Updated: Nov 28, 2022
Venture Capital fuels the fastest growing companies in the world
If you’re tuning in to this post, you may have heard the term Venture Capital being thrown around, but perhaps never fully understood the core concepts behind it. The goal of this post is to explain Venture Capital in simple terms and at a high level, to hopefully foster an understanding of the role Venture Capital plays in the startup ecosystem. As someone who only understood bits and pieces of the whole picture for a long time, I hope this post can serve as a robust foundation!
What is Venture Capital and Why Does it Matter?
At its simplest level, Venture Capital (VC) is funding given to a startup in exchange for equity in the company. In this context, a startup can be defined as a relatively new company that is growing and in need of money to help sustain its growth, while equity is percent ownership of a company. An example of this exchange would be an investor giving $500,000 to a startup to help it grow in exchange for 10% equity stake in the startup — while the implications of this exchange seem abstract right now, we will get into the details of what it means for both startups and investors.
Now that we know what VC is, this begs the question: why does VC exist, and where did the demand for this unique form of funding come from? After all, for the majority of America’s business narrative, most funding for ventures has come through various forms of loans and another debt financing. While the origins of VC in the US is an entirely different discussion in its own right, more basically VC has grown in popularity over the last 50+ years as people began realising that traditional bank loans and debt financing make little sense in the realm of startups. From the banks’ perspective, the majority of startups have a high-risk profile and ultimately fail, so it’s difficult to justify such a risky loan when there are much safer loans to make (and make interest off of). From the startups’ perspective, utilising loans or debt financing is disadvantageous since it is better to reinvest earnings to accelerate growth instead of losing earnings by paying back loans along with incremental interest. With the rise of these innovative, yet risky ventures in need of funding over the last 50 years, VC has stepped in quite adequately!
Fast forward to the present day, and VC still satisfies the funding gap in ways that small business loans, crowdfunding, and in some cases government or nonprofit grants can’t. What sets the VC system of financing apart from these alternatives is that it does not disrupt a startup’s cash flow and oftentimes comes with mentorship. This combination of non-disruptive funding in exchange for equity and dedicated mentorship has created a good (but not perfect) mutual fit and has ultimately enabled VC to play a large role in aiding modern technological innovation. In fact, the majority of the most impactful technology companies such as Apple, Amazon, Facebook, and Google have been recipients of Venture Capital and perhaps would not exist without the assistance of VC funding during their earliest stages.
Who Receives Venture Capital?
Any misunderstanding about which types of companies receive VC funding is well justified — we most often only hear about Apples and Facebooks of the world being built out of garages and dorm rooms before their rise to power with the support of VC. While these make for great stories, they unfortunately also convey the perception that all VC-funded companies are extremely small and young companies with a high probability of failure. I don’t wish to deviate too much by engaging in the fine details of when a startup stops being a startup, but it is important to understand that companies that have grown beyond the point of being startups also seek extra capital.To put things into perspective, there are companies that range from $100,000 in revenue with 5 employees to $100 million in revenue with 500 employees that require VC funding to continue growing.
This acquisition of capital to aid growth tends to occur in instalments known as venture rounds. Traditionally, these funding rounds progress from Pre-seed to Seed to Series A-F, and in between each round startups are expected to grow in market share, revenue, and product/service realisation. To provide a sense of how each round differs monetarily, the Pre-seed round typically ranges from $200,000 to $500,000 in funding, the Seed round typically ranges from $1 million to $2 million, the Series A round typically ranges from $5 million to $15 million, and so on and so forth. A useful aside to note is that in the tech lexicon, startups are often defined by their most recent venture round. For example, a startup that finished raising its Series C venture round would often be referred to as a “Series C company.”
Who Distributes Venture Capital?
Venture Capitalists help provide the resources for companies to grow!
Now that we understand the full breadth of companies that seek VC funding, we can dive into the other side of the coin — the suppliers of the funding for startups (brace yourself for an avalanche of terminology!) When it is time for startups to raise money, they usually seek the financial assistance of Venture Capital funds. These funds consist of two primary actors, the Limited Partners (LPs) and General Partners (GPs). In this partnership, the LPs are generally institutional investors such as university endowments, pension funds, insurance companies that provide the financing for the VC fund, while the GPs are the active investors who make the decisions on how to use the money provided by the LPs.
An important clarification to make is the difference between GPs and Venture Capitalists (VCs)— there are many types and levels of VCs, and in the pecking order GPs are the most powerful and influential ones. It should also be noted that these General Partners are generally industry veterans with business, research, and entrepreneurial experiences that make them very valuable to the companies they invest in. Thus, it is oftentimes the case that a GP who invests heavily in a startup will join its Board of Directors, and even if the GP doesn’t fill this capacity, he/she will also provide mentorship and guidance to the companies that receive investment.
