± BRIEF HISTORY

VC history is brief as most companies have established themselves over lastfew decades

* Details on following pages





6

VC INVESTMENT CONCENTRATION

Note: Data analysis for time period 1990-1996 in 1997 dollarsSource: Venture economics database

£ 6

11¤

¥

£

¥

1 CA

MATX

NJIL

Rest

£ 7

9¤

¤

¥

¥

0CA

MATXNJ

IL

Rest

¦

¥

¦ £

17

1¥

¤

17

¦ §

¦ ¤

1¥

1£

£

17

Other non-electrical

machinery

Office and computingmachines

Professionalscientific instruments

Communicationand electronic

All other manufacturingrelated industries

Drugs

Other machinery

Office andcomputing machines

Professionalscientific instruments

All other manufacturingrelated industries

Communication andelectronic

Drugs

Investments

Investments

Disbursements Disbursements

100% = 9, ̈

06

100% =© ,1

0

100% = ̈

,169 100% = 1

,1

VC activity by top 5 regions VC activity by top 5 Industries

Investment concentration has been in, California, and Massachusetts and in thehigh technology and medical/pharma industries

$ Millions



7













8

FUNDRAISING ± BRIEF OVERVIEW

� VC fundraising is complex and little understood outside VC industry due to complicated underlying rulesand regulations associated with fundraising

� Partnership agreements between limited and general partners tend to be complex often longer than a fewhundred pages

� Level of VC fundraising is influenced by a few identifiable factors:

±Capital gains tax rate:

Lower tax rate leads to higher willingness for corporate employee to becomeentrepreneurial leading to greater demand for VC capital

± Performance of public equity markets: There exists a strong correlation between the health of thepublic equity market and size of VC funds raised. However, IPO market does not appear to affectcommitments to early stage funds as much as later stage ones*

± Current Returns from VC related investments: Higher returns from VC funds have typically led togreater capital commitments to newer funds being raised

± Over- of under-investment by institutional investors: Studies have proven that institutional investorsare almost always more likely to irrationally over- or under-invest in speculative VC markets

± Government policy : Regulations and restrictions placed by local governments can adversely affectVC fundraising (e.g., in most countries IPOs by firms without long history of positive earningsis discouraged)

� Venture Economics study illustrates the following return economics for a VC investment:

Exit point for investmentReturn in excess of investmentPercent

Average holding period

Public market (i.e., IPO)Firm acquisition

19540

4.2 years3.7 years


Fundraising is the first step in securing funds for investment



9

A brief overview of the VC fundraising process addresses the following questions and issues:

� How are VC partnerships structured? Covenants and restrictions play an increasingly important role in aligning incentives andminimizing conflict between VC general partners and investors

± Contacts are hardly ever renegotiated. Negotiating and monitoring specific covenants is costly, thus contracting parties often do this only once

± Supply of VC services is relatively fixed and low, but, demand is high leading to greater consumption of private benefitsthrough fewer covenants and restrictions

± Fewer restrictions are found on funds generated during years with greater new capital inflows, and general partners enjoy ahigher level of compensation

� How are VCs compensated? Compensation analysis for VC funds is relatively uni form across the industry

± Older, larger and more established VC firms are more sensitive to performance, i.e., they command 1% greater share of capitalgains than their less established counterparts

± The fixed component of compensation is higher for smaller, younger firms and riskier funds

± There is no existing relationship between incentive compensation and performance

± There are 2 emerging models for VC compensation determination:

· Learning model : In early funds VCs will work hard without set pay-for-performance benefits in order to establish a good reputation

and gain increasing investor capital in later funds

· Signaling model : Assumes VCs know their ability and prove it to investors by having higher pay-for-performance component in totalcompensation because they establish themselves by accepting riskier pay

� Does VC structure matter? Corporate VC funds have many similarities and differences when compared to independent VC funds

± Typically, corporate VCs undertake similar investments with similar personnel, however, they have very different organizational formsand are typically structured as subsidiaries of the parent with little incentive compensation for the VC personnel

± Corporate programs select better investments related to their core business or add greater value to firms in which they invest

FUNDRAISING ± BRIEF OVERVIEW

To understand fundraising it is important to understand issues associated withcovenants, VC compensation, and different types of VC organizations



