Chronicles of Baby VC: How modern VCs work
In the previous article, we went through the history of Venture Capital, how it has been propelling human ingenuity and bold visions for centuries under different names, and when you might want to contact a VC. In this article we go more into details about how modern VC funds work.
The same way ancient VCs were investing into risky high reward voyages across the globe, modern VCs invest in their modern equivalent; high growth technology companies that have the potential to take whole industries and humanity itself by leaps and bounds into the most exciting voyage of them all; one into the future!
🏗 Structure
To best understand how VCs work, we need to start by following the money. Where do they get the money they invest in startups from?
To answer that, we must look at the structure of VCs. A typical VC Fund consists of two* main entities:
- Management Company
- Limited Partnership
The management company is what you usually think of when you first hear of VCs. These are companies like Sequoia, Bessemer, Senovo, whose job is to analyse and invest in startups. It is usually owned by the partners and hires all the analysts and associates you would meet on your fundraising journey.
The Limited Partnership vehicle includes all the investors, whose money the startups get at the end. These could be pension funds, large corporations, banks, family offices, and even charitable organisations. The money commited by Limited Partners(LPs) is called a fund. A management company can have multiple funds.
😍 Incentives
VCs are driven by sense of adventure, love of technology, and a dream of a better future. However, we still have to keep the lights on, pay the bills, and buy cakes to entrepreneurs when they come visit us. So, how what are the financial incentives of a VC?
The model usually goes like this. The management company raises a new fund every 4–5 years. During this phase, the partners of the management company go to LPs, show them their track record, and convince them to commit money to the new fund. This means that when a VC fund raises a $100M fund, the money is not actually there on their bank account, but rather that when they need to invest in a startup, the money will be transferred by the LPs.
A fund usually has a limited period of 10 years and has a special focus. This focus can be on a certain startup stage; pre-seed, seed, series A, etc and/or special industry, geography, or mode of distribution. At Senovo for example, we focus exclusively on early stage European B2B SaaS startups.
During the lifetime of the fund, the management company would filter through thousands and thousands of startups, searching for those special ones, that we fall in love with and then support with everything we have got. During this time, the main source of income for the VC is what is known as “the management fee”. This is usually around 2% of the fund size every year, and covers all the expenses of the VC; salaries of employees, office expenses, etc. So if a VC has a $100M fund, then they will get $2M every year to cover their expenses.
After the fund’s lifetime, most of the startups that a VC has invested in, should have reached maturity by then and had their exits. This is usually either being acquired by a big corporation, or being listed in the stock market through an IPO. The management company would then return to the LPs their money back, and 80% of the profits. The 20% are known as carried interest and goes to the management company itself.
As you can already guess by now, most of the profit a VC makes is actually from the carried interest, which means that a VC has to be very picky when choosing a startup, which is sustained by the fact that less than 1% of startups get venture funding.
It also means that every single startup in their portfolio, has to have the potential of returning the whole fund; at least give their LPs their money back. Think about it this way. If a VC has a $100M fund, and they know that 9 out of 10 startups fail. What would be the best strategy to follow?
A simple sound strategy would be the following. Choose 10 startups, which are worth $100M each. Give each of them $10M to acquire 10% of them. Each of these startups should then have the potential to at least become a billion dollar company, such that if 9 of them fail, and only 1 succeeds then your 10% already becomes worth $100M and you can at least give the LPs their money back. The more successful startups you choose, the more profits you and the LPs get to have.
Of course this is a very simplified example, and what happens in reality is much different, as you mostly end up with one dominant startup, that makes huge returns, such that it doesn’t really matter much how the other startups perform. But that is a conversation for another time.
The conclusion here is clear. VC money is for VC businesses. If you are planning to provide a commodity product or service like a supermarket, laundry, consultancy, or even a different flavour for a software that already exists. Then there are other ways to get your business running.
But if you have a technological edge, or are creating something new that can make you a dominant player in your industry, then VC is the right call for you!
*In reality a VC Fund consists of three entities, the third being the General Partnership, which is just a legal entity acting as general partner to the fund and usually owned by one of the managing directors of the management company on a fund by fund basis
Originally published at http://omarhedeya.com on November 7, 2021.
