The Venture Capital Lifecycle
This article provides a short introduction of venture capital, what it does, how it works and how the VC timeframe matches that of the entrepreneurs.
Purpose
The purpose of Venture Capital (VC) is to help young companies by providing capital in exchange for equity[1]. The companies that seek VC funds usually find it difficult to attract funds from other sources such as banks[2] , which need collateral; something that is not available at the early stages of a startup. Investing in these companies is high-risk but can potentially be very profitable for the VC firms and their investors. A VC company will not invest in a startup if they do not believe that they can get a decent return rate. This can be around 20%-30% for early stage companies and 10%-15% for the later ones[3].
There are many advantages for being a VC-backed company. According to Hellmann, Puri, and Da Rin[4], companies that receive VC funds appear to:
- grow faster,
- adopt more professional roles and structures earlier and
- be more likely to have a successful exit (M&A-IPO)
How VC it works
One question that many have is “Can I become a VC? Can I raise a fund?” The answer is yes, but it is important to know how the VC industry works. VC belongs to the greater Private Equity category with the difference that they focus on the early stages of a company. These VC firm are small, flat organisations[5] that gather a sum of capital, called “investment fund” or “fund” and is used to invest in startups. The fund is gathered from other investors, called limited partners (LP’s) that are usually large institutions such as pension funds or universities. So for someone to become a VC he needs to (a) be able to raise funds from investors and (b) able to find and invest these funds into startups.
The fund duration is usually 10–12 years, at which point the profits and the initial capital of the fund are returned to the LP’s. To cover expenses, the VC firm receives an annual management fee (typically 2% of the fund) and at the end of the fund a share (typically 20%) of the profits (called ‘carry’)[6]. When the fund is created the fund manager contributes a small percentage (1%-2%) to it. This is being done to show that the VC is taking a similar risk as the investors[7].
There are two ‘agency’ relationships in venture capital. The first one is between the VCs and the LP’s the second one is between the VCs and the startups[8].
The Venture Capital Startup Lifecycle
Before they jump in, entrepreneurs have to take into account the phases of the investor’s investment cycle. Three phases can be distinguished in the VC investment cycle[9]: the pre-investment, post-investment, and exit. The table below presents in more detail the main activities in each phase for both the entrepreneur and the VC.
The pre-investment phase
In the pre-investment phase, it is all about the deal. The investors and the entrepreneurs are trying to find, filter and impress each other with their ideas and resources. Gompers et al. (2016) find that 30% of deals are created through VC professional networks and 20% from other investors meaning that being in the VC circle is important. Once the deal is sourced and screened then the contract is created (called “term sheet”) that defines the exchange (funds for equity). The pre-investment phase is repeated in every round as startups are in need of capital and VC’s in need of startups to invest.
The post-investment phase
This phase is all about execution. The entrepreneur is focused on operating the startup and delivering on the promises that were made in the deal structuring cycle. Moreover, the entrepreneur has to think about the next funding round, especially if there is not enough traction to support the business. The VC has to provide value-added help, such as mentoring, hiring, introductions and/or raising media awareness but the primary role is to monitor and verify that everything is going as planned. The lead VC’s take a seat on the board of the company and are involved more firmly in the monitoring, and the value added.
The Exit
Exit occurs[12] when the venture[13] [14]:
- Goes public (IPO)
- Is being acquired (M&A)
- Is buying back the VC’s stock; or
- Is being liquidated (write-off)
VC firms have to exit their investments, as they have to return earning to their LP’s. Most common successful exits are that of IPO and M&A while the buyback is not that often in the early stages. Although the VC’s leave after a successful exit, that is not always the case for the entrepreneur who is directly tied to the well being of the startup. Finally, in the case of the write-off the startup ceases to exist and the proceeds, if any, going to the VC after creditors have been paid off.
Note: This article has been appeared first in www.whydotheyfail.com. It is based on the research for the project and dissertation named “Venture Capital failures. Why VC backed start-ups fail and how can we improve the failure rate” that was submitted to Warwick Business School on 05/03/2018 by Kostakis Bouzoukas.
[1] Gompers, P. and Lerner, J., 2001. The venture capital revolution. Journal of economic perspectives, 15(2), pp.145–168.
[2] Myers, S.C. and Majluf, N.S., 1984. Corporate financing and investment decisions when firms have information that investors do not have. Journal of financial economics, 13(2), pp.187–221.
[3] http://www.industryventures.com/2017/02/07/the-venture-capital-risk-and-return-matrix/
[4] Hellmann, Thomas F., Manju Puri, and Marco Da Rin. 2011. “A Survey of Venture Capital Research.” NBER Working Paper №17523. doi:10.3386/w17523
[5] De Clercq, D., Fried, V.H., Lehtonen, O. and Sapienza, H.J., 2006. An entrepreneur’s guide to the venture capital galaxy. The Academy of Management Perspectives, 20(3), pp.90–112.
[6] Gompers, P.A. and Lerner, J., 1999. What drives venture capital fundraising? (No. w6906). National bureau of economic research.
[7] Sahlman, W.A., 1990. The structure and governance of venture-capital organizations. Journal of financial economics, 27(2), pp.473–521.
[8] Casson, M. ed., 2008. The Oxford handbook of entrepreneurship. Oxford University Press on Demand.
[9] Tyebjee, Tyzoon T., and Albert V. Bruno. 1984. “A model of venture capitalist investment activity.” Management Science 30(9): 1051–1066. doi:10.1287/mnsc.30.9.1051
[10] Adopted from De Clercq et al. (2006)
[11] Tyebjee and Bruno, 1984
[12]MacIntosh(1997) also mentions the possibility of a secondary sale, in which only the VC’s shares are sold to a third party.
[13] De Clercq, D., Fried, V.H., Lehtonen, O. and Sapienza, H.J., 2006. An entrepreneur’s guide to the venture capital galaxy. The Academy of Management Perspectives, 20(3), pp.90–112.
[14] MacIntosh, J., 1997. Venture capital exits in Canada and the United States.