10

FUNDS RAISED COMPARED TO PUBLIC MARKET PERFORMANCE

0

000

10 000

1 000

0 00 400 600

00 1

000

Firstclosingof

funds$

R2 = 0.45 R2 = 0.36

There exists a strong correlationbetween health of public marketand volume of funds raised

Performance of public equity markets affects size of VC funds raised

0

00 0

4 00 0

6 00 0

00 0

10 00 0

1

00 0

14 00 0

0

00 400 600

00 1 000 1

00

Total IPOs

Raisedby VC

basedIPOs$

Total IPOs



11

FUNDRAISING ± VC PARTNERSHIP STRUCTURE

� Covenants and restrictions are important in VC funds as they govern the rules by which the general partnership operatesover the course of the fund

� There are two predominant approaches to understanding the determinants of contractual provisions:

Costly contracting theory

� Since negotiation and enforcement of explicit provisions isexpensive, covenants are included only when benefits of restricting activity outweigh the costs

� Empirical evidence suggests the following trends:

± Smaller funds have less covenants and restrictionsplaced on them

± Positive reputation of VC decreases the likelihood of covenants and restrictions placed on fund

± Increased sensitivity of VC compensation to fundperformance decreases need for covenantsand restrictions

Supply and demand hypothesis

� Relative demand and supply conditions in the VCmarket affect the covenants and restrictions in long-term contracts

� Empirical evidence suggests the following trends:

± When annual influx of funds is large fraction of existing venture pool (high demand), covenants andrestrictions fall

± Funds without ³gatekeepers´ have fewer covenants

± Older firms, and firms with higher compensation haveless covenants

Restrictions and covenants are complex part of fund raising, but, structured welllead to minimal limited partner (investor)/general partner conflicts whilemaximizing investor control over fund



12

FUNDRAISING ± VC PARTNERSHIP STRUCTURE

� Size of investment in any one firm to ensure fund management does not try to salvage a poor investment through follow-on rounds of financing

� Use of debt by partnership to decrease use of risky leverage to increase fund returns� Co-investment by organizations in earlier or later funds to discourage opportunistic

short-term behavior

� Re-investment by partnership's capital gains instead of distributing to fund limited partners

Managementof fund

Activities of generalpartners

� Co-investment by general partners to keep fund management objective

� Similarly, sale of general partnership interests to keep fund management objective

� Fundraising by general partners of new funds which may decrease existing fund focus

� Other actions by general partners which would reduce the attention paid to fund management

� Addition of general partners, usually referring to the additional of less tenured general partnersto lessen the load of fund management

Types of investment

� Other venture funds

� Public securities

� LBOs

� Foreign securities

� Other asset classes which may be deemed "inappropriate" from the limited partner perspective

Covenants and restrictions can broadly be classified into 14 categories which fallinto 3 buckets



13

31 11

! 11

1

" "

"

#

"

$

$ $

% &

$

#

1#

! ! !

! !

! ! 13.7

CHANGING EMPHASES OF COVENANTS AND RESTRICTIONS ON FUNDS OVER TIME

Over time, restrictions around management of funds, and types of investmentshave increased, while, restrictions on general partners have decreased

Covenants relating to management of funds

! .2 .7 72.1

' & .

"

7.1

77.8

35. 17.

3.7 29."

"

0.7

33.3

Size of investment in any one firm

51.9"

3.

8"

."

7"

.15

"

."

51.1

81.5

.2

77.8

35.3 2

.729.

1 .222.2

Use of debt by partnership

Co-investment in other funds

Reinvestment of partnerships capital gains

Co-investment by general partners

Sale of partnership interest by general partners

Fundraising by general partners

Other actions by general partners Addition of more general partners

Investment in other VC funds

Investment in public sector

Investment in LBOs

Investment in foreign sector

Investment in other asset classes

13.3

1978-82 1983-87 1988-92

1978-82 1983-87 1988-92

1978-82 1983-87 1988-92

Covenants relating to activities of general partners

Covenants relating to types of investment

8.8

Percent



14

� Compensation for VCs is typically structured as:

± An annual management fee (1.5% ± 3% of assets under management or capital committed or acombination of the two)

± Plus a percent of profits to be paid out as investment returns are realized (usually close to 20%)� In formal studies the share of profits allocated to general partners ranged from 0.7% to 45%, but, 81% of

all funds calculated this figure between 20% and 21%

� There are two models are used to calculate VC compensation. They are the learning and thesignaling models*

