Startup Advice

Things You Need to Know About Venture Capital

Did you know the total amount invested by the Venture Capitalists in 2020 is reached a staggering around $164 billion in the US alone? In case you are wondering what the global scale is, then that is about $321 billion. Besides, the world is filled with startups that are a result of venture capitalism.

Even though the venture market is growing at a record pace, awareness of how venture capital works is still low. The people with tons of money just sit around while thousands of excellent ideas struggle to succeed. Venture capital is an interesting concept that intermediates both.

This article aims to provide you with information on venture capitalists, venture capital, and more. Let's get started.

Who are Venture Capitalists?

To understand venture capital, we must first understand venture capitalists. These are the ace of the whole concept as everything rests on their shoulders. From investments to finding the right company, they are the ones who play cards here.

A Venture Capitalist, also known as a VC, works for a venture firm that invests in Startups or other companies with very high growth potential. Venture capital is a big part of any startup ecosystem; they invest anything from $1 million to hundreds of millions into startups.

Venture capitalists invest from early to late-stage, usually start at the Seed stage, and keep going to an IPO. The process can be pretty straightforward or can be quite complicated. Overall, the process varies from company to company.

Besides, as they say, always follow the money. So in this article, we are also taking a look at where the money is coming from. First of all, venture capitalists invest other people’s money, and it is not their own money. But what do they do to collect that money in the first place? Also, there’s more to cover.

In addition to that, venture-capital firms sometimes claim to have 2.5 billion under management. This means they manage the 2.5 billion on behalf of multiple funds. Just like any startup, most venture funds fail. Either they never raise enough money, or their performance isn't good enough, and they fail to raise a second fund.

Today, in this article, we will explain everything about Venture Capitalists. We will discuss the following topics.

What is Venture Capital
What are the Objectives of the Investment
What is the Focus of Venture Capital
Why Most Startups Fail; Why Venture Firms Avoid Them
How do Venture Firms Work
What is the Decision-Making Process?

What is Venture Capital

There is a concept called Limited Partners (LP) before we even consider the venture fund. That is where the money comes from. The money that ends up being invested in Startups actually comes from these LPs. Investors who wish to invest in a venture, but do not wish to manage their investments, place them in a venture fund instead.

Typical LP’s are:

Pension funds
Family offices
University Endowments
Insurance Companies
Foundations etc.

So all this money from the LPs goes into a venture fund. However, that is not the same as a venture firm. In order to invest all this money, we need a venture firm. The venture firm manages the fund and makes all the investments on behalf of the venture fund.

The venture firm gets paid a management fee, a percentage of the entire fund. The range of the fee is usually from 1% to 2.5% of the fund size per year. This percentage is of the entire fund. For this, the venture firms have a clear interest in raising a fund that is as big as possible.

Plus, the venture capital firm makes carry, which is whatever profit is made from the fund. The carry is usually between 20 and 30 percent of the fund's profits.

SO if you have the money coming from these pensions funds, endowments, etc., they are called LPs or limited partners. They invest in a venture fund. In the end, that money is invested in some amazing startups by the venture firm that manages the venture fund.

What are the Objectives of Venture Investment?

Investing raises a common question: why? Besides, what is their objective? The venture fund aims to maximize the return on investment. Make as much money as possible. Without making any money, the venture fund will be unable to raise a new fund.

In general, a fund has a lifetime of 10 years, but each fund only makes new investments for 3-5 years. So after 3-5 years, the venture firm has to raise a new fund, or else they will not be able to invest. We might never think about it, but it does happen. A venture firm with less-than-stellar performance cannot raise a new venture fund.

Investors in venture capital have one goal: they want to make as much money out of the fund as possible. Bringing in more money for future funds will ensure the firm's survival. Investors do not invest their own money but instead, raise significant funds from which to invest.

The venture firm's life is slowly being snuffed out if they cannot raise a new fund. This happens a lot in the venture business. It isn't easy to be a venture capitalist. Consider again, if they do not select the winners, they will die, so it is not an easy job.

So all about the return of the investment, maximize the profit of the fund. And as the fund is making a profit, the fund is also gaining a reputation to get more investment. This is a simple concept. The more money your investment will make, the more attention your firm will be getting; simple!

