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Investing Today for a Better Tomorrow

The Duties of a Venture Capitalist

Every venture capitalist has his or her own way of running a fund. Depending on the capitalist's position in a venture firm, common functions can include analyzing investment opportunities, working with management teams, attending board meetings, working on liquidations and exit strategies, performing industry research, working with limited partners, fundraising, and general fund administration.

Identifying investment opportunities is an ongoing task and is the most common function of any venture capitalist. Without deal flow, the money in one's fund becomes meaningless. Fundraising, on the other hand, is one of the most time-consuming and least productive functions in venture capitalism, though one of the most important. It requires significant time, travel, and resources, and it can take months, if not years, to complete.

Working with management teams is very common, of course, but not for all investors. Typically, value-add investors will spend lots of time with management. However, there are many firms that only invest, sit on the sidelines, and never spend a minute with management until it is time to sell the company. Therefore, I feel that identifying investment opportunities is generally the most common task amongst venture capitalists, with management following thereafter for value-add investors.

How the various functions of a venture capitalist are weighed largely depends on whether one acts as an active or passive investor. The more value-add services one provides, the more time one will undoubtedly spend helping management teams and portfolio companies grow and prosper. Funk Ventures is a value-add investor. One of my biggest investments of time, therefore, and one of the things I am most passionate about is helping our portfolio companies grow and working closely with our management teams to implement, monitor, and perfect their business plans.

Primary Strategies

The strategies a venture capital fund uses vary widely, depending on the fund,   its   portfolio,   and   the   general   market   situation.   Focus,   fund participants, the general partner's expertise, and market conditions all play a role in a fund's strategy.

Many venture capitalists will focus on markets that have just started growing rapidly, while others may choose a diversified range of markets and industries. While a diversified approach will mitigate risk, a focused fund, which targets a narrow market range, will usually be able to take better opportunity of market movements, particularly if they are positive movements. Calculating risk, for diversification and on a general basis, is a vital part of success for a venture capital fund.

The nature of the fund's participants is also highly influential. Funds working only with high net worth individuals, family offices, and smaller institutional investors may have different expectations than funds with limited partners such as large endowments, universities, and institutional investors. Comparatively, a fund's general partner with an accomplished entrepreneurial background may be better suited to participate in early-stage venture fund than a later-stage fund. The collective experience of the general partner team will play a significant role in identifying the stage and industry on which the fund will focus, particularly when the firm is new. After general partners establish a track record, limited partners often feel more comfortable allowing them to invest in markets less directly connected to their background and expertise.

Market conditions are extremely important to general fund strategy. For instance, an environment hostile to initial public offerings may prompt venture capitalists to establish investment liquidation criteria based primarily on mergers and acquisitions; since multiples paid in merger and acquisition transactions differ greatly from those in initial public offerings, the financial model of the fund may shift significantly. However, markets are constantly changing, and any general fund strategy based primarily on market conditions must be frequently reevaluated. As it is extremely difficult to predict market conditions, I find this approach problematic, but it is a common one in venture capitalism.

Personal Tactics

Dozens of strategies can help improve a venture capitalist's chances of success. Their effectiveness generally depends on the situation of an individual company, but some are more broadly applicable. At Funk Ventures, three strategies have made a significant impact on our business: attention to the management team, flexibility, and purpose.

The management team is key to any transaction we complete. Demonstrated success in previous undertakings, the desire to create shareholder value, and entrepreneunal spirit are essential attributes to success. Equally important is the synergy between the venture capitalist and the core management team. A venture investment is the beginning of a significant financial partnership that can last for as long as six years or even longer. If there is the slightest doubt that the relationship will be fruitful, the investment should proceed cautiously, if at all. However, an experienced venture capitalist can often quickly determine the potential in a relationship: When meeting an entrepreneur for the first time, I typically know within five to ten minutes whether I can work with him or her.

