Something Ventured
Sacramento Business Journal
Jun 6, 2008
By
What is venture capital?
What do venture capitalists look for when deciding whether to invest in a company?
What can the experience of venture capitalists who have participated in the growth of dozens of companies teach entrepreneurs building their own businesses?
On the first Friday of alternate months, we'll address these and similar questions from our perspectives as professional venture capitalists at DFJ Frontier, a firm with offices in West Sacramento and Southern California that invests in West Coast startup companies.
VC basics
Let's start at the beginning. Venture capitalists raise pools of money called "funds" and then invest the money in a portfolio of growing companies seeking a high rate of return for their investors.
Venture capital funds vary greatly in size, from just a few million dollars to several hundred million or even billions of dollars. The money comes from institutional investors, including pension funds, as well as from wealthy individuals. The California Public Employees' Retirement System, for example, is an investor in our firm and many others.
Venture capital funds are often organized as limited partnerships. Bill Draper, considered by many to be the father of modern, West Coast venture capital, established Draper, Gaither and Anderson as the first venture capital limited partnership in 1958. In these arrangements, the venture capitalists are the fund's general partners and manage the day-to-day activities of the fund. The investors are limited partners, who participate neither in the operation of the fund nor in the management of the fund's portfolio companies.
Although venture capital is a high-risk investment, it offers the potential for very attractive returns. Annualized net returns of 20 percent per year are not uncommon in our industry. However, venture capital is a long-term, non-liquid investment; venture capitalists return money to their limited partners only when they "exit" investments they have made, typically when a portfolio company is acquired or goes public in an initial public offering.
To generate returns of this nature, venture capitalists seek to make as many "home run" investments as possible, knowing that other companies in the portfolio, no matter how carefully selected, might go out of business or return nothing. A home run investment might return 10 to 20 times the original investment or even more.
Draper Fisher Jurvetson, the parent firm of DFJ Frontier, has had numerous high return investments, including Skype, Baidu and Hotmail. Some of the firm's portfolio companies have returned more than 100 times our investment.
Buying a stake
In a typical venture investment, the venture capitalists receive an ownership stake in the company in exchange for cash, which the company uses as operating capital. The ownership stake is generally in the form of preferred stock, which provides the investors with special privileges and protections that reduce the investment's risk. The venture investor will often take a seat on the company's board of directors, enabling him or her to monitor the investment and to guide and assist the company more effectively.
We believe that guidance and assistance are often overlooked aspects of the relationship between venture capitalists and the entrepreneurs running the portfolio companies. Good venture capitalists provide far more than just money. They facilitate introductions to prospective customers and partners, help locate and attract executives for the company's management team, help arrange additional financing if required, and contribute insight and judgment gained from serving many other companies in similar ways.
Everyone benefits from a successful venture capital investment. The limited partners receive a healthy return on their investments, the venture capitalists are paid well for their work, and the entrepreneurs receive an opportunity to grow and run a company in addition to their own financial rewards. A growing company also creates jobs and enlarges its region's tax base and prestige. A venture capital investment can also enable a company to commercialize green or sustainable technology or to accomplish other socially desirable objectives, as in the case of World of Good, a DFJ Frontier portfolio company that brings goods made by third-world artisans to market in the U.S.
In our next column, we'll discuss characteristics that make companies attractive investments to us at DFJ Frontier. We'll start by describing particular personal qualities that we think make entrepreneurs successful, we'll look at business models that we believe are highly correlated with success, and we'll finish with some thoughts about technical leadership and barriers to competitors' entry into the marketplace.
Scott Lenet is a founder and managing director of DFJ Frontier, an early-stage venture capital firm with offices in West Sacramento and Southern California. Oleg Kaganovich is a principal with the firm.
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