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. VC firms are usually made up of multiple partners.
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 VC firms 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.
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 VC firms earn money?
VC firms earn money mainly in two ways- through management fees and carry.
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. The active investment period is the time frame in which VCs identify investable businesses, conduct valuation and due diligence, negotiate term sheets and close deals.
Carry, or carried interest, is a prefixed percentage of profit general partners will earn once investors have been repaid their capital. Typically, this is 20% of profits, but very successful VCs can negotiate higher percentages. A VC firm can earn carried interest on a fund only if the fund achieves a minimum rate of return, called the hurdle rate.
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.
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”.
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.