Venture Capital 101: Everything You Need to Know
March 03, 2022
Venture capital is an elaborate topic that can be divided into several groups and categories. There is a handful of aspects associated with it and in this article, you will find out everything there is to know about venture capital and its intricacies.
To begin with, let's establish the difference between venture capital firms and venture capital funds.
Venture capital firms
Venture capital firms are organizations directly related to investing. They raise money from a multitude of sources, such as:
- Family offices: Family offices are private firms that provide financial services to one or several exceptionally wealthy families.
- Institutional investors. Institutional investors, such as pension funds, are organizations that invest money on behalf of others.
- High net worth individuals (HNWI). Individuals who have liquid assets over $1 million and allow VC firms to control their investments.
Broadly, the mentioned sources of money, also known as limited partners (LPs), invest in VC funds expecting a specific percentage of ROI.
Venture capital firms are organizations directly related to investing who raise money from family offices, institutional investors, and high net worth individuals.
There are different investment theories, theses, and practices across VC firms, that determine the investment size for any single startup. The essential roles that establish those practices are the management teams, market opportunists, business planners, and risk analysts. For instance, one thesis could be funding early-stage startups in the IT industry located in San Francisco. The same formula could apply to startups in later stages, different industries, or locations.
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VC firms not only provide promising companies with venture capital financing but also provide portfolio companies with advice, connections, and other additional resources that could be useful to startup founders.
How do VC firms make money?
VC firms make money by charging management fees and carried interest from limited partners, which is a percentage of the profits made from investments.
The standard procedure for the fees is based on the 2-20 model. Two stands for the 2% annual management fee of the total fund size. Twenty refers to 20% of any profits that the fund makes.
However, some exceptional VC funds implement the 3-30 model and justify it with their impeccable track record and high returns.
Venture capital funds
A venture capital fund is an accumulation of money provided by a number of investors who give the money to well-versed fund managers. In turn, the fund managers select a portfolio of promising startups and invest the money in them with a goal to gain competitive ROI.
VC funds are relatively large in size; they could vary from several million to billion dollars across different firms. Usually, the funds are not given to a single company; rather, they are distributed across many startups. However, some VC firms decide to invest their entire fund in one company.
Management of VC funds
VC fund managers are typically known as general partners (GPs). A general partner is a co-owner of a VC firm who is actively involved in the operations and shares the profits.
General partners' responsibilities are as follows:
- Raising money from limited partners;
- Finding promising companies;
- Conducting due diligence;
- Investing VC funds in bright startups;
- Maximizing profits for limited partners;
- Providing not only money but also advice and help to funded startups.
A venture capital fund is an accumulation of money provided by a number of investors who give the money to well-versed fund managers, typically known as general partners.
Pros and cons of investing in large VC funds
While investing in a large venture capital fund that has more capital than most others could sound promising in terms of future results and investment opportunities, those large funds also have their disadvantages. Below you will find a comparative list of pros and cons of investing in huge venture funds.
- Highly experienced venture capitalists manage your money;
- Diverse investment portfolio and multiple funds;
- The fund is able to deploy additional funding in successful companies;
- The funds usually go to later-stage startups to decrease the risk of failure.
- Large VC funds sometimes fail to deliver highly competitive returns due to more deployable capital than promising startups to fund;
- Sizable funds avoid investing in early-stage startups because of the high risk associated with it, missing out on the high reward potential.
As a result, it's important to set your priorities straight before deciding on the size of a fund you're looking to invest in. If you're more into consistency and (somewhat) assured profit, large-size funds would be the option to go; if you're more adventurous and a risk-taker, smaller funds that invest in early-stage startups could be your preferred option.
The brief investment process
There is a general tendency to diversify and distribute the VC funds between multiple startups and industries. There is no secret that 9/10 startups fail; therefore, it's important to implement the aforementioned strategy to improve the chances of landing on that 1/10 startup that will compensate the losses spent on failed startups.
Venture capital funds generally work under the following formula:
- Investment in startups lasts 2-3 years;
- Deployment of the capital lasts up to 5 years;
- Capital's return to limited partners is expected within 10 years.