How Do VCs Organize Themselves and Their Funding?
Generally, VCs work together in Venture Capital firms with the GPs of the firm leading the way and having the final say on which investments to make. Similar to how startups try to raise several funds from VC firms, the VC firms will raise several funds throughout its lifetime. As an example, the fabled VC firm Greylock Partners raised its $1B Greylock Fund XV in October 2016. Since XV is 15 in roman numerals, this indicates that Greylock as a firm has raised 15 primary funds since its inception in 1965!
Typically, each fundraised by a VC firm will have a full life of ~10 years — this consists of the initial investment phase, the growth and follow-on investment phase, and the exit phase. The initial investment phase is when firms invest in completely new companies, which usually only consumes less than half of the total fund size. The rest of the funds are reserved for follow-on investments for the companies from this initial batch that survives and continues to grow successfully. Finally, in the last few years of the fund’s life, the VC firms will try to liquidate their investments and get their money out by helping their portfolio companies make an exit (which we will discuss at the end of the post). It is also important to note that new funds are raised by a VC firm every ~3 years, which means that a firm will typically have overlapping funds that are simultaneously active, but at different phases. So, even if a VC firm is done making new investments with one fund, they would have already raised another fund to make new investments with while the prior fund has moved on to the follow-on and growth phase. To make this easier to conceptualise, I made the following diagram to provide an overview of the VC fund timeline:
A given VC firm can have multiple funds that are simultaneously active, yet at different phases
How Does a VC Decide Which Companies to Invest in?
The goal of the GPs at a VC firm is to develop a profitable investment portfolio through each fund that it raises. The approach for building a successful VC portfolio is similar to the approach for building any other type of investment portfolio, in the sense that it similarly requires significant research, due diligence, and diversification. But, with so many unique and promising companies to potentially invest in, where do VC firms start?
To build the right portfolio of companies, each VC firm begins by building and maintaining a large funnel of companies to evaluate and keep relations with, which is known as the firm’s company pipeline. These initial pipelines are generally quite massive and can range from hundreds to tens of thousands of companies depending on the size of the VC fund. However, VC firms have limited resources through their VC funds and are thus extremely selective with who they invest in — in fact, the typical VC firm will ultimately invest in less than 1% of the companies from the initial pipeline. The process of narrowing down this pipeline varies from firm-to-firm, but it generally involves close evaluation of companies through countless hours of networking and listening to pitches from entrepreneurs trying to sell their vision and business strategy in hopes of investment.
How Do VCs Make Money?
In exchange for all this work that goes into building a Venture Capital portfolio, VC firms generally receive their compensation by following the “two and twenty” fee structure that is prevalent in hedge funds. In this structure, the GPs of the VC firm take two percent of the total fund size as the management fee each year, while at the end of the fund life they keep 20% of the profit. So, in the case of the $1B Greylock Fund XV, each year the partners at Greylock are likely receiving 2% of the $1B fund size, which is $20MM! On top of that, at the end of Fund XV they will keep 20% of the profit, which is known as “carry” and can be quite a hefty sum if they made smart investments!
What is the End Goal For Everyone Involved?
Ultimately, for all these different parties in the VC and startup ecosystem, the end goal is a mixture of making money and having the desired impact on the world. For everyone to make money, the startup which receives VC funding needs to be successful and make an exit. An exit is essentially the way for any company and its investors to cash out, and this can occur through two different avenues: Mergers and Acquisitions (M&A) or an Initial Public Offering (IPO).
A merger, which is extremely rare for startups and is instead more common for more established companies, is when two or more companies decide to join together to form a single entity. A famous example of a merger was when the oil and gas giants Exxon and Mobil merged to form ExxonMobil, which we now see at gas stations around the country. An acquisition, on the other hand, entails a larger company completely buying out a smaller company. This tends to be a more common exit for startups compared to mergers since many bigger corporations find that they can streamline what they are building by acquiring a leaner, more efficient startup that’s trying to tackle the same problem. Interestingly, many acquisitions fall under a process informally known as an acquihire, which occurs when a larger company acquires a smaller company primarily for the skillset of the people. This tends to happen when the larger company doesn’t have the efficiency, personnel, or domain expertise to tackle a certain problem on their own, so they create a talent influx by bringing in the people from the smaller company that they acquire. The last major method of exiting, the IPO, is essentially when a company begins selling shares to outside investors, which is when it becomes “public.” This process is a bit more nuanced and could really have its own dedicated post, so I’ll leave this video and article to explain how it works.
I hope this article proved to be a useful guide for understanding the basics of what Venture Capital is, who the players are, and how all the different pieces in VC fit together!
This article originally appeared on Noteworthy, and has been republished here.