Venture Capital: Explained In 5 Mins
For the founders that need to know!
Hi all, this is Fundamentals in Five Minutes, where I take a topic relevant to start-up founders and challenge myself to summarise it in five minutes or less.
Today’s topic is all about Venture Capital. What it is, its purpose, and the pros and cons to consider for the founder.
I’m taking on quite a bit here and there’s lots to cover, so let’s get into it!
First up, what is Venture Capital?
Broadly speaking, venture capital is a subset of private equity and is the preeminent financing tool for small high growth start-ups.
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Venture capital is classed as a high risk/ high return type investment. Its job is to not only fund startups, but it is also designed to provide a high return for investors in the VC funds.
And with that, we’ve summarised venture capital is at a high level, now onto the VC model.
The VC Model
The venture capital model is pretty simple.
Venture capital is typically managed by specialist venture capital firms. These firms specialise in raising and allocating capital into high growth businesses.
VC’s raise funds from investors with the mandate of allocating portions of each fund to a number of high growth potential business.
This results in a portfolio of high growth companies that the VC manages, all on behalf of their investors.
The investors in such funds are usually institutional organisations looking for exposure in a high returning investment class to balance out a larger portfolio of ‘safer’ investments.
VC firms are usually remunerated on a “2 and 20” fee structure. This means they earn a fee equal to 2% of the total fees under management per annum, and they stand to make 20% of any net capital gains achieved by the fund as a performance bonus.
The theory of this fee structure is that the VC firm covers its operating costs with the management fee and receives an ‘upside’ if their investments grow well.
That’s the VC model summed up, now onto the purpose of Venture Capital.
The Purpose of Venture Capital
As mentioned before, venture capital is the preeminent financing tool for small high growth business and start-ups.
VC firms come in all shapes and sizes, with different investment thesis on when and how much to invest in certain companies. They can also specialise by industry or be vertical-specific to further refine how they invest.
From a founder’s perspective, however, venture capital can broadly be categorised as the capital you seek to grow, not necessarily to develop a product or idea. If a company is in product development or a market validation phase, this is where angel investment is arguably more suited.
As such, if a company has a product in the market and is seeking capital to finance its growth, it will often seek venture capital to do so.
And that wraps up the purpose of Venture Capital, now on to ‘how it works”.
How Venture Capital Works.
In it’s simplest form, venture capital is like any other capital transaction. The company agrees to sell a portion of ownership in the company in exchange for a cash investment from the venture capital firm.
Depending on the size of the deal, there will be a phase of due diligence (DD) prior to an offer of terms. This process is very much context-dependent to the situation, and the VC firm, and is also outside of the scope of this article.
Once DD is done, a term sheet is drawn up. A term sheet offers a high-level summary of the key points of the deal, including pre-money and post-money valuation, which will determine both the share price and the proportion of the company the investor will receive in returns for their investment.
If a company is raising capital from multiple investors, a company will nominate a ‘lead’ investor, who sets the terms for the raise. These terms are then presented to other investors who have the option to either accept or decline these terms. This makes for a cleaner and more transparent transaction for all parties.
And so that wraps up how Venture Capital works, now it’s onto the pros and cons of Venture Capital.
Pros and Cons
The risky nature of startups means more traditional forms of finance often don’t fit the needs of either the investor or founder.
This is where venture capital provides the main benefit to startup founders. It is a specific financial tool for start-ups to fund their growth activities.
Furthermore, good VCs can offer networks, expertise, and in some cases, validation and credibility for a start-up, over and above the funding they provide.
There are also, however, a few cons founders need to consider when taking on VC money.
The first is that VC’s can insist companies adopt less capital efficient growth strategies. Such strategies can set a company down a specific path that can result in the need for multiple capital rounds, which may not always be in the company’s best interests.
Second, because you are selling ownership in your company, you are tying yourself to a third party in a way that can be extremely hard to wind back should anything go wrong.
Third, and final, when push comes to shove, the VC has a responsibility to its investors, not the companies they invest in. This will influence how they behave as a shareholder and in the board room.
This may not always be a bad thing, but it’s this fiduciary duty that can lead to decisions not always favourable to the founders' wishes.
And, with that, we're all done! Venture capital all summarised in under five minutes.