How Venture Capital Works

7 min read

Not every new business requires venture capital investment.  Most businesses that succeed grow without taking on venture capital.

But some business owners, either immediately at the outset or later down the road, will decide to ‘raise funding’ to enable greater and faster growth.

If you’re considering venture capital for your business, you’ll want to understand how the venture capital industry works.

sandhill road

How Are Venture Capital Firms Structured?

Venture capital firms are usually set up as partnerships.  Venture capitalists are the general partners of the firm and manage the firm.

The money that venture capitalists invest in their portfolio companies comes from investors in the firm’s fund.

These investors–both very wealthy individuals and large institutional investors such as pension funds, university endowments, foundations, insurance companies, family offices and sovereign wealth funds–are limited partners of the venture firm.

The general partners of a venture firm will establish an investment fund, develop a prospectus describing the strategy of the fund and then reach out to raise money by having limited partners invest in the fund. Once the fund has been raised, the VC firm will begin investing in a portfolio of companies.

A successful venture capital firm will launch several funds over the course of its life. (If the firm is unsuccessful with its first fund, it will have much more difficulty raising a second fund.)

The average length of a single fund is seven to ten years.

Investments in portfolio companies are made over the first 2-3 years of a fund.  Returns on the fund are achieved over the last 2-3 years.

How Do VCs Invest?

Venture capital investment is a high-risk, high reward investing category.

Venture capitalists are equity investors.  They buy a percentage of ownership of the company in exchange for funds to help the company grow.  Because these investments are in private companies, the shares of the company are mostly ‘illiquid.’  That is, they cannot be sold on a public market the way shares of publicly traded companies can.

Therefore, VCs only make money once these companies ‘exit’ (also known as a liquidity event).  That is the only way for VCs to make a profit–so they are highly motivated to move their portfolio companies toward this quickly. A venture capital investment is not intended as a long-term investment.

VC firms are looking to invest in companies that have the potential to grow very quickly and ‘exit.’  A successful exit is usually either an IPO (initial public offering) in the public securities markets or an acquisition by a larger corporation.

The limited partners who invest in a VC fund are looking for high rates of return on their money–typically between 25-35% annually over the course of the investment.  They are looking for high returns with the funds they put into venture capital.

(It’s important to note that the limited partners aren’t actually involved in evaluating and investing in the portfolio companies.  That’s the role of the VC firm.  The limited partners are investing in the fund either because they believe in the approach or acumen of the general partners or trust them because of their track record of earlier successful funds.)

Furthermore, not all of the companies in a fund will succeed and exit successfully.  In fact, the majority won’t in a typical fund.  So, in order to hit the investment return levels necessary for their limited partners (and for their own ambitions), VC firms will typically focus on finding companies that have the potential for massive returns–10 times investment or more.

This minority of huge successes offsets the majority of smaller losses.

How Do Venture Capitalists Make Money?

Venture capitalists make their money in two ways.

The first route (and the most important one) is through the successful exits of their portfolio companies.  When a company exits, the profits are first used to pay back the investments of the limited partners.

After this initial payback, typically 80% of remaining profits go to the limited partners and 20% goes to the general partners (the venture capitalists).  Carry is the term used for the profit share that the General Partner of a fund receives when portfolio companies are sold.

The second way VCs make money is through management fees.  Typically, 2-3% of the money invested in a fund is used for the operating costs of the firm, including the salaries of the general partners.

An individual venture capitalist is usually awarded a percentage of profits based on the number of companies they are managing.  Success in the industry is built upon identifying, attracting and developing winners.

Do not underestimate the challenges and pressures facing VCs: they are attempting to deliver consistently high returns by investing in risky businesses that fail often.

VCs spend their time attracting new deals, reviewing business plans, monitoring and advising their existing portfolio companies, working on developing exits and raising additional funding.

How Are Venture Capital Investments Structured?

There are a lot of different details and options regarding the structuring of venture deals.

But the main components are usually determined by the venture capital firm’s desire to limit its risk, gain equity at a good price, gain a voice in management decisions and keep the option for additional future investment in the company (successful companies often raise several rounds of financing on the road to an exit).

Venture firms will usually try to have a liquidation preference in the deal. If the business does not succeed, the VC firm is given first claim to the company’s assets to recoup the value of their investment.  The firm receives priority over the founder and other management team members (and also other investors), who have common shares of ownership.

