Venture Capital

By and November 24, 2017Financing
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Venture capital investors (VCs) are often the most important capital providers for startups. By providing large sums of capital at high levels of risk, VCs enable startups to expand their operations beyond what startups could do on their own. Virtually all high-growth unicorn startups, private companies with over $1B (billion) valuations, have received VC funding. Whereas most lenders and investors are hesitant to fund unproven startups, VCs are willing to take additional risks and make these investments.

This article considers the inner workings of VC firms. Some of the topics addressed in this section include a discussion of the VC legal structure, how VCs are compensated, the lifecycle of a VC fund, fund reservations, and some historical trends relating to the VC market. Also, the article addresses how a thorough understanding of VC firms can benefit you as you raise equity rounds.

General Description

The goals of a VC firm are to (1) invest in promising young startups, (2) maintain its equity position as the companies grow, and (3) sell its equity stake for a large profit at a favorable exit1 opportunity. VCs typically enter the startup financing cycle after angel investors, but before virtually every other financing source. For more information about other types of investors see our Types of Startup Investors article.

Although VCs take risks other investors are unwilling to take, they remain selective with their investments. VCs seek to invest in startups with high-growth potential and the possibility of providing a large return on investment within the next 10-12 years. According to Dileep Rao, a Stanford instructor and former VC, 99.95% of entrepreneurs in the United States will not raise VC financing. Keep this in mind as you plan your startup’s financing and be prepared with a backup plan in case VC financing never materializes.

When VCs find a startup with the potential to generate a large return, VCs make sizeable investments. Hardly any VC firms invest in quantities less than $500k and larger firms often have a much higher minimum threshold. VC firms routinely make multi-million-dollar investments, and often work together to fund large deals.

The size of a VC firm is measured by the amount of capital that investors, called limited partners (LPs), have committed to the firm. This metric is known as assets under management (AUM). Some of the largest VC firms have AUM of over $1B, while smaller firms typically have AUM under $25M (million).

Regardless of size, nearly all VC firms operate using a fund structure. A good analogy for the relationship between VC firms and VC funds is to imagine that the VC funds are distinct divisions within the broader organization of the VC firm. Each VC fund represents a specific amount of capital contributed to the VC firm at a certain time to invest in startup companies. By the end of the fund’s partnership agreement (usually ten to twelve years after the start of the fund) the VC firm must sell the holdings associated with that fund and distribute the proceeds to the original capital contributors. Each fund represents a distinct legal entity that could have different capital contributors and negotiated restrictions.

Most medium- and large-sized VC firms simultaneously operate multiple funds with overlapping time horizons, so they continually invest in new startups. For example, a firm with $600M in AUM may operate three different funds of $200M each.

When raising funding, distinguishing between AUM size and fund size is critical. VC firms with a higher AUM may be more established and respected than smaller firms. By itself, however, AUM does not communicate very much about a VC firm’s current ability to invest. Founders should instead inquire about the amount of investable capital within the VC’s funds, ignoring the VC funds that have already been fully committed to other companies.

To illustrate this point, consider a VC firm with $500M in AUM that has already completed the investment phase for each of its funds, except a newly-created $125M fund. Since the fund’s $125M will be spread across multiple startup investments, each investee will likely receive about $5M. For startups looking to raise over $5M, the VC fund may not be able to accommodate such a large funding round despite its $500M in AUM.

Limited Partnership Legal Structure

VC funds are usually structured as limited partnerships, which consists of two classifications of partners: limited partners (LPs) and general partners (GPs). LPs supply the bulk of the capital for the investment fund but have no influence over the fund’s day-to-day operations. Decision-making power about a fund’s operations is delegated to the GPs, who are more experienced at vetting and managing investment opportunities. LP’s restricted participation results in limited legal liability for mistakes made by the fund.

Some common examples of the LPs that invest in VC funds include pension funds, insurance companies, endowments, high-net worth individuals, corporations, fund-of-funds, and even governments. A typical VC fund includes many LPs and the fundraising process of gathering capital commitments to launch a new VC fund can sometimes take years.

