Presentation of Phd. Harry J. Sapienza from University of Minnesota @ Ozyegin university in Istanbul, July 2012

1. Sources of Capital
for Entrepreneurial Firms
Harry J. Sapienza, PhD.
University of Minnesota
Ozyegin University, July 25, 2012

2. Introduction Fund Sources Formal VC Informal VC Reflections
25 Years of Studying
Venture Capitalists and Entrepreneurs
• How do VCs create, manage a portfolio of
investments? What influences success?
• What roles do Investors play? How similar/
different are these around the world?
• When do investors add more than money?
• When do entrepreneurs learn from investors?
• When do investors learn from entrepreneurs?
• What are causes and effects of conflict?
• How do investors make “gut” level judgments?
Ozyegin University, July 25, 2012

3. Introduction Fund Sources Formal VC Informal VC Reflections
Studies/ data collected over time
• VC Roles, VC-Entrepreneur conflict, valuation of investors, U.S.
• Roles, valuation of investors, UK, France, Belgium
• Roles of investors, Asia
• Target returns U.S., Europe, Asia
• Information exchange, fairness, U.S.
• “Ideal” contracts and role of trust, U.S.
• Syndication, reputation, involvement, U.S., Europe
• Learning by Investors, U.S.
• Decisions to Terminate or Exit at a Loss, U.S.
• Innovation and “Angel” Investor roles, U.S., Europe
• Business models and investors, Europe
• Entrepreneurs use of Story and investor evaluations, U.S.
• Signals of Competence and Integrity and Investor evaluations
Ozyegin University, July 25, 2012

4. Introduction Fund Sources Formal VC Informal VC Reflections
Outline of Today’s Topics
• (Outside) Sources of a Venture’s lifeblood
• “Appropriateness” of Sources
• Goals and Types of Entrepreneurs
• Tapping into venture capital– often an uneasy
marriage: Formal and Informal Venture Capital
• Formal (Institutional) VC
• Comparison of formal VC and informal VC
• Research Reflections on VC-E Relationships
Ozyegin University, July 25, 2012

5. Introduction Fund Sources Formal VC Informal VC Reflections
New Venture Money:
A Messy Proposition
• The typical entrepreneur does not want to
grow his business to extremely large
proportions
• However, even modest startups often need
more money to get going than is available
• This is where lending or investing starts…
A necessary evil?
Ozyegin University, July 25, 2012

6. Introduction Fund Sources Formal VC Informal VC Reflections
Typical Sources of Funds
• Own savings/ earnings
• 3F’s: Family, Friends, other Fools
• Customer advances, Supplier Credit
• Bank Loans
• Government loans, grants, etc.
• Private individuals (“Angels”)
• Angel syndicates
• Private Venture Capital, (Gov’t Venture Capital)
• Corporate Venture Capital
Ozyegin University, July 25, 2012

7. Introduction Fund Sources Formal VC Informal VC Reflections
How Stage or “Burn Rate” affects
Appropriateness of Sources
• Development and pre-sales
• Early sales
• Growth
• (Somewhat) Steady state
Ozyegin University, July 25, 2012

8. Introduction Fund Sources Formal VC Informal VC Reflections
How Growth Goals (or lack of)
Affect Appropriateness of Sources
• Most funding sources do not necessarily care
whether you seek to grow rapidly or not.
• For institutional venture capital, rapid growth
in the period following investment is critical
• For most business angels growth will be
important but need not be as dramatic
• For corporate venture capital, growth is good
but technology or customer space may suffice
Ozyegin University, July 25, 2012

9. Introduction Fund Sources Formal VC Informal VC Reflections
Preferences for
Control Versus Return
• ‘Passion’ about the venture may take several
forms– e.g.,
– passion to build the best technology,
– to solve an important or personal problem
– to create something for the family
– to create an organization one can run well
• From an equity point of view the key is, how
important is it to maintain control?
Ozyegin University, July 25, 2012

10. Introduction Fund Sources Formal VC Informal VC Reflections
Serial vs. First time
or one time Entrepreneurs
• “Serial” entrepreneurs, ones who have
created several successful ventures, are very
attractive to equity investors. Why?
• An untested, first time entrepreneur is risky
• The team of founders may be most critical;
Yet, there must be a leader
Ozyegin University, July 25, 2012

11. Introduction Fund Sources Formal VC Informal VC Reflections
Single versus Multiple-founder Firms
• The later the stage, the more important to
have a complete team
• Some investors like to have a hand in filling
out the team, but generally speaking a team
of top-notch people is very positive
--attracting great talent is a sign of value, charisma
--having no redundant or useless parts is a sign of
the organizational and business judgment of the
leader
Ozyegin University, July 25, 2012

12. Introduction Fund Sources Formal VC Informal VC Reflections
Informal and Formal Investors
• Much more is known about private,
institutional venture capital firms (VCFs),
though private individual investors (business
Angels) have been around as long commerce
has existed
• We begin with formal venture capital, then
compare what is known about business angel
investing and how it has learned from formal
VCFs
Ozyegin University, July 25, 2012

