Introduction to Venture Capital (Part II)
The Basic Concepts of VC — VC in Practice
The previous article — Introduction to Venture Capital (Part I) — discussed the previous article introduces VC and venture industry. Next, this paragraph will focus on, in practice, how the VC works by understanding the phases and the main tasks that the VC faces in each stage.
How VC Works
(1) Six Stages of VC
(2) The VC Fund Structure
Investment & Growth
(3) How Do VCs Choose Startups to Invest in?
(4) Why Do VCs Get Involved in Startup Operations?
(5) VC in Industry Sectors
(6) The VC Valuation Method(1) Six Stages of VC
VC works in six stages: fundraising, investment, growth, exit, returns, and re-investment. The first step for VC firms is to raise funds from limited partners (LPs). Then, VC firms make investments in high-growth companies in need of capital, screening start-ups for investment opportunities. During this stage, VC firms also help drive growth by acting as board members and advisors, providing strategic advice and making introductions.
After about 5 to 10 years, the goal of achieving a return is reached and the VC firm exits their investment, often through methods such as merger and acquisition (M&A) or initial public offering (IPO). However, if the investment is not successful, the VC firm may write it off. Both the VC firm and LPs benefit from the investment, and when all investments have been exited and the funds are terminated, proceeds are distributed to the LPs, who can then reinvest in new funds.
(2) The VC Fund Structure
VC funds have two main partners: general partners (GPs) and limited partners (LPs). The GPs are responsible for managing the funds, while the LPs are the primary funders.
VC firms raise funds for investment through their GPs, who have access to large pools of capital and are able to connect with investors and encourage them to invest in the fund, even though they do not contribute much to the pool. GPs raise funds for investing in their portfolio companies and diversify VCs’ investments.
The primary investors in the fund are LPs, who are individuals or institutions with capital looking to generate a high return on investment. The prospect of a high return motivates them to contribute to the fund.
While GPs also contribute funds, their contribution is typically smaller compared to that of LPs. Therefore, the LPs are the primary investors in the funds and receive the majority of returns generated from the investments. They play a critical role in making VC firm operations possible by providing significant portions of investment capital.
(3) How Do VCs Choose Startups to Invest in?
VC firms usually invest in startups that have innovative technology or business models but are typically illiquid and worthless. To identify the potential for growth, VC firms consider several factors when evaluating startups for investment.
A 2016 survey of 889 VC professionals at 681 firms revealed that team, business model, product, market, valuation, fit, ability to add value, and industry are all important factors that venture investors consider when evaluating investments in startups.
(4) Why Do VCs Get Involved in Startup Operations?
VC firms typically own a significant stake in startups and hold a seat on the company’s board. Additionally, they often provide strategic and operational guidance, expert management, and technical support.
VC firms‘ competitive advantage is the expertise and guidance they provide to the entrepreneurs in their portfolios. VC partners are actively engaged in helping the startups in their portfolio succeed, which not only helps increase the chances of success but also ensures a high return on investment for these high-risk, high-return businesses.
(5) VC in Industry Sectors
The most popular sectors for VC investment as of 2022 include software, commercial products and services, and consumer goods and services, with a particular emphasis on fintech software.
In 2022, according to CB Insights, the sectors in the spotlight for VC investment were fintech, retail tech, and digital health. Global fintech funding decreased by 46% YoY to $75.2B. Retail tech funding dropped by over 50% YoY to $52.9B. Digital health funding saw the largest YoY decline among sectors studied, plunging by 57% to hit $25.9B across 2,122 deals in 2022.
(6) The VC Valuation Method
The VC Valuation Method was introduced in 1987 by Harvard Business School. This approach is common in venture capital since comparable company analysis and discounted cash flow (DCF) methodologies have limitations for start-ups. Given graph shows the VC Valuation Method, comprised of six steps:
In this case, for its Series A investment round, a start-up company seeks $8M. By Year 5, the start-up is expected to generate $100M in sales and $10M in profit. The VC firm plans to exit by the end of Year 5 to return funds to investors (LPs). Comparable companies are trading for 10x earnings, implying an exit value of $100M ($10M x 10x).
Here, the discount rate is assumed to be the VC firm’s desired rate of return of 30%, which is applied to the DCF formula: $100M / (1.3)⁵ = $27M, known as the post-money value. You can then get the $19M pre-money value by subtracting the initial investment amount, $8M.
Finally, an ownership percentage of approximately 30% can be calculated by dividing the $8M initial investment by the $27M post-money valuation.
In a pre-money valuation, the company’s value is based on the capital it had before the financing round, whereas a post-money valuation includes all the new investments made after the funding round. Furthermore, in addition to evaluating whether EPS is increased or decreased following a transaction, an accretion/dilution analysis can be conducted.
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Click here: Introduction to Venture Capital (Part III)
