Venture Capital

It seems like everyone feels the need to explain how the VC industry works in graphics form. Since the very public success stories of IPOs by companies like Netscape, Yahoo!, Amazon, Google, and Facebook, interest in the phenomena of IPOs and venture capital have a large audience beyond the board rooms of private equity investors and investment bankers. Some of graphics are useful. But even this one from a 1998 Harvard Business Review article causes me to take strong exception.

For starters, entrepreneurs more often than not get their non-VC financing from their own savings, friends and family investments, business plan and pitching competition winnings, and possibly angel investors. Money from "corporations and governments" is a curious source to show as a source of funding for entrepreneurs. 

I take even greater issue with the so-called flow of "Ideas" from the entrepreneurs to the VCs in exchange for money. Recall that "ideas are a dime a dozen." Entrepreneurs actually provide ownership in the form of (usually) shares of preferred stock through Series A, B, C, etc. deals that they negotiate with venture capital investors. Venture capital investors often invest as a syndicate, meaning that they will team up for an investment in a specific company at a specific round of financing. Sure Venture Capital investors are interested in bold, possibly industry-changing ideas, but what they want for their money is an ownership stake in the entirety of the venture they're funding. They want to own a piece of the company you'll create in pursuit of the idea and ideally to sell that stake at a price at least 10x greater than what they paid in a liquidation event.

And one more (for now). Venture capital investors don't "give" investment banks "IPOs." Rather, their participation in the investment of promising adolescent stage ventures clears the way for them to possibly help take the company public through an IPO or keep it private through a sale to a larger firm. The shares that are exchanged with the investment banks for the cash they raise from their sale come from the pool of authorized shares of the company. The investment bank will engage in a two-sided function where they perform necessary due diligence on the company, audit its financial reports, and determine a potential post-money valuation of the company after it has become a public one. The other side involves creating a syndicate of investment funds like Vanguard or Fidelity, hedge funds, retirement pension funds, or valuable wealthy clients to get them to commit to buying, as a group, all of the stock that's being offered in the IPO. The investment bank takes the cash from the syndicate members based on their pro rata investment amounts and gives it to the company. The company issues the number of shares subject to the IPO terms to the investment bank, which passes them onto the syndicate members based on investment amounts. The investment bank doesn't trade in the shares they intermediate; they charge a usually handsome fee for running this process.