venture capitalist(VC) is a person who provides equity financing to companies
with high growth potential. The money that a venture capitalist invests in a company
is called venture capital. Venture capital firms are often limited partnerships
that comprise a few venture capitalists. Each venture capital firm manages a venture
fund, which is often comprised of a large pool of money--anywhere from $25 million
to $1 billion--that the firm invests in growth companies. A venture capital fund
consisting of third-party investments can finance enterprises that are too risky
for debt financing. Each
VC firm invests in several companies and this group of
companies is called the firm’s portfolio companies or portfolio.
Most VC firms have different kinds of executives: general partners, limited partners,
venture partners and entrepreneurs-in-residence apart from associates and office
staff. General partners are the primary investment professionals in a firm. General
partners collaboratively manage the firm’s venture fund. Limited partners are the
individuals who invest in the venture fund. Venture partners bring in deals and
receive income on deals they mark. General partners on the other hand receive income
on all deals.
Entrepreneurs in Residence are domain-specific experts who perform due diligence
on potential deals. These individuals are temporarily engaged by VC firms for a
short period. Typically, they are expected to conceptualize startup ideas or move
on to a CEO or CTO role at a portfolio company.
How do VCs generate money?
The primary objective of a venture capitalist is to manage his/her venture fund,
provide equity financing to companies that have high growth potential and generate
profits from their investments. VCs generate profit by buying a company’s common
or preferred stock, helping that company grow and liquidating their own stock once
the company reaches a certain size and market value.
venture capitalist invests money in a company by buying equity, thereby
becoming its shareholder. Given this situation, if the company fails, the VC is
not going to get his or her money back. Since VCs employ equity financing to fund
a company, the risk of loss is transferred from the entrepreneur to the VC. An
need not return the invested money because VCs own stock and become the entrepreneur’s
partners. If the company fails, the value of the VCs’ stock becomes zero.
Although equity finance appears intimidating from an investment point of view, VCs
manage the risk by
investing in multiple companies that have high growth, thereby
creating a portfolio. The logic here is that losses from any failed companies will
be offset by the high Return on Investment (ROI) from the successful portfolio companies.
In general, if a VC creates a venture fund and invests in ten companies, he or she
assumes that five of those companies will fail, three will generate low to average
returns, and two will be successful. The VC’s equity in the successful companies
generates such high returns that the losses are offset and the entire venture fund
increases in value.
How do VCs select companies to invest in?
Given the high risk, VCs rigorously research business ideas before they invest in
one. VCs should assess the idea, the business plan, the market dynamics, etc. before
investing in a company. The following paragraphs describe the four most important
aspects of their decision making.
Companies that target different markets and are at different stages require funding
for different reasons. It is virtually impossible to understand the dynamics of
every company that needs investment. Therefore, each VC focuses on a type of company
and specializes in that particular domain. For example, certain VCs focus only on
wireless communications, while others focus only on biotechnology or nanotechnology.
Therefore, it is important for an
entrepreneur to research the right set of VCs.
Different VCs focus on companies at different stages. Some VCs focus on early-stage
companies, where the risk is high, some focus only on expansion-stage companies
and others focus only on late-stage companies. Finally, there are other VCs that
focus on private equity and leveraged buyouts. In addition, VCs prefer to invest
in companies that are within driving distance. They want to drive to their portfolio
company and attend monthly board meetings.
VC firms are often considered to be in different levels or tiers. The VC firm’s
partners decide whether it is a tier-1 or tier-2 firm. Top-tier venture firms are
established firms that generally manage larger venture funds with more money being
managed and employ a higher number of experienced VCs who are specialists in their
focus areas. Sometimes, top-tier funds are small or second-tier funds have experienced
partners, but the above generalization usually fits.
Actions that indicate Top-tier firms:
- Large initial deals ($5-$20 Million range)
- Many deals per month (2 to 5) since they have more partners and more money
- A high percentage of their investments are in later rounds
- They frequently do merger & acquisition type investments along with pure venture
Actions that indicate 2nd-tier firms:
- Highly-leveraged, smaller initial deals
- Move faster than top firms
- At times, they prefer to co-invest in companies along with other Tier-1 VC firms
- They are more likely to nurture a deal that they feel has promise, although resource
limitations can make this difficult for them
It is important to know the dynamics involved in dealing with VCs at different rounds.
Startups that raise their first round of capital from 2nd-tier VCs often have trouble
finding top-tier VCs in later rounds. Top-tier VCs prefer to retain the managing
control of a startup, which might be difficult if the first round of capital was
raised from smaller 2nd-tier investors.
Dealing with Top-tier VCs often results in spending a large amount of time and money
negotiating terms with lawyers. 2nd-tier firms, on the other hand, move very quickly
to close the deal at hand.
VCs not only invest in companies, but also help companies succeed. They advise the
entrepreneurs and assist with customer contacts, market specific intelligence, etc.
A VC is successful only if his or her portfolio companies succeed.
Of course, VCs are also human beings with their own share of mistakes. Some VCs
make irrational decisions and do not treat portfolio companies fairly. Some become
greedy and deprive the founders and employees of returns. There are horror stories
all over the internet. Therefore, entrepreneurs should research the backgrounds
of the venture firms they deal with.
This article is intended to provide a brief overview about venture capitalists and
venture capital firms. You may want to explore other avenues using a Google search
to gain a thorough understanding of the concepts and workings of a
firm or a venture capitalist.
Pradeep Tumati (Principal, go4funding.com)