Outlining the Venture Capital landscape in this blog, we take you through the entire process of how startups actively seek VC funding for their entrepreneurial endeavors and how Venture Capital firms procure the working capital to boost the startups and give them a fresh lease of life. The blog also discusses the different sources of funding Venture Capital investment and why they choose to take that route. It’s an interesting outlook on the force that powered the startup revolution in the USA and is spreading its wings towards other growing economies.
- Brief Introduction
- Venture Capital – Void Filler
- Profitable Returns at Calculated Risks
- The Investment Profile
- At the Right Time and the Right place
- Scalable Returns for the VC
- Pay vs. Performance
- Time Management for Venture Capitalists
- Source of investment for VC capital funding
- In conclusion…
Introduction:
The startup wave is currently high and everyone wants to ride on it. Like a typical Hollywood potboiler, every aspiring entrepreneur is seen scouting new frontiers for finding prospective funding opportunities. All this, while standing on the cusp of dejection when out of nowhere appears the venture capitalist. The loyal and dependable pal who is always ready to help the hero through all periods of crisis!
The American venture-capital industry is perceived as the epicenter of economic growth. Tactfully sedimenting the popular myths from the facts, we strive to illustrate how important this piece is in the content of the U.S. economy and not merely another cog in the wheel. A detailed analysis of how Venture Capital firms operate and where they get their money from is sure to be a great learning experience for all, especially for entrepreneurs and definitely for aspiring entrepreneurs of the future.
Venture Capital – Void Filler
Venture Capital exists because banks are restricted by regulatory bodies to charge interest only up to a certain limit against loans and they have to be against hard assets owned. Public funding is not available without a prior record of proven stats amounting to $15 million in sales, $10 million in assets owned, and a history of consistent profitability.
Venture capital fills the void between – sources of funds for innovation and traditional, lower-cost sources of capital funding available for interested concerns. And to be able to retain its position on the cusp, the venture capital industry must find opportunities for investment that provide a lucrative return on capital to attract buyers for liquidating profits.
Profitable Returns at Calculated Risks
Venture Capital funds are usually drawn from very large institutions such as pension funds, financial firms, insurance companies, and university endowments. These institutions pool in a minor percentage of their entire portfolio to invest in the VC firm with the assurance of making 25-30% returns on their investment annually over the tenure of investment. Hence, these investors usually do not invest in the idea or the technology, but in the credentials and record of the VC firm to match their commitments of projected profits.
The VC firms structure an Investment Profile based on their initial analysis of the idea and the promise the technology behind it holds. The Investment Profile and its structure play an important role in influencing the Institutional Investors’ decisions.
The Investment Profile
The most popular myth that has been doing the rounds is that venture capitalists invest in good people and good ideas. However, the whole reality is that investments are always governed by good investment profiles. And a good investment profile typically operates in an industry that has competitively more scope for growth than the market as a whole.
Typically VC investment does not happen at the earlier stages of the innovation but when the innovation is being commercialized for the market. So VC investment enters at a crucial stage for a startup company and retracts just before the dip in sales to successfully liquidate the profits or sell them to equity firms. So a carefully structured Investment Profile is a very good reference for portraying the industry in the right light to encourage investors to put their confidence in the opportunity.
At the Right Time and the Right Place
As discussed earlier, VC firms typically enter the funding process for a startup when its innovation is going to be commercialized to make it market-ready. That’s where the huge cash influx goes into, making the technology or the innovation ready for the market. So, once the market launch happens, VC firms keep a keen eye on the sales trajectory and it is at the onset of the dip in the sales curve or just before that they typically choose to exit.
By choosing to invest in high-growth areas, they unload the risks of operating, to the company’s ability to perform. Investment bankers working for VC firms are always on the lookout for the next high-growth venture to fund for the market. As long as the timing is perfect, venture capitalists can exit the company and industry as seamlessly as their entry, reaping extraordinary returns at relatively low risk.
Scalable Returns for the VC
Typically, VC firms lookout for opportunities where they can fund two years of a company’s growth cycle and expect at least 10 fold returns. The actual benefits lie in the appraisal of the entire portfolio as investors draw 70% to 80% of the entire returns, and venture capitalists keep the remaining 20% to 30%. So the primary objective for the VC firm to get involved is to satisfy its quest for high profitability, both for itself and its investors.
Pay vs. Performance
In an ideal world, VC firms make profitable returns as expected on all their investments. But in the real world, not all plans go as per expectations. Sometimes, despite unlocking the constants and fixing the variables in an equation, the result is still not satisfactory and this is because there are a lot of external factors involved that contribute heavily to any company’s success. A slight deviation from the plan in any of the variables in the equation can make the entire forecast go topsy turvy and the VC firms stand to make break-even at best.
Hence, the VC firms often distribute their original investment in funds across many startups based on their projections for success, and often only one in ten funds pulls a winner that typically compensates for the rest of their funds as well.
Time Management for Venture Capitalists
Given the premise of the risk calculation involved in VC funding as described earlier, it is quite evident that VC firms or a Venture Capitalist partner can’t spend their time with any single entity but distribute it across the portfolio of companies held by them.
