Earlier this year, I got asked to join a new venture capital firm called Pilot Mountain Ventures. I’m thrilled and lucky to be involved. I’ve told some friends and family about it, and more often than not they smile and nod and don’t have any idea what that means. Largely due to prominent bloggers like Mark Suster, Brad Feld, and Fred Wilson, people in the startup industry know more about VC now than ever before. Still, it’s not a well understood subject by everyone else. It’s gotten more press lately since Mitt Romney secured the Republican nomination. More press, but regrettably not an informed press. So, I thought I’d put together a basic primer on how venture capital works. Got questions? Ask in the comments section and let’s have a discussion.
Venture capital funds are vehicles where investors commit a certain amount of money over a period of time that a VC calls to invest in startups. That’s the most basic way to summarize it. Each fund has some investment type it’s looking for (consumer internet, fintech, adtech, hardware, mobile, cleantech, and biotech just to name a few) and each invests at different monetary levels and stages. Some funds invest in an angel or seed round at as little as fifty thousand dollars. Typically, it’s before a company has a well-defined product or market. Later stage venture firms invest in more mature company at tens (and now with firms like Andressen Horowitz, even hundreds) of millions of dollars. All VC’s hope their startup investments, or portfolio companies, become wildly successful, gets further outside investment, and go public or get purchased. This is called an exit. This is where everyone makes their money.
Investors & the Investment Structure
Venture capital funds are only available to accredited investors. Accredited investors are people making $200K+ a year or folks with a net worth of $1M. Even if you make that much, investment minimums are typically much higher (think in millions) and you need to have some good connections to get the opportunity. The largest investors in venture capital are typically pension funds, for instance CalPERS (California Public Employee Retirement System, the largest in the world) or endowments, like Harvard’s or Yale’s. And once investors commit, they commit for the life of the fund. Venture investments aren’t like investing in the stock market, a mutual fund, or an ETF. Those are all freely tradable. VC investments are highly illiquid and have a lot of restrictions around them.
The typical fund incorporates as an LLC out of Delaware (side note: people always ask why business incorporate in Delaware. It’s because their business law is so well-defined that little is left to guess-work. Their laws are also business-friendly). But when a fund seeks investments, they won’t take money into the LLC structure. Neither will they invest through it. They’ll set up something else, called a Limited Partnership. For instance, USV is probably Union Square Ventures, LLC. When they invested in Twitter, they would have invested with USV Opportunity Fund, LP. So what’s the difference?
A limited partnership is a blind pool structure. It has two types of participants: limited partners (LP) and the general partner (GP). Both LPs and GPs contribute money to the fund, and that fund then goes out to invest in companies. However, all investment decisions are carried out by the GP. The venture capital LLC is the GP.These vehicles are called blind pools because when VCs invest money, the fund invests. The underlying investors are confidential, rarely disclosed, and have little discretion on where the money goes. Hedge funds and private equity funds also use the same LLC/Limited Partnership structure. They manage and control their investors money. GP is venture capitalist. LP is every other investor. Got it.
How to find investments (deal flow)
Finding companies to invest in is, in my opinion, the most important piece of venture capital. It’s called deal flow. It’s having a steady stream of companies seek you out to invest. It should be obvious why this is so important. You can’t invest in good companies if they don’t come across your desk.
So how do you find them? If you’re a VC, you’ve probably invested in an entrepreneur in the past. If they had a great experience, they’ll probably call you first to see if you’re interested. If you’re a brand name VC, like Union Square or Kleiner Perkins, people want to be associated with you. You have very developed networks and contacts, are proven to be successful, and your investment serves as a stamp of approval.
So what about for the rest of the world? NETWORK, NETWORK, NETWORK. Use your existing network and get the word out. There’s always someone looking for money and they’ll find you if you put yourself out there. Go to Meetups. Spend time at one of your city’s co-working spaces (New York has General Assembly, WeWork Labs, etc.). Serve as a mentor through programs like TechStars or Blueprint Health. Venture is first and foremost a people business.
How the Investments Work (or everyone makes money):
VC funds invest in high growth companies at early stages. The first round of investment is called a seed or angel round. Angel rounds are led by and derive their name from angel investors, high net worth individuals who invest privately, on their own, outside of a fund structure. After the angel/seed round, the remaining rounds are called A, B, C, D, etc. Each subsequent round gets the next letter. The amount invested and company’s value should increase in each new financings. In seed rounds, a fund might only invest $50k. There’s typically little financial data or history. It’s basically an idea or product, a team, and a market. This is the riskiest stage. Companies in later rounds get to evaluate a track record. They invest more money at a higher “valuations.” VC’s most commonly invest using Preferred Equity. These shares are higher in the company’s capital structure than common equity and confer more rights.