GPs manage the fund by looking for viable investment opportunities, evaluating potential offers, negotiating equity purchases, and providing subsequent support to portfolio companies. To keep incentives aligned, LPs often require that GPs personally contribute between one and five percent of a fund’s total capital. Having some “skin in the game” motivates GPs to act in LPs’ best interest.

Unlike a corporation, VC funds have fixed lifespans determined upon formation. LPs agree to give their money to the fund for 8-12 years, in hopes of earning a sizeable return once the fund has closed. If GPs wish to invest beyond the initial amount of capital contributed by the LP, they must fundraise again and create a new fund.

General Partner Compensation

Most partnership agreements compensate GPs for managing the fund via a two and twenty fee structure. GPs charge two percent of the fund’s committed capital annually as a management fee. This fee allows the fund to cover administrative costs including salaries, leased office space, and travel expenses. Although GPs receive a viable salary through the management fee, their largest potential income comes from the fund’s performance. GPs receive twenty percent of all fund profits above a hurdle rate specified in the partnership agreement. Another name for the GPs’ share of the excess profits is carried interest (or carry, for short). If a fund is successful, both the LPs and GPs will walk away with impressive returns.

Fund Lifecycle

During the first five or six years of a VC fund’s lifecycle, the investment team actively sources and evaluates investment opportunities in promising startups. VC firms often specialize by limiting their investment portfolios to specific industries, deal sizes, or stages of company development.  A fund’s investing philosophy has a direct influence on its characteristics. For example, funds targeting more mature companies will generally be larger in size than those specializing in early-stage ventures.

Given the high-risk nature of their investments, VC funds diversify their investments across many startup companies. Although the exact number of investments may vary from fund to fund, Tom Crotty, managing GP for Battery Ventures believes that “between 25 and 30 [companies] provide the proper portfolio effect.” After making an investment in a company, VCs are highly motivated to help the company succeed so that the value of their equity stakes increase.

To determine which companies would make profitable investments, VCs consider, among other factors, the strength of the underlying business model, management team, total addressable market, product design, strategic positioning, and underlying risks. VCs also prepare detailed valuation models that project how much they believe the startup is worth given assumptions about the startup’s future performance. The valuations analyze each prospect’s growth potential and its probability of achieving a profitable exit. (For more information on valuation models, see our Valuation article.)

Although helpful in the decision-making process, the valuation analysis is accurate only if the startup performs according to the given assumptions. As experienced and knowledgeable as they are, VCs cannot predict with absolute certainty which companies will become successful and which will fail. Receiving startup funding is not a clear indication that your startup will succeed; funding is an important stepping stone, not your end goal.

Despite a VC’s careful analysis, many once-promising startups fail due to market changes, technological challenges, or leadership shortcomings. VCs factor failure rates into their business model and expect complete losses on some of their investments. VCs focusing on early-stage startups assume extremely high failure rates, while later-stage VC firms project many fewer failures.

For example, Union Square Ventures, an early-stage VC firm, typically expects to lose the entire investment on one third of its portfolio companies, to recoup its investment on another third (1-1.5x return), and to generate large returns (7.5x or higher) on the last third. (When making the initial investments, VCs are not sure which startups will fall into which category.) Late-stage investors expect nearly 100% of their investments to provide positive returns, albeit at a much lower rate (close to 3x). Across an entire fund, LPs expect a minimum return of 20% per year, net of management fees and carried interest, with some funds providing returns exceeding 50%.

During a fund’s final years, VCs stop seeking new investment opportunities and instead focus their attention on assisting companies already in their investment portfolio. VCs provide support to portfolio companies by sharing insights from their industry experience, leveraging their personal networks, and occasionally providing additional financing in subsequent funding rounds.