Considering, every partner has a typical portfolio of ten companies and a 2,000-hour work year, the time spent on each company with each activity trickles down to a very negligible score. Assuming the total time spent with portfolio companies serving advisory positions and providing consultancy is 40%, then the time spent on portfolio companies is 800 hours per year. That boils down to approximately 80 hours per year per company, almost less than 2 hours per week. This statistic is at loggerheads with the image of VCs as the resident friend, philosopher, and guide.
Having successfully established the process of how Venture Capital funding works and how the VC firms manage their company portfolios and the investments directed towards them, we can now move towards discussing in detail the source of investment for VC capital funding. Earlier we have touched upon the same briefly while outlining the various sources contributing to the VC capital fund, but let us take this opportunity to delve into this area of how VC firms work in detail.
Source of investment for VC capital funding:
- ENDOWMENTS[1]
Endowments are the funds invested by Private Universities, typically the big private universities, although in some cases the public university systems, like the University of California system, also have a big endowment. Yale, Harvard, MIT, Stanford, Northwestern, are some of the biggest endowments available, to name a few.
In the case of the University of California system, its reputation precedes itself, and featuring this particular endowment on an investment or funding portfolio influences or opens the doors for a lot more to come. Like the same way a startup hopes to get the top VC on their board, VC funds are constantly trying to attract the heavyweight endowments on their board, to lead a VC fund portfolio.
Lighthouse Capital, a top VC firm had MIT as a lead endowment and when they pitched to other investors to join their fund it made a major impact, influencing the decision making to a great extent. The fact that MIT is perceived to be a thought leader in the venture capital world and when VC funds looked at MIT’s endowment in Lighthouse Capital’s investment portfolio, it helped them arrive at a decision quickly.
- PENSION FUNDS[2]
Pension funds are typically contingency funds set up for employees of a large private institute such as the California teacher’s pensions, the state-sponsored employee pension funds, and similar major pension funds. UTIMCO, the University of Texas/Texas A&M University pension fund is an apt example of a big pension fund that is active in venture capital.
Then again there are also local pension funds, like the LAPD and LAFD, police, and fire departments in the state of Los Angeles respectively. These pension funds are also interested in making profits from their available capital by investing them towards guaranteed returns in a given period. Specialized consultants, generally investment banking consultants as well as consulting firms shortlist, analyze and assess prospective venture capital funds by pitting them against each other and making recommendations to pension funds for investment.
A lot of local pension funds invest in VC. Again as essayed earlier, they might not divest their entire funds into a single VC investment portfolio but rather go ahead with partial investments amounting to let’s say 10 or 20%. Very often, it’s also, mixed in with hedge funds.
- FOUNDATIONS[3]
Foundations are, for the lack of a better term or verbiage, huge trust funds that have been set up for social causes by private wealth holders such as the Gates Foundation or the Rockefeller Foundation. There are quite a few similar numbers of such trust funds or foundations which have available capital at their disposal.
Now, with access to such large sums of capital, Foundations or Trust funds often look forward to investing in opportunities with guaranteed returns in a given period and the options boil down to VC funding. The reasons governing their choices are quite simple, the Foundations are looking at a long-term approach and so, they’ll typically invest a portion of their assets, again, in venture capital.
- HIGH NET WORTH INDIVIDUALS[4]
The next and final group is high net-worth individuals (HNI). These are people who are superior to private wealth holders in terms of the brand value they represent. They could be sports stars, celebrities, entrepreneurs, or simply accomplished professionals.
High net worth individuals accept the fact that they need to have a contingency for the future and typically invest in venture capital funds in the tech industries which have promise for growth and continuity. There is a lot of background work that goes into their decision making but that is a story for another day.
Interestingly, when it comes to HNI investing in VC capital funds, a lot of entrepreneurs who have been funded by VC firms look to invest their money with VC firms. This is because they have a clear understanding of the VC’s potential and ability to deliver as per commitment and their surge to prominence is a direct outcome of the dilutive capital that the VC invested in their startup.
High net worth individuals’ funding is typical when starting a new fund. Trickling investments from HNI keep piling up to raise the collection amount till it assumes a large figure, let’s say $1 million. With that amount in their favor, a VC firm now has a substantial fund to approach the big four for larger investments – foundations, endowments, pension funds, and family offices. Starting with HNI individuals, especially entrepreneurs who have themselves been recently benefited by the VC is an assured way of building funds. This is because HNI fund amounts are relatively smaller than the big four and they are easier to convince of the resulting outcome.
In conclusion…
Pension funds, endowments, and foundations are nontaxable funds and also, DO NOT have to pay taxes on their profits! They are focused on a long-term approach and do not mind signing up for 10 years if required. These funds are accountable to the public investors and hence, are making a long-term commitment which is part of the promise that their brand conveys. HNIs on other hand do not like to be holed up, they make accommodations from their capacity, and hence, they’re most unlikely to commit to multiple funds.
The big four funding options – foundations, endowments, HNI, and pension funds, primarily feature because of the bigger paychecks they can roll out. Also, the weight of that brand, the reputation, and its ability to invest equally in other funds make them all the more suitable for the role.
Hope this article has added value to your understanding of the VC investment landscape. Stay tuned for more such articles.