In this primer on VCs, we will explain what they do – or, to be more exact – how VCs raise, invest and ultimately make money.
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What is venture capital?
Venture capital is a high-risk, high-reward investment in young businesses and early innovations with the potential for explosive growth; but also the potential to fail completely.
The investors behind these VCs are people and organisations willing to lose their money. They are ready to accept losses in nine companies for a chance that the tenth will be the next Grab. They understand that for every Google, Facebook and Alibaba that was initially funded by venture capital, thousands of others have disappeared and been forgotten forever.
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What is a venture capital firm?
A VC firm is a legal entity established to make high-risk investments. VC funds, meanwhile, are the separate pools of money that the VC firm raises from outside investors. Each VC fund is designed to focus on a specific industry, technology or strategy.
When Georges Doirot set up his VC in the late 1940s, for example, his strategy was to finance “noble ideas” that could benefit humanity following a devastating world war.
Today, with the world becoming so much more complex and specialised, the funds in a VC’s portfolio must be equally specialised. A fund may focus on blockchain and artificial intelligence breakthroughs, or they may target more holistic initiatives such as renewable energy and food security.
Whatever their focus, these VC funds are usually structured as partnerships. The investors are Limited Partners, commonly known as LPs, while those managing the funds are called General Partners.
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When do VCs invest?
The short answer is early. VCs look for very new opportunities that have the potential for explosive growth over the next 10 years. These early investments are divided up into several phases.
Pre-seed: The earliest stage where founders try to transform an idea into a business plan. They are reaching out to family, friends and high-net-worth people, sometimes known as Angel investors, for both money and advice.
Seed: This is when a company is ready to launch its first product and typically where VCs begin to show up. Without any revenue, the business needs funding to pay employees and marketing to help them find, contact and secure their first customers.
Early stage: After a business has developed a product and found its first customers, it needs to increase production and sales before it can finally become self-funding. Financing during this period can be spread over several rounds as the business begins to scale. Series A and Series B rounds will see VCs funding new products and new markets, as well as acquisitions that help the company grow as rapidly as possible.
Late stage: By this time, a company has a stable of core products and a strong market presence. Funding during this period, often called Series C and D, continues to scale the business while preparing the company for a public offering. It’s a period when more large investors begin to get involved while some smaller, early investors decide to cash out.
When discussing these different stages of investing, it’s also important to understand a term called pro-rata rights. As more investors finance a company, there is a risk that earlier investors will see their equity be diluted. To protect their stake, VCs will often ensure they have pro-rata rights; or the right to continuously top up their investment, so their share of equity in the company remains constant.
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VCs are more than just investors
There’s another crucial point to make about VCs. The long journey from a good idea to a successful IPO can take up to 10 years or more and requires a VC to adopt a very hands-on role. They mentor and guide the founders, and often step up at critical moments of the journey.
When the founders of HashiCorp wanted to hire the seasoned executive David McJannet as their CEO, for example, they turned to their board member and VC partner Glenn Solomon of GGV Capital for help. As David recalled,
“I was like, I don’t really want to do this. (But) Glenn bought me a beer and said: if you do this, I’ll put in $15 million behind you, whatever number to de-risk it for you. So I said, okay.”
The partners at VCs use this network of contacts, their industry knowledge, and their deep experience advising other startups to provide founders with the operational expertise to run their companies day to day. They also deliver a long-term vision that improves the founders’ chances of success in the years to come.
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How do VCs earn their money?
There are two ways a VC makes money. There are the management fees that a VC charges for running a fund, and then there’s the return on a successful investment that can add up to many multiples of the initial outlay.
This arrangement is often referred to as ‘2 and 20’ – meaning the management fees are at 2%, and the VC’s share of the profit is typically benchmarked at 20%. Since the management fees have to cover the cost of running the fund – including the research, analysts and other expenses – it’s the share of the profit that earns a VC the bulk of its earnings.
And, of course, let’s not forget that venture capital is incredibly risky. It’s not unheard of for VCs to earn almost nothing after spending many years researching, financing and mentoring startups, many of which become successful companies, though not successful enough for a VC to make up for those startups that failed.
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Choose the right VC to give your startup a head start
Choosing the right VC to partner with is one of the most important decisions a startup founder will make. It’s about much more than funding. It’s the first step in a long journey requiring in-depth industry knowledge and an extensive network of connections to succeed.
