What do VCs do?
Well, they make money – serious money 🙂
The job of a VC is really weird. Imagine convincing someone to part with his money that you would sink into something that is almost certain to bomb (80%-90% of cases). Then imagine sifting through 100s of half baked-wild ideas to find those very few, typically 1%, that you feel (yes feel – there is no formula or model to make your life easier) is worth investing. Then imagine praying patiently 4-6 years for those ideas to hatch that would get your money back, maybe with some return. So every time you are going to raise money, every investment that you are making you are putting your credibility at stake – past performance is not indicative of future results. How would you feel when one after other your investees are vanishing in thin air?
Is this job envious? Well, may not be for most. But it certainly is for some, including me. There is this thrill of identifying something that is going to change the world (various degrees of changes from Google and Facebook at one end and 100s of unnamed ventures on other ends). There is this urge to connect the dots, see the pattern and figure out the changes that are going to happen a couple of years ahead in future. You know how it feels when you realize a dream? When you make this your job to realize dreams of others? Well, a VC’s job feels something like that. Never mind that there is a little chance of you getting wildly rich.
At a more practical level, VCs usually work in a team. They invest someone else’s money and, thus, have the fiduciary responsibility towards those investors. Since they don’t know which 1% of the 100s of business plans landing into their inboxes are going to click, they have to go through any and all that come through. Once they evaluate a plan (I would be writing later on this), they talk to entrepreneurs and their clients and potential clients. They rationalize the assumptions that entrepreneurs usually make, run the numbers themselves and analyze to assess the size of the opportunity, market growth, and competitive intensity. Once they invest, they provide the mentorship and support to the entrepreneurs.
Mentoring and support is an important element that a VC investment brings on the table, unlike other flavors of investments. VCs, bring with them a huge network and rich operational experience. Especially for technology ventures, maybe because of the tech background of the entrepreneurs, there is this need to fill the gap for sales and marketing expertise. VC can assist in providing such strategic directions. They can introduce the entrepreneurs with potential clients, vendors, and partners.
VCs do monitor whether product development cycles are on track, how the initial customers are responding to the product or service, how the competitive landscape is shaping up etc.
Entrepreneurship is a journey that has highest of highs and lowest of low in rapid succession. If you are an entrepreneur, you would immediately understand the need for a shoulder to cry on once the tide turns against you. Well, VCs do provide the shoulders to cry on. VCs who are an entrepreneur are better able to relate to the situation of an entrepreneur and can empathize with them.
With their huge experience, VCs can advise entrepreneurs in deciding when to go for funding and how many funds do they require. They also help entrepreneurs in deciding when to go for IPO or accept an M&A offer.
At the same time, it’s worth mentioning that a VC, especially a good one, understands that it’s the entrepreneurs who are creating value and not them. Hence it’s the entrepreneurs who would take the final decision on any matter of the venture and not the VC. The VC is only there to provide support and advice and not to take any decision on behalf of the entrepreneurs. A VC who starts forgetting this role-division would not be a successful one in the long run.
How does Venture Capital work?
VC (called general partner, GP, responsible for investing the fund and managing portfolio companies) typically raise money from high-net-worth individuals, institutional investors (called limited partner, LP – doesn’t get involved in day-to-day operations), etc for a fixed-life venture fund.
Suppose a VC raise $100 million funds with a life of 10 years. Typically VC would invest that fund in a number of early-stage ventures for 4-6 years. Once VC gets back his money through IPO, M&A or selling his stake in his portfolio companies to some other entity, he would 1st return $100 million to the investors (i.e., LP). After that, whatever amount remains, i.e., profit, VC would keep 20%-30% of that amount and return rest to the investors. Bigger and established VCs would keep 30% of the profit whereas smaller or newer VCs would keep 20% of the profit with the rest of the VCs falling in-between. So this is how a VC makes money.
Because of the higher failure rate of startups (8-9 failures out of 10), a VC expects a return of at least 10x on his investments. Once a startup fails, VC has to write-off that investment. At times, he may be able to find someone who still sees value in the venture that this VC thinks as a failure (or not going anywhere) and he may be able to sell his stake for 2x or 3x, whatever he can negotiate.
