How Venture Capital Works. Part 1: The Less Exposed Side
During my past career experience as both a startup founder and a venture capitalist, I was blessed with the opportunity to see the perspective from both ends of the table and get accustomed to the skills required as both a buyer and a seller in the startup investing scene. Through this series of articles, I would like to share the key learning from my time as a VC for my fellow founders. Hope you all do well for your fundraising and keep hustling!
Part 1: The Less Exposed Side of a Venture Capital
Venture Capital does fundraising
It might be shocking to some founders, but VCs do fundraising just like you. However, instead of a 14 slides pitch deck, they will need to prepare a 50 pages long Private Placement Memorandum (PPM) to potential Limited Partners (LPs). The PPM provides its investment plan and all legal details entailed to it. And just like founders, they do get rejected all the time.
The fundraising process could take a long time, sometimes VCs prefer to do a first or second close before officially closing the fundraising process. Let’s say a VC is aiming to raise a $100M fund. It will be hard to get $100M commitment at the same time, sometimes it could take years to max the full $100M commitment. When it has received an adequate commitment, the VC could decide to do a first close on that amount. By doing so it could concurrently deploy the money while keeping the fundraising process ongoing.
Venture Capital does not always have money to invest
Firm vs Fund. A VC firm could have more than one fund. Imagine a fund as a single business unit, so when a VC invests in your company, it is the fund; not the firm which invests in you. It also means that a VC firm could invest in your startup more than once through various funds.
As a startup founder, you should understand this mechanic. VCs don’t always invest all year long. They invest based on the availability of the fund. A VC firm could have two active funds, or sometimes they could have none. Ask for the investment thesis of the fund to the associates and you could assess whether your startup will suit the fund investment thesis or not.
Venture Capital aims for capital gain
When a fund invests in your company, it is looking for a higher-than-market return. For a growth stage investment, it may be looking for 2–10x total return, but for an early-stage investment, it could look for 100x or even 1,000x return. This could only be achieved through Capital Gain. i.e. selling the ownership to someone else. That’s why VCs prefer growth over profitability.
As a founder, you need to balance between the two. Don’t do crazy growth just because your investors told you. Their agenda is to multiply their investment while your agenda is to ensure the sustainability of your startup.
Sometimes Venture Capital is just testing the water
When you get an email from an associate asking for a meeting, there will always be a chance that he/she is only testing the water. Not all meetings will turn into an investment, but there will never be an investment without a meeting. So, please set your expectations accordingly. Don’t expect for the cash to be written on the spot. Please also consider the opportunity that they are just “testing the water”, i.e. they are just gathering data without any intention to invest.
Thank you for reading! In the next series, I will discuss more regarding the Business Model of a Venture Capital. Please let me know about your comment and please re-share if you find this article useful. You could connect with me at linkedin.com/in/erikhormein/.
Next article: How Venture Capital Works. Part 2: Business Model in this link.
