VC firms manage their investments to mitigate risks and exit profitably from investee companies.
They conduct thorough screening and due diligence of investable startups before expressing any interest to invest. Once they shortlist potential startups which meet their investment criteria, they share a Term Sheet with startup founders. A Term Sheet is a non-binding document containing the terms and conditions of a potential investment.
Founders can negotiate the terms and conditions of the Term Sheet. Only when both parties- the VC firm and the founders- agree on the terms and conditions, does the investment process move forward.
While a Term Sheet is a non-binding agreement, it acts as the foundation of other documents which specify the obligations of founders and VC firms in greater detail. These documents include the Stock Purchase Agreement, Investor Rights agreement, Certificate of Incorporation, Right of First Refusal (ROFR) & Co-sale agreement, and Voting agreement.
So how do VC firms mitigate risks and plan a profitable exit?
Choosing where and when to invest
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.
Boosting a startup’s value
After investing in a startup, a VC firm focuses on boosting the startup’s value in order to make a profitable exit in future. To that end, some VC firms follow a hands-on approach, which means that they get heavily involved in corporate governance, strategic planning and financial decision-making of the company. Others follow a hands-off approach, which means they are present in corporate governance and involved in financial decision-making only.
To boost the value of a startup, VC firms may help founders in many ways, like mentoring them, facilitating subsequent rounds of fundraising, and recruiting appropriate employees. They may also give founders access to their networks to help with acquiring customers, strengthening supply chains and lobbying.
Monitoring a startup’s progress
VC firms actively participate in Board Services and monitor the performance of startups. They want regular updates, the frequency of which may be specified in their Term Sheet. These updates include yearly financial statements, monthly or quarterly management statements, and weekly progress reports (which may be discussed over online/in-person meetings) as well as immediate notification of critical incidents like lawsuits.
Covenants in Investment Contracts
To protect their interests and avoid future conflicts with founders, VC firms impose certain conditions when investing. For example, a VC firm may go for a lock-in clause, which will prevent existing shareholders from selling their shares and leaving the company. This is an effective way of ensuring that a founder does not abandon his/her company after raising investments. Other covenants include permitted transfer, tag-along, and drag-along rights, exit ratchet, etc.
These are some of the measures VC firms adopt to mitigate risks and make capital gains from their investments. However, these measures are not fail-proof and investors should remember the 100/10/1 Rule, which suggests that an investor will screen at least 100 ventures and finance 10 of them to find only one venture which is very successful.