What Exactly Is Venture Capital?
How VCs operate, who works at a VC firm and common myths
Hey everyone 👋,
I hope you’re having a great summer so far (assuming it’s summer where you are of course!).
A few months back, I covered all things private equity and off the back of that I received a few messages asking how private equity differs from venture capital.
That’s a fair question and given that VCs have been in the news a lot lately because of economic woes they’re currently facing and the collapse of Silicon Valley Bank, I thought now would be a good time to delve into this world.
I’ll cover:
What is venture capital? Quickly explained 📝
How does venture capital differ from private equity?
Step-by-step guide on how venture capital works
📹 explanation
Common misconceptions 🤔
Who works at a VC firm and what do they do?
Key terminology 🕵🏼
A (very!) practical set of resources about venture capital
(Quickly) Explained…
Venture capital (VC) is a type of private equity. It's a form of financing that is provided by firms or funds to small, early-stage, emerging companies that are deemed to have high growth potential, or have demonstrated high growth (in terms of number of employees, revenue, or other relevant metrics).
VCs are willing to invest in these companies because they expect to receive a higher return on their investment than they would from investing in more established businesses.
VCs typically invest in companies that are in the early stages of their development, such as when a company is first starting up or when it is developing a new product or service. Many businesses need to raise venture capital to expand their operations or fund the creation of new products and services. Some startups require a lot of money upfront, so many companies backed by venture capital might run at a loss for a while.
That said, this culture of figuring out monetization and revenue generation later is seemingly becoming less common , thanks to rising interest rates and economic pressures. The glory days of raising a bunch of money to build a fancy office, hire employees and experiment until you figure out how to make unit economics work later looks to be coming to end. Just ask WeWork investors how that strategy played out.
You might also come across terms such as seed investment, Series A investment etc.
These are simply different investment stages for the start-up i.e. if a business is raising Series B in it means they’ve likely demonstrated a lot of traction, hired a team, found product market fit etc. They’re very much in scaling mode.
Here’s a look at what each stage means and where they’re typically sourcing funds from:
“VCs must find the handful of companies that will successfully go from 0 to 1 and then back them with every resource.”
Peter Thiel
How does venture capital differ from private equity?
Private equity and venture capital can sometimes get mixed up because they both involve investing in companies and cashing out to make money. But, there's a bunch of ways these two types of firms do things quite differently.
I’ve outlined how they stack up against each other:
How venture capital works - a step by step guide 💸
1: Fund Formation 🆕 - similar to private equity, a group of experienced investors, called General Partners (GPs), creates a venture capital fund. However, as I said, VC funds focus on early-stage startups, whereas private equity funds may target more mature companies.
2: Fundraising - venture capital funds raise money from external investors, known as Limited Partners (LPs). These can be individuals, institutions, or corporations.
3: Investment Period⏳ - during the investment period, VC funds actively seek out suitable investment opportunities i.e. they speak with countless start-ups and have scouts who are on the look-out.
4: Due Diligence and Investment 📝💰 - in both VC and private equity, due diligence is crucial before investing. However, venture capital often involves assessing innovative technologies, market disruption and the founders, while private equity looks into operational efficiency and potential improvements.
5: Portfolio Management 🤹🏼 - VC funds manage a portfolio of investments i.e. lots of start-ups. VCs provide hands-on support to the companies they’ve invested in, focusing on growth strategies and market penetration.
6: Follow-on Investments VC funds consider follow-on investments to support their portfolio companies. They often participate in subsequent funding rounds to help startups scale.
8: Portfolio Exit🚪- VC funds aim for portfolio exits. This often involves IPOs or acquisitions by tech giants, reflecting the startup ecosystem.
9: Returns to Investors 🤑 VC funds distribute returns to their Limited Partners after successful exits. The distribution structure might vary, but the goal is to provide investors with profitable returns.
📹 Venture Capital Explained…in 1 minute!
Common Venture Capital Myths 🤔
Myth 1: Venture Capital Is the Primary Source of Start-Up Funding.
Not true. Venture capital financing is the exception, not the norm, among start-ups.
Myth 2: VCs Are Innovators
It's quite ironic that venture capital firms present themselves as champions, backers, and even catalysts of innovation, while the VC industry itself has exhibited a lack of innovation over the last two decades.
Sure, various shifts have occurred in the realm of venture capital—increased numbers of funds, amplified capital inflow, and grander fund sizes— but the fundamental structures of funds, capital acquisition, and partner compensation have largely remained stagnant since two decades ago. Any noteworthy advancements in startup financing, like crowdfunding and platforms such as AngelList have emerged outside of the traditional VC sector.