Evaluating entrepreneurs, however, is only part of success in venture capitalism. Strategies also apply internally to the venture capital firm itself. Funk Ventures has pioneered a unique corporate structure that runs managed syndicates—miniature funds that focus on one portfolio company each—and venture funds simultaneously. By creating the opportunity for specialization, we can craft the limited partnership agreement to fit specific requirements and thus invest in opportunities we might otherwise have had to pass up. For example, regular venture funds might not be able to invest in a limited liability company or an S corporation because most institutional limited partners cannot realize any unrelated business taxable income from the fund's investments, whereas we could create a managed syndicate that would bypass these restrictions by only selecting limited partners for the transaction that don't have this restnction. This strategy has previously enabled us to pursue several otherwise unattainable opportunities.

Finally, purpose is often overlooked in the venture capital industry, often to the detnment of those in the field. The whole venture capital business has historically focused on return on invested capital without much thought to how those returns were achieved. Companies such as Enron or WorldCom have demonstrated stunning lapses of mtegnty. I decided that Funk Ventures would be a purpose-driven venture capital firm, one thatwould work to mutually benefit the end consumer, the portfolio company, the limited partner, and the venture capitalist. We invest in markets we believe have a significant and positive impact on people, society, or the environment, such as health and wellness, medical devices, and clean technology. This philosophy, and the internal and external environments it has created, have helped us create investment successes that go well beyond just good returns.

Significant Misconceptions

Venture capital is truly the backbone of our economy and has been for a long time now. Venture capitalists take significant risks and support unproven businesses, demonstrating the spirit with which past rulers funded fleets of ships to explore foreign lands. Taking significant risks in order to propel growth is fundamental to American capitalism and, indeed, to America itself. Discounting venture capitalism's place in society, however, is only one of many misconceptions about the industry.

Entrepreneurs often think venture capitalists are only good for writing checks. Those who have worked with a venture firm to successfully bring a company to an exit, however, know they have the potential to be far more. Most venture firms, especially those that focus on early-stage opportunities, are value-add investors. Much of the value of a venture firm lies in its network of relationships and the expertise and experience of its managing partners.

Many entrepreneurs are also oblivious to the fact that limited partners often have a significant impact on how the venture firm is run. Often, a venture capitalist will design the investment and corporate policies of his or her fund around the requirements and investment policies of major limited partners. Entrepreneurs should understand if, and how, this can affect their investments.

Finally, a common misconception is that venture capitalists don't understand   entrepreneurs'   problems.   On   the   contrary,   many   venture capitalists were entrepreneurs before entering their firms, and have seen both the good and bad aspects of founding companies. Furthermore, their expenence with a wide range of companies and industries gives venture capitalists knowledge of problems that are likely to arise and ways in which to handle them. Venture capitalists typically have a great deal to contnbute, and entrepreneurs should take advantage of lhat.

Looking a bit deeper, there are reasons for these misconceptions, but there are also ways for venture capitalists to combat them.

With regards to venture capitalists only being good to write checks, ihere is probably a certain sentiment about venture capitalists just being money-hungry, and all they care about is making more and more. To an entrepreneur that doesn't have a lot of venture expenence, it may just be natural to think these "nch guys" with all this money probably have nothing else to add except for their cash. Many entrepreneurs may not even want to be lectured or advised by a venture capitalist, possibly triggering an insecurity or creating anxiety about being watched over their shoulder by the venture capitalist. Either way, I have found that the best investments are value-add investments where the venture capitalist is clearly not "running" the company, but actively participates on the board and is willing and able to help in times of need, and where the entrepreneur is capable and confident about his or her business plan but willing to listen, take advice, and sometimes give in to suggestions that may be more suitable than their own.