13. Introduction Fund Sources Formal VC Informal VC Reflections
VCF Structure in U.S.
• VCFs are organized as general partnerships,
typically 3-10 partners and a staff that works on
information gathering, communication, etc.
• At any point in time, the VCF will have several
“funds” to manage, each with a limited life,
typically of 10 years, maturing at various times
• Limited partners “own” the funds VCFs
manage, and limit their liability by leaving fund
management to the VCFs
Ozyegin University, July 25, 2012

14. Introduction Fund Sources Formal VC Informal VC Reflections
The Formal Venture Capital Cycle
• Raising a Fund from Limited Partners
– Track record of General Partner VCs
– Investment climate and money availability
• Screening Criteria for potential investments
• Due diligence
• Deal negotiation
• Portfolio management (next cycle begins here)
• Exits and fund termination
Ozyegin University, July 25, 2012

15. Introduction Fund Sources Formal VC Informal VC Reflections
Pre-Investment Activities
• Establishing a 10 year limited partnership;
conditions and terms (typically management fee,
“carry,” restrictions on the general partners’
decisions and activities– no direct say in
management of investees)
• Raising a fund
• Searching for a pool of viable investments
• Investigating only the top prospects
• Negotiating 1st round of investment, investment
rights
Ozyegin University, July 25, 2012

16. Introduction Fund Sources Formal VC Informal VC Reflections
Criteria for Venture Selection
• Quality of Top Management Team, Lead
Entrepreneur
• Market Size, Competitiveness, Growth
Potential
• Viable Exit Routes
• Significant barrier to Duplication
Ozyegin University, July 25, 2012

17. Introduction Fund Sources Formal VC Informal VC Reflections
Valuation and Negotiation
• Use of Selection Criteria
• Setting ‘pre-money’ valuation is a backwards
process
• Setting terms to
– protect right to participate in success,
– minimize damage (to extent possible) in failure
• Negotiate information rights, board seats,
future equity fund raising, hiring
Ozyegin University, July 25, 2012

18. Introduction Fund Sources Formal VC Informal VC Reflections
Once the First Money Is In
• Typically, monthly reports are sent to investors,
focusing on progress on “milestones”
• Board meetings may be bi-monthly or quarterly,
with frequency highest at earliest stage
• Boards most often around 5 people: VCFs having
2 or 3 seats, 1 expert outsider, 1 or 2 managers
• Money is put into the venture in “rounds” and
“tranches”– serving several purposes
Ozyegin University, July 25, 2012

19. Introduction Fund Sources Formal VC Informal VC Reflections
Good Times and Bad
• Investors expect most of the ventures to be
disappointing-- most returns come from few
• The difficulty is determining whether to keep
the venture on life-support, or terminate
• Rough times are common; decision is not
trivial. Investors vary in incentive to continue
• When things are going well, the toughest
decision may be about leadership transition
Ozyegin University, July 25, 2012

20. Introduction Fund Sources Formal VC Informal VC Reflections
Exits
• Happy exits:
– In some cases, management buyback,
– Most commonly, acquisition or trade sale
– Highly desirable (in most ways) to investors, is the
initial public offering
• Not-so-happy exits:
– Liquidation or buyback
Ozyegin University, July 25, 2012

21. Introduction Fund Sources Formal VC Informal VC Reflections
Goal Differences Among
Investors
• Often the greatest conflict regarding the fate
of ventures has to do with the circumstances
of the investors. Things that may cause these
differences include:
– Differential liquidation rights
– Inability to participate in further equity rounds
– Differences in time horizons or needs for cash
Ozyegin University, July 25, 2012

22. Introduction Fund Sources Formal VC Informal VC Reflections
The Rise of Sophisticated Angels
• Long history of ‘Private’ Investors
• Angel Investing is “venture capital-equity investments
made by private individuals, directly in unquoted companies
in which they have no family connection...”
• It fills the gap between founders, family and friends
and institutional venture capital funds
• substantially larger than formal VCF market
-- in terms of amount invested in businesses at their start-up
-- and in terms of the number of such deals made in early stages
Ozyegin University, July 25, 2012

23. Introduction Fund Sources Formal VC Informal VC Reflections
Key Aspects of Business Angel Investing
• Unlike family/ friends, “arms length” relationships
• Unlike VCs, BAs are investing their own money
• BAs typically cannot get the same equity per $/TL as VCFs
• Significant barriers to linking BAs and entrepreneurs
• Estimated
– 3x to 5x the money;
– 40x the number of deals
• Countries, regional authorities, entrepreneurs, and BAs
have all tried to increase connections
Ozyegin University, July 25, 2012

