The private equity world has a lot of terminology.  In a prior post, I discussed the structure of a private equity fund, and introduced the terms "limited partners" (or "LPs"), the "general partner" ( or "GP") and the "management company."  In this post, we'll explore fund "sizes" and a little bit of how investments in private equity funds work.

The "size" of a private equity fund is based on the total amount of money all investors commit to invest in the fund - known as "committed capital."  Because a private equity fund invests capital over time, the fund does not need all of the investors' money at the inception of the fund, and so the fund "calls" capital over time.  Private equity funds typically have initial terms of 10 years, but most of the new investing occurs during the first several years (usually 3-5 years) of the fund, known as the "investment period."  As a result, the fund calls the bulk of capital from the investors during this investment period.
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​Let's use an example.

To read more, please click "Read More" to the lower right.

Basic Limited Partnership Structure
In a basic limited partnership, there are several passive investors (known as "Limited Partners" or "LPs") and the manager of the fund, (known as the "General Partner" or "GP").  The diagram below illustrates this basic structure.

This is one of a series of posts on fund terms.  Other posts include:

• Management Fee
• ​Carried Interest Overview
• Carried Interest – Preferred Return and GP Catchup
• GP Clawback
• Management Fee Offsets
• Key Person Clauses
• No Fault Divorce
• For Cause Actions
• Should Venture Capital Funds have a Preferred Return Hurdle?

Private equity funds (buyout, venture capital and growth equity funds) are typically structured as limited partnerships, which have two types of partners: limited partners, or LPs, which are passive investors in the fund; and a general partner, or GP, which is the manager of the fund.  As I evaluate funds, one of the fund terms that receives special attention is the amount of money the GP will commit to the fund - which is called "GP Commitment", "GP Capital Commitment" or "GP Commit."  ​

To read more, please click "Read More" to the lower right.

The Fortune article "Snapchat Actually Isn't the Hottest IPO This Year" argues that MuleSoft is actually a hotter initial public offering than Snap.  This argument is based on post-IPO trading metrics, such as first day "pop" (first day closing trade price vs IPO price) and price-to sales metrics.  It's an interesting article.  Link: http://fortune.com/2017/03/30/snapchat-ipo-snap-stock-mulesoft/ 

In a prior post "Mike Moritz on Private Equity (aka Leveraged Buyouts)" an opinion piece penned by the famed venture capital investor was discussed.  Now there's a rebuttal to Mr. Moritz's article.  ​

Stephen Davidoff Solomon's opinion piece "A Venture Capitalists's Misguided Critique of a Trump Adviser" rebuts Mr Moritz's article in a number of ways.  Whether you agree or disagree with the opinions of Mr. Solomon and Mr. Moritz, this very public debate is pretty fascinating.  

​Link to prior post:
http://www.allenlatta.com/allens-blog/mike-moritz-on-private-equity-aka-leveraged-buyouts 

Link to Mr. Solomon's article:
https://www.nytimes.com/2017/02/14/business/dealbook/a-venture-capitalists-misguided-critique-of-a-trump-adviser.html
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Link to Mr. Moritz's article:
https://www.nytimes.com/2017/02/07/opinion/stephen-schwarzmans-bad-business-advice.html 

Mike Moritz, the famed venture capital investor at Sequoia Capital, has published an opinion piece on the New York Times called "Stephen Scharzman's Bad Business Advice."  In this opinion piece, he takes a swipe at the leveraged buyout business, which is now known as private equity.  He focuses on the amount of debt used in these transactions and the attendant cost-cutting that often includes layoffs.  I have met Mike Moritz on a couple of occasions, and found him to be a very smart and opinionated person.  His piece is worth a read, even if you don't agree with his positions.  

Link:  https://www.nytimes.com/2017/02/07/opinion/stephen-schwarzmans-bad-business-advice.html?_r=0

The bottom line is that too much money is going into venture funds and companies, and too little is being returned to investors.  In my view, this will lead to overall lower returns for the venture capital industry and will highlight the need to be very selective when investing in venture capital funds in order to select only the best managers who can deliver exceptional returns.

