What is Venture Capital really?

Ever since startups like Flipkart, Ola, Uber, Airbnb became household names, millions and billions of dollars of funding have become an everyday affair. The firms that invest this money are the VCs or Venture Capitalists, firms that have generally chosen to remain in the shadows until recently. How do they make money, what do these VCs do and who becomes a VC?

The VC Business Model

We know that VCs put money into startups, but where does this money come from and why do they do it? Financially speaking, venture capital is an alternative investment, which in basic terms is an asset class other than stocks, bonds and cash. Venture capital is a type of private equity investment that involves investing in young, high growth companies by providing cash in exchange for equity. The term VC and PE are used separately to differentiate between the types of companies a VC or a PE would invest in. VC is used for young companies with limited or no cash flows while PE is for mature companies generating sizable cash flows.

Who gives them the money?

High net worth individuals or large funds are looking for investments opportunities outside standard investment classes. For them, a venture capital fund is an alternative investment possibility. Therefore, these HNIs/funds put money into a Venture Capital fund, and they are therefore known as Limited Partners or LPs. A LP is only liable for his/her/its capital investment. This is precisely why you would read articles like Sequioa hitting the road to raise its latest fund. A general fund lifetime is 10 years, i.e. after 10 years, the LPs want all their money back with a return. This results in illiquidity, or a lock in of funds, due to which LPs want a greater return. I used to be confused and wonder why this was so, but as you can now understand, a venture capital firm is essentially a fund manager.

How do they make money?

Why would some one put their money in a venture fund? For better returns as well as lesser correlation with standard asset classes. Once the fund has been raised, the General Partners, i.e. the partner at the VC who actually manages the fund and the company, starts looking for companies to invest it. We all read the hope that every VC has is that their investment is successful. As you can understand, a VC has bought some equity in a company and hopes that the value of the company increases, so that the value of the equity that they have also increases.

A general VC expectation of returns is of the order of 12% for 10 years, which is a 3x (1.12^10) return. This means that the value of a company should become at least 3 times in 10 years. Of course, paper value means nothing, because after 10 years, the money has to be given back by the VCs to their investors (LPs), so a VC needs to exit. A VC exit can happen in three ways 1) IPO or public market sale of equity 2) Sell out of the equity to a firm acquiring the startup 3) Sell out of equity to a PE (strategic sale). If a sale happens, the exit is successful and the VC can return the money to the investors. A snapshot, from the Harvard Business Review, explains the entire process.

Series A-H, Pre Money, Dilution and VC "jargon"

Flipkart getting Series D, Housing getting Series A : these have often been talked about in the general public space. Over time, as the VC space has become more open to public scrutiny, the process of funding has also become more streamlined (previously, it used to be very "hazy"). These series are nothing but funding rounds, where startups obtain investments. The rounds are as follows:

1. Seed Round : "Insiders" to the company provide capital to the startup
2. Angel Round : "Outsiders" or external investors provide capital in exchange for equity
3. Series A and so forth : Post the angel round, the series funding begins. Each series is led by an investor, known as the lead investor. The lead investor puts up the most capital for equity. There is also bridge financing, that is financing between two rounds. For example, if a company needs funding but it is too early to go the next series, it seeks bridge financing i.e. a bridge between two rounds.

(This part can be skipped in case one doesn't want to get technical)

To understand dilution, one must understand pre-money and post money valuation. Pre-money valuation is the valuation of the company without the financing it receives, therefore pre-money. As an example, if the company is valued at 10 million $, with a funding of 2 million $, the pre-money valuation is 10 - 2 = 8 million$ and post money is 10 million$.

Dilution happens with every additional round of funding. Taking forward this example, let's say the founder has 25% of the company before the round of funding, that had the company valued at 8 million pre-money. Let us say the company issued 1000 shares of stock, therefore each share is worth 8,000,000/1000 = 8,000 dollars. Now, if someone provides 2 million dollars for equity, they must be "issued" shares. Therefore, the investor gets 2,000,000/8,000 = 250 shares. Now the total number of shares is 1000 + 250 = 1250 shares. The founder, who had 25% of 1000 shares, still has those many shares. Therefore, after funding, the founder has 250/1250 = 20% of the equity, which is a dilution from 25% that he/she had initially.

The utility of pre-money and post money can be seen because it can be used in a very straightforward manner to calculate what we just took 5 lines of explanation to calculate. The ratio of the pre-money and post-money is exactly the dilution percentage, i.e. (pre-money/post-money)*stake = new stake. So if your ratio of pre-money and post-money is 0.8, the dilution percentage is 80%. As you can see in this case, it is (8,000,000/10,000,000)*25% = 20%.

What does a VC do?

As the success of the VC depends largely on the success of the companies that they invest in, a VC investor ends up doing one of these two

1. Deal Sourcing - Generating leads, identifying investments, due diligence and negotiation of deal terms
2. Portfolio Management - Directing the portfolio company, providing consultation, getting the right people to manage it

A portfolio company is a company that a VC has invested in i.e. is part of the portfolio of the VC. As you can see, a mutual fund portfolio also has portfolio companies, but managing it is less active and requires no human intervention. This is why a VC is an alternative investment, but exhibits the same structure and motive as any fund.

Identifying an investment opportunity and managing it is more complicated and time consuming than picking stocks, which is why VCs are well paid, and VC funds are therefore also expected to generate higher returns. As there is considerable human investment, the returns are expected to be commensurate. Bear in mind the use of the word expected, sometimes expectations do not meet reality.

Historically, 20% of a VC fund's portfolio generates 80% of the returns (Pareto principle) and therefore the expectations from some companies to generate returns is even higher. As an example, assume that you have invested $1 million in 5 companies, and you expect a return of 12%. Assuming that 4 companies fail (0 $value) the one company that was worth $250k has to be worth $1.12 million or have a 348% (3.48x) return. Usual portfolio consist of stars, middlers and failures and as you can see you need to have real stars to compensate for all the failures you have.

That is why you have star portfolio companies like an Uber, AirBnb, Flipkart that are expected to be supremely successful, and are good enough to generate returns for a fund even if the rest of the portfolio is useless. As an example - Whatsapp alone returned 6x the entire fund for Sequoia because of its sale to Facebook - a classic example of a superstar investment.

Who becomes a VC?

Being a VC is an extremely attractive profession, especially if you're looking to be working with entrepreneurs and getting to manage a wide variety of companies. Typically, ex entrepreneurs who've sold their company set up a VC. A team of ex entrepreneurs, ex consultants, bankers, B-School graduates and the like tend to populate the firm.

What do you need to become a good VC?

1. Luck
2. Business insight and acumen
3. Foresight or a "vision of the future"
4. Ability to communicate with an entrepreneur

It is an extremely challenging as well as exciting profession, which is why a lot of consultants/bankers/entrepreneurs are attracted to it. Nevertheless, it is has its risks, which is what makes it thrilling.

I blog about venture capital in India at Life of a Junior VC