With regards to not understanding how limited partners can influence the investment policies of the venture capitalist I think the cause is fairly simple: There are not many venture firms in the country. We are a tight and small community and have been notorious for keeping a tight lid on how exactly we do business. In the 1990s, you'd be hard pressed to find more than a dozen books in any library truly focused on venture capital. This has changed recently, but the inner workings of a venture capitalist are still mostly unknown to entrepreneurs, especially those who have never dealt with venture capitalists before, and those are the majority of the ones raising money out there. Further, venture firms have complicated structures. Understanding a term sheet and the terminology and deal structures we  tend  to  use with  companies  is  a  task of its  own,  but understanding how that relates to the fund, the structure of the general partnership, the structure of the limited partner (corporate, institutional, foundation, high net worth, family office, etc.) makes the whole thing even more complicated. An entrepreneur would truly have to understand how a venture firm works from the inside and how limited partners affect the business dealings of the venture capitalist. This may seem too much to bare for someone just interested in raising money, but I find that the truly capable entrepreneurs out there understand these issues. Someone should write a book on exactly how limited partners work with the venture funds and clearly portray case studies and how they affect venture transactions.

Elements of a Successful Venture Fund

Naturally, any fund must accomplish its projected annual returns, or it becomes nothing more than a chanty project for limited partners. To truly help a fund excel, however, venture capitalists must look beyond investment returns. There are several qualities necessary for a fund to succeed: active investment, a diverse portfolio, the right management, and deal flow. All are essential parts of a fund, each in its own distinct way.

Many funds only make passive investments rather than helping their companies grow or contributing to its value. Such a strategy may prove very successful but is unfulfilling and leaves a great deal to chance. In order to be proactive about success, I believe funds must make value-add investments that help move their portfolio companies toward their goals.

Maintaining a diversified portfolio gives a fund both security and mobility: A single company's failure will not mean the ruin of the fund, while the investors have the freedom to pursue multiple opportunities. Even if a fund clearly identifies industry sectors, it should at least focus on multiple verticals in order to stay flexible in different market environments. Most funds hold their portfolio investments over three to eight years, dunng which time markets can shift dramatically.

A fund must also have an experienced and entrepreneurial team who knows what it takes to build and exit companies. Venture capitalists must not only understand how businesses work at multiple levels, but they must also possess fundamental transaction, market, and human knowledge to select appropriate investment opportunities with the right management teams and in growing and scalable markets. A fund's general partner is a significant factor of any successful venture fund. Just as with portfolio companies, a fund is only as good as the people running it.

Finally, deal flow is essential for a successful venture fund. Capital contnbutions are meaningless without investments with which the venture firm can put them to use. Especially for first-time funds, it is important to establish deal flow well ahead of time: Since many investments take three to eight years to liquidate, a fund will try to invest almost all of its capital within the first three to five years to make sure that most or all portfolio companies have reached an exit by year ten (when venture funds usually get liquidated). Unless adequate deal flow exists, the investment process (and thus the fund's lifespan) may be lengthened, resulting in diminished internal rates of return to the limited partners.

Returns and Risk

Most venture capital funds desire returns of ten times their onginal investment within three to six years, though some will still invest in opportunities that generate five times their investment or more. This goal is passed along from the limited partners, who expect an annual return of approximately 20 percent. As most of the venture industry consistently delivers an average return of 19 to 22 percent per year, most venture capitalists will aim high and attempt to accomplish annual returns of approximately 35 percent from a given investment to satisfy this industry standard.

To the surprise of many entrepreneurs, in order to accomplish this, venture capitalists will often adjust a company's valuation. When evaluating an investment opportunity, the first step is to examine the proposed value and make certain it's in a range with which the firm is comfortable. After that, venture capitalists estimate their probable returns in a preferred stock transaction, add to that the probability of further funding rounds and anticipated dilution, and establish best and worst case scenarios. Then, by running expected deal terms through a variety of spreadsheets and financial models, the venture capitalists determine the investment's returns under various estimated exit scenarios. If such returns don't satisfy the limited partners' expectations but the venture capitalists wish to make the investment regardless, they will often try to lower the valuation in order to compensate for the potential lack of returns.

Even with such compensation, every deal remains risky. The virtue of investing in illiquid securities is making venture capital the nskiest asset class other than outright gambling. However, it is also the best-performing assets class in the United States and historically has been. Venture capitalists have learned how to use significant risk to their advantage, calculating variables and deciding which risks are worth taking.