Link:
https://www.bloomberg.com/gadfly/articles/2017-01-11/silicon-valley-startup-pipeline-needs-shot-of-drano

Now Fortune has published an article "The Ugly Unethical Side of Silicon Valley" which discusses scandals at portfolio companies.  I found this to be an interesting article.  My opinion is that scandal is likely more probable at startup companies than venture capital funds for a few reasons:

• Opportunity.  There's likely more opportunity for a startup executive to commit fraud, as accounting, sales and operating systems are typically not in place or if in place, not robust enough at startups to prevent fraud.  Venture Capital funds have fewer opportunities for fraud, as there are fewer moving pieces.  A VC fund pays the GP management fee and carry, pays for certain fund and transaction expenses (legal, accounting and insurance are typically the largest fees), makes capital calls and distributions, and makes investments - and that's pretty much it .  A startup has many more moving pieces.
• Culture.  Startups in many instances are like the Wild West - immense opportunity, gun-slinging attitude, and young entrepreneurs who typically don't have a lot of management experience.  Compare this to a venture capital fund, which typically has an in-house CFO and back-office team that is experienced and establishes a more structured, professional culture than many startups
• .Accountability.  Most startups fail.  If a startup executive realizes that the company isn't going to make it, there may be a temptation to maximize personal gain over doing the right thing (shutting the company and returning money to investors).  If a company fails, the winding-up process is typically very quiet and private (known as an assignment of the benefit of creditors).

"Fraud by Venture Capital Fund Managers" can be found at:
http://www.allenlatta.com/allens-blog/fraud-by-venture-capital-fund-managers

The Fortune article "The Ugly Unethical Side of Silicon Valley" can be found at (copy and paste in browser):
​http://fortune.com/silicon-valley-startups-fraud-venture-capital/ 

The Wall Street Journal has two articles today that are of interest to shareholders of startup companies, primarily former employees who hold shares of these startups.  The articles "Startup Employees Invoke Obscure Law to Open Up Books" and "Own Startup Shares? Know Your Rights to Company Financials" discuss laws that may require some startup companies to deliver certain financial data to shareholders which may help these shareholders value their stock.  

Specifically, the articles reference Section 220 of the Delaware General Corporations Law, Section 1501 of the California Corporations Code and Rule 701 of the Federal Securities Act of 1933.  These provisions may provide certain shareholders of some private companies the ability to obtain selected financial statements.

Links:
http://www.wsj.com/articles/startup-employees-invoke-obscure-law-to-open-up-books-1464082202

http://www.wsj.com/articles/own-startup-shares-know-your-rights-to-company-financials-1464082203

Business Insider had an article this week called "The steroid era of startups is over -- here's what 8 top VCs think will happen next" that made a number of good observations.  In this article, eight venture capitalists discussed how the environment has been changing, and the article identifies a number of ways the changing environment will impact startups.  The main categories are:

• VCs may not be as supportive in the future
• Expenses (and headcount) will be "slashed:
• Some companies will fold
• Startups that mainly sell to other startups will have problems
• Large companies may acquire startups, but only if it's strategic and at a discounted valuation
• Some startups will suffer a down round
• Other startups will be forced to recapitalize, wiping out early investors and employees
• Employees with huge paper profits (from options and/or restricted stock) will suffer
• All of the above signals a return to normal

Each category is discussed in the article, with comments from the VCs.  It's a good article and worth a read.

Link:
http://www.businessinsider.com/what-happens-when-tech-boom-turns-to-bust-2016-5

Bill Gurley, General Partner at Benchmark Capital and a leading venture capitalist, has posted a sobering, but excellent article about the state of the venture capital industry.  I generally concur with his viewpoint.  While a long read, it's definitely worth the investment of your time.

