Chapter 12
PROFESSIONAL VENTURE CAPITAL
FOCUS
In this chapter, we consider the highest profile segment of the venture investing markets:
professional venture capital. We discuss the origins of venture capital and the periodic
fluctuations accompanying major new technologies. We give special attention to the
professional venture capital screening and investment processes.
LEARNING OBJECTIVES
1. Discuss the history and current status of venture investing in the United States.
2. Explain the professional venture investing cycle and its relevance to entrepreneurs
seeking professional venture capital.
3. List major elements in the design and structure of a venture capital fund.
4. Describe the venture capital screening process and list characteristics central to
determining a venture capitalist’s willingness to invest.
5. Discuss the various roles a venture capitalist can take in providing financing and
services to an emerging venture.
6. Enumerate several terms or conditions to be negotiated when structuring venture
capital financing.
CHAPTER OUTLINE
12.1 HISTORICAL CHARACTERIZATION OF PROFESSIONAL VENTURE
CAPITAL
12.2 PROFESSIONAL VENTURE INVESTING CYCLE: OVERVIEW
12.3 DETERMINING (NEXT) FUND OBJECTIVES AND POLICIES
12.4 ORGANIZING THE NEW FUND
12.5 SOLICITING INVESTMENTS IN THE NEW FUND
12.6 OBTAINING COMMITMENTS FOR A SERIES OF CAPITAL CALLS
12.7 CONDUCTING DUE DILIGENCE AND ACTIVELY INVESTING
12.8 ARRANGING HARVEST OR LIQUIDATION
12.9 DISTRIBUTING CASH AND SECURITIES PROCEEDS
SUMMARY
DISCUSSION QUESTIONS AND ANSWERS
1. What is a professional venture capitalist? How does this occupation differ from that
of an angel investor?
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Refer to Figure 12.4 which shows Suppliers of Venture Capital as determined by
9. What is meant by the terms (a) capital call, (b) deal flow, and (c) venture investing
due diligence?
10. What is meant by the terms (a) lead investor, (b) SLOR, and (c) term sheet?
11. Why should entrepreneurs care what pressures venture capitalists face in carrying
out their professional money management (intermediation) function?
12. Why do venture capitalists make quick decisions on the infeasibility of some business
plans? When a business plan is not quickly determined to be infeasible, what
happens next and why?
Venture capitalists screen a large number of business plans in any given year. Due to
13. What should be the goal of the financial projections in a business plan submitted to a
venture capitalist?
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14. Is the compensation paid to venture capitalists (e.g. 2% management fee and 20%
carried interest) reasonable? What are a fund’s investors buying with this
compensation?
15. Why are venture capital funds typically organized as limited partnerships? In
particular, why are they private firms instead of public firms?
VC funds are typically private in part due to their ability to avoid registration with the
16. What can be learned from the SBA’s creation and the Internal Revenue Service’s
subsidy of venture investing through SBICs?
17. Discuss why it is important to have an exit event for each investment held by a
venture investment fund.
An exit event for each investment is necessary to bring a venture capital fund to
closure. The VCs must arrange for the liquidation or harvest of each investment and
18. From the Headlines – Tabula: Describe the role venture capitalists played in the
founding and expansion of Tabula. Comment on possible reasons for the involvement
of multiple VC firms.
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Answers will vary: Tabula was founded with venture capital and has completed
INTERNET ACTIVITIES
1. Summarize the nationwide venture capital investing by industry for the last available
quarter using a data source available on Web sites such as
http://www..pwcmoneytree.com or http://www.nvca.org.
Web-researched results will vary due to constant updating of the related web sites.
2. Visit a venture capital fund’s web site and summarize the fund’s history and current
activities.
Web-researched results will vary due to constant updating of the related web sites.
EXERCISE/PROBLEMS AND ANSWERS
1. [Venture Capital Firms] List three venture capital firms active in your region and
describe their investing style and restrictions.
As a starting point for this question, students can access the site
2. [Venture Capital Fund Raising] Locate a recent study covering venture capital
fundraising (not investing) for the previous year. Determine what the current sources
of funds tend to be.
http://www.nvca.org typically provides recent reports on fundraising activities by
3. [Venture Funding Attributes] Interview a local venture capitalist regarding what s/he
looks for in a promising venture seeking funding. Summarize your discussion.
