Activities

VC Industry Explained

Overview of the Financial Industry

The Buy-Side of the Financial Industry

Stages of Venture Capital Investment

Understanding Venture Capital

The Venture Capital Industry is best understood as one segment within the much larger financial industry.

Overview of the Financial Industry

The financial industry, as shown below, can be divided into two segments.

Both the Buy and Sell sides of the financial industry spend a great deal of time and money building the prestige of their organizations because prestige breeds confidence, and confidence, after all, is money. As the term is used here, "sell-side" refers to those financial firms that are characterized by having services to sell. Included in the sell-side are investment banks, brokerages, and commercial banks.

For instance, when a large company wants to sell some stock on the public stock exchanges, an investment bank will handle the legal, tax, and accounting affairs of the transaction. For providing these services, the investment bank receives a fee (between 2% and 10% of the money raised by selling stock). An investment banking firm's primary motivation is to sell these services, and we are therefore characterizing them as sell-siders.

Venture Capital firms are not on the sell-side.

The Buy-Side

Venture capital firms are on the "buy-side" because they are characterized by having a pool (or fund) of money to spend on buying assets of operating companies. The buy-side breaks out as shown in the diagram below.

Generally speaking, buy-side firms make money when they can sell their equity to another private investor, a corporation or to the public markets for more money than they paid. Descriptions of each segment of the Buy-side are included below. They are intended only to be very general in nature, so for those of you who like to create new, meaningless terms and sub-divide endlessly . . . chill.

Angels: Wealthy individuals with operating experience who typically invest between $50,000 and $1.5 million in exchange for equity in a young company. They often sit on the board of directors contributing their experience and advice in guiding a company through the difficult initial stages of growth.
Venture Capital Firms: Limited partnerships or corporations that typically invest between $250,000 and $20 million in seed to later stage private companies in exchange for equity. They sit on the board of directors and bring their business experience, industry expertise, financial expertise and contacts to bear on behalf of the company.
High-net-worth Private Placements: An event where sell-side companies organize a group of very wealthy individuals, corporations, asset management firms, and/or pension funds to make a direct investment into a private company. The amount raised from these sources is typically between $5 million and $50 million. In essense, the sell-side company is enabling the investors to bypass the middle-man (venture capital and equity investment firms). The downside is that 1) the company into which the money is invested doesn't benefit from the expertise of the venture capital firm, and 2) the sell-side company takes a substantial fee for its services.
Asset Management Firms: Highly diverse group of limited partnerships or corporations managing between $5 million and $20 billion and focusing on diversified investment strategies with public instruments (stocks, bonds, commodities, currencies, etc.).
Leverage Buyout Firms: Limited partnership or corporation that buys control of private or public firms using their own capital combined with debt (leverage) financing from third-party banks. New management is typically put in place and the company is often taken in a different direction. The size of these transactions can range from $1 million to many billions of dollars.
Hedge Funds: Limited partnership or corporation that buys and sells public market instruments (stocks, bonds, commodities, currencies, etc.), taking bets on market fluctuations. The size of these funds ranges from a few million to several billion dollars.
Traders: Divisions within sell-side companies (merchant banks, commercial banks and investment banks) that control and invest huge sums of money into public markets (stocks, bonds, commodities, currencies, etc.), taking bets on market fluctuations.

Stages of Venture Capital Investment

Venture capital firms invest in over five different stages of a company's growth as shown below. Note that some of these terms are unclear or overlap.

Seed: Investment of between $1,000 and $500,000 made when a company is just a few people and an/or an idea.
Start-Up: Investment of between $50,000 and $1 million in private companies that are completing product development and beginning initial marketing.
First Stage (or Early Stage): An investment of between $500,000 and $15 million made when a company has completed its product but has no, or little, revenues.
Second Stage (or Later Stage): An investment of between $2 million and $15 million when a firm has product and revenues and has often already taken other institutional money.
Third Stage (Mezzanine): An investment of between $2 million and $20 million into a profitable company for a major expansion generally leading to an IPO in 3 to 18 months.
Bridge: An investment of between $2 million and $20 million made only 3 - 12 months before the company "goes public," which means it issues equity shares for purchase by the public. Another common way to say "going public" is "IPO," or Initial Public Offering. The company is typically profitable at this stage. The reason a company would want a round of financing so close to the time it goes out and raises lots of money from the public is 1) to improve its balance sheet, 2) to get a prestigious investor on its board which will help it increase its value in the public markets, and 3) to hedge its bets in case it can't go public so soon.

Understanding Venture Capital

If having funds to invest characterizes buy-side firms, where do they get the money? Most of the money comes from pension funds and from the endowments of non-profit institutions (e.g. universtities, museums) but can also come from wealthy families and individual corporations.

Pension fund money must be invested to help its value grow over time. To maximize return and minimize risk, the pension money is invested in many places -- stocks, bonds, currencies, real estate, and "alternative investments." Typically, 3% - 5% of the total funds are invested into what pension fund managers call "alternative investments," and what we are calling the "buy-side" firms. Pension fund managers expect higher rates of return (15%-30%) from the buy-side firms and understand there is comensurately higher risk associated with such investments.

The aim of the buy-side firms is thus to provide those high rates of return to their investors. Only by producing high rates of return can buy-side firms continue to raise money and thereby stay in business. "He with the gold makes the rules" and the buy-side firms are therefore beholden to the pension funds. Likewise, the buy-side firm tends to have the upper hand with companies into which it invests.

We are overstating these power relationships to better illustrate them. On occasion, the power structure is, in fact, inverted. When a buy-side company is very hot (i.e. consistently producing very high rates of return) pension funds will compete to invest. And when an operating company is very hot (i.e. growing fast) buy-side firms often compete to invest. Nevertheless, the power relationships most often exist as shown below.