An infinite number of risks, and an infinite number of vanables, exist in venture capitalism. Venture capitalists must decide how many exceptions they're willing to make for a given opportunity and whether they can justify the risks to the limited partners, but a few exceptions are often made. I won't refuse a deal because the entrepreneur failed to obtain a patent; Til make sure it's filed instantly and secure the transaction by tranchmg out the investment so I can withhold further capital if the patent is not approved. If the management team isn't filled out, I can provide executives for the remaining positions if the existing team is what Im looking for. Even previous lawsuits aren't automatic grounds for refusal, provided that they don't stem from repeated reckless management.

Evaluating Opportunities

Opportunities can come to a venture capitalist in many ways. The most common is through one of the general partners' close circle of referrals, which can consist of friends, executives, attorneys, and most people they have done business with before. I assume this is different for every venture capitalist. Some may have really strong ties to the legal community, while others may be well known in the medical device space and therefore have many opportunities come their way from doctors. It definitely vanes greatly. These

In addition, entrepreneurs or investment bankers may solicit venture capitalists personally. The task of a venture capitalist is to find, in these opportunities, those that will be sound investments. Executive summaries provide  the  venture  capitalist with  an idea  of the  company's situation relative to several crucial attributes: management, the market and its potential scalability, intellectual property protection, the geographic location, the mechanics of the deal (amount of the raise, valuation etc.), and the opportunity to exit.

At Funk Ventures, we look for unique, differentiated, and superior products, services, and technologies. The more value the company can provide to the marketplace, the higher the chances of gaining market acceptance. The company must demonstrate that the marketplace will purchase its product rather than that cf a competitor. The market the company addresses also has to be at least $1 billion in size. Even a very successful portfolio company may only be able to capture a few percentage points of a given market, and a market of less than $1 billion would not enable significant revenues in such a case. The market must also be significantly scalable and show significant growth potential over the coming five to ten years. Such factors largely depend on the industry. Markets with slow or no growth, such as software, may still make excellent investment opportunities because of their enormous size.

Companies must also have as much intellectual property protection as possible. If such protection is less obtainable than desired, the company must establish that its product or service is superior to that of its competition, that it can keep competitors from duplicating its tactics, and that the lack of intellectual property protection is not a danger to the company's future. Often, being a first mover in a market can compensate for the lack of intellectual property protection; however, this often holds true for only a few years.

The relationship between the key management team and an active investor is invaluable to the portfolio company's success. Therefore, many venture capitalists prefer companies that are relatively local, requiring only one or two hours of plane travel. Particularly in times of adversity, when a venture capitalists expertise and value are most needed, the geographic location of a portfolio company can be quite important.

Although most venture capitalists use a standard procedure to make deals, terms can often be vital, particularly in difficult times. Preferred lock, historically    the    most   common    means    of   making   venture    capital investments, has several common rights and preferences, such as conversion to common stock, liquidation preferences, cumulative or non-cumulative dividends, redemption rights, and participation. Each is highly important to a deal's success; it's often possible to structure a deal with these preferences such that only true failure and the bankruptcy of a business would pose a significant risk of loss. Preferred stock transactions that lack some of these terms, or transactions that are poorly negotiated, will undoubtedly increase the risk to the venture investor.

Whether by merger, acquisition, management buy-back, or public offering, an exit has to materialize within three to eight years of initial investment, and predicting such exits is an important part of evaluating an opportunity. While it is difficult to establish by which means a portfolio company may liquidate, it is often possible to rule out an initial public offering, often by virtue of identifying that the company may not ever generate north of $150 million in revenues (a number often required for larger investment banks to get interested in a potential initial public offering). If a merger or acquisition transaction is more feasible, as in the majority of all venture capitalist-backed companies (about 80 percent exit through merger and acquisition historically), financial models and exit theory should be based on multiples that can be accomplished under such circumstances. Establishing exit strategies up front can help the venture capitalist negotiate better deal terms and make smarter investment decisions, all leading to a higher investment success rate.