Venture firms will also have antidilution clauses (or ratchets) to protect their downside in case a later round of financing is done at a lower valuation.  The venture firm will be given enough shares to maintain the value of its ownership stake–increasing its percentage of ownership as necessary.  This also comes at the expense of other shareholders, including founders, management and other non pro-rata investors.

Venture firms will also try to limit their risk on single investments by co-investing with other venture firms.

Venture firms will also often try to include blocking rights or disproportional voting rights or board seats for themselves.  This assures a say in major decisions, including selling the company, raising additional funding  or choosing the time for an IPO.

The venture firm will also try to have ‘pro-rata’ rights, which give it the ability (but not the obligation) to invest additionally in future fundraising rounds if the company is successful (and investing in the company becomes more attractive and therefore more competitive).

A cap table is maintained as a breakdown of ownership stakes in a company through its rounds of financing.

cap table

How Do VCs Select Their Portfolio Companies?

Venture capital firms are very selective about investing. For every 100 business plans they review, they may only invest in one or two.

Raising venture funds is a challenge for most entrepreneurs in and of itself. (The exception to this is very successful entrepreneurs raising funds on a subsequent venture.)

Venture firms will determine the attractiveness of an investment (as they complete their due diligence) based on several considerations.

A potential investment must have the possibility for large and rapid growth.  Does your business potentially serve a very large market?  Is it in an industry with demonstrated rates of high growth in the near future?  There is a reason that much VC investment is concentrated in a limited number of industries such as software, biotechnology and energy.

A young company must also have a strong management team.  Outside of owning defensible and unique patents, most successful businesses are not founded upon a single great idea.  Success is dependent upon a smart, skillful and dedicated founder and management team.

A company must also line up with the interests or a particular firm.  VC firms typically limit the types of companies they invest in.  They will have a specific view and approach to investing–their investing ‘thesis.’ (This is also what helps the firm differentiate itself when raising funds from limited partners.)

Some VC firms will only invest in particular industries, such as biotech or B2B software.

Some VC firms will also typically invest only in certain stages of a company’s growth: seed, early, growth or late.

Some VC firms will have rules of thumb that favor certain investments over others (for instance, avoiding solo founders).

Is The VC Route Right For Your Business?

If you’re a business owner, your sources for funding generally come down to friends and family (for either loans or equity investments), bank loans, angel investors or venture capital.

Friends and family may not have the necessary funds or interest in investing or you, as the owner, don’t want to accept these funds even if they’re offered.

Bank loans can be hard for young businesses to secure, especially if they’re adopting a new approach to doing business.  These businesses are risky and banks can’t legally charge interest rates high enough to justify the risk of a loan.  Young businesses also frequently don’t have enough assets to secure these loans.

Angel investors can be another source of equity investments (and often invest prior to VC firms making a later investment).  But angel investors have typically been limited to making smaller-sized investments and often don’t bring the other resources to the table that venture firms do.

When these other sources of funding are unavailable or not the right fit, venture capital can be a good alternative.

If you choose venture funding, you’ll be ceding equity.  You’ll be trading away a significant portion of the company you are working so hard to build.  But you’ll also gain access to venture capitalists who can serve as experienced mentors and who have an interest in your business succeeding.

Successful venture firms can introduce you to their network for opportunities not only for staffing but also for potential customers.  And your business can gain the visibility and credibility that can come with investment from a recognized firm.

The entrepreneurs that succeed with VC funding often describe it as a true partnership that brought valuable intangibles to the table beyond the money itself.

Keep in mind thought that not all VC investments end up being great fits.  VCs have large demands on their time and if your business falters, attention and advice might end up being directed at other portfolio companies that are doing better.

It’s important to not just look at the money on the table, but to talk with other entrepreneurs and the firm itself and learn about their approach.

Perhaps even more fundamentally, you must decide if your goals align with the firm’s goals.  Remember, VC firms need very large successes to achieve their financial goals.

If your business starts to grow at a strong rate, would you be willing to take on extra risk (and cede more equity) to go for a ‘homerun’ exit?  Some VCs might pressure you to do this, even if you’re happy with a more modest success.

When you take on venture capital, you’re taking on other voices in the direction of your business.

2018-08-14T13:17:52+00:00
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