Chapter 2

Understanding Venture Capital

Source: https://fundersclub.com/learn/guides/vc-101/understanding-venture-capital/

Successful VCs have mastered the art of spotting one of the lucky few startups that make it big, and betting on them when it’s still too early to tell whether they’ll succeed.

What are Venture Capital firms (VCs)?

Venture capital firms (VCs) are money management organizations that raise money from various sources and invest this collective capital into startups.

VCs raise these funds from family offices, institutional investors (pension funds, university endowment funds, sovereign wealth funds, etc), and high net worth individuals (with assets over $1 million), who allow the VC firm to manage their investments.

The size of VC investments in a given startup can vary widely based on the particular investment theory and practices of each firm.

The influx of VC cash, along with the additional resources, advice, and connections VCs can provide, often serves to help startups to grow rapidly and dominate their market.

VC firms typically make investments according to a particular thesis – for example, supporting startups in a particular stage, industry, or geographic region.

EXAMPLE

Union Square Ventures (USV) is a notable VC firm toting a portfolio packed with big hits: Tumblr, Twitter, and Coinbase, to name a few.

USV invests according to a particular strategy, concisely summed up by partner Brad Burnham in a tweet that became the firm’s official investment thesis: “invest in large networks of engaged users, differentiated by user experience, and defensible though network effects.”

This means that USV looks for companies that can scale (like Twilio), bring together huge groups of people or connect a marketplace (like Twitter), provide a seamless user experience (like Codeacademy), and thrive off of the network effect – the more people who use it, the more valuable the tool is.

This is a particularly concentrated approach to VC investing that has served USV well.

In 2015, US-based VCs raised about $28.2 billion in total, and deployed nearly $60 billion to 4,561 startups, according to the National Venture Capital Association.

As a point of comparison, all US-based angel investors (individual investors who directly invest their own money in startups), raised and deployed over $24 billion in 2015, spread throughout more than 71,000 companies.

This demonstrates the longer lifetime of venture funds, which are generally deployed over a period of several years, and the smaller average check sizes of angel investments vs. venture investments.

It can be near impossible for new investors to get access to top startups through proven VC firms. Each fund has a limited number of spots for investors, and many top-performing VC firms already have a backlog of previous investors who get top priority on their new funds.

What are venture capital funds?

Parties that invest in VC funds give their money to experienced fund managers, who are responsible for investing that capital in high-promise startups and making a competitive return on the investment.

VC funds are pools of money, collected from a variety of investors, that a fund manager invests into a collection of startups. A typical VC firm manages about $207 million in venture capital per year for its investors.

On average, a single fund contains $135 million. This capital is usually spread between 30-80 startups, though some funds are entirely invested into a single company, and others are spread between hundreds of startups.

Who invests in venture capital funds?

Parties that invest in VC funds are known as limited partners (LPs). Generally, LPs are high net worth individuals, institutional investors, and family offices.

Breakdown of LP Capital Invested in VC Funds:

• Majority institutional: pension funds, endowment funds, etc. Institutional fund managers will generally invest some of the capital within VC funds, with the goal of achieving a certain overall percentage of return (say, 15% increase) each year
• Small percentage from high net worth individuals: individuals with a net worth of over $1 million in liquid assets who invest their personal wealth in startups or VC. Many VC funds limit participation to individuals who clear $5 million in net worth.

EXAMPLE

David F. Swensen, manager of Yale’s $25.4 billion endowment fund, pioneered a groundbreaking investment strategy in 1976. He diversified the fund, then composed of stocks and bonds, by including multiple asset classes, and led Yale to become one of the first universities to invest in venture capital.

Venture capital went on to become Yale’s best performing asset class, generating a 33.8% annual return from 1976 to the present day. Yale’s endowment fund is packed with tech giants like Amazon, Google, Facebook, Pintrest, Snapchat, Uber, Twitter, and Airbnb.

Venture capital now makes up 16.3% of Yale’s overall investment portfolio, and its endowment fund generates 33% of the university’s overall budget (as opposed to 10%, before Swensen’s management).

Who manages venture capital funds?

