What are VCs and how do they profit?

Venture capitalists (VCs) or VC firms are the providers of venture capital. Venture capital is a type of financing given to startups which have long-term growth potential. It is provided in exchange for equity. VCs may also offer mentorship to startup entrepreneurs.

Venture capital may be given at various stages of a company’s growth. Generally, it is provided at the seed stage. VC firms are usually made up of multiple partners even though the prevalence of solo VCs is on the rise.

VC firms create limited partnerships with investors who provide the majority of the funding. The VC firm itself is the general partner in these partnerships. The limited partners may be insurance companies, pension funds, and charities, endowments of universities and hospitals, as well as wealthy families/individuals. Generally, VCs pool investments from multiple sources.

Some of the most famous VC firms in the world are Andreessen Horowitz, Sequoia Capital, Accel Partners, FirstMark Capital and 500 Startups. In Bangladesh, Startup Bangladesh Ltd, BD Venture Limited and SBK Tech Ventures are some well-known VC firms. Examples of a few globally renowned solo VCs are Oren Zeev, Josh Buckley and Elad Gil.

Although VCs invest in high potential startups, the investments are still risky as companies cannot provide proof of success in their early stages. This is why banks avoid this kind of funding. When making investment choices, the aim of VCs is to minimize risk while making big gains from their investment.

How do VCs make investment choices?

Some of the key focus areas for a VC when assessing a potential investment are:

• Quality of management– VCs look for accomplished people to play central roles in startups, preferably people with proven track records of building businesses with high ROI.
• Size of addressable market– Having a large addressable market is not only important for gaining traction, but also desirable in the event that a VC wants to exit the business through a trade sale. The larger the addressable market, the larger the chances of a trade sale.
• Competitive edge of product/service– VCs want to invest in products and services which provide solutions to existing problems and create value for customers in the process. They want their portfolio companies to have first mover’s advantage, so that those companies can profit off their product/service before competitors enter the market and capture a share of it.
• Risks– Investing in early-stage startups is risky considering that they cannot show the financial statements which more mature companies can. VCs conduct thorough due diligence of startups before deciding whether or not to fund those. They assess the regulatory/legal issues which may arise as the company grows, the demand of the product/service in the long run, and the potential for exiting the investment profitably in future.

How do VCs mitigate risks?

To minimize the risks of investment, VCs diversify their portfolio by investing in multiple companies and in various industries. Although VCs allocate a specific portion of their fund for each company, funding is normally provided in stages- not in one go. The initial funding a company receives is generally smaller than subsequent funding as the risks are larger in early stages than in later stages when more information is available about each company’s performance.

If a startup performs well after receiving the first round of funding, the VC firm will continue to invest in it. If it does not perform well, the VC firm will not provide subsequent rounds of funding. In the latter instance, the VC firm incurs a smaller loss by offering a portion of the fund initially than if it had given away its entire fund allocated for that startup in one go.

What is the life cycle of a venture fund?

The standard life cycle, or holding period, of a venture fund is 10 years. This means that the VC firm has 10 years to invest its entire fund and return profits to its investors. At any given time, A VC firm may be handling more than one fund.

In the first few years of a venture fund, VCs focus on identifying investable companies, investing in the most promising ones, and assembling a strong portfolio of companies. After that, they are wary of adding early-stage startups in their portfolio as the remaining time in a 10 year fund may not be enough to ensure a profitable exit from those companies.

How do VCs profit from their investments?

VCs earns money mainly in two ways:

• Management fees– After a VC raises funds, it charges its investors an annual fee to manage their funds. This fee is a prefixed percentage of the total fund, typically 2% per year. So, if a VC raises $50 million for a fund, it will charge a management fee of $1 million per year.

When the “active investment” period of a VC’s life cycle ends, the percentage of management fee is reduced every year until the fund is closed. Active investment period is the time frame in which VCs identify investable businesses, conduct valuation and due diligence, negotiate term sheets and close deals.

• The carry– Carry is a prefixed percentage of profit a VC will earn once investors have been repaid their capital. Typically, this is 20% of profits, but very successful VCs can negotiate higher percentages.

From our previous example, let’s imagine that a fund of $50 million had been initially invested into a portfolio of companies, and the companies eventually went public or were acquired by others. The fund’s investments are now worth $100 million. In this case, the VC’s investors will get back their $50 million first, then the VC will get a profit of 20% of the remaining $50 million, which amounts to $10 million. This $10 million will be shared by the general partners who run the VC firm.

The 2% management fees combined with 20% of profit is the standard fee structure followed by VCs when dealing with investors. This is called “Two and Twenty”.

What are the exit strategies of a VC?

A VC can pursue one of several exit strategies mentioned below:

• Initial Public Offering (IPO) – This is the most common exit strategy in which the company lists its shares publicly on a stock exchange. The VC can then sell its shares, hopefully for a profit as it is expected that a company’s shares will appreciate in value over time.

• Mergers and Acquisitions (M&A) – Mergers happen when two companies combine to become one. Mergers can happen through purchase, in which Company A will purchase Company B and then incorporate company B’s assets into company A. Mergers can also happen through consolidation, in which two firms of the same size join together concertedly.

Acquisitions occur when one company buys the majority of shares in another company, effectively becoming the owner of both companies.

• Special Purpose Acquisition Companies (SPACs) – A special purpose acquisition company (SPAC) does not have any business operation and is formed solely to raise capital through an IPO. This capital is used to buy a private company, which can then trade its shares publicly. The benefit of an SPAC over IPO is the shorter duration in which a company can go public.

• Liquidation– When a company is unable to repay debts, it may stop operating and sell off its assets to repay creditors. This is called liquidation. Any money remaining after liquidation is paid to shareholders.
• Share buyback– This happens when an investee company buys its shares back from investors.
• Secondary market– Before a company goes public, VCs who provided initial funding may sell off their shares to other investors. This trade takes place in a private equity secondary market as the company’s shares are not publicly listed.

Conclusion

It is important to note that not all startups which receive funding will end up being successful. Around 90% of startups fail, making venture capital financing a risky business. For investments that end up being successful, the rewards to VCs are huge.

Sources: Forbes, Startup Genome, Corporate Finance Institute, Investopedia, Agile VC, Kruze Consulting, Alumni Ventures, Allen Latta, Seraf Investor