Tuesday, May 19, 2009

The Stages of Venture Capital Investing

The following is Part 2 of my five-part series on the roles of angel investors and venture capital investors in emerging technology sectors with explosive upside potential, such as the nanotech, cleantech, biotech, information technology and new media sectors.

In Part 1. I gave a general overview of the playing field. Below, I examine the stages of an emerging growth companys lifecycle and the types of investment that it hopes to obtain at each relevant stage.

Introduction

Many investors are confused by the differences between angel and venture capital. This isn’t surprising; the categories are overlapping and are used inconsistently.

However, there are some broad generalizations that can be drawn, typically based on the timing of the investment and the purpose of the investment in the companys lifecycle. Depending upon the timing, you can draw some basic conclusions as to the type of investor that will be involved (e.g. single angel vs. angel consortium vs. venture capitalist).

And, in each category, you can glean the form the investment will take (e.g. common stock vs. convertible debt vs. preferred stock) and the size of the return investors can expect. That is, if there’s a return—very few private emerging growth investments are actually a success. More below the fold.

Seed Round

The earliest investment stages are usually characterized as seed rounds, proof of concept investments or angel investments.

These investments usually don’t occur until after the target entrepreneur has tapped out his friends and family in what’s usually called a friends and family round.

The money you invest is intended to allow the founders of the company to do their initial research, to complete the initial programming or to apply for the initial patent(s). Companies at this stage usually don’t have a saleable product and don’t have very many employees, other than the founders/inventors.

Traditional venture capital funds very rarely invest in seed rounds. Rather, seed investors typically consist of angels that is, wealthy individuals or groups of individuals that are willing to invest their own money and take the extreme risk involved in making equity investments into companies that often only have a good idea.

Occasionally, a seed investor may be a publicly or privately funded incubator established to help entrepreneurs or scientists get their ideas off of the ground.

In the seed round stage, the amount of the investment is typically small, say $100,000 to $500,000, seldom more than $1,000,000. Also, the investor usually takes common stock in the company—the same stock that the founders get.

Alternatively, the investor will take a convertible note that allows him to have the protection of debt at the beginning but with the possibility of converting and receiving the upside of equity. Typically, the conversion will occur in concert with the closing of the next round of investment and will be at the same per share price used in the next round.

Often, you receive some sort of additional incentive for making a seed round investment such as a conversion discount or grant of warrants.

Investments at the seed stage are extremely risky and are subject to significant dilution when new investors come in during later stages. Consequently, angel investors look for returns of at least 10x their initial investment, and sometimes as high as 20x or 30x their initial investment.

Early Stage Venture Round

The next stage of investment is early stage venture capital. Investors usually aren’t interested in making this type of investment until the company has a proven product and a business plan.

However, it isn’t necessary that the target be profitable or even be producing its product. The funds invested will be used to mass manufacture the product, market the product, build a sales force and further develop the product.

Typically, these sorts of investments are made by early stage venture capitalists, larger angels or angel consortiums. Early stage venture capitalists and angel consortiums usually have smaller funds to deploy which makes them more suited to making the relatively smaller sized investments found at this stage of a companys life.

In this stage, the amount invested is typically in the $1,000,000 to $5,000,000 range. The investors will almost always be purchasing Series A preferred stock of the target. This type of stock is superior to the common stock held by the founders and any seed round angel investors and will typically come with dividend rights, liquidation preferences, some form of anti-dilution rights and a right of first refusal on stock sales by the founders and seed round angels.

Often, the investors will also receive pre-emptive rights, redemption rights, drag along rights and other rights and preferences.

Investors at in early stage investments will typically look for returns of at least 5x their initial investment and would gladly accept higher returns.

Growth Stage Venture Round

After the Series A round, there may be multiple additional rounds of equity financing. These types of funding are often called growth capital or mezzanine financing.

Usually, the company seeking this sort of investment will either be close to profitability or will have a clear path to profitability and the funds are meant to allow the company to expand its sales force and marketing efforts and ramp up its revenue growth. The money may also be used to develop additional products or to research expansion ideas.

These investments are usually made by the larger venture capital funds and the amount invested can range from $1,000,000 to $25,000,000 or higher, depending on the company and the market opportunity.

The investor typically will receive additional rounds of preferred stock—for example, Series B or Series C preferred stock—and each successive round will generally have superior rights and preferences to the prior rounds.

Investors at this stage may still look for 5x investment returns, but depending on the opportunity and the trajectory of the company, may settle for 2x or 3x returns.

Bridge Round

Occasionally, investors will be willing to invest bridge capital into a company in the growth phase of its life cycle, or one that’s on the cusp of the growth phase. This investment takes the form of debt that bridges the gap in funding between rounds of venture capital financing.

These investments range in size depending on the company and the market opportunity and they’re made by all types of investors, depending on the size of the investment. The lender may be an existing investor in the company or it may be a new angel or venture capital fund that’s contemplating making the follow on round.

Usually, the debt will be represented by a convertible note that will automatically convert into the next round of preferred stock, sometimes at a discount. Also, investors will usually want some sort of warrant coverage to provide equity upside in the deal.

Investors at this stage expect a blended return that takes into account the interest rate on the debt and the potential value of the equity. These target returns vary greatly, but often move in the 12 percent to 18 percent range.

Buyout Capital Round

The final stage is characterized as acquisition or buyout capital. This is used by the company to purchase the assets or stock of other businesses that will then be absorbed into or added onto the target company.

The investors may be the companys existing venture capitalists or it may be a private equity fund that’s building out a platform in the companys industry.

In the latter case, the investment may come with a right to purchase the company outright in the future. This type of financing also occurs when a companys angels and venture capitalists start planning their exit strategy.

By putting together the right pieces it may make the company more attractive as an acquisition candidate or perhaps more eligible for an IPO.

In the next three parts of this article, I’ll explore angel investing, angel syndicate investing and venture capital investing, in greater detail and I’ll discuss the important characteristics of each mode, including typical legal and business issues.