What is Venture Capital?

Venture Capital in India has been generating a lot of interest, but it pales in comparison to the obsession you’ll find among the U.S. startup community. If you are interested in entrepreneurship or finance, it is important for you to understand how venture capital funds work, who runs them, where the money comes from, what they look for in start-ups and what they expect from you after they’ve transferred a whole lot of money in your startup account.

In this new mini-series on MBA Crystal Ball, we’ll cover some basic ground so you can carry on an intelligent conversation (peppered with the appropriate jargon) with VCs and entrepreneurs, without revealing the fact that you don’t have an MBA.

Till you gain more expertise in the field, let’s try to manage with the 20-percent-knowledge- 80-percent-confidence formula. Alright, let’s dive in.

What is venture capital?

In simple terms, Venture Capital (VC) is the initial funding that is sourced by a startup from an external team when conventional sources of financing (like a bank loan) aren’t possible.
Often, the entrepreneur and her partners would pool in money from their own pockets to get an idea off the ground. Once the ‘proof of concept’ has been proved, there is generally a need to pump in more money to scale up the startup and give it critical mass.

But at an early stage, there is more risk involved. So it’s tough to walk into a bank and get a loan sanctioned (no matter what their TV advertisements say).

Almost all entrepreneurs think their start-ups have the potential to become the next Facebook or Google. Investors take a more cautious approach before investing. The conservative institutions (like banks) prefer lower but more predictable returns. Venture capitalists, in contrast, don’t mind playing the high-risk-high-return game.

What are venture capital funds?

VC funds are similar to mutual funds, in the sense that they manage and invest the funds of others in return for a share in the profit. The folks (i.e. rich guys & companies) that invest in the fund are called ‘Limited partners’. The professionals who manage the fund are called ‘General partners’. Each fund has a size (e.g. $100 million, $250 million etc) and a finite lifespan (typically 10 years). Some have a focus on specific niche (e.g. biotech), others are flexible.

How do Venture Capital funds operate?

A startup can go through various rounds of funding. The initial round of funding called ‘Seed capital’ is done by the entrepreneur directly or from family/friends (some add a third ‘F’ to that list – fools) who believe in the business model. Venture capital firms come in after this stage to provide ‘growth capital’. In return for this investment, venture capitalists take a stake in the startup. They may get a seat on the Board of the company.

[Here’s a secret. Many entrepreneurs want the money but hate giving away control.]

How Venture Capital funds make money?

Venture capital funds hope to ‘exit’ from their investments and make a profit in a predefined time-frame by selling their stake. The idea here is that the startup is valued more as it grows, so there’s a need to infuse more money into the business. That’s when the initial investors re-coup their investment and move out.

The exit can happen in one of two ways.
– The startup gets acquired by a bigger fish in the same or related industry
– An Initial Public Offering (IPO) after which the company goes public

During the lifecycle of each fund there are two ways that the venture capital fund makes money:

1. Management fees: This is the fuel to keep the basic operations of the fund going. It can be up to 2% of the venture capital’s committed capital.

2. Carried Interest: Or simply ‘Carry’. This is the real honey that attracts all the bees. The General Partners (managers of the venture capital fund) get a share of the profit (roughly 20%).

The rest is returned to the Limited Partners (the original investors). The senior guys within the VC fund get the big chunk of the goodies, and some honey drips down to the junior guys as well. When you are dealing with amounts that run in millions of dollars and a VC team that’s very small (compared to the regular investment institutions), the dripping can be significant.

How much money do Venture Capital funds invest in each company?

In order to diversify its risk, a VC fund would not invest 100% of its funds in one company. So they create a portfolio of investments. They shortlist companies that are within their preferred industry niche and have a due-diligence and valuation process (more on this later). They meet the founders of the company, evaluate business plans and then take a call.

The investment in each company can differ. For instance, in a $100 million fund, there might be 10-20 portfolio companies. Some companies may get $5 million, while others might get over a $10 million.

What happens after the Venture Capital funding is done?

