hello this is dr. Adam Jay Bach in this audio presentation we're going to begin our conversation about venture capital we're going to talk a little bit about angels and VCs who are different types of venture capital fund errs and then in the second part of the audio presentation we'll look more carefully at the VC model and specifically at a capitalization example so it's important to recognize there's significant differences between angels and venture capital funds so I'm going to just walk through this basic distinction angels are individual investors investing their own personal funds they make their own individual decisions on every investment you are dealing with individuals who may be very sophisticated and quite capable of doing quantitative analysis but very often angels are making investments based on emotions or a gut instinct usually based on how well they like the entrepreneur and how excited they are about the technology when angels make investments in start-up companies the amount of oversight they provide varies significantly some angels are very active may even get involved in management or on the board but some angels will provide funding and then step back and let the entrepreneur just progress without them generally speaking when angels make an investment the documentation is less complicated the deal terms are usually more straightforward venture capital firms are managed funds that is venture capitalists go out and they raise a fund of money from a variety of sources wealthy individuals corporations pension funds insurance companies and so on and they pull all of that money together and they create a standardized investment process where a single decision brings in money from all of those sources at once so it's important to understand that while angel investing is kind of a hobby in some ways venture capitalists are doing a job they're managing other people's money and that means that they have legal responsibilities so they usually require very active oversight of the companies that they invest in they'll take a board seat they'll demand information they want regular updates and in the investment process they usually want a lot of protection for their investment so the investment documents tend to get very complicated as the venture capitalists want to make sure that their money is being well spent and that if things go wrong that they may have control over how the company behaves once things begin to go badly an angel Network is a slightly different entity altogether it's a it's a group of angels who work together to make investments they usually create an investing or screening committee who will look at the deals before deals are brought to the attention of the entire membership which could be 50 angels or more and then each individual angel then can opt into a given investment or pass on any given opportunity the idea behind this is that by working together the angels can do better diligence research on the deals and then negotiate better deal terms because more money is being invested all at once very often these networks then set up a special-purpose entity often an LLC which they each put their money into and then the LLC makes a single investment in the startup company that's very advantageous to the startup company because then it only has one shareholder there are many of these angel networks and there's I believe more than 20 of them in Wisconsin Wisconsin Investment Partners is the oldest angel network in Wisconsin formal angel network and the largest local example how do you get to angels well the best way to get to angels is to start with your own network keep in mind that angels don't generally advertise that they're making investments because that would cause many many people to reach out to them so they often try to remain relatively unknown in the community there are many events and organizations that bring angels and networks together Wisconsin has a state funded organization called the Wisconsin angel Network which over time has had more or less roles and kind of organizing angel activities service providers are usually great links to wealthy angel investors attorney accountants bankers angel investors need all of these they use attorneys they use accountants they use bankers and so very often that those service providers can be connections to angels and there are specialty people who provide connections business brokers and investment bankers a good local example is Baker Tilly but the reality is that very often no matter where you start you're going to have to do a lot of calling yourself reaching out to everyone you know and saying I've got a startup company I'm looking for people who might be interested in making investments and startup companies do you know anyone like that this there is no shortcut to tracking down angel investors it's one of the most common questions I get from students how do I find angels and the answer is simply you do an enormous amount of legwork you look at deals that have already been done you talk to the local networks you and you pretty much speak to everyone you know and try to find out if they have suggestions for people who might do this kind of investing so when we think about venture capital more generally it's important to recognize that it's tech it's an it's an asset class it's a type of investment the idea behind it is that it's a high-risk high-return investment and the whole reason that there are multiple kinds of investment products is because different kinds of opportunities have different risk reward profiles so if you are willing to accept a very low return but you want very low risk then you're best off investing in things like US government bonds or investment grade corporate bonds but if you have extra cash and you are interested in a diversified portfolio then venture capital can be a realistic element in a diversified portfolio the hypothesis behind it is very simple startup companies early-stage businesses have the potential for superior returns initially they're very illiquid that is you can't easily sell a stake in a startup company but if you're prepared to wait five to ten years and the company is well managed and has an interesting opportunity then the returns it generates can be very very high much higher than what's available in the stock market or any other obvious investment opportunity you have to accept that there's a lot of risk associated with it these kinds of exit events are usually either a sale to a strategic buyer or much more rarely an initial public offering keep in mind that initial public offerings are unbelievably rare so in the United States there's about 600,000 new companies formed every year and only about 150 to 200 companies go through an IPO in any given year so the it's not a good idea to kind of assume that your proposed exit is an IPO a much more likely successful exit as a set as a sale to another company so for venture capital firms to succeed they have to be very very diligent in their investments selection and how they monitor the companies they invest in so again this the simple mechanism by which venture capital funds operate this wonderful handwritten drawing courtesy of Dan'l chefs key is that venture capitalists raise funds from different limited partners pension funds insurance companies family offices high net worth individuals and so on they pull all that money together into a single venture capital fund and the venture capitalist serves as the general partner of the fund which you may remember from our discussion about entities means that they are responsible for all of the decisions and they're liable for all of the funds under their control they usually take a fee of something like 2% of the fund amount on an annualized basis to pay their salaries and expenses and they take 20% of the profits of once the