The main reason behind this VC investing is that startups usually don't explode overnight. It could take years before the startup grows into a highly profitable company.
Venture capital returns
If the investments in successful startups provide better returns than the accumulation of losses from failed startups, investors profit from the VC fund. The interesting dynamic in VC investments is that one successful startup can compensate for the losses of many failed ones.
Internal rate of return (IRR)
Internal rate of return refers to the annual percentage of returns that portfolio companies or funds have generated throughout the entire length of an investment. As a result, higher IRR signals that the investment performance is better and vice-versa.
IRR consists of the following:
- Size of the investment;
- Cash flow expectations from the investment;
- Timing of cash inflow and outflow.
Generally speaking, the success of investing in VC funds lies in the selection of the venture capital firm. Top VC firms that have access to some of the best startups out there are safer to invest in since the highest returns are generated in the top 25% of funds.
The IRR preferences differ according to the stage of the startup. For instance, general partners investing in seed-stage startups should seek an IRR of at least 30%, whereas later-stage startups are less risky and the optional IRR for those is 20%.
Why VC funds?
Startups rely on venture capital funds because instead of returning the money in case of failure, they guarantee an equity stake in case the startup succeeds. It's the perfect solution for startup companies that require additional capital in order to scale the business over time.
There are two main types of investors that invest in startups: angel investors and venture capitalists.
An angel investor invests with their own money and isn’t concerned about the returns whereas a venture capitalist invests from a VC fund and expects a significant amount of returns in case of success.
Considering other ways to get funds, for instance, private equity firms mostly deal with companies that are already well-established and seek to buy them out.
Traditional loans require collateral that cannot be guaranteed in most startups. Even if they had collateral, repaying a huge debt after the business fails is a heavy burden to take upon yourself. Furthermore, the vast majority of startups don't have the qualities to be eligible to take out a loan in the first place. And the minority that does, faces rather uncomfortable terms: high-interest rates, late payment fees, warrants, and other aspects that diminish the desire to get a loan.
Venture capital firms do not invest with the obligation of reclaiming the money which is a win-win situation for both parties. Even if some startups fail and the VC fund loses money, it's still likely to land on a deal that will compensate for the losses.
However, if the startup becomes extremely successful, it will pay a lot more than it received. On the other hand, the startup most likely wouldn't have made it without the investment so it can still be considered a fair trade.
VC firms are optional choices for startups because they provide the startup with funds and advice without demanding the money back in case of startup's failure; instead, the VC firm generates returns that compensate for previous losses when a funded startup succeeds.
There is a general formula in terms of VC funding rounds: Pre-seed stage, Seed-stage, and Series A-F.
The different stages receive different funding amounts:
- Pre-seed stage startups receive funding of around $200 to $500k;
- Seed-stage startups receive around $1 to $2M;
- Series A-F stage startups receive progressively increasing funds starting from $3 to $5 million and going significantly higher.
The stages are defined by the startups' performance and demonstration of results.
Ultimately, there are a few factors in play when it comes to the endgame of VCs and startups: profit, recognition, impact on the world, and other values depending on the investor.
To share in the first aspect, profit, the funded successful startup must make an exit. Making an exit refers to cashing out either through mergers and acquisitions (M&A) or initial public offering (IPO).
Mergers happen when two or more companies merge into one entity. However, mergers are quite scarce in startup companies. It usually takes two already established companies to perform a merger.
Acquisition refers to a large company buying out a smaller one. It's a more favorable approach for startups. Some large companies want to streamline their product building process and, therefore, they buy a smaller startup that tackles the same problem.
Initial public offering
IPO essentially happens when the startup starts selling its shares to investors outside of the fund that supplied the supporting capital. IPO is a more complex process that entails quite a number of aspects, but the fundamental truth is as mentioned before.
The capital markets don't stay stagnant; they change all the time. Nonetheless, the fundamentals of VC remain. VC firms are the accelerators of startup companies that provide them not only with money but also valuable advice that helps the startups succeed and make an explosive impact on the industry market.
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