Here's the link
http://abovethecrowd.com/2016/04/21/on-the-road-to-recap/

There were no initial public offerings (IPOs) of tech companies in the first quarter of 2016, according to the National Venture Capital Association (NVCA).  This is the first time since the depths of the Great Recession that no tech companies have gone public in a quarter.  Six life science companies did hold IPOs, but the total of six venture-backed IPOs in the first quarter of 2016 is the lowest tally since the third quarter of 2011, when there were five IPOs.  To add to the misery, there were 79 reported mergers and acquisitions of venture-backed companies, down from 105 in the fourth quarter of 2015 and down from 97 in the first quarter of 2015.

As liquidity events are crucial to the venture capital lifecycle, this is troubling news.  

Link:
http://nvca.org/pressreleases/biotechnology-companies-leading-way-six-venture-backed-ipos-recorded-first-quarter/

According to the Business Insider article "'The Great Reset': Venture Capitalists and Startups Have Shifted from Greed to Fear," the technology startups and venture capitalists have begun to temper valuation expectations.  This is driven by a number of factors, including (1) the slowdown in the tech IPO market, (2) public tech company valuations have declined, some significantly, making many private tech companies looking overvalued, and (3) some tech companies are now laying off people.  

The article indicates that the conversation is changing between venture capitalists and startups, with VCs asking tougher questions, and now looking for "cockroaches" - companies that can survive in any market.

It's an interesting article and worth a read.

Link:
http://www.businessinsider.com/the-great-reset-vcs-startups-go-from-greed-to-fear-2016-2?op=1

There's an insightful article on TechCrunch "Will the Bubble Burst? Ask Your Cabbie" that I found interesting.  The author recounts the first Internet bubble and then the credit/real estate bubble and how he realized that the markets were overvalued at these times and how he avoided the market downturns.  From that experience, he then looks at the current environment.  It's a good article and worth a read.

Link:
http://techcrunch.com/2016/01/30/1269710/

Investment in US venture-backed companies reached $15.7 billion in the first quarter of 2015, according to data provided by Dow Jones VentureSource and quoted in today's WSJ.com article "Startup Funding Hits 15-Year High While Valuations Set Record."  A few highlights from the article:

• The $15.7 billion invested in 1Q2015 is up from the $15.6 billion invested in 4Q2014 and up from $12.4 billion invested in 1Q2014.
• Venture-backed companies had the highest median valuations on record during the first quarter.
• The largest financing in the quarter was a $1 billion round by SpaceX.
• There were 12 venture-backed IPOs in 1Q2015, down from 23 IPOs in 4Q2014.
• M&A was down in 1Q2015, with 104 deals in the quarter, down from 109 in 4Q2014, and the amount paid in 1Q2015 was down a whopping 71%, at $9.9 billion, compared to the $33.8 billion paid in 4Q2014.

Link to article: 
http://blogs.wsj.com/digits/2015/04/20/startup-funding-hits-15-year-high-while-valuations-set-record/

San Francisco's South Park neighborhood is centered by a beautiful park surrounded by Victorian homes.  Over the past several years, there has been an influx of venture capital firms to the neighborhood.  The Re/Code article "Has South Park Finally Become the New Sand Hill Road?" takes a look at this phenomenon.  But it's not just South Park - venture capital firms are either headquartered or opening offices all over San Francisco.  San Francisco is also home to many venture-backed companies, including Twitter, Uber, and more.  San Francisco has become the new epicenter of technology venture.

Link: http://recode.net/2015/04/13/has-south-park-finally-become-the-new-sand-hill-road/

Scott Kupor, Managing Partner of venture capital firm Andreessen Horowitz, has an interesting blog post "What's Holding Tech M&A Back?" that's worth a read.  In the post, Kupor asserts that only 10% of tech mergers & acquisitions have been "growth" transactions - deals "involving rapidly expanding, venture-financed private companies or modern software-as-a-service providers."  Worse, 40% of this deal volume has been by five acquirers - Facebook, Google, Microsoft, Oracle and SAP.

