This post will tell you all the basics you need to know about venture capital. If you have questions, feel free to email me at email@example.com.
This is the fourth post of study notes from the Insider’s Guide to Silicon Valley Investing program with Stanford University and 500 Startups. This part was taught by Mike Lyons and Pedram Mokrian. This is one of the longer posts.
What Is Venture Capital?
Venture capital is equity financing, where an investment partner sits along side the entrepreneur and assists in strategically MANAGING RISK associated with building high potential, fast growth and capital efficient companies.
Venture capital is NOT:
- Rich people spreading money in outlandish and risky ideas
- Corporations seeking out ideas to steal and build on their own
- Highly structured financial transactions
- Debt or buyout equity capital with majority ownership
Bottom line: You shouldn’t structure your way to returns (because you can’t).
Three Types of Venture Capitalists
A good venture capitalist is a thoughtful, experienced ally, who sits along side the entrepreneur as a partner and a mentor, knowing full well that their fate is intertwined. Most venture capitalists fall into the following three types — domain expert, operator or networker. A domain expert is someone who’s deep into a certain field and knows everything going on in this industry. An operator, or a growth expert, is someone who has a track record of growing and scaling a company. A networker is someone who can make important intros to domain experts, operators, or your next investor.
The Venture Fund Structure
The image on the left is the structure of a private equity fund, but the idea is the same.
Venture Fund is the main investment vehicle used for venture investing. Each is structured as a limited partnership governed by partnership agreement covenants, of finite life (usually 7–10 years). It pays out profit sharing through carried interest (about 20% of the fund’s returns).
Management Company is the business of the fund. The management company receives the management fee from the fund (about 2%) and uses it to pay the overhead related to operating the venture firm, such as rent, salaries of employees, etc. It makes carried interest only after the Limited Partners have been repaid.
Limited Partners (LPs) is someone who commits capital to the venture fund. LPs are mostly institutional investors, such as pension funds, insurance companies, endowments, foundations, family offices, and high net worth individuals.
General Partner (GP) is the venture capital partner of the management company. GPs raise and manage venture funds, set and make investment decisions, and help their portfolio companies exit, because they have a fiduciary responsibility to their Limited Partners.
Portfolio Companies (Startups) receive financing from the venture fund in exchange for shares of preferred equity. The fund can only realize gains if there is a liquidity event (such as mergers and acquisitions or IPOs) and these shares can be converted to cash.
Three Investment Funds Types
1. Focus on Stage (early, mid or late). Later stage means large capital requirement and decreasing risk and return. Most big funds have to go late stage because of their fund size.
2. Focus on Geography. Some dedicated regional funds focus on prevailing market dynamics, i.e. 500 Startups has the 500 Kimchi fund for South Korea.
3. Focus on Sector. Popular industry sectors include med-tech (Incube Ventures), biotech, IT, greentech (Nth Power, Tech Partners), etc.
How Returns Are Generated
As we mentioned before, venture funds can only realize gains if there is a liquidity event (aka “exit”), which generally means one of the following three situations:
1. Share Purchase: A buyout of an investor’s position via a new investor looking to buy ownership or the company repurchasing stock.
2. Acquisition (M&A): Strategic acquisition by an incumbent who is buying a differentiated technology, a large customer base, a rockstar team, or some other combinations. Google, Facebook, Yahoo, j2 Global and Microsoft are among the top buyers in the tech space.
3. Initial Public Offerings (IPO): Large stand-alone businesses with stable customer base, product strategy and growth potential, i.e. True Car, Alibaba.
What Fraction of Venture Investments Exit?
If you still remember from the previous article, over 70% of startups fail or die. Among the survived, venture-backed companies, what percentage actually gets to an exit? Use your market knowledge and make a wide guess here.
As a percentage of total investments in past decade, how many percent of companies exit above $100 million and $500 million? How about $1, or even $2 billion?
Ready for the answer?
› 3 % of companies exit above $100 million
› 0.7 % exit above $500 million
› 0.2 % exit above $1 billion
› 0.06 % exit above $2 billion
Now you know why VCs always say 90 of 100 portfolio companies will fail. It’s very true. Let’s look at the chart below and the do the math.
In the 1,000 companies hand-selected and funded by venture capital, only two of them can get to an exit over $1 billion. Five companies exit between $500 million and $1 billion. A total of 30 lucky ones exit for over $100 million. Another 70 have some sort of an exit. That leaves us 900 companies with no exit. Let me say this again to sink it in. VCs filter thousands of deals each year and select the most promising ones to invest in. Yet, 90% of the funded companies fail. Told you venture capital is no easy business!
Dynamics of A Venture Fund
Most venture funds last over a period of 7–10 years but are only active in the first 3–4 years. At the end of Year 4, majority of the fund will already be invested. The rest of the fund enters a harvest period for follow-on investments in a few good performers. Many VC funds reserve about 50% to support existing portfolio companies. A smaller fund may not even do follow-on investments because they require a larger capital for a small incremental ownership. In other words, ownership gets more expensive and the economics does not always make sense. As an entrepreneur, you need to do your research and know a fund’s vintage (yes, just like wine), which refers to the year when the fund was raised. If a fund is over four years old, don’t even bother because most likely it won’t have much money left for new investments.
What about returns? Let’s say fund A is $100 million (see graph below). In Year 10, if the total valuation of the portfolio is $180 million, the management company makes $16 million (20% of the profit) after the Limited Partners get paid back first. Sounds easy? Not really. Assuming that the fund has roughly 20% ownership in every portfolio company, the portfolio valuation will need to grow to nearly $1 billion to achieve the goal.
Summing up: Lifetime of a Venture Fund
Each fund is typically active for 3–4 years, but has a lifetime of ~10 years for harvesting returns.
A large portion (sometimes ~50%) of a fund is reserved for follow-on investments to support existing portfolio companies.
A firm may have multiple funds running at the same time, but typically only one is active for new investments.
The amount of capital left unallocated in a fund is known as “dry powder”.