� There are a few existing trends within the VC industry pertaining to compensation:*

± Compensation for larger and older funds are more sensitive to performance/variable compensation.Typically, they also have lower fixed base compensation and command a higher share of profits

± Fixed component of compensation is higher for smaller, and younger VC firms or for funds focusing onearly stage or high-tech investments

± There is no apparent relationship found between incentive compensation and performance

VC compensation has remained unchanged over time with most VCs followingrelatively similar compensation structures


FUNDRAISING ± VC COMPENSATION



15

Key assumptions

Level of pay for performance sensitivityover time

Level of fixed fees over time

Level of fixed fees andeffort level

Variance in pay-for-performance sensitivityover time

Level of pay-for-performance sensitivityand performance

FUNDRAISINGS ± VC COMPENSATION

� Assumes information symmetry� There is symmetric uncertainty between

investor and VC about the ability of the VC

� Assumes information asymmetry� VC confident of their ability and signal this in contracts

they offer to investors

� VCs are incented to work hard on their first fund� Sensitivity of compensation to performance is

higher in the VCs second fund

� New and smaller VCs confident of their ability will havehigher pay-for-performance incentives in first fund

� Older and more established VCs should have lessincentive compensation

� No apparent trend� Fixed fees could rise, fall or stay the same

� Fixed fees for older and larger VCs should be higher due to increased insurance demanded

� Higher investment and monitoring costs shouldlead to higher fixed fees

� Higher investment and monitoring costs should lead tohigher fixed fees

� Pay-for-performance sensitivities across periods arepositively correlated to performance of VC fund

� Pay-for-performance sensitivities acrossperiods should be unrelated to performance of VC fund

� Pay-for-performance sensitivities across periods arepositively correlated to performance of VC fund

� Cross-sectional variance should be lower for new, younger VCs than for older, establishedVCs

� Cross-sectional variance should be lower for older,established VCs than for younger, newer VCs

Learning model Signaling model

Major differences

Learning and signaling model try to explain how fixed and performance-basedcompensation differs across VCs



16

18 ( 8

17( 8

19( 2

17( 6

FIXED BASE COMPENSATION AND SENSITIVIT Y OF COMPENSATION FOR VCS

Age of venture organization

18( 9

18( )

19( 0

1) (

9

No earlier funds

Four years or less

Between 4 and 8years

More than 8 years

41 2

41 2

4 1 3

41 9

181 8

191 9

18 1 2

12 1

1

No earlier funds

Between 01 0 and

01 2% of entire

industry

Between 01

2 and0

1 7% of entire

industry

Greater than 01 7%

of entire industry

41 2

41 4

41 2

2 1 1

Focus on high tech

Other industryfocus or no focus

Focus on earlystage inv 1

Other stage or nofocus

4 1 6

4 1 6

41 6

4 1 6

161 7

181 8

18 1 9

181 3

Jan 78-Dec 84

Jan 82

-Jun 86

Jun 86-Dec 88

Jan 89-Dec 92

2 1 2

4 1 6

41 3

4 1 4

Objective of fund

Size of venture organization

Date of closing

Base comp

Sensitivity of compensationto performance

Base compPercent *




* NPV of base compensation as a percentage of committed capital

Older funds havelower fixed basecompensation

structure

Older funds havelower fixed basecompensation

structure

.

Riskier fundshave higher fixed

basecompensation

Larger fundshave lower fixed base

compensation

structure

Larger fundshave lower fixed base

compensation

structure

NPV of basecompensationincreased by

about 2%over time

Percent

Base compPercent *

Base compPercent *



17

VARIABLE COMPENSATION ± SHARE OF PROFITS RECEIVED B Y VCs

Age of venture organization

4 5 .

6

4 5 .7

4 5 .

7

4 1.

8

No earlier funds

Four years or less

Between 9 and 8years

More than 8 years

@ A .

9

@ A .

B

@ A

.C

@ 1.

D

No earlier funds

Between A .A andA .

@ % of entire

industry

BetweenA

.@

andA

.7% of entireindustry

Greater thanA

.7%of entire industry

Focus on high tech

Other industryfocus or no focus

Focus on earlystage inv.

Other stage or nofocus

@ A .

C

@ A

.

B

@ A .7

@ A .

B

Jan 78-Dec 8 9

Jan 8 C -Jun 8 D

Jun 8D

-Dec 88

Jan 8B

-DecB

@

Objective of fund

Size of venture organization

Date of closing

4 1.

