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Venture Capital (VC): What is it in Simple Words?

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Venture Capitalists

Over the past decade, venture capital funding has grown as a result of the explosion of startups and billion-dollar exits. The forecast was that the trend would continue until the health crisis emerged and put the brakes on the expected growth.

In fact, there is a decline in seed-stage startup investments because VCs have become selective in their investments. They are looking for strong businesses that can grow when the economy rises from the effect of the pandemic.

The good side of VCs is that they prefer long-term investments which have helped them resist short-term changes. They want to invest in startups that will give them outsized returns after 10 years from now. They have always invested in companies designed to jump-start changes in business or consumer behavior.

So then, this post explores the definitions, thought processes and motivations of VCs. It dives into what startups want and what VCs look for in each investment stage.

What is Venture Capital?

Venture capital finances startups using pooled funds from wealthy individuals and institutional investors. In simple terms, companies get capital to develop their businesses as investors grow their wealth.

Venture Capital firms create venture funds from capital raised from investors which they use to buy equity in startup companies. Since this is a long-term investment (often takes 5-10 years before maturity), the VC firms hold on to it until a liquidity event arises such as an initial public offer (IPO) or acquisition. This is when they realize profits from an investment they made years back.

As a result of making high-risk investments VC firms get high returns. Actually, most VC is invested in early-stage companies and a certain percentage in late-stage companies. The risk is high in startups because nearly two-thirds of startups backed by VC fail, it’s also invested in products with a high potential to scale but they might be not profitable at the moment or in emerging technologies.

At the same time, a VC firm is a good startup portfolio can prove to be profitable. For instance, Accel Partners invested in Facebook in 2005 and received enormous returns when it excited through IPO.

On the other hand, startups prefer VC because it finances their operations without a debt burden. This means that when startups receive venture capital funding they pay for it using company shares; therefore, it’s not a debt and they don’t have to pay it back. Venture capital is an attractive financing option and startups can take in such investments at every stage of their growth.

Aside from money, VC gives these young businesses support, guidance, networks and other resources because they have years of experience working with startups and a broad network of investors, industry experts and talents. Therefore first-time founders benefit from the mentorship they receive from these VCs.

Venture capital is especially active in B2B software, B2C software, D2C industries and life sciences. Actually, VCs and VC firms are into the software industry because of its giant addressable market and low up-front costs. As a result of venture financing, Twitter, Google and Slack are now dominant companies in such a sector. The same applies to the life sciences sector which offs regulatory and technological protection against completion in addition to a huge addressable market.

Why Do VCs Invest in Startups?

VC firms are interested in companies with high growth potential and they take stakes in such businesses because of the huge returns they expect after 5-10 years.

These investors are big risk-takers and so their return rate is 10X or more when they invest in startups that can transform the industry. Still, such young businesses have higher chances of flopping.

For instance, Peter Thiel was Facebook’s early investor and he specializes in startups focusing on new technology as opposed to those replicating an existing one.

Therefore the majority of VCs invest in incremental companies and also ride on trends.

Why Do Startups Prefers VC Funding?

Banks prefer established businesses because they’re less risky compared to startups which aside from a promising idea they don’t have collateral or numbers (balance sheets or income statements) to support their business.

Generally, mature businesses have the equipment, factories, and patents that bankers can cling to in case of foreclosure but startups have only the idea and a few office furniture.

On the other hand, VCs don’t need these documents or collateral when gauging the value of an early-stage startup. Instead, they evaluate early startups using other metrics such as the founding team, market size estimates and the product.

As mentioned, VCs are paid back using company stake and such returns are uncapped as long as the investors can justify how risky it is to invest in such a startup. So the investor can earn oversized returns compared to debts because equity-based financing has no upper limit while debt can only receive the principal plus agreed interest.

As a result of this financing model, startups have accelerated growth because they concentrate on growing the company as opposed to paying debts. Actually, it’s more beneficial to investors when startups concentrate on growth because it will give them better returns upon their exits.

On the other hand, equity financing has some consequences not evident in traditional bank loans. These are;

Loss of Upside: VC investors are given a percentage of the company shares and thus a percentage of the total price of an IPO or acquisition as the company exits. So VC firms that get a bigger equity stake ends up with huge returns while the founders and the employees don’t get as much as they should have had they opted for debt financing.