Myth 3: All VCs are rich
VC funds are not limitless. VC firms have to make smart decisions that fit their company's business plan, and they have a limited (though sometimes large) budget to work with.
The money that the VC firm can invest is separate from the VC's personal wealth. VCs, like other professionals, run the gamut in terms of what stage of wealth creation they are at. Some have big wins under their belt, but not all.
Myth 4: VCs Generate Incredible Returns
Some do, most don’t.
In a recent report by some of the leading business schools in Europe, it was found 45% of European venture capital (VC) investments fail or do not secure returns above 2x the investment, according to a new report by leading European business schools.
The report also found that 28% of the investments exceed expectations, and 9% earned above 10x invested capital.
If you’re interested in some more detail on this point, then read this piece which is an excellent debrief on how VCs make money and how they often are not the mega-bucks businesses you might think they always are.
👩🏻🦰🙍🏽♂️ Important roles at VC firms
A VC firm is just like any other company in that, depending on its size, it will have marketing, finance and operations teams, but I want to specifically hone in on three roles you’ll hear a lot about in the context of VCs:
Managing Partners/General Partners (GPs): Managing partners or general partners are senior members of the VC firm who are responsible for setting the overall investment strategy, making key investment decisions, and managing the firm's portfolio. They often have significant experience in the industry and play a pivotal role in raising funds from limited partners (LPs).
Investment Partners/Partners: Investment partners, also known as partners, are responsible for sourcing, evaluating, and executing investment opportunities. They work closely with entrepreneurs, conduct due diligence on potential investments, negotiate terms, and participate in investment decision-making.
Associates/Analysts: Associates and analysts support partners in deal sourcing, due diligence, and analysis of potential investments. They often perform market research, financial modeling, competitive analysis, and help prepare investment recommendations.
🔑 terminology worth knowing
Investment Thesis 📝: A VC firm's guiding principles and criteria for making investment decisions, including industry focus, investment stage, and geographic preferences.
Pitch Deck: A presentation created by startup founders to showcase their business idea, market opportunity, team, and financial projections to potential VCs.
Due Diligence: The process through which investors thoroughly assess a startup's business, technology, financials, and legal aspects before making an investment.
Exit Strategy: A planned approach for how investors, including VCs, will eventually realize a return on their investment, often through an initial public offering (IPO) or acquisition.
Convertible Note: A type of short-term debt that can be converted into equity in the future, commonly used for early-stage startup investments.
Equity Stake 🍰: The ownership percentage that a VC holds in a startup, usually obtained in exchange for the capital invested.
Valuation: The estimated worth of a startup, often determined through negotiations between the startup founders and the VC investors.
Term Sheet: A non-binding agreement outlining the key terms and conditions of an investment deal, serving as a foundation for further negotiations.
Portfolio 🧱: The collection of startups in which a VC firm has invested; these investments together make up the VC's portfolio.
Limited Partner (LP): Individuals or entities that invest capital into a VC fund, entrusting the VC firm to manage and invest the fund on their behalf.
General Partner (GP): The management team within a VC firm responsible for making investment decisions and managing the fund's operations.
Unicorn 🦄: A privately held startup valued at over $1 billion, often a significant achievement and goal for both startups and VCs.
IPO (Initial Public Offering): The process by which a company offers its shares to the public for the first time, transitioning from being privately held to publicly traded.
Burn Rate 🔥: The rate at which a startup consumes its capital to cover operating expenses, often used to assess its runway (time until it runs out of funds).
Runway: The length of time a startup can operate before needing additional funding, based on its current burn rate and available capital.
Exit Event: The point at which investors can realize a return on their investment, such as through an IPO or acquisition.
Acquisition: The purchase of a startup or company by another business entity, providing an exit opportunity for investors.
A practical set of resources about venture capital
If you’re interested in learning more about venture capital, here’s a selection of resources which should help:
🎧 Podcasts
The Knowledge Project (+ the blog Farnam Street! note: not only related to venture)
📚 Books
High Growth Handbook by Elad Gil
The Hard Thing About Hard Things by Ben Horowitz
Venture Deals by Brad Feld & Jason Mendelson
Powerful by Patty McCord
Zero to One by Peter Thiel
📰Newsletters
Benedict Evans, weekly
The Term Sheet, by Polina Marinova (Fortune)
Thank you very much for reading 🙏 if you found this helpful and enjoyed the post, I’d be super grateful if you could hit the ❤️ below - thank you!
And if you have topics you’d like me to explain just hit reply and let me know.
DISCLAIMER: None of this is financial advice. Concepts of Finance newsletter is strictly for educational purposes.
Thoroughly brilliant read!
I'd also recommend The Power Law by Sebastian Mallaby. An excellent read on the history of Venture