4

4 5 . E

4 1.1

4 5 .

6

Percent Percent

Older VCsdemand

higher shareof profits

VCs investingin higher-risk

industriesdemand


Larger VCsdemand


Norelationship

betweendate of

closing andprofits

demanded

Percent Percent



18

FUNDRAISING ± VC STRUCTURE IMPLICATIONS

� VC organizations typically exist in one of two forms:

± (Traditional) independent VCs that are run by general partners with external/outside investors being limited partners

± Corporate VCs that are typically structured as corporate subsidiaries of the parent organization

� The specific form has implications on organization structure, compensation, and type of investment:

± Corporate funds have similar missions and are staffed by individuals with backgrounds resembling independent organizations ± They are structured as corporate subsidiaries and have much lower incentive-

based compensation

± Good corporate funds are more likely to invest in a technology/company that has potential synergieswith their existing business

� Contrary to popular finance literature, the structure of a corporate organization is not a barrier to success. Rather a well-definedmission, and strategic commitment/focus are seen as critical to achieving a sustainable program

� Analytic evidence about corporate venture funds compared to independent venture funds suggests that corporate venture funds:*

± Invest less in start-up and mature private firms. They are disproportionately represented in companies in middle stages(e.g., ³development´ or ³beta´)

± Investments are more common in California, but, investments with strong strategicfit are more frequent elsewhere

± With strong strategic focus invest heavily on high-tech industries

± Backed firms are more likely to go public and less likely to be liquidated

± Pay a higher premium for a comparable investment

± Invest in later and larger financing rounds in slightly older firms

± Make a lot fewer and shorter term investments over time

Investing and focus varies by structure of VC entity




19

FUNDRAISING ± VC STRUCTURE IMPLICATIONS ± BRIEF HISTORY OF CORPORATE VCs

Major milestones

� First corporateventure fundbegan in mid 60s

1960s 1970s 1980s

� In 1992, corporateventure basedcapital under managementrepresented 5% of VC pool

� Interest of corporations incorporate VCfunds increased inmid 90s due tohealthy publicmarkets

� In 1997, corporateventure basedcapital under managementrepresented ~30%of VC pool

1990s

� Number of activecorporate venturesincreaseddramatically inearly to mid 80s

� In 1986, corporatefunds managed$2 billion or 12%of VC pool

� In 1987, marketcrash led tocorporate venturesbacking their commitment toventure investing

� By early 70s over 25% of S&P 500firms attemptedcorporate ventureprograms

� In 1973, market for IPO declinedabruptly ± typicalcorporate VCestablished in late60s was dissolvedin 4 years

Corporate VCs are even newer than independent VCs



20

53F 7

63F 7

14 F 025

F 2

VC STRUCTURE TRENDS

100% = 32,634 investments between 1983-1994

Corporate VCs tend to focus on development and, beta stage investment inCalifornia in the high tech sector

33G 644

G 4

5G 5

DevelopmentShipping

17G 0

14G 2

15G 1

27G 9

25G 9

Medical

Communications

Computer software

Other

Status at time of investment

Industry of firm

Corporate VC only

Start-upRe-startProfitable

Beta

Computer hardware

CA Western

statesEasternstates

Location of firm

MA

2F 5

7 F 16 F 9

35G 9

42G 9

6G 4

DevelopmentShipping

16G 2

22G 114

G 0

23G 5

24 G 2

Medical

CommunicationsComputer software

Other


Industry of firm

Corporate VC and strategic fit

Start-upRe-start

Profitable

Beta

Computer hardware

51F 3

59F 6

16 F 529 F 1

CA Western

statusEasternstates

Location of firm

MA

6F 4

2F 8

31 G 244

G 8

4G 1

DevelopmentShipping

16G 8

15G 5

16G 2

27G 3

24G 2

Medical

Communications

Computer software

Other


Industry of firm

Independent VC only

Start-upRe-startProfitable

Beta

Computer hardware

52F 7 60 F 8

12F 6

23F 4

CA Western

statusEasternstates

Location of firm

MA

2F 3

10 F 4

7 F 3

5F 6



21

2 H .

I

21.1

1P

.Q

R S .1

I .2

1 % = 2, investments between 198 -199

Corporate VC investments are more likely to go public, less likely to liquidate,have higher valuations, invest in later rounds, and invest over shorter periodsof time

Acquired

Privatelyheld

Status in spring 1998

Corporate VC only

Registrationfiled

IPO completed

Liquidated

Corporate VC and strategic fit Independent VC only

Status in spring 1998 Status in spring 1998

2H

.S

1 I . R

1P

.H

R 9.