Loss of Control: Definitely VCs will want a seat as members of the board because they are shareholders. As a result, they may have a big influence when important decisions are being made such as when to launch products or company exits through IPO or acquisition. The reason behind this pressure when making major decisions is because the VC wants to grow its overall fund performance so they may support what brings huge returns as opposed to moderate success.

The Flow Chart of Venture Capital

VC firms raise funds from limited partners (LPs) who are wealthy individuals, family offices or institutional investors who act on behalf of their client organizations. Institutional investors comprise insurance companies, pension funds, university endowments and nonprofit foundations.

So the VC firms are given tens of billions of dollars to manage or invest in diversified portfolios. As a result, the firms’ investment strategies are influenced by the LPs’ interests and incentives such as growing the latter’s asset base and provide funds for running the institution.

For instance, pension funds finance pensioners’ retirements, the nonprofit foundation finances their grants while insurance companies pay out claims. Therefore any investment decision that the VC firm makes must favor the LPs such as produce excess returns and grow their asset base.

VC firms use their projections into the performance of the funds as well as their track record when pitching to LPS. Funds charge a 2% management fee which takes care of the firm’s operating expenses such as day-to-day operations, rent and employee salaries.

It also charges 20% carry or a percentage of the profit the fund makes. This can be discouraging to LPs when VCs grow the fund by thin margins. Therefore, VC firms are expected to deliver market-beating returns in order to compensate for the long-term illiquidity, high risk and high fees.

VCs firms are able to give high returns are viewed as prestigious while those that report losses have a bad reputation. Some well-known VCs are Andreessen Horowitz and Sequoia.

Since VCs are expected by LPS to make outsized returns, they also look for high-performing startups. They want to invest in companies that can deliver 10-100 times their investment. Therefore, they want to invest where they can get astronomical returns in order to cover for the inevitable failures since nearly 67% of startups backed up by VC fail.

Therefore few elite firms that the fund has can manage to bring in the biggest return while the long tail brings average return rate.

Because there are few top investment opportunities, VCs competes among themselves to get a seat at the table of such financing rounds. Actually, such highly sought-out rounds are usually led by elite firms like Accel Partners, Sequoia Capital and Kleiner Perkins.

How Do VCs Get Startup Founding Deals?

VCs are expected to deliver market-beating returns to LPs and therefore it’s crucial for these firms to get high-profile investment rounds in order to meet that expectation. If they miss such deals the fund will be marked as underperforming compared to the competitors and its reputation will take a hit.

VCs relies on their strong network to boost the quality of their deal flow. The goal of such relationships is to capture investment opportunities by connecting VCs with promising founders. Still, the fund has to build a strong brand to help it generates a steady flow of inbound deals.

VCs network when they invest jointly in startups, attend industry events or sit on the same board.  Those in the same network invite each other to investment rounds or a VC can recommend a startup to another firm if it doesn’t match its criteria.

These firms also depend on a professional network of M&A lawyers, investment bankers, entrepreneurs, LPs and more. These are individuals they work with in the startup ecosystem.

Additionally, the firms can get referrals from accelerators who later become their joint investors. University entrepreneurship centres and MBA programs can provide leads. For instance, DoorDash began as a Stanford Business School project. VCs can also resort to cold emailing potential startup founders expressing their interest in partnering.

The level of competition in the VC world is intense and also the number of unicorn startups is low. Therefore VCs have to look for other ways to maximize their exposure in order to attract the highest-quality deals thus deliver good returns to their investors.

In view of that, a good flow of inbound deals can be a good source of VC investment opportunities. However, to get them a VC has to build a strong brand through value-add services and thought leadership marketing.

Thought Leadership: Other investors and entrepreneurs should look up to them for authority and expertise. They can do that by speaking publicly at various entrepreneur events, tweeting, blogging and writing platforms. For instance, Union Square Ventures’ Fred Wilson has been sharing in his blog different behind-the-scenes insights about the industry.

Value-add Services: VCs that combines thought leadership with value-add service lures top startups. So aside from offering capital VCs should provide network, mentorship and technical support. For instance, First Round Capital holds mentorship programs and leadership conferences that target early-stage founders while Andreessen Horowitz offers startups marketing and accounting services.

