What is Venture Capital?

Venture capital is money provided by professionals who invest alongside management in young,
rapidly growing companies that have the potential to develop into significant economic contributors.
Venture capital is an important source of equity for start-up companies. Professionally managed
venture capital firms generally are private partnerships or closely-held corporations funded by private
and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign
investors, and the venture capitalists themselves.
Venture capitalists generally:

Finance new and rapidly growing companies;

Purchase equity securities;
Assist in the development of new products or services;
Add value to the company through active participation;
Take higher risks with the expectation of higher rewards;
Have a long-term orientation

When considering an investment, venture capitalists carefully screen the technical and business
merits of the proposed company. Venture capitalists only invest in a small percentage of the
businesses they review and have a long-term perspective. Going forward, they actively work with the
company's management by contributing their experience and business savvy gained from helping
other companies with similar growth challenges. Far from being simply passive financiers, venture
capitalists foster growth in companies through their involvement in the management, strategic
marketing and planning of their portfolio companies. They are entrepreneurs first and financiers
second.
Commitments and Fund Raising
The process that venture capital firms go through in seeking investment commitments from investors
is typically called "fund raising." This should not be confused with the actual investment in "portfolio"
companies by the venture capital firms, which is also sometimes called "fund raising" in some circles.
The commitments of capital are raised from the investors during the formation of the fund. A venture
firm will set out prospecting for investors with a target fund size. It will distribute a prospectus to
potential investors and may take from several weeks to several months to raise the requisite capital.
The fund will seek commitments of capital from institutional investors, endowments, foundations and
qualified individuals who seek to invest part of their portfolio in opportunities with a higher risk factor
and commensurate opportunity for higher returns.
Who Invests in Venture Capital Funds?
Because of the risk, length of investment and illiquidity involved in venture investing, and because the
minimum commitment requirements are so high, venture capital fund investing is generally out of
reach for the average individual. In addition, in order to operate within the exemptions from
registration afforded by the federal securities laws, most venture capital funds solicit only "accredited
investors."
Generally speaking, the following general categories of persons (or entities) are accredited investors:

Any natural person whose individual net worth or joint net worth with that person's spouse at the
time of purchase exceeds $l million;
Any natural person who had an individual income in excess of $200,000 in each of the two most
recent years or joint income with that person's spouse in excess of $300,000 in each of those years
and has a reasonable expectation of reaching the same level of income in the current year;

Certain banks, savings and loan associations, broker dealers, insurance companies, investment
companies, business development companies, and employee benefit plan;
Nonprofit organizations, corporations, and partnerships not formed for the specific purpose of
acquiring the securities and with total assets in excess of $5 million;
Any trust with total assets in excess of $5 million not formed for the specific purpose of acquiring
the securities, whose purchase is directed by a sophisticated person as described in the SEC rules;
and
Any entity in which all the equity owners are accredited investors.
Disclosure Requirements:
If offers and sales are made solely to persons a fund reasonably believes are accredited investors,
there is no specific requirement to prepare a comprehensive private placement memorandum. If one
or more sales are made to investors who are not accredited, a detailed private placement
memorandum must be prepared and distributed to all prospective investors in the offering, including
accredited investors. The preparation and distribution of a comprehensive private placement
memorandum requires extensive legal work and is a time-consuming and expensive undertaking. This
is one of the reasons many funds decide to sell only to accredited investors.
The antifraud provisions of the Securities Exchange Act of 1934, as amended, and comparable state
laws apply even though a funds offering is exempt from registration under the 1933 Act. This means
that while the registration exemption may not require a fund to prepare a private placement
memorandum, the antifraud statutes do require the disclosure to investors of all material facts
concerning the investment and contain onerous penalties for failure to make full and truthful
disclosure. A fund should keep a record of, and notes on, all documents given to offerees and should
avoid supplementing any such documentation orally; if it does, it should carefully make records of any
such discussion.
Investment Focus of the Venture Capitalist
Venture capitalists may be generalist or specialist investors depending on their investment strategy.
Venture capitalists can be generalists, investing in various industry sectors, or various geographic
locations, or various stages of a companys life. Alternatively, they may be specialists in one or two
industry sectors, or may seek to invest in only a localized geographic area.
Not all venture capitalists invest in "start-ups." While venture firms will invest in companies that are in
their initial start-up modes, venture capitalists will also invest in companies at various stages of the
business life cycle. A venture capitalist may invest before there is a real product or company
organized (so called "seed investing"), or may provide capital to start up a company in its first or
second stages of development known as "early stage investing." Also, the venture capitalist may
provide needed financing to help a company grow beyond a critical mass to become more successful
("expansion stage financing").
Length of Investment
Venture capitalists will help companies grow, but they eventually seek to exit the investment in three
to seven years. An early stage investment make take seven to ten years to mature, while a later stage
investment many only take a few years, so the appetite for the investment life cycle must be
congruent with the limited partnerships appetite for liquidity. The venture investment is neither a
short term nor a liquid investment, but an investment that must be made with careful diligence and
expertise.
The shares of stock a venture capitalist buys from a company are usually "restricted
securities." Restricted securities refer to shares of company stock that were not registered in a public
offering and consequently cannot be resold or transferred until certain events occur that exempt the
resale from registration or fulfill the registration requirements. Usually, the certificates for restricted
securities bear legends identifying the limitations on their transferability.

The reason that the shares of stock purchased by a venture capitalist are restricted securities is that
most companies rely upon exemptions from the 33 Act registration requirements when selling their
shares and thus do not register them. As a result, the venture investor cannot resell them without first
causing the company to either register the shares with the SEC and state securities commissions or
complying with an exemption to those registration requirements. It is for this reason that venture
investors look to other devices or exits such as Registration Rights or Co-Sale Agreements to enable
them to liquidate, or cash out.
Registration Rights
Registration Rights entitle investors to force a company to register the investors' shares of company
stock with the SEC and state securities commissions. This registration, in turn, enables the investors
to sell their shares to the public. Registration rights give investors liquidity by enabling them to free
their shares from the transfer restrictions imposed on unregistered securities by the federal and state
securities laws. Venture capitalists invariably require them as a condition of funding.
Registration rights come in two varieties: demand rights, which enable investors to require a
company to register their shares for sale in public offering any time an investor demands;
and piggyback rights, which allow investors to include (or "piggyback") their shares in a public
offering the company is already conducting. Most companies have no trouble giving an investor
piggyback registration rights as long as his rights are subject to the veto of the company's underwriter.
Giving such rights does little to disrupt a company's plans and does not require the special effort of
demand registrations.
Co-Sale Agreements
A Co-Sale Agreement is an agreement that requires management members to share any future sale
of their stock with the present investors. Sometimes referred to as tag-along provisions, they are
usually entered into at the insistence of the outside investors as a condition to their providing funding.
The purpose of a co-sale agreement is to prevent important management members from selling out
and leaving the investors "holding the bag." While co-sale agreements do not prevent management
shareholders from selling their shares at a profit, they do force them to share the benefit of their sale
with the investors by allowing the investors to include their shares in the sale.