Venture Capital 101
A Crash Course
by Laksh Mody
I love reading and learning about the venture capital industry, so I thought I would put together a little Q and A on the basics of the venture capital industry. Fun fact: most deals do not happen in nightclubs.
Venture Capital Overview
What is Venture Capital? How does it fit into the world of financing?
There are two types of financing: debt and equity. Debt financing means: I’ll give you this money, if you promise to pay it back to me with interest. Equity financing means: I’ll give you this money in exchange for owning part of your company. Venture capital (VC) is financial capital provided to early-stage, high-potential, companies in exchange for equity in the companies it invests in.
What is the structure of a venture capital firm?
A VC firm is comprised of limited partners (LP’s) and general partners (GP’s). Limited partners (pension funds, educational endowments, foundations, insurance companies, wealthy people) are investors in the venture capital firm’s fund . General partners (ex-CEO’s and founders) are are the ones who run the fund, source deals, make investment decisions, and maintain the portfolio. Fun Fact: 99% of the fund comes from LP’s while 1% comes from the GP’s.
Industry norm is that 20% of deal profit goes to GPs while LPs get the remaining 80%. Additionally, 2% of the fund size goes toward fund expenses, such as paying the salaries of the GPs and any additional staff (associates, analysts, etc). That means, if you have a $100M fund, $2M of that money automatically goes to the GPs who decide how to use it.
What are the different sources of capital?
Angels: A wealthy individual who invests their own money, usually in a business in which they have expertise. These are ex-founders and wealthy people.
Super Angels: An angel who is the lead investor of a group of angels (syndicates).
Micro Seed Funds/Accelerators: Small funds that do a lot of small investments in exchange for a small amount of equity. Accelerators tend to sell themselves as providing additional support such as mentorship, business connections, and a range of professional services (such as help on the legal part of your company). Examples of these are Y-Combinator, Kima Ventures, Techstars, etc.
Venture Capital: Medium funds that invest greater amounts of capital for greater amounts of equity. Examples of these are Andreeseen Horowitz, Sequoia Capital, Google Ventures, etc.
Growth Equity: Big funds that invest huge amounts of money to expand a successful business model. One example is Summit Partners.
What are the different types of rounds?
Seed: Initial funding to build initial product and prove business model
Series A: Build core team and launch core product
Series B: Expand team and expand product portfolio
Series C: Scaling the business model
Series D+: Geographic expansion of business
If you are wondering what round a company is in or are curious about its funding history, take a peek on crunchbase.com.
How does venture capital work?
- Entrepreneur gets introduction to multiple VC firms
- Entrepreneur pitches business to VC firms
- Term sheet written if VCs want to invest
- Build business further
- VCs repaid through: acquisition, IPO, or bankruptcy
Trends in the Venture Capital Industry
Fund Size
Seed funds, which we will define here as funds that have less than $50M to invest, are now a well accepted norm at 67% of all funds (represents 6% of total $ raised).
Traditional VC is what has been impacted the most. They are decreasing in both total dollars and the number of funds.
The top 20 firms generate 95% of the returns
Simply put, the distribution of returns on VC investments are heavily concentrated in the “top” firms (if we assume about 1000 VCs, then we are dealing with only 2% of the firms). This is because a few of the companies will end up hitting it big (billion dollar companies), while many other investments will fizzle and die. Fun fact: this also means that there are quite a few VC firms out there that are casually losing money.
VC Returns
In 2013, the 10 year return for venture capital was 7.8%, while the S&P 500 was 7.3%, the Dow Jones Industrial Average was 7.9%, and growth equity was 13.1% (mmmm, I’ll have some growth equity please!). As you can see, venture capital on average is not the best investment. This is probably the most important part of this post: There are a few people who will make enormous returns (ex: the original investors in Facebook), but most will end up losing their money.
Marc Andreessen explained this very succinctly in Y-combinator’s course: How to Start a Startup. To summarize what he said, the venture capital business is completely a game of outliers. There are about 4,000 venture fundable companies a year. 200 are funded by a “top tier” VC and 15 will get to $100M in revenue, which will generate 97% of the returns for the entire category of VC.
Are we in a bubble? Two sides to the argument…
1. Have no fear, there is no bubble here.
Although the number of IPOs has been increasing, it is tiny compared to the number of IPOs from the previous bubble.
IPOs are grounded in mature companies (look at the median price/sales @ IPO metrics) which have way smaller valuations than companies during the previous bubble.
2. There is a bubble and you need to panic.
Valuations have been steadily increasing and have increased across all types of investments ranging from seed to later stage. As you can see, Series D+ has increased by far the most. This is because there are only a few companies that make it to that level, so in order for VCs (and private equity firms and hedge funds) to compete for these deals, they end up giving the companies favorable deals, which usually means more money.
Additionally, the total dollars invested in Q2 2014 marks the largest quarterly investment total since $13.1 billion was invested in Q1 2001 (the previous bubble). VC investments for the first half of 2014 reached $22.7 billion, the highest first half total since 2001.
Lastly, one of my favorite anecdotal pieces of “evidence” of a bubble is Fab.com, which “was burning through $14 million per month at its peak before it went through a drastic round of layoffs and decision to pivot the business.” Fun fact: that level of spending makes investors uneasy…
Thank you to Brett Goldstien, Krishnan Mody, Nalin Natrajan, and Sukhpreet Sembhi for reading drafts of this post.
