Business, Law, and Innovation

Venture Capital Industry

Lecture 4Spring 2014

Professor Adam Dell

The University of Texas School of Law

Private Debt 35%

Equity Securities 31%

Public Debt

19%

Bank Deposits

12%

Private Equity = 2%

Macro View - Total U.S. Capital Markets

For-Profit Capital Market by SegmentTotal = $48.4 trillion

Private Equity is just a sliver of total capital markets, but it plays an important role in driving economy

LBO Funds

$740B

VC Funds

$260B

Macro View - Hugely Important to Economic Growth

As much as 18% of US GDP attributable to venture backed companies.

Macro View – Sector Concentration...Why?

4Source: VentureOne

% Invested in Sectors of VC by YearTotal = 100%

IT is consistently over 50% of funds invested, but Healthcare has been growing in importance

after tech/dotcom frenzy of 2000 as Baby Boomers age

$94.8B $36.4B $22.1B $19.7B $22.4B $23.8B $25.7B

2000 2001 2002 2003 2004 2005 2006

Information

Technology

Healthcare

Business/

Consumer/Retail

Other

Sector 2006 Median Deal Size

$7.0mm

$8.0mm

$5.7mm

$7.5mm

Macro View

• VCs invest in a limited number of sectors.• Most startups are not suited to be venture bets.

– Not capital efficient, no home run potential– Other sources: credit cards / debt / friends and family $ / Small Business Investment

Corporation (SBIC) & Small Business Administration (SBA) loans.

• New Market = no incumbent, so a new entrant can capture the prize.• Massive Market = lots of room for winners and wiggle room.• Capital Efficient = doesn’t take a lot to get the business off the ground.

J Curve

Portfolio Theory of VC

2x-4x

Nu

mb

er o

f S

ucc

essf

ul C

omp

anie

s in

a C

ycle

Return Multiple Expectation

5x-10x0x-1x

Total Write-off

Get a little more

than our $ back, but not

worth the effort

Home Runs

$100mm Fund, 20 bets, 2 big wins….up to $15mm in any given company

Diversified investments within IT:

SecurityStorageNetworkingSocial MediaRetail.comMobileAdvertising

7

20 bets: 2 HOME RUNS

18 WHATEVERS

Of the 20 bets that a VC firm will make, in a normal distribution of returns (and considering the risks), 2 companies will generate the vast majority of the returns.

But you never know which 2 they will be, so every investment has to have home run potential & be capital efficient.

7

Portfolio Theory of VC:

1995-2000 Portfolio Outlook

2x-4x

Nu

mb

er o

f S

ucc

essf

ul C

omp

anie

s in

a C

ycle

Return Multiple Expectation

5x-10x0x-1x

Total Write-off Get a

little more

than our $ back, but not

worth the effort

Home Runs

Crazy Time

Everybody jumps into VC(hedge funds, private equity funds, grandpas)

Drive prices up

Drive returns down

Macro View

• Most VC Firms Loose Money

• Yet a few great firms make all the $– Kleiner, Sequoia, Benchmark, Accel

• Impossible to Time the Market– Market Conditions

• Public Markets• Customer’s willingness to buy / good vs. bad economy

• If you build real value (regardless of market timing), you’ll probably make money.

Portfolio Management – Fail Fast / Focus on Winners

With limited capital, and the knowledge that the odds are stacked against success, a VC needs to know which companies are the “winners”…what do you do?

Kill the losers. Get them to “fail fast”

Be objective about which companies you continue to fund.

Focus on the “winners”

Every company that is not CF+ is on it’s way to going out of business..

Skills of Top VCPE Investors

Personal Networks

Strong personal networks enable investors to generate dealflow, be the first to learn about industry developments, help portfolio companies secure talent, and provide critical business development introductions.

ManagementExperience

Investor generally sits on Board and serves as close advisor to CEO and management team. When company faces tough decisions (e.g., firing vs. making payroll in a down quarter), it is helpful for investor to be able to draw on personal experience and serve as advisor.

Selectivity & Specialization

With large pipeline of deals and limited time and resources, must efficiently sift through potential investment opportunities. Critical to leverage technical knowledge and to prioritize opportunities based on anticipated return. Each Partner in a firm generally actively manages only around 5-10 investments at a time, depending on lifecycle, so must choose wisely.

IndustryKnowledge

Important for investor to know lay of the land—key competitors, industry developments, technical specifications—to make informed decision about making investment, as well as how to manage development and exit.

Focus onValue Creation

Unlike public companies, ownership and management are generally aligned because of shared economic interests, focused on an exit. It is in investor’s best interest to remain involved and watchful, guiding strategic decisions to create value.

Skill/Experience Description

..and ;)

– Salesmanship– Credibility / Integrity– Tolerance for Risk– Pattern Recognition– Curious…Looking for the next Big Thing

13

It’s a Small Club: Ex. PayPal

PayPal was a highly successful start-up founded in 1998 and sold in 2002 to eBay for $1.5B. The founders and top management have gone on to significant success and remain interconnected:

Sources: Wikipedia, Sequoia Capital, PayPal, Facebook, LinkedIn, Slide, Thank You for Smoking, YouTube

Max LevchinCo-founder

Peter ThielCo-founder

Roelof BothaCFO

Jeremy StoppelmanVP Engineering

Russel SimmonsEngineer

Co-founded successful internet site yelp in

2004

Joined top VC firm Sequoia Capital in

2003

Invested in YouTube in 2005—sold to Google for

$1.6B

Started hedge fund, Clarium, & vc firm, Founders Capital.

Personally invested in:

Founded web property:

Involved with:

Invested in:

Advised: