Finance - Bottazzi Lecture 7

Corporate financial and policy control: Venture Capital :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Corporate financial and policy control: Venture Capital


Why Seek Venture Capital? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why Seek Venture Capital? Lower cost sources of capital are exhausted Venture capitalists have expertise that will aid business development e.g., marketing, organization, production


Why Seek Venture Capital? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why Seek Venture Capital? Lower cost sources of capital are exhausted some types of firms require large investments in R&D or fixed investments before cash flows begin$ biotech chip manufacturing banks are restricted from making equity investments in these types of activities since there are no short-term cash flows, it's hard to design a debt security that matches the financing demands of these firms friends and relatives often have limited resources and/or unwillingness to make a large undiversified investment


Why Seek Venture Capital? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Why Seek Venture Capital? Venture capitalists have expertise that will aid business development usually require a majority equity stake perhaps among a set of VC firms VC partners often become active board members VC partners help hire complementary personnel people who have the skills not held by incumbent management e.g., if the entrepreneur is an R&D specialist, hire a CEO who can manage marketing, production, etc. the process of preparing a sequence of business plans forces the company to focus on the financial viability of their projects


Costs of Venture Capital :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of Venture Capital High cost of capital target required returns in 20-40% range Loss of control VC's claim rights to control most important decisions high failure rate founder/entrepreneur can be displaced frequent financing rounds require constant performance


Costs of Venture Capital :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of Venture Capital Turnover of founders - case studies Lotus Compaq Apple All of these firms had significant VC investments


Costs of Venture CapitalLotus :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of Venture CapitalLotus Mitch Kapor was founding CEO took cash flows from sales of Lotus 1-2-3 and reinvested them in "Symphony" (first office suite) artificial intelligence software board (dominated by VC firms) fired Kapor and replaced him with Jim Manzi Manzi: a marketing person who was tasked to maximize profits from 1-2-3 Kapor was a major stockholder when he was fired Manzi was later replaced (by IBM takeover) because he was not maximizing the value of Notes


Costs of Venture CapitalCompaq :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of Venture CapitalCompaq Rod Canion was founding CEO original business strategy was to sell an IBM-clone PC that was much higher quality than IBM for a slightly higher price as high quality/low price clones began to make inroads in the business community (e.g., Dell, Gateway, etc.), Compaq profits fell


Costs of Venture CapitalCompaq :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of Venture CapitalCompaq Chair (Ben Rosen) was one of the original VCs he asked whether Compaq should be trying to compete with Dell etc. by making a lower quality/price product Canion repeated engineers' answer that it would take a long time to develop such a product Rosen sent a couple of mid-level engineers to go to a trade show, buy components, and create a clone in their hotel room it took them less than 3 days to create a workable product! this led to Canion's firing


Costs of Venture CapitalApple :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of Venture CapitalApple Steve Jobs was the CEO/founder he was good at R&D product development & marketing were slow pricing was expensive Jobs was spending a lot of money on developing the "Lisa" machine


Costs of Venture CapitalApple :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of Venture CapitalApple VCs on the board fired Jobs and replaced him with John Sculley marketing person from Pepsi at the time Jobs was the largest single shareholder (about 14%) Apple started to focus on making Macintosh a commercial success later, Apple replaced Sculley Michael Spindler Gil Amelio finally Jobs, again


Costs of Venture Capital :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of Venture Capital Contrast with Microsoft they had only a small VC equity position even now, Gates owns a very large control block of stock short of certifiable insanity, it is hard to imagine how Gates could be fired on the other hand, he seems not to have fallen into the errors that affected Lotus, Compaq, and Apple


Costs of Venture Capital :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Costs of Venture Capital Common features: VCs have strong equity positions and continuing board membership they have enough control to fire the founding CEO, even in "successful" companies even when founder has a large remaining equity position


What Industries Use VC? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION What Industries Use VC? Industries with large capital needs, longhorizons computer hardware/software biotech communications Geographically concentrated Silicon Valley (CA) Route 128 (MA) Specialized knowledge by VCs also, easy on-site monitoring


Cycles in VC? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Cycles in VC? Supply: pension funds, endowments, others with long horizons wealthy individuals tends to increase when recent realized returns are high e.g., profitable IPOs that were financed by VCs Demand: tends to be concentrated by industry


Cycles in VC? :8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Cycles in VC? Pricing: Gompers & Lerner find prices increase when supply increases demand pressure somewhat similar to what happens to inflows into mutual funds that have had recent good performance implies that future performance of investments made in "hot" markets may not be the same as the period that attracted investors