Venture Capitalists raise capital to invest in early stage companies. These are high risk-high return investments and investors who provide VC firms with capital include large financial institutions or wealthy individuals. VC firms at some level are similar to mutual funds. Like mutual funds, VC firms raise capital for a fund and then deploy that capital in companies that match the VC fund’s investment mandate. Some of these firms have a mandate to invest in companies of a particular sector (example, technology), other in stages of a company (seed vs early vs profitable businesses, etc.), so on and so forth. VC funds are closed ended, which means that a certain fund size is targeted and that once financial commitments are met for that fund size then that fund is closed to any other investors. Another difference with Mutual Funds is that VC funds do not sit with the committed capital but call for the capital as and when investments are identified.
Venture Capital funds have gained huge popularity in recent years because of returns they generate and the positive impact they have on fostering entrepreneurship.
1. Committed Capital
Similar to mutual funds, these companies are judged by the returns they generate from their funds. Investors that provide capital to VC firms are called Limited Partners (“LPs”) and they compare different VC funds before committing to providing capital into any fund.
UNLIKE a mutual fund, VC funds do not raise all their capital on day one. The get ‘capital commitments’ from investors. Capital is then ‘called’ from each of these investors as and when the VC decides to invest in a particular company. If an LP does not honor a capital call, there are several punitive measures that adversely impact the LP, including, at times, forfeiting previous investments into the VC fund. As an example, consider a VC fund that has USD 100 Mn of committed capital from 3 LPs – one who has committed USD 50 Mn, another who has committed USD 30 Mn and a third LP who has committed 20 Mn. It does not mean that the VC fund has USD 100 Mn in a bank account. When the VC fund identifies, say a USD 5 Mn transaction, it will go back to all its LPs and call the capital. Each LP will then contribute pro-rata to this transaction, so LP1 will give USD 2.5 Mn, LP2 will give USD 1.5 Mn and LP3 will give USD 1 Mn.
2. Structure
VC funds are raised for a period of 7 to 10 years. Within this period the VC fund needs to call all committed capital, make investments and then exit them. VC funds are either structured as trusts, partnerships or companies. The LPs own the fund and the VC investment firm (“GP”) is a financial advisor or the investment manager of the VC fund. A GP may, at one time, manage more than one fund.
VC funds are also monitored significantly by LPs and therefore build documentation across commercial, financial, legal, technical aspects of a transaction before completing an investment.
3. How do VC’s make money?
The GPS get paid in two ways:
1) LPs pay a certain management fee (usually of 2%) of committed capital annual to the GP
2) LPs provide an incentive mechanism to the GP. This is called the Carried interest or the Carry. LPs set a threshold level return, usually around 8%. If the GP generates more than 8% from the fund, then the LPs give a certain share (usually around 20%) from this incremental return. As an example, if a VC fund generates 15% return, then the incremental return, that is, the difference between 15% return and 8% return is taken and multiplied by 20%. This value is called the Carried Interest or Carry.
4. VC portfolio
VC funds generally see a high mortality rate in their portfolio. Usually, in more than half of the companies, the VC fund gets barely as much back as the amount invested. A few winners generate returns at the entire fund level. For this reason, VC funds generally start by making small investments in a company. If that company scales up, the VC fund invests more and increases the allocation to that company. VC funds have a more ‘machine gun’ type approach of making small investments in many companies as compared to a Private Equity fund that has more of a ‘shotgun’ type approach of making concentrated bets.
5. Criteria that VCs use to evaluate investments
VCs generally want conviction on the following aspects before progressing with an investment.
a. Market
VCs need to have conviction on the market. The potential market has to be potentially large and rapidly growing. There have to be enough credible metrics that can give comfort on this aspect to VCs.
b. Business model
The business under consideration should not just solve a problem but upon reaching steady state also be able to generate revenues, profits, Return on Equity and growth
c. Growth
The target company should ideally be showing rapid growth in revenues. However, in case the company is earlier in its evolution and revenue is not a focus at present, there should be some revenue driving metric that is showing rapid growth – this metric could be users, downloads, pageviews etc.
d. Team
The team should have strong credentials – these could include pedigree, relevant experience, strong referrals or managerial ability. Above all, VCs look to get comfort on integrity. Several background checks are undertaken on the management team. VCs also seek to understand if the management team is rationale in its approach to the business. This is important as VCs will have to work with the management team to navigate through market trends – VCs will not partner a management which they feel will not approach the business in a rationale and structured manner.
e. Rights
VCs seek some exclusive rights for themselves following an investment. These rights usually give the VCs veto rights on strategy of the business, Right of First Refusal of future fundraise, ability to sell the business if an exit is not provided to them in an agreed timeline, among other rights.
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