VC firms will typically employ one or many fund managers, or general partners (GPs) to run their funds. GPs are responsible for making smart investment decisions and maximizing returns for the LPs who invest in the funds they manage.

GP responsibilities include: - Raising funds from LPs - Sourcing top startups - Performing due diligence - Investing fund capital in high-promise startups - Delivering returns back to investors in the fund (LPs) - Providing value-add to fund portfolio companies beyond just capital, including introductions, advice, introductions to follow-on investors, etc.

VC funds tend to be large – ranging from several million to over 135 million.

Investing in larger VC funds comes with advantages and disadvantages.

Pros: - Experienced VCs with inside knowledge manage your investments - Most large funds include a diverse base of companies - The fund has follow-on capital on-hand to deploy to successful portfolio companies looking to raise additional funding, which maximizes the investors’ equity stake in already proven, successful companies - Large funds tend to invest in later-stage startups, which have a lower risk of failure than seed and very early- stage companies

Cons: - Huge funds frequently fail to deliver market-beating returns, as there is sometimes more capital to deploy than high-promise startups to invest in - Large funds are less likely to invest in early-stage startups, which are a riskier investment than later-stage startups, but have a greater potential for outsized returns

Like individual startup investors, fund managers tend to diversify each VC fund by investing in multiple startups within different industries, in order to maximize their chances of landing on a startup that generates returns which more than compensate for all failed investments.

VC funds are structured under the assumption that fund managers will invest in new companies over a period of 2-3 years, deploy all (or nearly all) of the capital in a fund within 5 years, and return all capital to investors within 10 years.

Funds have a long lifetime because it usually takes years for the startups they invest into mature and grow in value. For example, many GPs will hold off on closing out a fund by liquidating the investments within it if a liquidity event has not yet occurred for promising startups within the fund.

In exchange for investing your money and managing the fund, VC firms typically charge management fees and carried interest (carry), on a percentage of the profits made on fund investments.

This is referred to as the 2-and-20 model: VCs typically charge 2% of the total fund size per year for management fees – the operational and legal costs required for the fund to operate – and 20% carry on any profits the fund makes.

Top VC funds sometimes employ a 3-and-30 model, and are able to justify these higher fees because their track record still leaves investors with greater net returns.

EXAMPLE

In 2003, the Sequoia Venture XI Fund raised $387 million from about 40 LPs, mainly institutional investors.

In 2014, Sequoia closed the fund, and reported $3.6 billion in gains, or a 41% annual return.

Sequoia partners collected 2.5 billion – 70% of the gains.

Venture Capital Returns

Investors in a VC fund profit if the returns from successful startups outweigh the losses from failed startups. This does not mean that the majority of the startups within the fund have to be successful – often, one big winner within a fund can make up for a portfolio full of losses.

Fund managers can choose to liquidate all or part of a fund in order to pull the capital out and distribute profits to investors. This can happen when a company within the fund IPOs, is acquired, etc.

Generating market-beating returns depends heavily on investing in a top VC fund with connections to top startups and proven returns, rather than spreading capital across multiple funds, as the highest returns are concentrated among the top quartile (top 25%) of funds.

According to a report by Cambridge Associates, the median of all VC funds sometimes outperformed and sometimes underperformed public market benchmarks, such as the S&P 500, from 1981 - 2014, while the top quartile of VC funds have consistently outperformed the S&P 500 in the last three decades.

Avg IRR (Internal Rate of Return) from 1981 - 2014:

• Top Quartile of VC Funds: 24.89%
• Median of All VC Funds: 11.94%
• S&P 500: 12.66%
  

However, while the top 25% of VC funds have pulled in a 24.89% IRR over the past three decades, the top 2% of funds (the 20 best performing funds) consistently pull in between 30 - 100% returns – even when the median is much lower. This is an example of power law distribution.

In venture capital, power law distribution dictates that the most successful fund will generate a higher rate of return than all the other funds combined, the second best fund will generate a higher return than the third best fund and all the other funds combined, and so on. Startup performance also follows this trend, as discussed in Chapter 1 of this guide.

