How does Venture Capital (VC) Work?

Just imagine for a second that you are that buzzing entrepreneur looking for capital to plough into your latest project; traditional lending institution’s doors are closed, but you then hear about ‘Venture Capital’ (VC) and you wonder: “what is VC and how does it work?” 

This article serves as an overview of the world of VC, from its definition, to how best to approach VCs.

What is Venture Capital? 
VC is an alternative investment asset class. Given that alternative investment assets have higher risk profiles, the expected return to investors in this space is commensurately higher. VCs provides risk capital to early stage businesses where there is substantial project risk and perceived (exponential) long-term growth potential. The investment is made in equity as opposed to debt (such as a bank loan) with the expectation that at a later stage (the ‘exit’), it can be sold for a significant profit. 

VC firms invest in biotech, healthcare, IT and software. These industries are scalable and have a strong track record of delivering high returns. But despite individual successes, most startups  fail and fewer will break-even. VCs have to invest in a number of firms to find the ones that return large enough margins to bail out the portfolio. In reality, less than 10% of a portfolio’s investment is successful enough to return 5-10x, which is a minimum requirement in order to break even on the entire portfolio.

Types of VCs
There are various types, but the common ones are: institutional, corporate and angel syndicates. Institutional VCs like Atomico and Accel Partners are usually structured as a partnership. Corporate VCs are departments within or subsidiaries of large companies which invest in start-ups. They primarily invest within their core business area where they can add most value to the startup and vice versa. Examples of corporate VCs are GM Ventures and Siemens Ventures. Angel syndicates, such as Beer and Partners, pool together a number of Angel investors. With an aggregated fund they have the financial clout of traditional VCs but without the (un?)necessary structure. Sometimes, they are also referred to as Super Angels.

Structure of a VC firm
Most VC firms are structured as partnerships with two types of stakeholders: the general partner (GP) and one or more limited partners (LP). Limited partners are usually institutional investors like banks, university endowment funds, insurance companies, foundations, pooled investment vehicles and high net worth individuals (HNWIs). LPs commit a fixed amount of money to the fund. The GP is the actual VC firm and is in charge of managing the fund’s investment and will typically have some skin in the game by committing anywhere between 5% and 15% of the fund’s capital. Initially, the GP is paid 2% of the fund size in management fees and 20% of profits in excess of an agreed threshold that returns all the LP invested capital as well as compensates the LPs for the risk. A typical fund has a lifespan of 7-10 years.

Process of Venture Capital 
Operators within a VC firm i.e. GPs add value to their portfolio companies by bringing their networks, technical and managerial expertise to the table. Usually, entrepreneurs seek VC investment after there has already been a round of investment from what are usually called the 3Fs: Friends, Family and Fools; other rounds of investment may also come from seed and Angel investors. VCs normally invest between 1-10 million EUR/GBP/USD in a company which has some traction. Traction is defined by key metrics for that industry e.g. a growing customer base, merchant contracts signed, hours spent on site, click-throughs, etc. However, cash is king and every VC prefers to see revenue although most will not readily admit it. On a more positive note, there have been recent developments which empower entrepreneurs and this may influence a VC’s decision on when to invest. Some of these include the rise of crowdfunding; increase in secondary markets; and online resources such as AngelList which pair up investors with entrepreneurs.

How to approach a VC?
VCs typically receive more than 700 business plans a year, so first impressions are extremely important in this industry. Following the business plan - and if the VC thinks there is potential in the business idea - there will be a first meeting during which the entrepreneur usually pitches to the VC about his business idea. It usually takes between 3-6 months or sometimes even up to a year between the first meeting and an investment. Thereafter, there can also be further rounds of investment from VCs, and if all goes well, there is an eventual exit. An exit usually means a trade sale i.e. selling the business to a larger business - for example Facebook’s acquisition of Instagram - or an initial public offering (IPO).

Advisors
Obtaining funding from VCs can be a gruelling process; one that entrepreneurs dread as they fear it takes them away from managing and growing their business. It is actually estimated that only 3% of businesses in the market successfully raise VC or Angel funding. However, there is capital! Last year, venture capitalist members of British Venture Capital Association invested 347 million GBP in 407 companies. One just has to ensure that one is investment ready to access this capital. Some consultancies or advisory firms exist to make life easier for entrepreneurs and their start-ups, by providing support and guidance through the fund-raising process. As only 2-5% of businesses in the market are deemed investment ready, it could potentially be beneficial for start-ups to engage with such advisors. Although some may say that engaging with such firms takes much needed capital out of the business, the positive benefit of such engagement is that it enables the entrepreneur to focus on what he/she knows best: growing the business.