This paucity of growth transactions is due to two main factors: (1) venture-backed companies are staying private longer due to the significant availability of private capital available to these companies; and (2) public companies are hamstrung due to activist investors, which are demanding actions like stock buybacks, dividend distributions and breakups - short-term actions to books stock price - at the expense of actions that enhance long term shareholder value such as investing in R&D or growth-oriented acquisitions.

It's a thought-provoking piece that's worth a read.

Link to blog post: http://a16z.com/2015/04/10/whats-holding-tech-ma-back/

Mike Moritz, the Chairman of famed venture firm Sequoia Capital, has cautioned that valuations are very high and that a number of "unicorns" - startups that are valued at over $1 billion - will become extinct.  Both Business Insider and Fortune have good analyses of Moritz's warnings (the remarks were made originally in an interview with The Times of London, but the article is only available to subscribers).

Moritz joins other notable venture capitalists, such as Bill Gurley of Benchmark, in warning of valuation concerns in Silicon Valley.

While Moritz does believe that valuations are "very sporty" and that some unicorns will fail, he also adds that "a good number" of unicorns that will succeed.

Moritz also feels that while there will be a setback in Silicon Valley tech, he does not believe it will be as bad as the tech bubble bursting in 2000 because companies today are more sustainable.

Links:
Business Insider article:
http://www.businessinsider.com/michael-moritz-warns-that-the-bubble-is-about-to-burst-2015-3
Fortune article:
http://fortune.com/2015/03/24/sequoias-moritz-joins-chorus-of-concern-about-silicon-valley-valuations/

Bill Gurley warned of there being "no fear in Silicon Valley right now" at South by Southwest, according to this article by Fortune.  While he said that we may not be in a tech bubble, we are in a risk bubble.  He added that he thinks there will be some "dead unicorns" this year, a unicorn being a startup with a valuation in excess of $1 billion.  Gurley also warned that if the free flowing capital dries up, it could have a ripple effect that will affect more than money-losing startups.  It could affect San Francisco real estate prices as well as companies that rely on spending by these startups.

It's a good article and worth a read.

Link to Fortune article about Bill Gurley:
http://fortune.com/2015/03/15/bill-gurley-predicts-dead-unicorns-in-startup-land-this-year/

Link to Fortune article "The Age of Unicorns":  
http://fortune.com/2015/01/22/the-age-of-unicorns/

Link to Fortune's "The Unicorn List":
http://fortune.com/unicorns/

Mark Cuban has published a post on his Blog Maverick site called "Why This Tech Bubble is Worse Than the Tech Bubble of 2000", which is an interesting read, but one with which I generally have a different perspective.

The distinction Mr. Cuban makes is that in the Tech Bubble of 1999-2000 the tech companies were publicly traded, while today the tech companies (apps and small tech companies) are not.  Mr. Cuban contends that investors in public companies during the Tech Bubble had liquidity - the ability to sell their stocks on the public market.  Today, investors in these private companies have no liquidity, and so can't sell their stock if things turn south.  

A second point he makes is that there are significant numbers of "Angel" investors investing in these companies and he first states that he thinks most of the investments made by these angels are under water because of the lack of liquidity.  He then takes a jab at equity crowdfunding, the rules for which have not yet been finalized by the SEC, because he believes "there is no reason to believe that the SEC will be smart enough to create some form of liquidity for all those widows and orphans who will put their $5k into the dream only to realize they can't get any cash back when they need money to fix their car.

I respectfully disagree with much of Mr. Cuban's post.  First, he assumes that we are in a bubble today, while I think there is lots of disagreement on this point.  Please see my prior blog posts on this for more on whether we are in a bubble.  Second, as the law stands today, it is mainly accredited investors who invest in these private companies.  An accredited investor in the US is one who has net worth of $1 million (not including the value of their primary residence) or who has income of at least $200,000 each year for the last two years (or $300,000 together with their spouse if married).  This seems to contradict Mr. Cuban's comment about these Angel investors not knowing what they have gotten into.  Third, the Jumpstart Our Business Startups (JOBS) Act does provide for annual limits on investing through equity crowdfunding platforms.  The Act provides that people earning under $100,000 the investing limit is the greater of $2,000 or 5% of their income.  These limits suggest to me that the maximum losses incurred by "widows and orphans" should not be devastating.

