Chapter 14

Chapter 14

Venture Capital

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Learning Objectives• How venture capital fund structure is influenced by

regulation and other factors.

• How venture capital fund structure influences the kinds of investors who can invest.

• How the role of the fund’s general partner changes over the life of the fund.

• How the contract structure of venture capital funds promotes efficient investment and management.

• The role of reputation in defining relationships among the venture capitalist, investors, and portfolio companies.

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14

Historical Development of Venture Capital As an Institution


• Legal environment:

–1933 and 1934 SEC Acts

– Investment Company Act of 1940

–ERISA Act (1974 and 1979).

• Fund structure:

–Closed-end mutual fund.

–Limited partnership.

Fig 14-1


Figure 14-2


Venture Capital Investments by Stage of Development

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Figure 14-3



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European Venture Capital and Private Equity Funds Raised in 2001


Expected Allocation of Funds Raised in 2001European Venture Capital

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Private Equity Raised by Investor Type (1997 - 2001)European Venture Capital

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Organizational Structure of Venture Capital Investment


Figure 14-4

Summary of Terms:Venture Capital Limited Partnership Agreement


Managing The Investment Portfolio


The Venture Capital Investment Process (Figure 14-6)


Allocation of Venture Capitalist Time (Figure 14-7)


Incentive Conflicts and Structures



Figure 14-8

End of Chapter Questions


Question 14-1

The early venture capital funds were organized as closed-end funds. More recently, most venture capital funds are being organized as limited partnerships. What do you see as the key differences between the two forms that help explain the shift?


Question 14-2

How do the reputations of fund managers, investors, and entrepreneurs bear on the efficient operation of a venture capital fund? How do you think venture capital contracts might be different when a manager, investor, or entrepreneur does not have an established reputation?


Question 14-3

In the late 1990s, the carried interest of some of the leading venture capital funds increased from 20% to 30%, and the funds have tended to shift more of their focus to making somewhat later-stage investments. These changes occurred at the same time that the number of venture capital funds was increasing, total capital commitments to funds were increasing and business angel investing was growing and become more organized.

• Can you think of a competitive reason why the carried interest percentage might increase at the same time these other changes were taking place? Can you explain why investors in the funds might be willing to accept the higher carried interest? Finally, can you think of any way you might be able to test your conjecture?


Question 14-4

Venture capital firms normally try to solicit investment capital at the same time they are looking for deals. They also can extend the life of a fund for several years beyond its planned liquidation date.

• How might these practices contribute to enhancing the value of the fund? How might they affect the kinds of investors the fund seeks and the kind of ventures it invests in?


Question 14-5

Usually, venture capital firms do not sell their shares when one their portfolio companies has an IPO. Often, the IPO underwriter precludes them from doing so.

• Why might underwriters want to limit venture capitalist selling?

• Under what conditions would you expect them to permit the venture capitalists to sell some of its share during the IPO?

• Assuming underwriter will permit some selling by the venture capital firm, why would the venture capital firm want to sell instead of waiting until after the lock-up period (normally 180 days) to sell?

• How are your answers to these questions related to the extent of under pricing of the IPO?


Question 14-6

A venture capitalists has a carried interest of 20% of appreciation in excess of return of capital. Limited partners get their money back first, and then receive 80% of capital appreciation.

Consider a venture in which the venture capital fund plans to invest $5 million. The entrepreneur has a total wealth of $2 million, $500,000 of which must be committed to the venture.

The venture capitalists expects that the venture will have a market value of $15 million in four years, which is when harvesting is expected. The venture capitalists assessment of uncertainty can be described as a standard deviation of harvest values of $10 million.

Suppose both the general partner and the limited partners are well-diversified. Assume that the risk-free rate is 5% and market rate is 11%. The market standard deviation is 20% on annualized basis. The correlation between the venture and the market is 0.3. (You can assume this is the correlation of any investment security of the venture).


Question 14-6 (Continued)Use simulation to estimate expected cash flows and standard deviations of cash flows for both parties under the following contracts. Use a valuation template for diversified investor to value each party’s claim and compare the following allocations. Make any other assumptions you need.

a) The venture capital fund receives interest of 14% per year and 20% of the equity. The loan principal and the interest are paid in year 4 to the extent that the venture has cash available to do so. (In each year, the loan balance increases by the amount of interest owed.)

b) The venture capital fund receives interest of 6% per year (similar to part a) and 30% of the equity.

c) The fund receives 40% of the equity.d) Which allocation would the entrepreneur prefer and why

(assume the entrepreneur has the same expectations for performance)?

e) Which of these contracts do you think the limited partners would prefer and why? Which would the general partner prefer?