After the investment, the role of individual venture capital funds may vary. Some prefer taking a hands-on approach – by providing strategic advice, operational help, industry contacts, technical know-how, exploring synergy across their other portfolio companies.

Others assume that the entrepreneur knows best and avoid any operational involvement. As long as the basic milestones are met, both sides are happy. If there are serious deviations from the planned or promised roadmap, the boardroom discussions start becoming less pleasant.

Enough gyan for this post! What would you like to read about in the next posts on this topic?

Read the next post: Venture Capitalist salary range in India & USA


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Sameer Kamat //
Sameer Kamat
Founder of MBA Crystal Ball. Author of Beyond The MBA Hype & Business Doctors. Here's more about me. Connect with me on Google+ | Twitter | Facebook | Linkedin

11 Comments

  1. Rohit Gupta says:

    Hey Sameer,
    It was a very informative post. I’ve been following your blog for quite sometime, and love your no-nonsense approach.
    This series looks interesting. It’ll be great you could throw some light on topics like marketing, personal finance, low-cost start-ups and business-plan formulation.
    Keep up the great work!

  2. Sameer Kamat says:

    Thanks for the kind words, Rohit bhai. And for your suggestions.

    We’ll keep that in mind. We published a post earlier on Business Plans.
    Here’s the link –> Business Plan FAQ: What is it and how to create one?.

    Are you grappling with the MBA vs entrepreneurship question? Or clear about the next steps?

  3. Shashank says:

    Hi Sameer,

    Nice post and completely gyaan-loaded :)

    I would like to know few things in your next post:
    – How to select MBA schools based on return-on-investment?
    – How to research best schools for particular streams, e.g. Finance, Marketing, etc.?

    My question might come across as very basic and I am not sure if you have already talked about this on your site. I am just starting to consider doing MBA and hence such basic questions keep popping in my head :D

    You are doing a great job helping out information seekers, keep up the great work :)

    Thanks,
    Shashank

  4. Sameer Kamat says:

    @Shashank: I was curious to know what else we could cover in this VC series.

    But your points about general topics are welcome too. Added to our list of probable topics to consider for future posts. Thanks

  5. Tara says:

    Sameer Bhai! As usual, it was a very interesting for a person like me, who knows nothing about finance related topics. :)

    I’d like you to consider writing a mini series on Finance 101 for young Indians (things that cover banking, budgeting, personal finance planning, investing, etc.) as these things are not really taught anywhere, even by parents. From here, you could move on to intermediate and more advanced topics related to MBA level topics.

    I also agree with what ^^ Shashank and Rohit said.

    A Great Read!

    Thanks,
    Tara.

  6. Sameer Kamat says:

    Tara behenji, shukriya!

    Some of the topics (like personal finance planning) may not be directly related to the core focus of this site, so we’d have to (as they say in moviews) ‘stay in character’ and retain the general focus.

    But there are some under the bigger Finance umbrella that we could definitely take up. Thanks for chipping in.

  7. Rohit Gupta says:

    Your candid tone is quite refreshing!
    I’m going to be a graduate soon, so I’m not really considering jumping on the MBA bandwagon. I’m just going with the flow as of now, and trying to discover myself gradually. :)
    Thanks,
    Rohit.

  8. Madhukarreddy says:

    Hi Sameer. Thanks a lot for sharing this. Could you explain the funding process. How the VC’s decide the amount of funding? Will it depend on the needs of the venture? If not, is it practical to get funding from multiple VCs to maximise funding?

  9. Sameer Kamat says:

    @Rohit: Always good to start the background work early. Hope you find the post-MBA career of your choice soon.

    @Madhukar: This would require a longish answer and I’m not sure how many of our regular readers might be interested in going deeper though. Think you could post your query on our Entrepreneurship thread?

  10. Preetham says:

    Hi Sameer

    Nice article, your website turning out to be a complete package for MBA aspirants.
    For those who turn to MBA for the alluring salary. This is the right place to start.

    Thanks,
    Preetham

  11. Sameer Kamat says:

    Thanks, Preetham. Hope you have more than just the salary on your mind when you are looking at MBA programs :-)

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