Tuesday, May 19, 2009

The Stages of Venture Capital Investing

The following is Part 2 of my five-part series on the roles of angel investors and venture capital investors in emerging technology sectors with explosive upside potential, such as the nanotech, cleantech, biotech, information technology and new media sectors.

In Part 1, I gave a general overview of the playing field. Below, I examine the stages of an emerging growth company’s lifecycle and the types of investment that it hopes to obtain at each relevant stage.


Many investors are confused by the differences between angel and venture capital. This isn't surprising; the categories are overlapping and are used inconsistently.

However, there are some broad generalizations that can be drawn, typically based on the timing of the investment and the purpose of the investment in the company’s lifecycle. Depending upon the timing, you can draw some basic conclusions as to the type of investor that will be involved (e.g. single angel vs. angel consortium vs. venture capitalist).

And, in each category, you can glean the form the investment will take (e.g. common stock vs. convertible debt vs. preferred stock) and the size of the return investors can expect. That is, if there's a return--very few private emerging growth investments are actually a success. More below the fold.

Seed Round

The earliest investment stages are usually characterized as seed rounds, proof of concept investments or angel investments.

These investments usually don't occur until after the target entrepreneur has tapped out his friends and family in what's usually called a “friends and family” round.

The money you invest is intended to allow the founders of the company to do their initial research, to complete the initial programming or to apply for the initial patent(s). Companies at this stage usually don't have a saleable product and don't have very many employees, other than the founders/inventors.

Traditional venture capital funds very rarely invest in seed rounds. Rather, seed investors typically consist of angels that is, wealthy individuals or groups of individuals that are willing to invest their own money and take the extreme risk involved in making equity investments into companies that often only have a good idea.

Occasionally, a seed investor may be a publicly or privately funded incubator established to help entrepreneurs or scientists get their ideas off of the ground.

In the seed round stage, the amount of the investment is typically small, say $100,000 to $500,000, seldom more than $1,000,000. Also, the investor usually takes common stock in the company--the same stock that the founders get.

Alternatively, the investor will take a convertible note that allows him to have the protection of debt at the beginning but with the possibility of converting and receiving the upside of equity. Typically, the conversion will occur in concert with the closing of the next round of investment and will be at the same per share price used in the next round.

Often, you receive some sort of additional incentive for making a seed round investment such as a conversion discount or grant of warrants.

Investments at the seed stage are extremely risky and are subject to significant dilution when new investors come in during later stages. Consequently, angel investors look for returns of at least 10x their initial investment, and sometimes as high as 20x or 30x their initial investment.

Early Stage Venture Round

The next stage of investment is early stage venture capital. Investors usually aren't interested in making this type of investment until the company has a proven product and a business plan.

However, it isn't necessary that the target be profitable or even be producing its product. The funds invested will be used to mass manufacture the product, market the product, build a sales force and further develop the product.

Typically, these sorts of investments are made by early stage venture capitalists, larger angels or angel consortiums. Early stage venture capitalists and angel consortiums usually have smaller funds to deploy which makes them more suited to making the relatively smaller sized investments found at this stage of a company’s life.

In this stage, the amount invested is typically in the $1,000,000 to $5,000,000 range. The investors will almost always be purchasing Series A preferred stock of the target. This type of stock is superior to the common stock held by the founders and any seed round angel investors and will typically come with dividend rights, liquidation preferences, some form of anti-dilution rights and a right of first refusal on stock sales by the founders and seed round angels.

Often, the investors will also receive pre-emptive rights, redemption rights, drag along rights and other rights and preferences.

Investors at in early stage investments will typically look for returns of at least 5x their initial investment and would gladly accept higher returns.

Growth Stage Venture Round

After the Series A round, there may be multiple additional rounds of equity financing. These types of funding are often called growth capital or mezzanine financing.

Usually, the company seeking this sort of investment will either be close to profitability or will have a clear path to profitability and the funds are meant to allow the company to expand its sales force and marketing efforts and ramp up its revenue growth. The money may also be used to develop additional products or to research expansion ideas.

These investments are usually made by the larger venture capital funds and the amount invested can range from $1,000,000 to $25,000,000 or higher, depending on the company and the market opportunity.

The investor typically will receive additional rounds of preferred stock--for example, Series B or Series C preferred stock--and each successive round will generally have superior rights and preferences to the prior rounds.

Investors at this stage may still look for 5x investment returns, but depending on the opportunity and the trajectory of the company, may settle for 2x or 3x returns.

Bridge Round

Occasionally, investors will be willing to invest bridge capital into a company in the growth phase of its life cycle, or one that's on the cusp of the growth phase. This investment takes the form of debt that “bridges” the gap in funding between rounds of venture capital financing.

These investments range in size depending on the company and the market opportunity and they're made by all types of investors, depending on the size of the investment. The lender may be an existing investor in the company or it may be a new angel or venture capital fund that's contemplating making the follow on round.

Usually, the debt will be represented by a convertible note that will automatically convert into the next round of preferred stock, sometimes at a discount. Also, investors will usually want some sort of warrant coverage to provide equity upside in the deal.

Investors at this stage expect a blended return that takes into account the interest rate on the debt and the potential value of the equity. These target returns vary greatly, but often move in the 12 percent to 18 percent range.

Buyout Capital Round

The final stage is characterized as acquisition or buyout capital. This is used by the company to purchase the assets or stock of other businesses that will then be absorbed into or added onto the target company.

The investors may be the company’s existing venture capitalists or it may be a private equity fund that's building out a platform in the company’s industry.