What is the Focus of Venture Capital?

Venture capital firms typically have a focus and don't just invest in any business at any stage. If you engage with a venture firm or talk to them at any time, it's a good idea to figure out their focus. You are wasting your time if the venture firm and your startup do not match.

In seeking as much information about the space as possible, they might be looking into that particular industry or even a competitor. In that case, you’re wasting your time. However, this is beneficial for them as they are gathering valuable intelligence for themselves.

There are different types of focus, and they can vary based on some consideration factors. The following are three typical ways a venture capital firm can focus.

#1 Stage Focus

Almost all funds have some kind of focus here. Generally, venture firms start at the seed stage and can go all the way to a very late stage. The funds that invest in the Seed stage usually don’t lead in a B round it is ok to engage with the stage even if the focus doesn’t match as long as the venture fund invests LATER than the stage you’re at.

So if you’re at the Seed stage, it’s ok to engage with a venture firm only invests at the A round stage. The other way around, if you’re at a B round stage and the fund only invests in Seed round, that would be a waste of time.

#2 Geography Focus

Most funds also have some kind of geography focus. Some are very narrow, whereas others are comprehensive. SEED Capital, for instance, invests only in Denmark, while Balderton Capital invests in Europe, a somewhat broader geographical area. A lot of the venture firms in Silicon Valley only invest in Silicon Valley.

So basically, there are venture capital funds, which are only limited to a particular area. Fortunate for you if you are within that area. However, unfortunate if that is not the case. Yet, there is one general rule, and that is highly related to geography.

As a general rule, the later stage the company is, the further away it can be geographically. They are more mature and can be managed across oceans. On the other hand, early-stage companies usually need a bit more babysitting, and therefore, the early-stage funds require their investments to be close geographically.

#3 Sector Focus

The final one is a focus on Sector, this can also be multiple sectors, industries, or technologies. This can vary a bit; some of them like marketplaces, some like Blockchain others prefer SaaS companies. It is noticeable that most venture firms are very open to anything scalable that can be a great investment.

However, it is more common than a specific focus the venture firm may have a blacklist. Specific industries that they don’t like to invest in. Several instances have been observed where venture capital funds are unwilling to fund games and hardware.

So these are the three focus areas that venture firms usually have Stage, Geography, and Sector. You will see venture firms that say they are stage agnostic will invest anywhere and in any sector. However, when it comes to reality, it just isn’t true.

Don’t listen to what they say, look at what they do. Look at the companies they’ve invested in, look at their portfolio. The portfolio tells you exactly what their focus is, the portfolio never lies.

It is crucial that you understand their focus so you don’t waste your time on irrelevant investors. They may want to talk but could be fishing for information with no real intent of investing.

Tip: Try to look at the portfolio of the Venture Capitalists. See what type of projects they have invested in before and whether they match your interest.

Why Do Most Startups Fail?

Before moving into the process of the venture firms, let’s get an idea of why startups fail. This is also the reason why most venture firms try to avoid startups. However, the level of potential startups provide is much higher. Yet, the risk is too high to ignore.

The stage of the startup matters a lot in terms of investment. The earlier the startup, the higher the risk Investing in a growth stage company that has a product-market fit. In addition, the stages of growing revenues are very different from doing an angel round before a product-market fit and before a revenue stream. The risk at the angel stage is much much higher than at the growth stage.

Understanding that most startups fail is important to understand the thinking of investors. With so many startups failing, early-stage investors have to get the return on their investment from the few companies that do make it.

An Example:

Let's take a look at a simplified example. We have an investor that invests $1000 in 10 different companies. The investor has invested a total of $10,000 in those companies. Now let's assume that 8 of them go down, or at least what has been invested has vanished. Now the last 2 companies have paid back the investment for all 10 companies plus profits on that.

In this case, 10,000 was invested, and we have 2 companies left, and although we only invested 1,000 in those two companies, we have gotten a 5,000 return on those two companies just to break even on the 10,000 investment. That if 5x meaning 5 times the money back. Investors also have to make money in the real world, so aiming for 10 money back is probably more realistic.

So when you offer an investor 10% interest on the investment, the investor doesn't say no because he is a greedy bastard. The investors say no because the risks in early-stage startup investing are extremely high and investors need a better return just to break even.