R

I . R

Acquired

Privatelyheld

Registrationfiled

IPO completed

Liquidated R I .

R

19.H

18.H

R I .

Q

I .

H

Acquired

Privatelyheld

Registrationfiled

IPO completed

Liquidated

Median round of investment

Median pre-money valuation

at time of financing ($ millions)

Median number of investments

Median timespan per investment

18.Q

R . I

2.I

1. I

Corporate VC only Corporate VC only and strategic fit Independent VC only

1 H .

I

R .

I

P

.I

P

.2

12.S

2.I

2.1

8.I

VC STRUCTURE TRENDS



22













23

INVESTING ± BRIEF OVERVIEW

� Factors limiting access to capital for entrepreneurs include:

± Uncertainty which affects willingness of investors to contribute capital, and suppliersto extend credit

± Asymmetric information from entrepreneurs who know more about the company's

prospects than investors, suppliers, and strategic partners ± Nature of firm assets as firms with tangible assets may obtain financing on more

favorable terms

± Market conditions at a given point in time

� VCs use a few different mechanisms to mitigate investment risk between investors and portfolio companies:

± Active monitoring and advice: Lead VC visit entrepreneur once a month on averagefor 4-5 hours each. Non-lead VCs visit firm once a quarter for 2-3 hours. Both alsoreceive monthly financial reports

± Controls on compensation to align multi-party incentives including:

· Widespread use of stock grants and options for entrepreneurs

· Vesting of stock/options over a multi-year period for entrepreneurs

· Dilution of entrepreneurs stake in subsequent financing if targets are not realized

· Performance based compensation for VC leading tofurther alignment of incentives

� In order to alleviate information gaps in the industry, VCs act as intermediaries or "agents" for investors looking to tap into the riskier entrepreneurial market by

± Scrutinizing firms before providing capital to them, and

± Monitoring them afterwards

VCs act as the "intermediaries" between entrepreneurs and investors



24

INVESTING ± BRIEF OVERVIEW

VCs play an integral role in addressing conflicts and issues related to principal-agent problem across investors and entrepreneurs

� Allow VCs to monitor performanceof investment over time and changeinvestment strategy accordingly

� VCs concentrate investments in early stagecompanies and the high tech industry due toexistence of large informational asymmetries

� Firms that go public have typically receive

more total financing and more rounds of it� Early stage firms receive significantly lessmoney per round

� Increases in asset tangibility increase financingduration and reduce monitoring intensity

� Allow VCs to actively overseeentrepreneurial venture toensure multi-party incentivesare aligned and investment isgetting traction

� Composition of board in portfolio companyis shaped by need for oversight

� VC representatives are added to board after management changeover (e.g., change inCEO) and additional rounds of financing

� Geographic proximity is an importantdeterminant to board membership. Thecloser the proximity of portfolio company toVC, the higher the likelihood of boardrepresentation by VC

� Allow VCs to diversify their existing holdings and get a"second opinion" on theinvestment

Why is it done? Results from analysis

� VCs co-invest with other VCs to diversify awayfirm-specific risk and reduce overall portfolio risk

� In early rounds of financing, VCs syndicate onlywith VCs that have similar experience or expertise

Staging

Activeoversight

Syndication



25

INVESTING ± INVESTMENT STAGING

Staged infusions are the most effective way of managing capital

Factors affecting structure of staged VC infusions:� Agency and monitoring costs represent costs associated with reducing conflict of interest between entrepreneurs, investors, and VCs through careful

monitoring of investments. ± Two types of agency costs existing in entrepreneurial firms include:

· Entrepreneurial investment in strategies, research, or projects that have high personal returns but low expected monetary payoffs to shareholders· Entrepreneurial investment in negative NPV project

± Intangible assets are associated with greater agency costs i.e., firms with higher market-to-book ratio have greater agency and monitoring costs� Venture capital, liquidity, and investment affect VC money invested per round and frequency of investment

± Larger fund inflows lead VCs to invest more money per round and invest more often

Examples of VC staging include:

T

.5T

.U

2.V

1/U

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Apple Computer $ raisedMillions

$ raisedMillions

Price per share$

Price per share$

At each stage,increasing price

per share andgrowing

investment

reflectedresolution with

regards TO uncertainlyconcerningApple's

prospects

Stagedinvestmentsallowed VCsto intervene

and pricesubsequentrounds sothey could

earn fair rateof return

Fed Ex

̀ /U

̀

9/U

V V

/U

` ̀ /U

̀



26

INVESTING ± INVESTMENT STAGING

� Results from analysis on staged investments concludes the following:

± Percentage of VC invested in high technology is highest compared to other industries*

± Average ratio of R&D to sales is 3.43% for VC investment industries as compared to1.30% for all industries

± Maturing of VC industry is evident through relative decline of early stage financing, andgrowing importance of later stage financing*

± VCs may know more about late-stage firms and therefore may invest more money for longer periods of time*

± Duration of financing declines for late-stage companies (i.e., there is less time betweensubsequent financing events)*

± Cash utilization for larger firms is faster because working capital needed expands withproject size*




27

VC INVESTMENT B Y INDUSTRY AND STAGE

VCs have invested primarily in high-tech and have focused more investment inlater stage financing

* High-tech defined as communications, computers, computer-related, computer software, electronic components, other electronics, bio-tech and medical/healthrelated industries

** Early stage defined as seed, startup, early, first round investments

*** Late stage defined as second, third, or bridge stage investments

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i

7.7i

e .1 e g

.7i

h .

h

e

i

.f

1i

.e

7.1

1g 7

f 1

g 7

d 1

g 77 1

g 7

c 1

g 7

g 1

g c h 1

g c 1 1

g c 2 1

g c e 1

g c

i

1g c f

1g c d

1g c

7 1g c c

1g c g

Early stage**

Late stage***



28

.

.2

.0

.08

.08

.2

.0

0.8

0.97

DURATION, INVESTMENT AND CASH UTILIZATION B Y STAGE OF DEVELOPMENT

Investment duration decreases whereas amount of funding and cash utilizationincrease with round of funding

0 5

2 709

, 9

2, 88

2, 7

2, 59

2,8 5

, 59

,0

Seed

2,255

,

2,025

2,292

2,

2,8

, 7

, 0

Start-up

Early stage

First stage

Other early

Expansion

Second stage

Third stage

Bridge

Early stage

Late stage

Time to next fundingYears

Amount of funding, 1997$ Thousands

Cash utilization, 1997$ Thousands



29

INVESTING ± INVESTMENT MANAGEMENT

VC involvement is a lot higher during periods when need for oversight is high,and geographic proximity to portfolio company is near


Need for oversight Investment proximity to VC

� Overtime size of board of directorsgoverning company increases asmoney invested into companyincreases

� VC directors account for singlelargest type of directors on aportfolio company's board*

� Periods of senior managementtransition (C-level executive) leads

to high need for oversight by VC

� Transaction costs associatedwith frequent visits and intensiveinvolvement reduced if VCs areproximate to the firms in their portfolio*

± Over half of VC firms haveventure board members infirms within 60 miles

± VC board participation dropsdramatically with distance



30

Other quasi-insidedirectors

BOARD MEMBERSHIP B Y ROUND NUMBER

Size of board increases over time with VCs accounting for single largesttype of directors

* Outside directors

** Inside directors

*** Quasi-inside directors

3p

q r

r 0

q 3

1s

q

p

t q

u

s

q 1

p

q

v

3 q

v

VCs*

Senior manager**

Corporate partner*

Other outsidedirectors*

Academic affiliatedwith the firm***

Junior manager**

Professional affiliation of board members at time of last financing roundPercent

1w

x

0

1w y �

� w 0�

� w 1

�

0w y �

0w y �

1w 0�

1w � �

1 w � y

1w

x

0

1w �

1

1 w � 3

0 w � �

0 w � �

0 w � �

0w �

x

Mean number of board members

VCs Other outsiders Insiders Quasi-insiders

First round

Second round

Third round

Later round



31

PROXIMIT Y AND BOARD MEMBERSHIP FOR VENTURE INVESTORS

Closer proximity to venture investment leads to higher likelihood of VCinvolvement at board levels