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Answers will vary.
4. [Venture Capital Firms] Determine the three largest venture capital firms in the U.S.
How much money do they have under management? In what areas, if any, do they
specialize? Where are they located? Where are their branch offices?
The venture capital sites (on the WWW) and annual reports (in libraries) typically
5. [Conducting Due Diligence] Suppose you become an intern at a local VC firm and
are asked to assist in due diligence on a proposed investment in a telecommunication
company. Explain how you would approach such a task and where and how you
would structure your investigation. What data sources would you use?
First, one typically would read the business plan/pitch submitted for consideration.
After identifying strengths and weaknesses on a first pass, assuming that there are
6. [Term Sheet Terms] List ten terms you might find in a venture capital fund’s terms
(see Figure 12.6). Explain what they are and why it might make sense to structure
them the way they are.
Refer to Figure 12.6 for a guideline on how to evaluate student answers.
7. [Venture Investing Example] Find a recent Wall Street Journal article on venture
investing and summarize it.
Answers will vary.
8. [Recent VC Investment Levels] Update Figure 12.1 in terms of recent levels of VC
investments
Answers will vary.
9. [Venture Capital Investing Information] List ten web sites or hardcopy magazines
that contain venture capital investing information that might be of use to
entrepreneur’s seeking venture capital.
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10. [Recent IPO Example] Locate a venture-capital-backed firm that recently completed
an initial public offering (IPO). Provide a summary of the venture’s history and
success through the IPO and to date.
MINI CASE: INTERACT SYSTEMS, INC.
Interact Systems, Inc. has developed software tools that help hotel chains solve
application integration problems. Interact’s Application Integration Server (AIS)
provides a two-way interface between central reservations systems (CRS) and property
management systems (PMS). At least two important trends in the hotel industry are
relevant. First, hotels are shifting away from the manual booking of room reservations
and electronic bookings will continue to increase as more bookings are made over the
Internet. Second, competitive pressures are forcing hotels to implement yield
management programs and to increase customer service. By integrating the CRS and
PMS through Interact’s AIS, inventories can be better managed, yields improved, and
customer service enhanced.
All reservation traffic is routed from the CRS to individual hotel properties. This
allows Interact Systems to create a database that can be used to track customers and to
facilitate marketing programs, such as frequent stay or VIP programs, as a way of
increasing customer satisfaction. Interact forecasts application integration expenditures
in the hospitality industry to exceed $1 billion by 2018.
Greg Thomas founded Interact Systems in 2011 and developed the firm’s
middleware software and hospitality applications. He has 12 years of systems
applications experience and currently is Interact’s Chief Technology Officer. Eric
Westskow joined Interact in early 2015 as President and CEO. Prior to that time, he
worked in sales and marketing in the software industry for over 20 years.
Interact Systems’ AIS software development which began in 2011 went through
several design changes in 2012. The first product was sold and installed in 2011. Sales
were only $500,000 in 2012. However, now that the firm has dependable market tested
AIS products ready to be shipped, revenues are expected to reach $20.8 million in 2018.
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Greg Thomas founded Interact Systems with $50,000 of his own savings plus
$50,000 from friends. Two private investors provided an additional $200,000 in 2013.
In addition, $1 million was obtained from a venture capital firm, Katile Capital Partners,
in early 2015 in exchange for an equity position in Interact. The firm currently is seeking
an additional $5 million to finance sales growth.
A. A VC is considering providing the additional $5 million. What type of fund (stage
specialization, industry focus, etc.) would you approach? In what part of their
investing cycle would you hope to approach them?
The VC’s funding criteria need to include this venture’s industry (software,
B. Discuss how Interact Systems would be expected to fare in the VC screening
process involving each element of Figure 12.5.
Venture capital firm requirements: giving up equity position anyway; previous
VC investment; size is not unreasonable for this stage with sales in place
C. Discuss typical issues that might be addressed in a term sheet using Figure 12.6
as a reference.
Answers will vary depending on students’ perceptions from the description and how they