In the latter case, the investment may come with a right to purchase the company outright in the future. This type of financing also occurs when a company’s angels and venture capitalists start planning their exit strategy.

By putting together the right pieces it may make the company more attractive as an acquisition candidate or perhaps more eligible for an IPO.

In the next three parts of this article, I'll explore angel investing, angel syndicate investing and venture capital investing, in greater detail and I'll discuss the important characteristics of each mode, including typical legal and business issues.
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Friday, May 1, 2009

When Venture Capital Fits - Part 1

Below the fold is Part 1 of an article I recently wrote for the New Tech Investor e-newsletter. Many thanks to the publisher, Gregg Early, for the opportunity to write a longer piece. Stay tuned for parts 2 through 5.
When Venture Capital Fits - Part 1

Nanotechnology is a catch-all term for the sciences of the super small. It's notable not just for the amazing discoveries being made in labs, but in the ways in which these “pure science” initiatives are being commercialized in the cleantech, biotech, medical device and information technology sectors.

The world of nano has crept into each of these sectors with the potential for revolutionary technical advances and explosive commercial growth.

One clear example of this is Sapphire Energy. This cleantech company is working on squeezing high-octane fuels from algae.

They're doing this by using mesoporous nanoparticles to extract crude oil from living algae without harming the plants in the process. These sponge-like materials are capable of collecting only small amounts of oil, but they're deployed in very large numbers.

Once the collection process is completed, a catalyst will be used to produce biodiesel and bio jet fuel. Sapphire already has tested its bio jet fuel with Continental and JAL.

According to Sapphire, it's ramping up production estimates to 1 million gallons of algae-based diesel and jet fuel per year by 2011. By 2018, Sapphire is expecting to produce 100 million gallons per year.

By 2025, that number could reach 1 billion gallons per year, which would represent approximately 3 percent of the US renewable fuel standard. That's an exciting emerging growth prospect.

But how do individual investors get involved in pools of innovation such as Sapphire? You could turn to public equities. However, you may find that public companies aren't ideal for investing in innovation, especially as pure nano plays.

This is not to say that public tech companies aren't doing some important work; they are. But for more stable, mid and large cap public companies, diversification tends to dilute pure tech returns.

It makes a lot of sense from a risk management perspective for the public company to have its eggs in more than one basket. If any one product or product line is a failure, the others can make up for it. But, the flip side is that if one product or product line has an explosive success (for example, because of the successful implementation of a nanotech) this success will be muted by the other product lines.

If you're looking for pure exposure to nanotech, this isn't an ideal situation. If you're looking to invest in pure nanotech plays and then hedge against any nanotech exposure risk by owning companies in other industries or by making investments in other asset classes, a large public technology company isn't your best choice.

Another problem with investing in a public nanotech company is that often the explosive run up in equity valuation has already occurred. Typically, exponential valuation increases happen between the founding of a company and its various private equity rounds and then again during and immediately following the company’s initial public offering.

When investing in a private early stage company, it's possible to invest at a much lower equity price, albeit with much higher risk. As an aside, this concept is essentially the backbone of the traditional venture capital industry business model: Invest in a relatively large number of early stage companies and let the small number of explosive successes balance out the large number of failures. To put it very generally, 1/3 will fail, 1/3 will break even and 1/3 will generate returns orders of magnitude beyond your initial investment. In the aggregate, your investments are a success.

It's factors like these that drive many investors seeking exposure to nanotech and other emerging technologies to invest in private emerging growth companies.

For example, Sapphire was founded in 2007 and is already one of the most well funded companies in the sector, having raised more than $100 million from Bill Gates’ investment firm Cascade Investment, as well as ARCH Venture Partners, Wellcome Trust and Venrock.

Ways To Play Private Equity

Generally, there are three ways to get into the private equity market:

1) invest in seed stage or early stage companies as an individual angel;

2) invest in early stage companies as part of either a formal or informal syndicate with other angels/early stage venture capitalists;

3) invest as a limited partner in a venture capital fund that will then invest in several early stage or growth stage companies.

There are distinct differences between these three strategies. The first mode, investing as an angel, is a solo activity. It's up to you to identify the opportunity, negotiate the terms of the investment and bear the entire amount of the investment.

Since angel investments are usually made very early in the company life cycle, the associated risk is very high. That is, most angel investments don't pay off, but the rewards can be huge.

The second mode, investing as part of an early stage syndicate, is a group activity. No particular investor is in charge and democracy is usually the rule of thumb.

Using syndicates allows an individual investor to take a smaller piece of a larger number of companies, but it also carries with it loss of control and oversight over the investments. Syndicates can also be a great source of deal flow and a ready advisory panel that can be a sanity check to the investments.

The third mode, investing as a limited partner in a venture capital fund, is completely hands off. The investor is investing in the vision and/or track record of the venture capitalist and will depend on the venture capitalist to make and manage all investment decisions.

It's crucial that you match your investment goals with VCs sharing similar goals. For example, an investor that wants to maximize exposure to nanotech and its commercialization wouldn't want to invest with a generalist VC or a VC focused on Web 2.0, SaaS or cloud computing sectors.

The next part of this series will explore the various stages in a private company’s life cycle and the related forms of investment a company will hope to receive at each relevant stage.

In particular, I'll examine the differences between seed stage, early stage and growth stage and what types of money is being invested during each phase.

Parts three, four and five will take a closer look at the three modes of investment discussed above, angel investing, syndicate investing and venture capital investing, and each will look in detail at the important characteristics of the mode, including typical legal and business terms.
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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.