Note: Sample consists of 700 VCs and their private biotech holdings

Distance from VCs nearest office to firm headquartersMiles

3

3

Nearest

venture director Median distanceventure director

Probabilityof joiningboard

7

1

7

3

73

1

1 1

7

Farthestventure director

Mean Median First Quartile Third Quartile

30 7 3 1

<5 5-50 50-500 >500

Distance from VCs nearest office to firm headquartersMiles; percent



32

INVESTMENT SYNDICATION

VCs use syndication to resolve informational uncertainties and diversify r isk

Better decisionmaking oninvestments in earlyrounds

Prevent exploitationby early round VCs

Buy window dressing Diversify risk

� Investments made byseveral independentorganizations may bebetter than singleorganization

� Investments made byseveral independentorganizations may bebetter than singleorganization

� Earlier VCs may exploitinformationaladvantages; to avoidopportunistic behavior lead VC shouldmaintain investmentshare of equity

� Earlier VCs may exploitinformationaladvantages; to avoidopportunistic behavior lead VC shouldmaintain investmentshare of equity

� VCs makeinvestments in later rounds to promisingfirms despite highlyattractive returns topresent to investorsas marketingcollateral

� VCs makeinvestments in later rounds to promisingfirms despite highlyattractive returns topresent to investorsas marketingcollateral

� By coinvesting inseveralinvestments VCscan spread riskover multiple firms

� By coinvesting inseveralinvestments VCscan spread riskover multiple firms



33













34

EXITING ± BRIEF OVERVIEW

Exiting is the last step in the VC cycle at which point VC returns invested capitalto investors

� VCs hold significant ownership and control in firms they take public

± Lead VC holds 19% stake

± All VCs hold 34% stake

± VCs hold a third of board seats

� VCs repeatedly taking firms public develop relationships with underwriters and auditors leading to venture-backed IPOs having higher-qualityunderwriters and auditors than nonventure IPOs

� Analytic study of 320 VC-backed and 320 non-VC backed IPOs between 1983-87 showed:

± Underwriters of VC-backed firms are more experienced than underwriters of non-VC backed firms

± Institutional holdings of VC-backed firms post-IPO are higher than comparable non-VC backed firms ± VC-backed IPOs have lower fees associated with going public than non-VC IPOs

± VCs retain a majority of equity after IPO

± Underpricing of VC-backed IPOs less than underpricing of non-VC backed IPOs

� VCs tend to take firms public at market peaks, relying on private financing when valuations are lower

� Young VC firms take companies public earlier than older VCs in an effort to establish a positive reputation

± Young VCs have been on IPO company's board of directors for 14 months less than older VCs in same scenario

± Furthermore, IPO companies they finance are 2 years younger and more underpriced than older VC companies in same scenario

� VCs typically do not sell at time of IPO as this is perceived as a negative signal of "insider" cashing out; they typically cash out after (6 months ) "lock out"period by

± Returning proceeds of sale to investors through open market sale

± Transferring securities to investors at open market price

� After significant increases in stock prices prior to distribution to investors, abnormal returns around the distribution are negative and significant,comparable to market reaction to public ly announced secondary stock sale

� Analyzing long-run performance of over 4,000 VC-backed and non-VC backed IPOs between 1972-92 we notice

± VC-backed forms do not underperform market after going public

± Poor performance of IPOs relative to market benchmark confined to smallest nonventure offerings (typically under $50 million in market cap)

± VC-backed offerings earn positive risk-adjusted returns

± VCs bring companies public that have considerable staying power



35

EXITING ± EFFECT OF MARKET CONDITIONS ON DECISION TO GO PUBLIC

Good VCs take advantage of public markets as most favorable exit scenario.


� IPOs coincide with peaks in equity valuations, while no clear patterns appear in private financings, implyingVCs are able to time market, taking companies public when industry valuations are highest*

� VC experience has a mixed effect on firm financed. These firms in general have*

± More established underwriters

± More established auditors (typically Big 5)

± Larger total funds raised

± Less equity retained by employees and management

± Less likely to employ a bundled offering (e.g., 1 share of stock and 1 warrant)

± Lower 1st-day returns from IPOs

� Another explanation for established VCs' apparent superiority in timing IPOs is better execution throughexperience





37

IPO CHARACTERISTICS B Y FIRM AGE

Established VC-backed firms have more experienced/better underwriters andauditors, less equity retained by employees, higher funds raised, and lower percent of IPOs which are unit offerings and lower returns

Note: Sample consists of 136 biotech IPOs, 1/78-9/92

Older, moreestablished firms

Newer, lessestablished firmsCharacteristics

� Carter-Manaster ranking 6.6 4.8

� Most frequent firm (number) Hambrecht & Quist (6) D.H. Blair (14)

Underwriter

� Percent of firms in "Big 5" 98.5% 96.1

� Most frequent firm (number) Ernst & Young (26) Ernst & Young (21)

Auditor

� Percent of equity retained by employeesand management

7.2% 11.8

� Funds raised $33.7 million 25.6 million

� Percent of IPOs that are unit offerings 4.4% 25.0

Offering

� Initial return (percent) 10.3% 15.4



38

EXITING ± EFFECT OF REPUTATION ON DECISION TO GO PUBLIC

Reputation of VC has positive impact on portfolio company at time of IPO


� Younger VCs have a tendency to take firms public earlier ("grandstand") in order to establish a reputationquickly and successfully raise funds for future offerings

� Early IPOs can lead to greater underpricing as signal toward weaker company quality and uncertainty

� Empirical analysis about reputation of VC firms implies that younger VCs tend to:* ± Raise additional funds soon after portfolio firm IPO ± Have smaller follow-on funds ± Have younger companies at IPO date ± Have board members on portfolio companies for shorter periods of time ± Have higher levels of underpricing on IPO date ± Have a lower IPO offering on IPO date ± Have lower-quality underwriters ± Have less prior IPO experience ± Have lower total equity ownership of portfolio company ± Have lead VC equity ownership in portfolio company

± Have lower market value of lead VCs equity post IPO ± Have higher aftermarket standard deviation in returns



39

COMPARISON OF IPO STATISTICS FROM YOUNGER AND MORE ESTABLISHED VCS

<6 years old >6 years old

Average time from IPO date to next follow-on fund (months) 1 6.0 24.2

Average size of next follow-on fund (1997 $ millions) $87.9 1 36.6

Average age of venture-backed company at IPO date (months) 55.1 79. 6

Average duration of board representation for lead VC firm (months) 24.5 38.8

Average underpricing at IPO date (percent) 1 3.6% 7.3

Average offering size (1997 $ millions) $18. 3 24.7

Average Carter and Manaster underwriter rank 6.26 7.43

Average number of previous IPOs 1 6

Average percent of equity held by all VCs prior to IPO 32.1% 37.7

Average percent of equity held by lead VC prior to IPO 12.2% 1 3.9

Average market value of lead VC's equity after IPO (1997 $ millions) $9.5 1 4.7

Average aftermarket standard deviation (percent) 3.4% 3.0

VC firm age at IPO

Note: Experience of VC firm was used as reasonable proxy for reputation. Older firm had better reputation through it's ability to raise andmanage multiple funds over time



40

EXITING ± VC SHARE DISTRIBUTION

VCs prefer distributing shares to limited partners/investors than 'cashing-out' of investments

� At point of exit VC has 2 options when returning investment to limited partner

± Cash out of investment in open market and return proceeds to limited partners after "lockout" period

± Transfer owned shares to limited partners without liquidating in open market

� However, more often VCs choose to distribute shares to limited partners and sometimes to themselvesbecause

± SEC rules restrict large sales by corporate insiders (VCs). Typically, sale of 1% of equity or averageweekly trading volume is permitted, thus selling entire stake may take some time

± Tax motivations incent VCs to distribute shares as tax consequences and payments can be deferred to alater date

± Selling shares has a negative impact on prices



41

EXITING ± VC-BACKED OFFERINGS PERFORMANCE

� Severe underperformance of all IPOs during past 20 years suggests investors may be too optimistic aboutprospects of firm issuing equity for 1st time

� However, further analysis has shown VC-backed firms outperform non-VC backed firms over a 5-year period when returns are weighted equally, and underperformance in non-VC sample driver by small issues

with market capitalization less than $50 million

VC offerings have generally outperformed the market



42

COHORT VC-BACKED VS. NON-VC BACKED IPO PERFORMANCE

2

400

500

00

97 77 78 79 80 8 82 8 84 85 8 87 88 89 90 9 992

Equal weighted 5-year buy-and-hold returnPercent

VC� backed

Non� VC backed

VC backed IPOs have strong tendency to outperform non VC backed IPOs over a period of time

Documents

604989 the Venture Capital Cycle