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.
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.
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.
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.]
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.
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.
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?