Question 14-7

You are considering whether to launch a new venture capital fund and have decided to build a financial model to help you make the decision. To begin, you need to model the relationships among several factors: venture performance, returns to the venture capital fund, and allocation of the returns between the limited partners and the general partner

• Portfolio investments: Suppose a representative or typical venture in which your fund might invest would require four years from investment to harvest. To represent the uncertainty of the cash flows of the venture, assume that the harvest cash flow can be described as a normal distribution with mean of $20 million and standard deviation of $40 million, except that simulated negative outcomes imply that the venture fails and generates a harvest cash flow of zero.


Question 14-7 (Continued)

• Investment agreements: Further, in typical venture capital contracts with portfolio companies of the type you hope to attract, the standard terms are that the venture capital firm receives convertible preferred stock and is entitled to a liquidation preference equal to 1.5 times the initial investment

• The limited partnership agreement: Finally, the partnership agreement would provide that the general partner charges an annual fee of 3.125 percent of the net capital invested in each venture. For simplicity, assume that for each $100,000 invested in a venture with four years to harvest, the fund pays a total of $3,125 x 4 or $12,500 to the general partner in management fees. On each investment, the limited partners would be entitled to receive all of their invested capital back before the general partner would share in any of the gains. Once the initial investment is returned from the harvest proceeds of a portfolio company (including the management fee), the general partner shares 20 percent of the gain.



Build a model to simulate the harvest cash flows of the venture and the allocation of the cash flows to the limited partners, the general partner, and the entrepreneur. Use the model to simulate the expected cash flows and cash flow risk of the following three assumptions about the size of investment and share of equity. Be sure to incorporate the liquidation preference and the limited partners’ right to return of invested capital before any gains are allocated.

a) The venture capital fund commits $2.5 million in exchange for preferred equity convertible to 15 percent of the common stock.

b) The venture capital fund commits $5.0 million in exchange for preferred equity convertible to 25 percent of the common stock.

c) The venture capital fund commits $7.5 million in exchange for preferred equity convertible to 35 percent of the common stock.



Value the various financial claims and discuss the adequacy of returns for the general and limited partners and for the entrepreneur. In valuing the claims, assume that the annual risk-free rate is 3.0%, the annual return on the market is 8.0%, the annualized standard deviation of market returns is 20%, and the correlation of harvest cash flows with the market is 0.15. The entrepreneur has $2.0 million of wealth available to invest in the market.


Question 14-8

Reconsider problem 7. Model the cash flows of the venture capital fund and use the model to evaluate the general partnership capital account balance and cash returns available to the partners under each assumption for each average investment amount in problem 7. Base the cash flow model on the following assumptions:

• There are three members of the general partnership and each can oversee the fund’s investments in five ventures.

• The expected life of the fund is ten years. Each partner is expected to add one new venture to the fund’s portfolio each year in years two through six. Each venture is harvested four years later (in years six through ten).

• During each of the four years while a fund is invested in a venture, the partnership collects its annual management fee of 3.125 percent of the capital invested in the venture.



• On the expected harvest date for a venture, the fund realizes the carried interest on the investment (i.e., difference between the general partner’s expected cash flows of the venture and the cumulative management fees related to investment in the venture).

• The management fees collected in each year plus the carried interest collected in the year comprise the general partnership’s revenues for the year.

• Annual operating expenses are expected to be $1.0 million per year in all years, including the initial year (year 1).

• Each partner would like to receive an annual draw of $200 thousand against the capital account balance.

• Assume all figures are in real terms so that you do not need to make adjustments for inflation or interest on capital balances.



• Depending on the average size of investment, what initial capital balance would be necessary to keep the fund from developing a negative net cash position at any point during its expected 10-year life?

• If you think of the initial capital balance as a loan from the partners that is repaid out of the ending balance, how well are the partners expected to do depending on the average size of investment?

• What do you conclude about how the average investment size bears on the size of the fund and the profitability of venture capital fund management?


Question 14-9

Continuing with the cash flow analysis from problem 8, suppose that syndication enables each partner to oversee ten ventures instead of five. That is, the firm’s partners would only be lead investors in about half of the ventures and would be more passive in the investments where other funds act as lead investors. Assume that the total costs do not change, but the number of investments in each period doubles.

• How does this affect the economics of making average investments of $2.5 million?

• How does syndication affect the size of the fund, the required initial capital, and the expected capital balance at the end of the fund?


Chapter 14

Economy & Finance

Transcript of Chapter 14