Wednesday, April 18, 2012

What I like about Venture Capital - part II

Ok, so I've briefly introduced what Venture Capital is, in the previous post.

Now, on to more interesting stuff: what's so special about it?

Well, a number of things, really, but let me start by one aspect that is rarely discussed: VC deals, once they are consummated, are one of the very rare occasions in business where interests are fully aligned for all the stakeholders. All share the same ultimate goal of building a big and valuable company. That means, very objectively, that the value of the shares of the company becomes higher than what each party paid for them, or put into them. Both success and failure are truly shared. Let's look into that in some detail.

First, the entrepreneur, and the team that he chose. Unlike other types of investment logics, the VC will not be looking to replace the incumbent management team. Indeed, the VC will steer away from an investment opportunity if he is not impressed with the people behind it. In fact, most VC investors will put that at the top of their investment criteria, and will investigate it in depth – there needs to be evidence of competence, of great resilience, of unquestionable integrity, of leadership skills and of a strong will to take the company forward, and there needs to be a good level of "chemistry" between the team and the VC. So, the VC will be backing not just the company, but the team itself. At times, there may be competency gaps that need to be covered as part of the development process of the company (the most typical example is the entrepreneur with a solid scientific background but who lacks management skills); these gaps are usually openly identified and discussed, and, for the good of the company, the means and timing to overcome them are agreed, usually finding mechanisms to keep the founding entrepreneurs adequately involved and rewarded. At the end of the day, the entrepreneur's reward is being a shareholder in a valuable company that he created – and deciding whether or not (or when), he will be cashing it in.

The same goes for the rest of the company's employees. In a well managed venture-backed company, a significant amount of shares will have been reserved for, and distributed among, the key staff. Throughout the life of the investment, that stake in the company works not just as a retention mechanism, but also in ensuring, once again, the employees are fully committed to the development of the company.

At the other end of the investing value chain, are the entities that invested in the Venture Capital fund that subsequently invested in the company. Individuals, family offices, institutional and corporate investors, pension funds, economic development funds. Many of them look for a purely financial return on their investment; some of them aim for local economic development; all of them benefit from the positive development of the companies in the VC fund's portfolio, and will be incentivized, if called on it (albeit perhaps somewhat rarely), to help in the process – for example, by opening doors for commercialization of a given product that is more closely related to their core activity.

In the middle, the VC investor. He chose the company in which to invest their investors' money. He chose it over other investment opportunities that he had. He did so at a time when the company was very young and the investment very risky. He invested in a very illiquid asset, because he believed in its potential for a high reward. So, he will be in it for the long run, not seeking quick returns. He will want to take the company to a stage where he can exit from the investment with a significant return, but he is ready to wait for the right time, and to contribute actively.

Most importantly, he's got skin in the game: firstly he has the obligation to provide strong returns on the capital invested to his own fund investors – if he does not, then those investors will not be coming back, and his ability to raise more funds to invest is at risk, and so is his activity as a VC; secondly, the VC investor will usually take a share of the gains above a certain level of return to his investors, so no return means no bonus – and that is typically a very heavy component of his pay. So, the VC investor's interests are fully in sync with everyone else's: to turn the startup into a big, successful, valuable company. For that, he will be allocating a significant portion of the time of one of its most senior people to help develop those companies, and more often than not, share in on the accountability by occupying a position in the company's Board of Directors. That person is fully motivated to carefully monitor and contribute very actively in the company's development. 

Surely enough, different VCs will have invested in a given company at different times and with different valuations, and that does tweak each one's expectations: those that came in earlier will want to exit earlier; those that invested at a lower valuation will have good returns from lower exit valuations; the dilution suffered by each will also play a role in its motivation. But ultimately, they will all benefit from the most successful development of the company.

Ok, so interests are aligned. So what? Well, this little fact makes things a whole lot easier for everyone. There's virtually no politics, there's no hidden agendas, no bullshit. Sure, there will always be exceptions to this. It is a business dealing with many variables, and it does involve money, so let me know when you find a system that is immune to being corrupted if it gets contaminated by external or crossed interests. But the point that I'm trying to make is that that's what they are: exceptions to a model that, by design, is efficient. This may not mean much for everyone. In fact, some would miss the complexity of a more politicized game where you play with other parties without necessarily knowing their hand nor, more importantly, their overarching objective – that is a discipline in itself and there is undoubtfully merit to those that truly master that art. Me, I like the transparency that is inherent to VC, and I'm truly happy to work in an industry with this feature.

While this is, to me, a key characteristic, it is hardly the only one that I like about VC. For my next post on this topic, I will dig into a few other aspects that make this such an appealing activity.

Thanks for reading.

In it for the long run...

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