fund generates positive returns and so there clearly have a huge incentive to generate as much return as possible because they share in those profits and then they invest that money into a series of portfolio companies so this is that model as we just described it the money is provided by partners the general partners are the fund managers and this is the compensation structure that I just described this is a fairly important element of the growth economy companies backed by VCS account for a significant proportion of gross domestic product as well as a significant amount of private sector jobs the it's important to recognize that they also generate a significant amount of job growth over time the actual returns for venture capital funds are good but maybe not as spectacular as you might think if the weighted average return was about 10 percent that's not great but the point is is that some do extremely well the top quartile generating 30 percent returns which is significantly higher than you would expect in the stock market on an annualized basis but it's really important to remember that relatively few firms gener receive venture capital funding some statistics show that less than 2% of Hall high-growth firms get venture capital funding which would be well under 1% of all firms and all new firms in the United States it's been around 30 billion dollars a year you might be interested to know that angel funding is significantly more than this angel funding is usually estimated at between 50 to a hundred billion dollars a year in the United States many many of the companies you're most familiar with are venture backed that is they've received venture capital funding at some point in time everything from Microsoft and Genentech Apple Dropbox Groupon major medical device companies like Boston Scientific services businesses like FedEx and so on investments size ranges especially depending on when the investment happens in the stage of the company so angel investments tend to be relatively small in total under a million dollars individual angel investments themselves as part of a round tend to be more in the range of 20 to $100,000 and then as firms grow and require more funding say into a stage and an around a series a round the average funding becomes more significant about five million dollars and keep in mind that this also depends significantly on where the company is so a a round in California is much more likely to be above ten million dollars whereas an in Wisconsin is likely to be significantly less than $5,000,000 when seeking venture capital there's kind of four main factors that venture capitalists like to consider the capital itself the contacts that you have who your corporate counsel is and how much credibility the organization really has and credibility covers a lot of things how knowledgeable are you about the technology and the market opportunity how much experience does the team have in the past what milestones has the team already hit and does it appear to recognize some of the big challenges ahead the due diligence process by which a deal actually gets closed is can be quite extensive here it's suggested that it can be done in about three to six months it can go more quickly but it can also go much longer it starts with an introduction and usually some sort of pitch deck that's provided usually a business plan comes a little bit later there may be a phone discussion or some kind of conversation usually it takes about a week to a month for the VC to perform its initial review and then let the company know if it wants them to come and make a presentation majority of companies who submit their information uh venture capitalists will be turned down without a presentation if you are invited to do a presentation to the venture capital firm you can expect that to be quite a challenging experience I can be very fun and a great learning opportunity but can also be quite challenging venture capitalists are very smart individuals and they often have really deep sector experience they may ask you questions that you simply cannot answer usually once that takes place the venture capital firm will let the company know if it thinks it's interested and there'll be a due diligence period that can range from weeks to months during which it's checking a lot of background information requesting a lot of documents and then beginning the new deal negotiation and that deal negotiation can be quite challenging as well especially if the company is desperately need of money where the VC has a lot of opportunities in front of it VCS make decisions ongoing basis about whether to invest in new ventures and then how to support those ventures over time some of the key factors that VCS will take into consideration how familiar they are with the market how strong the they perceive the founding team to be is there some proprietary protection these would be usually in the form of patents how fast is the market growing venture capitalists like to invest in really attractive growing markets and then how strong and how numerous is the competition keep in mind that to two items one is that you might think that venture capitalists don't want to invest in companies that have competition you might be under the impression that what you want to tell a VC is that there's no competition at all in reality VCS usually like to see some competition because that indicates there really is a market if no one is doing what you're doing then that means there's the risk that maybe what you're doing nobody actually needs one of the other things that people don't often realize about dealing with venture capitalists is venture capitalists are usually technology indifferent that is they don't they don't have a specific enthusiasm for a specific technology what they're really interested in is opportunities and so opportunities are defined by how big markets are and whether there's an unmet need and so very often entrepreneurs go to the venture capitalists thinking that if they can convince them that they have a cool technology then the venture capitalists will invest and in reality the technology is very often the last thing that the venture capitalists worry is about usually the first thing is how good the team is and how big the market opportunity is so how do you get VC funding well the first step is usually referral by a trusted source it's quite tough to get interest from a VC if you're cold calling them there has to be a mechanism for an attractive exit you have to plan to grow your firm significantly maybe to a good rule of thumb is growing your firm to 50 million dollars in revenues in three to five years if your firm does not have that kind of potential where there's an exit opportunity where the VC can earn 10 to 15 times their money back then you're simply not an attractive potential investment and most VCS won't look at you and then finally you have to be aligned with their fund strategy are you in an industry that there that they're skilled and skilled at and interested in are you in the right geography most VCS tend to invest in a fairly specific geographical locus how much of how big is the investment you need VC funds tend to have a very specific investment size that they focus on and then where in the life of the fund are they if a VC is in the 10th year of their fund which is the last year the odds are good they're not making any more new investments because they've got to close the fund out relatively soon so there's a lot of factors that may have nothing to do with your organization or your opportunity at all that may determine whether a VC is interested in your opportunity so this is our starting point on angels and VCs and in the next audio presentation we're going to walk through a capitalization example so you see a little bit of what this process actually might look like