How do Venture Firms Work?

You may be wondering how venture firms work. Well, we are going to cover that now. The following will explain how they find their investments and who they are.

First, they need to find their investments. They will have inbound interest, startups that come to the venture firm to look for investment as a venture firm. Founders will send them emails and submit business plans to the venture firm. To get more inbound, the venture firm will create a bit of buzz through press and events.

More important than the inbound is probably the outbound. It is getting out and trying to find the most exciting startups to invest in. This is done by having an extensive network that has the finger on the pulse in the startup community—a network of incubators, angel investors, founders, executives, etc.

They will look at hundreds of investments for every investment that they make, so competition is fierce. It is a lot of work to go through all these investments. Even wondered who the people are working inside a venture firm are?

Tip: It’s always ideal for getting along with the people around venture capital. They will have good interest and excellent insights into the industry. Besides, if you are lucky, you may get along with anyone from a venture firm.

The Hierarchy at Venture Firms:

If you are how a venture firm’s hierarchy is like, well, we got you covered. Below are the parties that are involved in the hierarchy.

#1 General Partner

#2 Venture Partner

#3 Principal

#4 Associate

At the bottom of the hierarchy, there are principals and associates. The principal will be a little bit higher in the hierarchy and may be on track to become a partner at the fund. Associates are more junior, and they help source and vet deals for the firm.

The decision-makers are the partners in the fund. General Partners or GPs are the people that run the fund. Sometimes, Venture Partners are also loosely affiliated with the fund; they usually source deals and get paid on whatever they bring to the firm.

Well, this is the old structure. Things have changed a little bit lately. Founders have figured out that they want to speak with partners as they make all the decisions. Spending time on associates and principals can be a waste of time.

This is because it is another barrier to getting to the partner as you have to repeat everything. This meant that founders stopped taking calls and replying to emails from principals or associates, making their work difficult.

A Newer Approach:

The solution that the venture firms found was basically to call everyone a partner. So now there is some kind of hierarchy, but they’re all called partners, which is a little bit hard to maneuver.

The concept can be cleaned with an example, and here is a great one. We did a quick check on venture firm Andreessen Horowitz on LinkedIn, and they now have 55 employees with the title partner. This is a very big partner meeting every Monday if they are 55 people in the room.

With 55 partners making decisions, you can't run a partnership! It is so apparent that Andreessen Horowitz’s own partners aren’t even buying the story. We also found one partner with quotation marks around his title on LinkedIn, saying “Partner”. Not even their own “partners” are buying it…

Therefore, they are not partners but associates or principles with a fancy title. Understanding who is a partner and who are associates or principals is a complex problem. At once, one can be a partner and later turn out to be an associate. Nothing is impossible here!

It is harder to find the “real” partners now but look for General Partner. Or you can just look at the resume. If the partner comes straight from college or only has 2 years of management consulting, they’re probably not a real partner.

Tip: Ideal strategy is to find the General Partner. They are also full-blown partners.

What is the Decision-Making Process at a Venture Firm?

The decision process for the venture firm can vary a lot. However, here we want to give you a general idea of what a process can look like. It can be long or short, but it always involves a great deal of work.

Generally, the process follows the following steps.

#1 Talk to a partner

#2 Probably meet another partner

#3 Present at the Partner Meeting

#4 Vote at the Partner meeting!

At first, you talk to a partner and this can be one meeting or more likely many meetings, sometimes over a very long time. It all depends on where the Startup is. Obviously, during this process, questions are being fired back and forward. Usually a lot of questions and a lot of numbers.

Hopefully, at some point, the Partner says that they are interested in investing and would like you to meet another partner. This is something they do a lot. They want to get a second opinion, sort of a sanity check to make sure that this really does look like a good investment.

If that goes well you get to the partner meeting. At this point, your odds of investment are very high. When two of the partners have already agreed, the chances of the rest of the partners agreeing are extremely high. Maybe even as high as 50%. So it really is yours to lose!

After that, they vote and if it goes in the right direction, they are ready to invest. This may sound very simple, but the process is not that easy in any way possible. The process may take several days, weeks, or months of persuasion and dedication to make them understand the potentiality.