EXAMPLE

Wealthfront studied 1,000 VC funds, and found that the top 20 funds – 2% of funds – generated 95% of the returns across all 1,000 funds.

Unfortunately, top VC firms are nearly impossible to invest in as a newcomer, as the original LPs often become repeat investors, and space in these funds is extremely limited.

Why do startups raise VC Money?

Venture capital is an ideal financing structure for startups that need capital to scale and will likely spend a significant amount of time in the red to build their business into an extraordinarily profitable company. Big name companies like Apple, Amazon, Facebook, and Google were once venture-backed startups.

Unlike car dealerships and airlines – companies with valuable physical assets and more predictable cash flows – startups typically have little collateral to offer against a traditional loan. Therefore, if an investor were to issue a loan to a startup, there’s no way to guarantee that the investors could recoup the amount they’ve lent out if the startup were to fail.

By raising venture capital rather than taking out a loan, startups can raise money that they are under no obligation to repay. However, the potential cost of accepting that money is higher – while traditional loans have fixed interest rates, startup equity investors are buying a percentage of the company from the founders. This means that the founders are giving investors rights to a percentage of the company profits in perpetuity, which could amount to a lot of money if they are successful.

The Cost of Raising Venture Capital

Startup investors generally expect a 20% or more yearly return on their investment, and will take this number into account when determining how much to offer you for your business.

A lender will typically charge 7.9-19.9%. At face value, it may appear less costly for a startup to take out a loan.

However, most startups do not qualify to receive loans at all, and ones who do typically will receive loans with expensive terms attached such as high interest rates, late fee penalties, and warrants (free equity to the lender). Startups are also often forced to turn over company IP and other assets in the event of a default on payment.

Early-stage startup investing offers potential for astronomical growth and outsized returns (relative to larger, more mature companies). This potential can make acquiring startup equity an attractive investment opportunity to prospective investors, albeit a risky one.

For startup founders, taking VC money can come with huge benefits – experienced startup investors can offer valuable support, guidance, and resources to new founders that can help to shape their company and increase its chances of success.

Getting access top startups can be challenging for VCs, as the best startups can be more discerning when deciding who to take capital from. In these situations, startups often heavily weigh the additional benefits a VC firm has to offer aside from just capital.

This is why it’s important for VC firms to build a reputation for adding value by helping their portfolios with recruitment, customer acquisition, access to follow-on funding, advice, and other challenges startups encounter.

Venture capital financing is also ideal for startups that can’t get very far by bootstrapping. Although many founders self-fund their startups while operating out of a cramped apartment until they’ve reached profitability, bootstrapping doesn’t work for companies that require capital up-front just to build and test their MVP (minimum viable product), or for founders who wish to scale their businesses faster than bootstrapping permits.

Startup Fundraising Rounds: Seed to Series C and Beyond

Startups raise venture capital in phases, commonly referred to as “rounds”.

Startup fundraising “rounds” refer to primary issuances of venture capital – instances when investors get a lot of capital together and invest in in the startup in one shot, or, at times, in two or more increments, known as tranches.

Each fundraising round is generally correlated with a new stage in a startup’s development, and is often tied to a valuation event (events that affect a startup’s worth, based on the price per share one would have to pay in order to invest in the company).

Common benchmarks according to startup stage:

Benchmarks at each financing stage can vary widely for each startup, depending on their industry, geography, and individual goals.

Seed Stage

Rounds typically range from less than $1 million to $3 million dollars.

Have generally demonstrated early traction; need capital to continue product development and acquire initial customer-base.

Series A

Rounds typically range between $3 million to $10 million.

Usually have achieved strong product-market fit; seeking additional capital to scale their customer/user base and increase revenue.

Series B

Rounds typically range from $5 million to $25 million.

Startups should be able to demonstrate highly measurable results (strong revenue, large market share, repeatable growth engine); focused on scaling their internal team and achieving market domination.

Series C and later-stage startups

Rounds range from over $10 million to $100 million.

Can generally demonstrate large scale expansion; focused on developing new products or expanding into new geographies. Subsequent rounds are labelled Series D Series E, and so on, and are usually spaced around 18-24 months apart.