Selection of Investments

VCs rely on data and intuition when assessing a startup investment opportunity and its value. The following is what is contained in the data the VCs are interested in.

1.    Market Size

The first thing that VCs considers is the total addressable market (TAM) because their goal is to chase and invest in bigger markets. These investors are looking forward to exiting a startup at 10-100X of their initial investment thus considered elite.

Alternatively, a VC can invest in a company whose addressable is small in the beginning but grow it over time. For instance, Uber’s addressable market was small but the ride-hailing company has grown it in the 10 years by 70X. Actually, Uber has dominated the auto market and ride-hailing is now a better option to owning a car because of increased ride availability and decreased cost.

Still, predicting the impact a product will have on a given market can be a challenge. However, factoring in the role of technology in establishing new markets is helpful when evaluating an investment rather than focusing entirely on TAM.

2.    Founding Team

Startups that seed-stage have only a pitch deck otherwise everything else is wrong. Investors at this stage focus on the founder because, in most instances, the startup has an incomplete team, wrong product and strategy.

An attractive founder has strong problem-solving skills and this is established by the way they think through some scenarios that investors create during the interview. The response shows whether the founder is flexible when addressing some challenges, pivot the product when needed or adapt to market changes.

Founders should be knowledgeable about the market and industry that they are looking to disrupt. So they have academic, cultural and industry knowledge that inspired them to come up with that idea

A serial entrepreneur or a unicorn startup founder is VCs first priority when picking investment opportunities. These are experienced entrepreneurs that have previously taken a young company from zero to billions of dollars in revenue.

Further, serial investors understand how to transition a company across different growth levels, have media coverage, and extensive network that can help them attract resources and recruit top talent.

The initial PayPal employees turned into founders of highly successful startups such as Palantir, Yelp, Tesla and LinkedIn. These startups attract VC funding easily because of their previous experience.

3.    The Product-Market Fit

Product-market fit is characterized by quick adoption and a low churn rate. This happens when the product entirely meets a need in the market. Most of the startups that fail in their first year have no product-market fit and so VCs are interested in this component when investing in early-stage companies.

It’s important to note that getting a product-market fit can take several months and years. Also, it’s not a permanent element and so a company can lose it because customer expectations are always changing as well as lack of proper adjustments.

Startups can use quantitative benchmarks to measure their progress. For instance, the High Net Promoter Score (NPS) measures how customers recognize the value of a particular product and recommend it to their family and friends. So a customer who feels very disappointed when they can no longer use or get your product makes up the market for your product.

Therefore, VCs use product-market fit to determine whether the startup will be successful or not. They want to fund businesses that have already achieved it and if not, one that has a concrete road map towards achieving it.

Actually, startups seeking Series A stage funding should have achieved the product-market fit or have visible progress that shows they’re almost there.

What are the Important Components of a VC-Startup Agreement?

The term sheet is what both startups and VCs use when defining the condition of investment. The nonbinding agreement contains valuation, liquidation preference and pro-rata rights.

·         Valuation

A startup valuation is used to establish how much equity a VC gets from a given investment amount. For instance, if the company’s pre-money valuation is $100M and the VC is financing it with $10M then, the investor will get a 10% equity stake and $110M is its post-money valuation.

Therefore the higher the valuation the better for the founders because they’re able to sell a smaller stake of their company for the same amount. As a result, the existing shareholders who are mostly the founders, previous investors and employees get a lower share dilution hence outsized compensation when the company exits through acquisition or IPO.

Additionally, parting with a lesser stake allows the company to raise more funds down the line and still maintain the dilution level low.

On the other hand, high valuation has added pressure and high expectations from investors. Such founders are not expected to make mistakes and each round of borrowing should double the previous round’s valuation.

Further, investors of a high-valued company will reject moderate exists because their return will be lower due to the small stake in the company. However, they will not have an issue with moderate exits when the company has a lower valuation.

·         Pro-Rata Rights

Investors can participate in the startup’s future financing rounds because of the pro-rata rights. They also have the right to right to secure the equity amount they own.

The initial investors’ shares get diluted with each financing round and so they have to follow on in their investments. For instance, their 10% equity stake is lost by 10% when the company offers a 10% stake in another round of funding.

