- The venture capital industry:
Venture Capital (VC) investment is a way to fund a company. VC makes investments in emerging companies, the riskiest investment class known.
VC is a financial industry in which institutions raise money in high-risk companies that possess paradigm-changing ideas or technology.
Companies that take VC to get more than money. They also get the expertise of the VCs and VCs network of advisors and business people.
Companies that take venture capital grow large very quickly or are acquired in a few short years.
Companies that benefit the most from VC are those that have a disruptive technology or product that they aim to grow very large, very quickly.
Venture capital tends to invest in companies built around software, drug developments, medical devices, engineering devices, and other cutting-edge technologies that are considered disruptive to current markets.
Disruptive technologies are innovation that could not have been predicted. VC looks for disruptive technologies because the potential for a huge return on investment is greater when the business hinges on very risky technology or market integration. High risk can equal high reward.
VC-backed companies are sold after five or seven years in an acquisition or on the stock market in an initial public offering (IPO).
VC are professional investors who give start-up money in exchange for equity in the company. These investments are high risk and also potentially high return.
VC firms tend to specialize because the deal with risky investments so they have to make sure they understand their chosen industry and technologies inside and out.
VC will look for the following before investing in a company:
- A company that has a product or has made a lot of progress toward a product.
- A strong team that can execute its plans.
- That the company has connected with its target customer and understand its market.
We can differenciate two kinds of companies:
- Seed stage companies: they have no revenue or little revenue.
- Stage 2 companies: they have between 5€ million to 50million in revenue.
- The venture capital fund team may include:
- Limited partners (LPs)
Provide the bulk fiance that goes into the fund. These can be individuals, institutions, or other funds (Pension, Endowment, other). LPs are generally silent partners of a fund and can express their pleasure, or displeasure, with the running of the fund by contributing, or not contributing, to the next fund the VCF raises.
- General partners (GPs)
The individuals who run the firm and make the final decisions on behalf of the fund. GPs often put personal capital into the fund, somewhere between 1–2% of the total fund, to have ‘skin in the game’ and show investors they believe in what they are doing.
- Venture partners
Not all funds have Venture Partners, or VPs. When used, VPs are tasked with sourcing quality investment opportunities for the fund and are compensated on the number and quality that ultimately receive investment.
Mid-level investment professionals who are often the star performing associates, or experienced individuals from other industries, who are on track to becoming a Partner. Not all firms have principals, small firms will typically skip this title and just have General Partners and Associates.
The junior position within the team, associates are often tasked with a lot of the leg work that goes into reviewing and filtering deal flow early in the process. Companies that are of interest are then passed up the chain.
- VC fund lifecycle
As all the companies in the portfolio are sold, the money is returned to the original investor (Limited Partners) and the fund closes.
When a venture capital firm invest, they intend to keep that company in their portfolios for four to seven years.
VC backed companies have quick growth potential, large growth potential and a smart and flexible team.
The general rule is to aim for at least 10X return on investment in five years.
To have this growth potential, a company must have these desirable attributes:
- Large market: are there enough people or businesses with enough money willing to buy the product that this company sells.
- Growing market: is the number of people or businesses that will be willing to buy this product in the future increasing?
- Game changer: is the product or technology going to change the way people or businesses do things?
- Team experience: is the team able to execute to grow the business at least in the short term?
- How a VC fund works
- Fundrasing: The VC meets with potential limited partners to get them to invest their money in her fund. Money comes from wealthy individuals, pension funds, insurance companies, family offices, foundations, and other pools of cash. LP: provide capital. (called like this because they have limited liability when they participate in the fund). VC has to gather up the total value of the fund, which often exceeds $100 million. VCs do this through a process called selling the fund, in which they have to convince investors to participate. Once they have collected enough money, they close the fund, and after it’s closed, none is allowed to put more money in. VC and investors enter into a limited partnership agreement, which stipulates things like the kind of company the fund will invest in, the amount of money that will be invested, the phase of development of the company and the amount of time before the money is to be returned to the limited partners.
- Investing: The VC meets with many companies to find a few that she will invest in. After the fund is closed, the vc has to collect applications from companies who want to be funded. Having a constant stream of interested companies companies is called deal flow. Then the VC screens through deal flow, invites companies to pitch, and begins due diligence on the companies it likes.
- Screening initial interest:
- Management team that has the track record and experience to execute.
- A big idea in what will be a very big market.
- A company/product that has the ability to be the leader in the sector.
- Many potential strategic buyers or initial public offering (IPO) potential and a near term exit which is a potential for 10 times and 30 times return in the three to seven years.
- Meeting with companies and seeing their pitch
If the meeting goes well, the VC moves to the next stage, due diligence.
- Following up with due diligence
Due diligence is the process of researching a potential investment so well that everything is known about that company.
- Managing: After the fund invest in a company, the VC actively participates on the board of the company, works with the CEO and makes business connections to make sure that the company is making good business decisions.
- Harvesting: when companies undergo liquidity events such as an initial public offering, merger, acquisition or a sale of shares to another firm, the VC manages the divvying of funds to all the shareholders.
The exit strategy is the most important part of the job for a VC. In most of the cases, the only way a VC makes money is when the company is sold through an initial public offering (IPO) or is acquired by another company (merfer and acquisition, or M&A) or a private equity firm.
To have a succesful exit, several key contidions must exist:
- Rapid growth
- Strong and coherent management team
- Favorable market
- Economic conditions for acquisition or IPO
- Sufficient traction to justify acquisition by a key player in the market
- How VCs generate their income:
- Management fee:
The VC firm earn a management fee that covers its cost for creating deal flow, screening, due diligence, serving on board, coaching, accounting and reporting and engineering the exit. Normally is 2% of the money invested.
- Carried interest at the exit
Typically 20% of the net profit after an exit.
- Interest from investing their own money
- Trends in VC
Software is the most popular industry for VC investors, a trend that’s remained unchanged as the years have gone by. Other industries are maintaining historical figures, too.
For 2018, this trend will continue to be a big part of the landscape. Software companies are constantly making progress and creating innovative new products for the world. These companies will lead the industry in the number of successful startups and new ideas.
Technology is a driving force in many people’s daily lives, so it makes sense to focus investments into this area. Venture capital experts expect to see more examples of new technology ideas related to green energy, home automation, self-driving cars, education, and more.