Challenges of the Industry

The first challenge in venture capitalism is the significant investment of time, energy, and money necessary to raise a fund. This is often a tremendous hurdle for the general partners and may seem like a project of its own.

Further, another difficult aspect of establishing a fund is ensuring access to meaningful deal flow. Regardless of the amount of capital a firm has under management, a lack of quality deal flow will cause tremendous challenges. Making investments in bad deals due to a lack of deal flow (quantitative or qualitative) can have equally negative affects on returns. Creating deal flow takes time, and first-time funds or recently established firms will struggle with this much more than more mature firms.

Another challenge is that of assembling an appropriate fund management team. Just as entrepreneurial management is essential to making smart portfolio investments, fund and venture firm management is key to successful venture capitalism. Creating a smooth structure within the venture capital firm, however, is easier said than done: As venture capitalists tend to be successful and intelligent, many of them have large egos and strong opinions. Particularly in smaller funds overseen by two or three partners, provisions often require unanimous agreement on investments, which can lead to tension f transactions are being sponsored but not approved by all managing partners. It's essential to build long-lasting partnerships: A fund can last for ten to thirteen years, a true test of personal and professional compatibility.

Explaining the Fund

When n fundraismg mode, the general partners typically explain the fund's goals by means of a presentation. Such goals are often easily explained, as they relate largely to financial concerns and a concrete business model. Other goals, however, may include obtaining a certain desirable type of portfolio investments. It is sometimes helpful to draw parallels between the fund's expected returns and the way in which the venture capitalist expects to accomplish them.

For a firm such as Funk Ventures, the key question for our general partners is typically whether to approach limited partners from a financial or social perspective. Many limited partners in our funds greatly support our philosophy, while others are solely investing for purposes of generating financial returns. Understanding the limited partner's financial objective and level of social responsibility is essential for Funk Ventures to explain the fund's goals in a manner that will convince the limited partner of their value and achievability.

Useful Resources

Market data is highly important both before and after an investment. Getting a good sense of what a portfolio company can liquidate for in a merger or acquisition transaction or initial public offering is essential to making an educated investment decision and to perfect valuations when facilitating a transaction. Many tools exist in the marketplace, and it is easier than ever before to track venture financings and exits and see how they impact a transaction you are currently considering for investment or exit.

There aren't many resources I truly find applicable in every situation. Each opportunity requires a different approach to research, and no single tool will provide you with the whole story. I tend to keep a fundamental approach to research and using tools: The most helpful strategy is keeping up with industries, market trends, and technologies that matter most to the venture capital firm. Reading relevant newsletters and trade journals, and discussing market trends and opportunities with other venture capitalists, are still some of the most meaningful resources to me.

Advice

Nothing is ever set in stone. You can run all the projections in the world, apply risk and reward theory, work only with the smartest entrepreneurs, focus on the most promising products and markets, and still run into problems you never expected. Success as a venture capitalist depends on how well you work in times of trouble when your portfolio company needs you the most.

For entrepreneurs seeking capital, my most common piece of advice is to leam the rules of the game. Raising capital is as much an art as a science: Entrepreneurs have to understand not just their own business, but also the inner workings of the venture firm, the venture capitalists expectations, and why we have them. Too many entrepreneurs lose their savings, relationships, and more spending years chasing after venture money, only to learn that they could have avoided it all by correcting a few simple mistakes. With today's resources in the venture capital business, it is inexcusable for an entrepreneur not to understand the inner workings of a venture firm.