I do agree that the lack of liquidity in private company securities means that it is harder to exit the investment, but my view is that sophisticated investors understand this already, and for unsophisticated investors there are protections in place already (and probably more to be included in the SEC rules) that will prevent them from betting the farm on a poor, illiquid investment.

Link to Mark Cuban's post:
http://blogmaverick.com/2015/03/04/why-this-tech-bubble-is-worse-than-the-tech-bubble-of-2000/

Links to prior posts on whether we are in a tech bubble:
http://www.allenlatta.com/allens-blog/are-we-in-a-venture-capital-bubble-more-thoughts
http://www.allenlatta.com/allens-blog/is-venture-capital-in-a-bubble
http://www.allenlatta.com/allens-blog/fred-wilson-on-the-bubble-question
http://www.allenlatta.com/allens-blog/tech-bubble-andreessen-and-conway-say-no
http://www.allenlatta.com/allens-blog/tech-bubble-two-views

Venture capital funds are marketed as a 10 year limited partnership, with two one-year extensions that can be exercised by the General Partner in their discretion in order to liquidate the portfolio and wind-up the fund.  This implies that the life of a fund should be 12 years, right?  Not in my experience.

Now there's a thoughtful article by Diane Mulcahy, a senior fellow at the Ewing Marion Kauffman Foundation and an adjunct lecturer in entrepreneurship at Babson College, on the topic called "The New Reality of the 14-Year Venture Capital Fund."  This Institutional Investor article discusses recent data that indicates that the median fund takes over 14 years to end.  It's a very interesting article and worth a read.

In my experience, the strategy of the fund and vintage can influence the overall lifespan of a fund.  So for example, 1999-vintage funds that invested in early-stage technology companies had two economic downturns to work through, which extended the lives of these funds.  Conversely, later-stage funds that invested in pre-IPO tech companies in 2006-2007 will likely have shorter lives.  I have worked with several funds where the life span was well over 14 years, so this article was very interesting to me.

Link:  http://www.institutionalinvestor.com/blogarticle/3428857/blog/the-new-reality-of-the-14-year-venture-capital-fund.html#.VOZ73vnF-y4

There's an interesting post by Glenn Solomon, a partner at GGV Capital, on his blog, called "Why Private, Late-Stage Valuations are Skyrocketing."  This is an interesting read, and I recommend it.  In the post, he points to four reasons why valuations of private, later-stage venture-backed companies have seen such extreme valuations:

• Scarcity - private companies are harder to access than public companies, so when a private company raises money, "fierce competition ensues for these scarce slots" in the best companies.
• Momentum - the strategy of paying high valuations in private rounds has paid off, which attracts more capital to the system, and creates momentum for the strategy to continue.
• Fear of Missing Out (FOMO) - VCs want to be associated with winning companies.  While the ultimate metric to judge a fund is the long-term return, in the shorter term, VCs can claim success by investing in companies that are perceived as "winners."
• Gains - a critical question is how much of the returns from these healthy valuations are paper returns and how much are from true realizations.  Solomon does not answer this question.

I generally agree with the points raised in this article, but would add a few more:

• Public valuations.  The Nasdaq 100 Technology Index (NDXT) is up over 17% in the past year.  The stock price for Box, Inc., the cloud-based file sharing company, is up nearly 50% from its IPO price.  Frothy public valuations also add to the private, late-stage valuation frenzy.
• Results and the Halo effect.  Many of these later-stage private companies are posting remarkable results, such as hyper-revenue growth.  It is these stars that lead the pack in valuation, and other later-stage companies benefit from the halo effect.