How VC Firms Work & Why You Care
Venture Capitalists...are rich guys...who invest in people...and take huge risks. There is a lot of misinformation about VC's and how the industry works. It is easy to imagine that VC's are rich guys who invest in startups simply because they like the founders and are taking on huge risks.
There really is much more happening behind the scenes. Although it may vary from VC firm to firm, VC's are actually using data and a financial strategy to make their investment decisions. So if you are interested in seeking Venture Capital funding you will be more successful if you understand how VC's work.
Let’s start with the biggest question:
Where do VC’s get their money from?
VC’s are actually a lot like entrepreneurs, except that they are basically bankers dressed in jeans. But what entrepreneurs and VC's do have in common is 1) they both go out and raise money to fund their businesses and 2) they need to return the money to their investors.
VC’s raise money from institutions (companies) and private individuals (regular people) and put that money in a fund. Once the fund is created, the VC uses a portfolio strategy to invest in a range of high risk companies (startups, companies that a traditional bank would not loan to).
A portfolio strategy is one where someone invests in multiple “things” to reduce their overall risk. Essentially avoiding “putting all your eggs in one basket,” the VC invests in multiple companies with the expectation that some won’t do well, others will perform ok and few will provide a great return.
Each fund has a different name and will be treated separately. The VC then expects a certain return on the cash invested into each fund. The VC firm then gets a commission on the return and pays back their investors.
For example, A VC is likely expecting that in one portfolio: about half of the companies either don't return any money or only return the original amount invested and 10% to 20% of the companies will give them a 10x or higher return. The rest of the companies return something in between. This will give the VC a return rate of 25% to 30% over the entire portfolio.
Why does this matter to you? If you are seeking VC investment you have to understand that timing is very important. Even if you get an investor that is genuinely interested in investing in your startup, he or she needs to have cash in their current fund for whatever category your company fits into their portfolio. For example, a VC may say “we aren’t investing in any e-commerce businesses at this time.”
What do VC's invest in?
You may have heard: “VCs invest in a great team” or in a great business plan and financial model. And, yes this is true, but that is only a part of the package. It is a must that the VC believes in the team and is confident in their business plan and financial projections.
What more is that your company needs to be a in a high growth market segment. That means businesses that are inherently small or human hour based, for example, do not typically get VC funding.
For example, a consultancy. A consultancy business model basically trades hours of employee’s time for revenue. This is not scalable and will never become scalable. The company’s limiting factor to growth is the number of employees it can hire and train. That makes it very difficult to become a huge company and is therefore not a good candidate for VC investment.
But Uber, a taxi service, turned a small everyday business into a huge business, which had $5.5 billion in revenue in 2016, building a new market with its technology. We’ll see how it plays out, however, since they still are losing a lot of money.
High growth market segments are to some extent theories based on actual data and what they are seeing in the market. The VC believes that this segment is ready to grow significantly and fast over the next x number of years. The VC uses his or her theory to create his portfolio and bet on those companies which he thinks have the best chances at making it.
Because VC's have this theory about particular market segments growing fast, they often times specialize in those segments.
Why is this important to you? You need to focus on VC's that invest in your market and make sure that your plan shows an opportunity that is very large and growing.
Now that you understand generally how things work, keep in mind the following:
- VC's are bankers: after the industry of the company and the team are a good fit, they want to see financial projections that show how big the opportunity is (hundreds of millions). VC firms do their homework and usually know the market very well. Do your homework and show them that you, too, know the market and how you are going to go after it.
- Funds can work for or against you. It’s not personal (always). Since VC's use a portfolio strategy, they are looking to fill their portfolio with a particular assortment of companies. Use that to your advantage whenever possible. Getting in early in the fund if possible.
- Don’t forget about the exit. Align your business goals and describe to your investors the who, what, when and why of your company’s exit.
To learn more about how Venture Capital works this article is worth a read. It is an oldie, but a goodie.
Bonus: Here is a list of VCs that raised in 2016 in the US. Check it out to see which firms are looking for companies to invest in.