Company valuations are important. Basically, a company’s valuation is what someone thinks their company is worth. Investing $1 mil into a company that values itself post investment at $3 mil is different than if post investment valuation is $10 mil. You own 33% versus 10% of the company. The company valuation isn’t a number calculated by a hard formula. It’s something VC’s and portfolio companies negotiate during the investment process.
Why Do Companies Get Venture Funding?
Companies should never take venture funding unless they have to. Look, good VC’s absolutely add value. But if you can build a sustaining enterprise without them, you keep all the equity and control. Do that, don’t split it. Every investor takes shares out of you and your employees’ pockets. Make the decision with care.
Fine, you made the decision you needed outside funding. Maybe you need to cover costs, like salaries or servers. Maybe you want to ramp up your enterprise, and getting money in lets you create tons of value in a short period of time. You bring a VC investor on board. Not only will they give you money for a percentage of your company, they’ll typically request to sit on your Board of Directors. So there’s your money, and there’s your control. They’ll work with you on long-term strategy and decisions. They’ll advise and consult on decisions. They’ll hear you when you need a CFO or developer, then tap their networks to give you recommendations. They’ll introduce you to customers, and generally pimp you out. Their goal is to make you more successful. They will market the hell out of you.
Different people look for different things. Some funds specialize in verticals. Others have themes. One of the biggest themed funds I know is Roger Ehrenberg’s IA Ventures. IA, short for Information Arbitrage, invests in Big Data companies. All of their investments fit into the general theme of managing massive amounts of data and coming up with answers.
So you find companies that fit your overall strategy. Now you need to evaluate them. Financial analysis means very little. In new, high growth markets, the one thing you can be sure of is the projections are wrong. Most of that data is unknowable. It’s less about quantitative analysis than qualitative. Product, market, and people. You’d love to see all three together. In reality, that’s tough at a seed stage. For me, I view people and founding teams as the most important part. Without good people, the startup is doomed from the beginning. If the venture firm likes what they see, they’ll perform due dilligence. That means they’ll contact customers, people who’ve worked with you in the past, industry experts, to find out if you’re full of it or not. If all goes well, time to negotiate a term sheet. The term sheet details your investment.
Venture firms look for home runs. If they invest in 10 companies, they know most of them will go completely bust. However, if one of those becomes Facebook, Dropbox, Airbnb, well that one outsized return will make your entire portfolio profitable.
How Folks Make Money
You’ve had a company for four years, things have taken off, and Google loves what you’re doing. Instead of developing it in-house and competing, Google buys you for a cool $100mm. That’s quick and, from an investor’s perspective, painless. From an entrepreneur’s perspective, acquisitions are still difficult, typically because of culture shock or letting people go. The other option is to IPO and go public. Let the market dictate what to pay you and sell your shares on the NASDAQ.
So let’s go with the $100mm Google exit scenario. From the VC side, pretend they invested $500k and that yielded a 20% ownership interest. As the company raised more money, their ownership was hypothetically diluted to 11%. The VC fund nets $11mm on a $1mm investment. 22x return. Not bad. VC’s distribute the original investment back to all investors pro-rata. The remaining $10mm gets split 80/20 though. The VC earns $2mm and splits the remaining $8mm to investors. The $2M is called “carry” and it’s how VCs make money.
From the entrepreneur side, entrepreneurs and other founding members originally own 100% of their company. Eventually, they’ll sell pieces of it away. Some, they’ll give out to new hires as an incentive. Others, to investors. And they’ll also set aside a percentage of the company into an option pool. When distributed, the options convey the right to purchase a share at a certain price. Hopefully that price is below actual stock price. So when you get bought, convert those options to stock, have Google buy the stock, get rich, and go start another company. Sounds easy. It’s a beautiful cycle when it works.
Look, I know this is drastically simplified. This doesn’t discuss things like clawbacks, full-ratchets, down rounds, non-disclosure agreements, convertible debt/equity. Blah blah blah. This is meant to convey, at a basic level, what happens in venture capital. Ultimately, VCs invest in people. They invest in a vision of the future. I think that’s cool.