How venture capital works part II
Venture capital and fundraising
In this part I will try to explain what I learned about raising money, angel investors, venture capital funds, private equity, how they operate, which functions they fulfil.
They are rich individuals, people who have built successful companies and sold them off and who want to actively manage their own money. They also can be former managers who are looking for new challenges. Often they have a very specialized knowledge in one domain. They can be good fit, because they have often have experience in the sector they are investing in, though often their capabilities are limited (looking at raising new rounds or helping you hire new people). Be careful, some of them just want to invest money but have no idea of how business really works (think rich dentist).
Venture Capital Funds
A venture capital firm invests money in startups for equity. Usually a venture capital firm raises money from multiple institutional investors for a fund and then invests in multiple startups with this money. I will explain in detail how they work, so it becomes clear which motives they have. The most common model is the 220. The management company takes 2% management fee per year, and 20 percent of the profit, the “carry”, at the end of the fund which typically lasts 10 years. They are expected to perform at a rate of 4 to 5 times net of the invested money.
Ok, let's pause for a moment, what does this timeframe mean for the venture firm? Within 10 years, they have to go through the process of getting stakes in valuable companies, hold them for some time and sell off their shares before the 10 years are over, so they can return the money to the investors.
These funds can have different sizes, ranging from 20 million to the lower billions.
Often they also invest focused on an industry sector and depending on the size of the fund also focused on the company stage (Series A, B, C).
Typically a fund is invested in around 20 companies with different but similar investments. The fund is run by it's partners, they share the profits of the fund and vote on which investments should be made.
By Urbanrenewal (Own work) [Public domain], via Wikimedia Commons
We opened a 220 venture capital fund and raised 100 million with a 10 year runtime. A return of 5 times is expected. How much money do we have to generate in order to satisfy our investors?
2% are 2 million per year for ten years are 20 million. Additionally, 20% "carry" of the prospected 500 million go to the managers at the fund's end. That's are a hundred million, but we have to return 5 times net to our investors, so we need to earn more money. In total we have to earn 620 million. Half of all startups of the portfolio in a fund usually fail, so a company now has to make 12x to to be profitable for the fund. Or at least it must have the potential to make it. So if I, as a manager, invest 5 million in exchange for 30% shares (I am making numbers up now), then it has to be able to return me 60 million after a maximum of 10 years, the faster the better. If a company grows that fast, it needs money, a lot. That means another investor will come on board and thus dilute my shares, so I will end up with around 10-15% of the company. Let's assume 10% for the sake of the argument. So I invested 5 million and I expect 60 million return. If I own 10% at the time of sale, the valuation of the company should be around 600 million.
How VCs select companies
This is highly subjective and are more thoughts of how I think things work than empiric evidence. What I heard from one venture capital partner was this: First of course, checksize, sector, stage and geographic location preferences of a fund and a company must align, but after that there are some simple truths. The team is more important than the idea. If the people behind a project are not 100% motivated and committed to the company, there is 0 chance a VC will invest. They have to like you and get along with you, you will be working with them intensively for a couple of years, so this makes perfect sense to me. Also, the company should have some traction, paying customers and a viable product. As mentioned before the market has to be big enough to be able to create a multimillion dollar company, otherwise the investments makes no sense for the fund.
What are they good for?
VC funds are no charities, if they will give you money, they will make sure to get the most out of it from you. In my eyes th is a crucial thing to keep in mind when dealing with them. What will I really get from them, if it is only money, it is probably not a good deal. They have been in this game, the startup world, far longer than you. They know every trick and have dealt with situations, which are completely new to you multiple times. They know how to handle them and how to handle them in a way that is advantageous to them. I don't want to paint a picture of greedy gruel capitalists, but on the other hand: Money makes the world go round. They will vote you out of your own company if the have to and they will make sure they have the power to do it.
So what's good about them then?
Of course they have their legitimation and there are extremely good reasons to take money from them. First and foremost, money enables growth, a small stake of a bigger pie is always nice than a big piece of a small pie. VCs have extensive networks, and once they are invested in you and you can show progress, once the next round comes up to raise, it will be easy, they have a lot of contacts and access to people which can help you. They can also help you with recruiting
Here come the big players. They take money from superrich individuals and huge corporations and invest it. Their customers have one big problem, they have so much money, that it is difficult to put it to work, they need to employ people to actively manage their money, thus private equity. They make up the top of the elite of professional investors, they have all the right tools and people. They are able to bring in right people for key C-letter (i.e. CEO) positions. Depending on their incentives they will either lead very big rounds and get you ready for IPOs or sell you off to large companies, if you fit in their portfolio.
As one can see there are multiple ways of getting funding for a company. Each of them is definitely stage specific and bears it's advantages and disadvantages. Next time I will try to explain how the process of selling a company works and how to value a company.