However, they can use their pro-rata rights to pitch in and prevent further share dilution by new VCs who wants a bigger share of the company. This can be a source of tension between the company and its early VCs during subsequent rounds.

·         Liquidation Preference

This is a clause in the financing contract that explains who gets what during the company liquidation. VCs are the preferred shareholders and takes the first priority during the payout.

It’s the seniority structure that spells out the order with which the preferences are paid. For instance, in standard seniority, the most recent investor is paid first while in a Pari passu seniority all preferred shareholders are paid together.

For that reason, a startup should manage its liquidation stacks carefully as rounds increases and more investors join the company. Failure to do that can result in disproportionate rewards thus locking out founders and their employees during the payout.

The Startup Financing Cycle

There are many rounds of funding that a startup goes through in its lifetime.

Seed Stage: The founder has an idea and the funding helps him to develop a product, user base and market. At this stage, the company can either wind up if the money runs out before gaining traction or it may gain more users and jump to Series A. A company allocate a higher percentage of this funding to developing the minimum viable product (MVP). The initial stage funding is mostly done by the founder’s family, friends and angel investors. Some startups may opt to skip this round and go straight to Series A especially when the founder has prior experience in this particular market, has established credibility and a scalable product.

Series A: Early-stage startups raise the Series A capital to develop both the business model and product. Founders and the team want to optimize the user base and expand distribution in order to prove to investors that both the product and business model are profitable. Because it’s a growth-oriented round companies use the capital to find customer segments, explore new business channels, and new markets. This round is led by VCs such as Benchmark, Sequoia and Greylock who invest between $2M and $15M. On the other hand, business angels have no power to impact the round or set the price and so they usually co-invest at this stage.

Series B: Startups seeking this round are well established in their principal market and are looking for funds to scale rapidly. So, what the company is looking for is to ramp up its marketing and sales effort’s, acquire smaller companies or expand geographically. As a result of the activities that are involved here, the VCs invest tens of millions and the round is led by Series A as well as some later stage VCs like IVP.

Series C: The late-stage round helps the company to scale revenue growth because it’s approaching profitability. These funds are used to expand both geographically and even internationally or prepare it for an IPO. Investors in this round include early-stage VCs, late-stage investors such as hedge funds, private equity firms, big secondary market firms and late-stage investments banks arms can also participate. These VCs invest tens to hundreds of millions.

Late Stage: Unlike investments in other stages the late-stage investment is less risky. In the initial stages, the startup has no commercially scalable product but it’s there in the late stage. However, these investors generate higher returns because the low valuations early-stage startups had a lot of time and much more room for growth. The only advantage with later-stage investments is that they are safer because the company is more established and the funds are used to go public. Further, late-stage rounds are used to suppress competitors, drive down prices, and prepare for an IPO.

Exit: A company can exit through an IPO where the private investors sell their shares to the public for the first time. During this time, shareholders enjoy high payouts while founders retain control of the company. Alternatively, private investors can exit through mergers and acquisitions. While this is an option that can be more profitable to investors, founders tend to lose control of their company. Facebook acquired Instagram in 2012 but the latter’s founders had to leave in 2018 due to irreconcilable differences with Mark Zuckerberg.

Do all Startup Companies Choose Venture Capital Financing?

No. There are some companies that don’t raise funds through VC rounds but rather opt for cash flow, savings or debt.

They choose to bootstrap because it allows them to maintain the ownership of the company and grow it sustainably. They avoid pressure from external investors that expect the company to grow rapidly every month.

Also, this pressure can cause the company to overlook their long-term creative vision. Wistia is a video-sharing platform that opted for debt as opposed to VC. The company’s founders preferred the profitability constraints from debt because it’s healthy for the business than pressure and high expectation from the VCs.

Is Venture Capital the Right Option for You?

Financing a technology company via VCs is the best option because they tend to scale easily. VCs also prefers such companies although they also invest in non-tech businesses. VC financing is appropriate for startups oriented towards rapid and huge growth.

These investors prefer working with founders with big ambitions and don’t want to retain full control of their company because they will likely go through the seed to late-stage VC rounds.

I'm a passionate full-time blogger. I love writing about startups, how they can access key resources, avoid legal mistakes, respond to questions from angel investors as well as the reality check for startups. Continue reading my articles for more insight.

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