24. Introduction Fund Sources Formal VC Informal VC Reflections
Portrait of a ‘Typical’ U.S. Business Angel (circa 2000)
• Age 47-54 years old
• Sex Male
• Annual family income ~$100,000
• Net worth ~$2 million
• Experience Extensive, some entrepreneurial
• Education Bachelor’s; half with advanced
• Number of investments 2 every three years
• Investment rate in 8% of deals
• Average amount invested $60,000
• Preferred stage Startup 56%; Earlier 24%
• Co-investment Formerly alone, now syndicating
• Control 56% have minority voting position
Ozyegin University, July 25, 2012

25. Introduction Fund Sources Formal VC Informal VC Reflections
Business Angels Around the World
• Evidence suggests that the profile of business angels
is similar around the world
• Typical investment in ‘chunks’ of
– $10,000
– $25,000
– $50,000* mode
– $100,000
– $250,000
• BA investing recent trends
– More sophistication in diligence, terms, negotiations
– More syndication
Ozyegin University, July 25, 2012

26. Introduction Fund Sources Formal VC Informal VC Reflections
Angel vs. VC Characteristics and Practice
• VCs have more investing experience
• BAs have more startup management experience
• VCs have wider, more consistent access to new deal flow
• VCs ‘share’ flow more
• BAs conduct less due diligence
• BAs use less routinized valuation
Quote from Angel: “...I rely less on the numbers, but more on the subjective
impression of the entrepreneur--it has to feel right and I have to believe in
it. I don't have to be analytical, I can go on instinct unlike the venture
capitalist. I don't have to rationalise my investment decision to a boss at
the end of the day"
Ozyegin University, July 25, 2012

27. Introduction Fund Sources Formal VC Informal VC Reflections
Investment Motivations of Angels
Angels rate making money highest, but two other motivations are
also important:
Realize financial gain 4.09 rating out of 5
Play role in entrepreneurial process 3.68 rating out of 5
Have fun, achieve satisfaction 3.68 rating out of 5
“...I feel this is a fantastically exciting sport!” Angel quote
Van Osnabrugge, 1999*
Ozyegin University, July 25, 2012

28. Introduction Fund Sources Formal VC Informal VC Reflections
Sampling of Top Investment Criteria for Angels
Comparison with VCs
1. Enthusiasm of entrepreneur 4.69
2. Trustworthiness of entrepreneur
3. Sales potential
4. Expertise of entrepreneur 4.33
5. Likes entrepreneur upon meeting
6. Growth potential of market
7. Quality of product 4.15
8. Investor involvement possible
9. Able to reach break even without more funding
10. Low initial expenses 3.44
11. Is local
12. Investor understands business/industry
13. Good potential exit routes 3.12
Above scale is of importance of criterion from 1= not important, 3= somewhat
important, and 5= extremely important
Ozyegin University, July 25, 2012

29. Introduction Fund Sources Formal VC Informal VC Reflections
Significant Differences in Angels’ and VCs’ Criteria
• In comparison to VCs, Angels
– rely less on the expected financial return criterion
– are more concerned with cost containment criteria
– focus less on entrepreneur’s track record & expertise
– are more concerned the venture is nearby
– are more insistent on being operationally involved
– are more interested when own strengths fill venture gaps
– rely less on the business plan
– are less concerned that a clear exit path exists
Ozyegin University, July 25, 2012

30. Introduction Fund Sources Formal VC Informal VC Reflections
Recent Experience as Angel Investor
• “Bands of Angels” becoming common
• Sophistication / professionalism of practice
increasing, but still much “solo flying,” and still
much room for personal motives
• Loose organization like herding cats
• Dedication, risk-taking on individual level
varies widely
• What I like…
Ozyegin University, July 25, 2012

31. Introduction Fund Sources Formal VC Informal VC Reflections
Reflections from Research, Practice
• Quality of relationship is very important in rough
times– times are rough more often than not
• Process favors those with greater stack of money
• The closer the relationship the more conflict, but
also more satisfaction (all else equal)
• A venturing ‘community’ tends to develop in
areas with great activity; reputation is critical
• ‘Gut feel’ and group process play big roles
• Entrepreneurs are optimists, investors are
pessimists
Ozyegin University, July 25, 2012

32. Introduction Fund Sources Formal VC Informal VC Reflections
Advice to Entrepreneurs
• Seek appropriate sources of funding
• Understand yourself– is control of the
creation more important than wealth
realization?
• If you do take VC, do your own due diligence
• Understand that investors’ want to get out
with as much as they can as soon as they can
• Keep the investor informed throughout the
relationship; honesty and openness lead to
better terms, more leeway Ozyegin University, July 25, 2012

33. Introduction Fund Sources Formal VC Informal VC Reflections
Conclusion
• I have found this process to be a fascinating
blend of the personal and the impersonal
• It is about making good, well-considered
decisions in the face of tremendous
uncertainty: persistence, determination, and
risk-taking with reason
• It is also very much about people. This should
be not be forgotten.
Ozyegin University, July 25, 2012