Learn The Way Venture Capital Works

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For any startup, raising money is a complex issue. While startups can raise money from a number of sources, the main one is venture capital and today we are going to learn about the way Venture Capital works.

Raising Money And The Idea Behind Investing

The first thing a VC firm has to do is raise a “fund”. So even though we think of VCs as investors themselves, the first step is for them to ask other investors for money, just like startups do. The people who invest in a VC fund are called LPs (Limited Partners).

Once the money is raised, the VC firm will go out and invest it. Many VC funds have some sort of “investment thesis,” which makes the scope for the types of investments they’re seeking. For example, some funds might be specifically looking to invest in consumer social networks, while others might focus on enterprise software-as-a-service. Whatever the thesis is, the VCs will go out and find companies that match that thesis and invest in them.

Venture money is not long-term money. The idea is to invest in a company’s balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that the institutional public-equity markets can step in and provide liquidity. In essence, when a VC makes an investment, what they’re really doing is purchasing partial ownership of the startup in exchange for some amount of money.

Timing Is The Key

Timing Is Everything. More than 80% of the money invested by venture capitalists goes into the adolescent phase of a company’s life cycle. In this period of accelerated growth, the financials of both the eventual winners and losers look strikingly similar. Picking the wrong industry or betting on a technology risk in an unproven market segment is something VCs avoid. Exceptions to this rule tend to involve “concept” stocks, those that hold great promise but that take an extremely long time to succeed.

By investing in areas with high growth rates, VCs primarily consign their risks to the ability of the company’s management to execute. VC investments in high-growth segments are likely to have exit opportunities because investment bankers are continually looking for new high-growth issues to bring to market.

The Logic Of The Deal.

There are many variants of the basic deal structure, but whatever the specifics, the logic of the deal is always the same: to give investors in the venture capital fund both ample downside protection and a favorable position for additional investment if the company proves to be a winner.

In a typical start-up deal, for example, the venture capital fund will invest $3 million in exchange for a 40% preferred-equity ownership position, although recent valuations have been much higher. The preferred provisions offer downside protection. For instance, the venture capitalists receive a liquidation preference. A liquidation feature simulates debt by giving 100% preference over common shares held by management until the VC’s $3 million is returned. In other words, should the venture fail, they are given first claim to all the company’s assets and technology. In addition, the deal often includes blocking rights or disproportional voting rights over key decisions, including the sale of the company or the timing of an IPO.

Two Common Kinds of Exits

In Startup Land, there are two common types of exits: acquisitions and IPOs.

An acquisition is by far the most common type of exit. This is where a bigger company buys the startup outright. So for example, if you were to start a company that makes an awesome email spam filtering app, Google might acquire you in order to incorporate your technology into their Gmail product. They’d give you some amount of money (either in the form of cash or Google stock) and you’d give them your company.

IPO is basically when a company lists themselves on the stock market so that anyone who owns stock in that company can sell it just like they would any other publicly traded stock.

Whether it’s an acquisition or an IPO, venture capitalists rely on these exits to turn their stock into cash, because they have to repay their LPs.

Conclusion

As long as venture capitalists are able to exit the company and industry before it tops out, they can reap extraordinary returns at relatively low risk. Successful venture capitalists often operate in a secure niche where traditional, low-cost financing is unavailable.

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