Another piece of advice is that entrepreneurs should be sure to raise sufficient capital to truly allow the company to execute its business plan. Venture capital should bring a company to clearly identified milestones at which point additional capital will be required to expand the company. Many entrepreneurs underestimate the amount of capital required, and some purposefully raise too little capital to avoid significant dilution of their equity. Either way, venture capital should not be used to put out fires or catch up from senous overspending during the current round. It is probably easier said than done, but the financial projections have to be very thoroughly thought through, which is very hard with an early-stage company. Even assuming that your projections are fairly accurate, too many unforeseen things can happen that would require an adjustment in your projections. Hence, I think it pays off to readjust projections and models very frequently to get a true sense of what is happening with the company at any given point. Entrepreneurs almost always need more money than they expect, so a good rule of thumb is to raise at least 25 percent more capital than you anticipate. However, this is a tough call when this 25 percent can raise very significant and "unnecessary" (from the entrepreneur's point of view) dilution. I don't know if there is truly a good way to go about this other than to be realistic about capital needs and to not raise a penny less than needed to achieve the next milestone (or the milestone that is required to allow the company to increase its valuation and raise further capital).

Recent Changes

There is no doubt that the late 1990s were filled with irrational and unrealistic venture transactions. The most significant trend, one that still has a large impact on venture capital today, is exponential growth in the average size of venture funds. For a short time, after the closing of the first billion-dollar venture funds, it seemed as if there was no end to prospenty.

After the market crash, most venture firms returned committed capital to their limited partners due to a lack of investment opportunities: It was no longer easy to invest $1 billion over the course of five years while still focusing on diverse early-stage opportunities. Venture capital firms either had to find several dozen investment opportunities for each fund or had to increase investment size  significantly,  diverting their focus  toward later-stage opportunities. Fund  sizes,  therefore,  returned to  more historical means in the years following the crash.

However, in 2005, limited partners raised a significant amount of money, and capital contnbutions into venture funds rivaled those of 2000 and 2001. Several billion-dollar funds have since been raised. As a result, one clear and imminent change in the industry is the convergence of venture capital and private equity. Many venture funds will continue to engage primarily in later-stage, pnvate equity-style transactions. At the same time, many pnvate equity firms and hedge funds take an opportunistic approach more commonly found with venture capital firms. I think the investment firm of the future will be one that is either niche-focused or one that can operate in both an early-stage venture capital and later-stage pnvate equity environment, letting the market dictate at any given time how to weigh the portfolio accordingly.

Changes for the Future

One of the changes that would be most meaningful to me is a general trend toward more socially responsible investing in the markets that I consider highly impactful (health and wellness, medical technologies, and clean technology). We have reached a time where I believe it is possible to achieve equal or better returns by investing in and supporting markets that actually contribute positively to society.

I comfortably predict that the next twenty years will be filled with problems and challenges of enormous proportions. Baby boomers are aging rapidly, yet our health care system continues to be ineffective and unaffordable, making it more difficult to get good treatment with every year that passes. Simultaneously, we continue to pollute our environment, and clean technologies are still unaffordable to the average citizen, moving us closer and closer to the point where severe natural catastrophes, global warming, and senous illness through environmental exposure become a sad reality of everyday life. The venture capital community has a tremendous opportunity to make a difference by supporting companies that focus on improving our health care system, by providing wellness services and products to citizens to increase their health, well-being, and quality of life, and by investing in sustainable environmental technologies that preserve our natural resources and decrease the negative impact  conventional energy policy lias on our hearth and quality of life.

A.ndy J. Funk, an experienced entrepreneur turned venture capitalist, expertly combines his passion for investing with an altruistic vision to make positive and impactful differences in the world A.s the underlying driver of the Funk Ventures philosophy, Mr. Funk believes businesses can make significant and positive contributions to people, society, and the environment.

A.n entrepreneur since age eighteen, Mr. Funk 's diverse accomplishments include the successful establishment and sale of several industry-leading companies, including online charity pioneer Helping.org (acquired by ^America Online) and advertising ageny Microdyme (acquired by iBoost). Mr. Funk's entrepreneurial success and ongoing appetite for building businesses led to the formation of Funk Ventures, a multifaceted investment firm that specialises in venture capital, business acceleration, and real estate.

A.s chief executive officer and chairman of Funk Ventures, Mr. Funk has been actively involved in the funding, development, and sale of more than a doyen companies since the firm's inception. Embracing vision and pportumty, Mr. Funk enthusiastically creates and invests in businesses that have shaped, and will continue to shape, the future of our society.

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