What is Venture Capital?
Ever heard of Google, Facebook, Amazon, or Uber? These are all very successful Venture Capital backed companies. So, how does the Venture Capital industry work? Whose money do they invest? How do they make money?
(Note: This is for people with limited or no knowledge of VC)
Venture Capital can get very complicated, but in general, there are three major players in this space: Limited Partners (aka LPs), Venture Capital Firms (aka VCs), and startups (aka Portfolio Companies or Portcos).
The model works like this:
- An LP gives money to a VC firm with the expectation of at least getting returns better than the stock market
- A Startup needs funding to grow exponentially and capture a major share of the market or develop an entirely new market. They take money from a VC firm in exchange for equity in their startup
- A VC firm takes money from LPs and invests that money in promising startups. When these startups exit, a VC firm takes a cut of the profits and returns the rest to LPs.
More details are below.
Let’s start with the Venture Capital Firm. The primary goal of a VC firm is to raise money from LPs (more on them later), invest it into promising startups, and provide above-market returns to the LPs.
A VC firm starts by convincing LPs to invest money into their Fund. Once a fund reaches a specific threshold (a 10M fund or 100M fund for example), the VC firm starts looking for startups to invest in. It’s worth noting that VC firms don’t invest all of the capital raised into startups, some of the money is used to pay the VC firm's administration fees (typically 2% annually).
Each fund has a lifespan (typically 10 years) in which a VC firm needs to generate returns for their LPs. The majority of the fund is invested into startups within the first couple of years and the remaining funds are saved to re-invest in the best-performing startups in the later stages of the fund.
If the first fund does well, the VC firm will raise another fund (Fund B in the image). This can have the same LPs as before and potentially more if the VC firm can prove its success. This can continue indefinitely (the oldest VC firm is more than 100 years old).
Next, let's talk about the LPs. These are corporations, university endowment funds, pensions, governments, individuals, and any other entity that’s looking to invest their assets.
If you have massive amounts of money to invest, first off congratulations! But, now you face a very good problem — where do I invest it all? Some of the most common options are the public stock market, bonds, real estate, hedge funds, LBOs, or Venture Capital. So why invest your hard-earned money in Venture Capital?
- Returns in venture capital can often beat other asset classes (dependent on industry, overall market, and quality of VC fund)
2. Investing in Venture Capital can be a part of a diversified portfolio. The Yale University endowment fund, perhaps one of the best-known LPs, allocates approximately 20% of its assets to Venture Capital
3. It allows you to invest in startups addressing an area you’re passionate about — think climate and/or social equality.
Finally, let's talk about the startups themselves. There’s a key distinction between a VC-backed startup and a small business. A VC-backed startup needs to be able to grow exponentially fast and reach a large customer base (a local barber shop is a small business, but an online booking system for self-care, including haircuts, can be a VC-backed startup).
Startups need a lot of capital. They need to hire talent, develop their products, grow their customer base, and so much more. To get the money to grow, they get money from a Venture Capital firm and in return, they give up equity in their company (think shark tank). For example, a startup could get $5M from a VC in exchange for 20% equity (meaning the overall value of the startup is $20M of which $4M belong to the VC).
An investment in a startup is not liquid. This means you can’t buy/sell shares like you would with other publicly listed stocks. For a VC or any investor to get money for the shares they own is for the startup has to “exit,” which is typically an acquisition or an IPO.
- An acquisition exit is when a startup is bought out by another firm. The new firm buys the shares of the new firm from the existing shareholders, finally giving the original investors an avenue to sell their shares. For example, in 2014, Facebook bought WhatsApp for $22B, which allowed Sequoia Capital (a renowned VC firm) to get a return of $3B from an investment of $60M.
- An IPO exit is when a startup grows large enough to IPO on the public stock market. During the process of an IPO, the existing shareholders get a chance to sell their shares. A great example of this is Uber, which was a VC-backed company that IPO’d recently.
Until an exit, a VC gets no money from the startup. There are methods to quantity what the investment is worth on paper, but there is no return on capital until an exit.
When a startup exits, all the value is given back to the shareholders — the VC investors, founders, friends, and family. Of the money returned to the VC firm, a majority goes back to the LP (typically 80%), and the remaining stays with the VC (typically 20%). See the image below for more details.
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