Thinking of starting your own business? This series on funding will cover the basics of what you need to know to get your startup financed. We kick off the series with an introduction to venture capital and discuss the various responsibilities of the venture capitalist.
Venture capital is a type of private financial capital, specifically tailored for early stage, high risk, high growth-potential companies. Venture capital provides the much needed capital for companies that cannot get funding via traditional bank financing, often because the company is still in the ideation stages of startup and does not have a product and/or positive cashflow and sales. Venture capital can be used as an option to fill in the fiscal void between initial seed funding and commercialisation, often referred to as the “Valley of Death.” Venture financing can thus help new technologies make it to the market, with the downstream effect of creating jobs and spurring the economy. In the U.S., venture-backed companies employed 11% of the total U.S. private sector workforce and generated revenue equal to 21% of U.S. GDP.
So what are the basic roles of the venture capitalist (VC)?
First and foremost, money must be raised to generate a fund. VCs typically get money from their Limited Partners, which include private and public pensions, finance and insurance funds, endowments and funding from foundations, funding from individuals and families, and sometimes corporate finances. Once a target amount is reached, VCs will “close” the fund and start the fund cycle. VCs can have overlapping funds, and each fund has a pre-determined lifecycle, typically 10 years.
The Fund/Investment Manager
The VC now takes on the role of investment manager, deciding which start-up companies are the most promising ones to invest in. Deal flow is important for VCs, as it is necessary for them to maintain access to the most innovative and creative ideas as early as possible. However, the reality for entrepreneurs is that a typical VC firm receives about 500 business plans a year, and an initial screen quickly narrows it down to 20 or so to undergo more detailed due diligence. Subsequently, the VC picks only two or three ideas to fund. This is known as a ‘business plan funnel.’
Let us look at an example, which we will call ‘NewCo,’ as VC Standish Fleming did in his series of articles. In return for the capital, VC firms typically ask that they manage NewCo, and receive a significant share of the company, termed equity. The shares are allocated based on the valuation at the time of investment.
VCs typically create a portfolio of companies that fit well in their investment strategy. Said strategy can be based on stage (e.g., early stage, clinical development stage) or type (e.g., biopharmaceuticals, medical devices, medtech). VCs typically invest in new companies at the early stages of the fund cycle, because once they have committed to the investment (and allocated the resources for follow-on financing), there is little left for another major investment.
The Company Manager
Venture capitalists may also become co-founders of NewCo, and many of them also act as founding CEOs, before hiring a full-time CEO. Venture money is also synonymous with “smart money,” because venture funding also brings the experience and knowledge of starting a company. Over the next few years, the VCs will manage NewCo and help the company grow. In addition, they will frequently reinvest more as the company grows through further rounds of funding.
Once NewCo is mature enough, or it is progressing towards the end of the VC fund lifecycle, or if the opportunity is right, the VCs need to get their money back to repay their Limited Partners. Hence, they have to plan an “exit strategy” to liquidate their assets. There are two common strategies: 1) A larger company (either big pharma, or a larger competitor) acquires NewCo, or 2) The company goes public and issues an Initial Public Offering or IPO (like the highly publicized Facebook). Once the money comes back to the VC, they first return the initial investment to their Limited Partners. Thereafter, they usually take 20% of the profits (following the two and twenty rule of private equity, where 2% of the initial investment goes towards management fees and 20% of the carried interest, or carry, goes to the VC firm).
The multiple hats that VCs wear as fundraisers, managers and strategists, combined with their expertise and substantial appetite for risk, reaffirms venture capital as a major player in helping new innovations reach the marketplace.