When someone mentions the words “Venture Capital”, what is the first thing that comes to your mind? Is it well dressed businessmen in the midst of a heated negotiation? Maybe some big names such as Marc Andreessen and Ben Horowitz? Or perhaps it is simply bags of cash stacked to the heavens? Well these are certainly the images shown in a quick search of the term. It is no wonder the industry is surrounded by an air of glamour and mystery. However, this series on Venture Capital (VC) aims to provide a clear overview of what exactly VCs do and how they do it. This first part of the series will describe the job of a VC and address some of the critical aspects of being a VC.
What does a VC do?
Basically, a VC is an investor that provides capital for start-ups and other small private companies in exchange for a percentage ownership of the company. Their ultimate goal is to earn a significant return on their investments through the eventual success and exit of the company. This means that the interests of the investor and the business owner are both aligned towards creating a valuable company. Businesses make use of the capital to continue operations and hopefully expand. In order to make the most of their investments, VC may even provide management expertise or allow companies access to their personal networks. In the end state, VCs will ideally make profits that are many times more than their initial investment in a liquidation event such as an Initial Public Offering (IPO) or trade sale.
What are the returns like?
One of the highest returns made by a VC include the $3 billion return made from Sequoia Capital investment in WhatsApp when it was acquired by Facebook. If the investor was an individual, he would have enjoyed 100% of the returns. On the other hand, as VC firms manage their client’s money, the majority of the profits is returned to them. Nevertheless, almost all VC firms operate with a “2 and 20” fee structure. This means that VCs are paid 2% of the assets under management per year as well as 20% of the total profits made from an exit, also known as carried interest. This might sound like a modest amount initially, but will add up quickly when managing billion dollar funds.
So what’s the downside?
Being a VC is inherently risky, as they are putting money in very young companies with high potential for growth. With the smorgasbord of up and coming startups, VCs are also spoilt for choice when deciding on a sound investment. Thus there is a very high chance that the business will fail, resulting in considerable losses for investors. There is therefore plenty of research that must be done before each investment, and VCs always ensure that everything from the business model to the management team are poised for success before putting any money down. You can expect to go through countless different companies before finding anything potentially valuable.
Can I become a VC?
VCs generally come in the form of wealthy individuals or VC firms who manage various funds. Many VCs who invest using their personal assets look for interesting companies within industries that they are familiar with. They also tend to invest large amounts in order to acquire a substantial portion of their company and influence their direction. On the other hand, VC firms accept money from a variety of clients and are entrusted with generating returns for them. As such, most firms attempt to mitigate their risk by investing in a large number of firms in the hope that one or two of them will become so successful that its gains outweighs any losses made. In short, unless you have a considerable amount of liquid assets, you are better off trying to join a VC firm.
Hopefully this first part of the series has given you some idea of how VCs make money. In the next part, we will discuss the specific organisational structure in a VC firm and what you can expect when working in one.