3 types of transactions in venture capital

Venture Capital is a complicated business with a lot of things on its plate.

However, yesterday, during our team dinner one interesting idea that was circulated by Michael that can simplify what venture capital is all about.

In most business, there are usually 2 types of transaction:

  • buy services of a counterparty, this creates costs
  • sell value-added service or product to your clients, this creates revenue.

This applies almost of all of the companies.

In a case of venture capital, the there is also a third type of transaction, let’s review:

1. Investing into a start-up:

This is the simplest of the transactions, as there are many startups, most of which require funding. Just as in typical businesses it creates investment costs for the fund. Everyone can spend money.

2. Exiting from a start-up:

This transaction is a way harder than the first one, as it requires larger PE funds or strategic buyers to put their own capital and they do have quite a high opportunity cost to invest elsewhere. Typically, to be successful at accomplishing this type of the transaction you have to create an auction and this usually if a start-up has a unique competitive edge over the competition, a growing monopoly is an ideal case.

3. Limited partners committing into the fund.

The third type of transaction is the hardest one. In the first two types, the buyer or the seller sees an immediate value, be it growing revenue and hence value in first one or receiving cash. Commitments by limited partners to fund on the other hand are very long-term in nature with cash locked-in for several years, sometimes even a decade. That is why in order to close a fund, you are successful only if least a dozen investors at a single point in time express sound interest before you can close and a hurdle effect plays a big role here. Lining up and closing professional money whom person respect, trust and follow is a skill which often requires heavy of negotiation tactics and plenty of skill.

If you can succeed at nailing those 3 types of transactions, then you have cracked the VC business model and will enjoy economic freedom for quite some time.