Given the risk involved and his responsibilities towards the investors, big financial return (at least 10x return) is the prime motive of a VC’s investment in a venture. Since a VC would have to return the money to the investors, all his investments must have a clear exit opportunity.
For example, if there is some venture that is valued at Rs 5 crore today and becomes Rs 30 crore at the end of 5 years, it won’t be of an interest to a VC since he won’t be able to get at least 10x return on his investment, even if he owns 100% of the start-up, which itself is impractical.
Similarly, suppose there is a venture with 50% profitability at the revenue of Rs 20 crore year-on-year (assuming no growth). Though this is a great business, such a venture is of no interest to a VC because there is no clear exit opportunity for him.
Hence, for a venture to be interesting to a VC, it should be in a fast-growing potentially large market with a very few players. Such a venture would not only present an opportunity for big financial return (priority 1 for a VC) but also have clear exit opportunity (priority 2 for a VC) through IPO or M&A or some other means.
By looking at a proposal, a VC would be able to figure out the potential gain from the investment or the exit scenarios. But that is the single most important thing that could risk an investment? That is the quality of the entrepreneurs a VC is banking on. No wonder, you would hear VCs saying that they are investing in the entrepreneurs and that if they are not comfortable with the entrepreneurs, there won’t be any deal, whatever be the potential of the business idea.
To minimize his risk further, a VC may insist on some revenue traction or some customer of the product or service of the venture. He would feel more comfortable if there are some other VCs lined up to fund that particular idea. He may further add some protective clauses in the agreement.
Valuing a Venture
Every business plan that a VC receives includes an attractive budget and an aggressive growth plan. Assumptions related to minimum market penetration, product pricing, and gross margin are usually over-optimistic. A VC has to rationalize the assumptions and run sensitivities based on various scenarios (competitive pricing pressure, degree of execution, seasonality). The resulting rationalized forecast may be a fraction of original forecasts.
Discounting from the original forecast may reveal significantly greater capital requirements than first expected. However, this revised capital requirement could guide the venture’s long-term financing strategy. How much must be raised now? When will the next financing be needed? What significant milestones will be accomplished during that time? An understanding of the long-term financing strategy is crucial. A seasoned entrepreneur would work with his investors to develop a financing strategy based on building value from one financing to the next and understanding how value will be measured.
Following are the different stages of financing a venture:
The seed financing will provide the capital needed to support salaries for founders /management, R&D, technology proof-of-concept, prototype development, and testing, etc. Sources of capital may include personal funds, friends, family, and angel investors. Capital raised is limited due to its diluting impact at minimal valuations. The goal here is to assemble a talented team, achieve development milestones, proof of concept and anything else that will enable the entrepreneur to attract investors for the next financing.
Series A Financing
The Series A is usually a company’s first institutional financing and is led by one or more venture investors. Valuation of this round will reflect progress made with seed capital, the quality of the management team, product-market fit and other qualitative components reflective traction of the business being built. The objective of this round of financing is to continue progress on product development, hire top talent, achieve key milestones, further validate product-market fit, initiate business development efforts and attract investor interest in the next financing (of course, at an increased valuation).
Series B Financing
The Series B is usually a larger funding round than the Series A. At this point, we can assume that product development is completed and technology risk removed. There may also be some traction for an early revenue stream. Valuation is gauged on the basis of numerous subjective and objective data— talent, product market fit, potential revenue streams, intellectual property, milestones achieved thus far, comparable company valuations and rationalized revenue forecasts. The objective of this round of financing may include operational development, scale-up, further product development, revenue traction and value creation for the next round of financing.
Series C Financing
The Series C is usually a later stage financing that could be for various reasons including to strengthen the balance sheet of the company, provide operating capital to achieve profitability, finance an acquisition, develop further products, enter a new market or geography, or prepare the company for exit via IPO or acquisition. At this stage, the company often has predictable revenue, backlog, and EBITDA at this point, providing outside investors with a breadth of hard data points to justify the valuation. Valuation metrics, such as multiples of revenue and EBITDA, from comparable public companies, can be compiled and discounted to approximate value.
Each financing is designed to provide capital for value-creating objectives. Assuming objectives are accomplished, and value is created, financing continues at a higher valuation commensurate with the progress made and risk mitigated. However, problems can and will arise during this time that may adversely affect valuation.