As different portfolio companies experience exits (usually IPOs or acquisitions), the VC fund will distribute the proceeds back to the LPs. Since each portfolio company has a different exit timeline, the exits are usually staggered over the latter half of the fund’s lifecycle.

At times, VC funds still have illiquid2 holdings in some of their portfolio companies at the end of the fund’s term. To accommodate these situations, most limited partnership agreements allow for a couple of one-year extensions (requiring LP approval) that temporarily prolong the life of the fund. If VC firms have used up all their extensions or the LPs do not consent to an extension, the firms are legally obligated to somehow distribute the fund’s returns to the LPs. The GPs can sell the remaining holdings at the best available price, facilitate the sale of the LP interests to other investors, or in rare cases distribute private stock to the LPs.

To summarize, a VC firm hopes to invest in startups in the first years of a fund’s lifespan, maintain its equity position as the company grows, and then sell the equity stake at the end of the partnership’s specified timeframe.

Reserves

VC funds typically set aside some of their capital so that the firm can invest these reserves into its portfolio startups at a future date. For example, a $200M fund may initially only invest $150M in startup companies and maintain the remaining $50M in reserves. By allocating some capital for future use, VC firms preserve financial flexibility to provide additional support to their investment companies in the final years of the fund.

A VC firm’s reserves are typically used in one of three ways. Sometimes the reserves are never invested, in which case the funds are simply returned to the fund’s LPs at the end of the fund’s lifespan. Other times, the reserves are used for follow-on investments when successful portfolio companies raise additional financing. The VC fund can expand or maintain its ownership level in the investee by participating in subsequent equity funding rounds. Finally, the fund may invest additional capital into a struggling portfolio company to ensure the startup’s survival.

Historical Trends

After the Great Recession, a low interest rate environment and renewed interest in the technology sector spurred an influx of capital invested into private companies. The global amount of AUM within the VC industry has grown from $271B in 2008 to $524B as of June 2017. The increased funds have resulted in a record amount of dry powder, which describes capital that has been committed to a VC fund but has not yet been invested. As of April 2017, the U.S. VC market had over $80B in dry powder that GPs could use for future startup investments.

Although the United States accounts for most VC investment, the National Venture Capital Association (NVCA) reported that the U.S.’ share of global VC investment has dropped from 81% in 2006 to 54% in 2016, partly due to increased investment in Asian startups during that period. As of 2016, the NVCA also tallied 898 American VC firms, 1,562 total funds, and a median fund size of $50.8M. American VC funds invest across all the major industries, but the technology sector has become a central focus for the VC industry. The percentage of total VC investment allocated to software startups has grown from about 25% in 2010 to nearly 50% in 2016.

Many companies have chosen to postpone a liquidity event such as an IPO and instead opt for large late-stage funding rounds to finance their operations without the restrictions of being a public company. Due to these decisions, many VC firms have struggled to unwind their investments within the window specified by the partnership agreement. The market pressures have elongated the time between VC investments and exits from the historical average of 5-7 years to the current 10-12-year window.

Due to increased investor interest, delayed startup exits, technological innovation, and many other factors, many investors are giving startups higher valuations than ever before. In 2008, CrunchBase estimated that only 8 startup companies could call themselves unicorns.3 This number has since increased tremendously: as of November 2017, CrunchBase counted 267 unicorns. Even non-unicorns have seen increased valuations; KPMG reported in January 2017 that median valuations in the U.S. have increased across all stages of VC investment from 2010 to 2016.

Why Does VC Structure Matter to Companies Seeking to Raise Financing?

The preceding information about VC firm structure will help you to understand the motivations that drive VC partners to make important investing decisions. The discussion below addresses three ways in which a thorough understanding of VC investors will help you to make better decisions for the future of your startup

1. Investment Intent – Unlike founders who typically have a deeply-rooted connection with their companies, VCs have the fiduciary responsibility to seek a return for their LPs, not the startups they invest in. Although these firms involve themselves in understanding the details of the startup’s operations and strategy, the GPs’ end goal is solely focused on their financial return. In most cases, the investor’s pursuit of a large return coincides with the startup’s long-term best interests, but you should be fully aware that certain situations may cause some misalignment due to differing stakeholder motivations.

All VCs are return-focused, but they have different beliefs about the preferred relationship between investors and management. Some firms desire considerable involvement with the management team, while others take a more hands-off approach. Additionally, firms that specialize in specific industries often take a more nuanced investing approach compared to a generalist VC firm.

2. Exit Opportunities – Ideally, the interests of each investor and the management team align perfectly. Such harmony becomes increasingly difficult to maintain as the number of interested stakeholders increases throughout the startup financing process. Late-stage companies often have many sets of investors, each with their own set of objectives and preferences. For example, Uber has over 80 different capital providers including angel investors, VC firms, sovereign-wealth funds, corporate investors, and banks. When contemplating exit opportunities in such complicated capital structures, management should look for areas of compromise and recognize that it may be impossible to please all the company’s stakeholders.

To illustrate how difficult the situation can become, consider a startup with two VC investors. Imagine that the first venture fund, VC-A, made an early-stage investment in the startup four years ago. At the time of investment, VC-A was in the third year of a seven-year partnership agreement. Two years after VC-A invests, VC-B acquires ownership in the startup via its own equity investment. However, VC-B is only in the first year of its seven-year fund cycle when it consummates the Series B funding round.

As the startup considers potential exits, VC-A is highly motivated to exit quickly because it is now in the last year of its fund agreement. Conversely, VC-B may push to postpone an exit in hopes of garnering a higher valuation in the future since VC-B still has four more years before closing its fund. Negotiating compromises among shareholders with conflicting incentives can be difficult. The discussion becomes even more complex in scenarios with more than two investors, and when factors such as ownership percentage and corporate governance influence are considered.

3. Valuation Pressures – Understanding a venture fund’s circumstances can provide insight into the firm’s offer and valuation. For example, consider a fund with $200M of unreserved capital entering the fourth year of a seven-year limited partnership agreement. The GPs are “behind schedule” for deploying their cash based on the fund’s life cycle. Having been outbid in prior years, the GPs may be extra aggressive in their valuations to try to land a top startup. The GPs may even value the startup for more than they believe it is worth to utilize their excess cash before it is too late.

Another situation that may cause VCs to over-value a startup occurs when the GPs of a newly established VC firm have an ardent desire to win deals and prove themselves to the LPs of their fund. Founders should be aware of these potential pressures instead of quickly accepting the offer with the highest valuation. Overly aggressive valuations can harm a startup in its next financing round if it struggles to meet the lofty growth targets that investors expect from a high valuation. Issuing equity as part of a “down round”4 not only hurts existing investors but generates negative sentiment about the company.

The above examples illustrate how no two funding rounds are alike. Market conditions and stakeholder pressures change rapidly, so investors should not necessarily base their expected valuations on what a similar startup received the year before. Instead, founders should come up with a range of reasonable valuations and view potential investors as long-term strategic partners, not merely as standardized capital providers competing on price alone.

In summary, entrepreneurs and founders should understand the motivations and investment horizons of all potential investors before closing a funding round. Conducting some simple “investor due diligence” can save a company from unnecessary complications down the road.

Selecting the Right Investor

This section highlights many of the financial and nonfinancial criteria that you should use to evaluate offers from potential investors. Although each investment offer is unique, the guiding principles listed in this section can help you make a more informed decision when selecting investors.

This section assumes that your startup has received interest from multiple VCs and you are deciding which one(s) to select. Few founders have the luxury of choosing which investor is most compatible with their company. VC fundraising is an extremely competitive process, and as mentioned previously, only a small percentage of startups that pursue VC investment receive it. The topics listed in this section represent some important considerations that you should be aware of, but sacrificing some or all these considerations may be necessary to secure the funds your startup needs. Founders should always vet potential investors carefully, but for many startups, a VC willing to invest in the company will automatically become the “right” investor.

A common misconception among founders is that an investor’s only role in the company should be to provide financing. A startup investor’s industry experience, financial expertise, and network can be just as essential to a startup’s success as the contributed capital. The quality of the partnership between investors and management can also greatly impact a startup’s prospects for success. As you review the considerations below, note that this list is not exhaustive. There are probably additional criteria that you should consider based on your company’s unique circumstances.

  1. Capital Amount – Your company should have specific investment needs and/or expansion goals in mind when raising new funding. The investor’s ability to provide sufficient capital to meet those expectations is paramount.
  2. Terms of the Offer/Valuation – The details of an investor’s offer reveal important information about how much dilution founders will experience, whether board representation is required, and how much the investor values the company. An investor’s demand for non-traditional terms is cause for concern, even if the size of the offer perfectly meets your company’s needs. (For more information see the Valuation and Dilution and Stock Option Pools )
  3. Network Connections – Investors specializing in a specific sector often have a vast network of connections with suppliers, clients, bankers, attorneys, accountants, and other investors. These connections can prove invaluable for your company’s future growth. The more well-connected an investor is, the more value he or she can provide to your startup.
  4. Industry Experience – A VC with experience in one industry may not be as effective when investing in a different industry. Look for an investor with deep knowledge about your specific industry so that you can leverage your investor’s expertise to guide the company through the inevitable challenges that lie ahead.
  5. Track Record – Look for investors with a track record of helping other companies reach the success that you aspire for. For example, if your startup’s goal is to become a publicly-traded company someday, you should seek investors who have previously guided a startup from its early stages to a successful IPO.
  6. Time Commitment/Level of Involvement – Every investor desires a different level of day-to-day involvement in the businesses they invest in. Learn about investors’ preferences and partner with investors whose level of involvement matches your expectations.
  7. Time Horizon – As mentioned previously, investors often have constraints requiring them to exit their investments after a certain period. Be aware of these constraints and strive to preserve sufficient flexibility to accommodate a delay in your company’s expected exit timeframe.
  8. Personal Relationships – Investors and management work closely together from the time the deal is finalized until the company’s eventual exit. For early-stage investments, this partnership can last over a decade. Evaluate your relationships with potential investors and select investors whom you enjoy working with.

In an ideal pairing, an investor meets your startup’s preferences for each of the criteria listed above. However, most companies must prioritize which criteria are most important and compromise on the less-important factors. This prioritization will be unique for each startup based on their strategic goals. Assess what additional resources and capabilities your company needs from investors to meet its goals, and seek the advice of trusted advisors with startup financing experience before making a final decision.

Conclusion

VC firms are one of the leading capital providers for startup companies, and their investments enable some startups to achieve growth that would otherwise be impossible. General partners at VC firms raise capital from LPs, make investment decisions, advise portfolio companies, and eventually return most of the fund’s profits to the LPs after 10 to 12 years. Knowing these details about a VC’s operations, you can identify important questions to ask potential investors during the fundraising process. As you consider the VC’s responses in light of your startup’s priorities, you will be better prepared to select investors that will act as valuable partners for many years to come.

 


 

Resources Consulted

 


 

Footnotes

  1. Exit – A significant financing event that allows a startup’s early-stage investors to liquidate their holdings and receive a return on their investment. Common exits for startup companies include an acquisition or an initial public offering.
  2. Illiquid Holdings – Holdings that cannot be easily traded on the open market. Stock ownership in a privately-held company is an example of an illiquid asset.
  3. Unicorn – As mentioned at the beginning of the article, the term that describes a privately-held company that has achieved a valuation of at least $1B.
  4. Down Round – A down round is an equity funding round where the startup’s valuation is lower than the valuation it received in the prior funding round.
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Author Douglas Jepsen

Doug was born and raised in San Jose, CA. Outside of school, he enjoys running, reading, and hiking. Doug will be joining KPMG's Deal Advisory group in Fall 2018.

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