by Ting Gootee, CFA, CAIA
Much has been written about venture capital, an industry that has been experiencing the biggest growth since the 2008-2009 Financial Crisis and in history. I’ve been very fortunate to take a front-row seat as the person who helped conceive, launch, and scale Elevate Ventures, a state-sponsored venture capital firm from 2009 to 2022. Unlike traditional venture capital firms, Elevate Ventures’ dual mandates in economic development and in generating financial returns, has made it uniquely positioned to work with founders before they become venture ready and to take on investment risks that very few private sector investors were willing to take on, at least during the first few years that we were operating. Through that process, I got to see and vet thousands of startups, conducted diligence on well over a thousand of them at various company-development stages and ultimately built an investment portfolio of over 400 startups across all sectors. Such broad experiences have led to deep perspectives over time, including some overall observations about the industry that continues to play an important role in our innovation economy and I am still passionate about.
During that process, I have also come to appreciate how the industry managed to transform itself by becoming more communicative and open book about who we are and what we stand for. That includes private deal data bases like Crunchbase and PitchBook, real-time venture coverage by the likes of TechCrunch, VentureBeat, Axios, and many others, and most informatively, various digital content produced by people working at venture capital firms themselves. Such proprietary content tends to focus on industry trends, fund investment thesis, deal terms, portfolio growth best practices. A few I followed and learned a lot from are Fred Wilson at Union Square Ventures, Brad Feld at Techstars and Foundry, Tomasz Tunguz at Redpoint Ventures and Theory Ventures, Reid Hoffman at Greylock, Peter Thiel at Founders Fund, Ben Horowitz at Andreesen Horowitz and Mark Suster at Upfront Ventures. When founders can Google how to be a better founder, industry novices like me were Googling how to become a better VC. Makes sense, right?
When it comes down to it, however, it’s really about how to win in an increasingly competitive industry. As the chart indicated below, venture capital supply has continued to grow since the Financial Crisis, resulting in over $300 billion in capital still available for investment at the end of 2022. When extrapolated against the ten-year average total deal value of $144 billion a year, that would suggest at least two more years of capital available for investment with no new capital raised.
In simple terms, venture capital is a professional money manager.
Most of us are familiar with big money managers like Fidelity and Vanguard through exposure to our 401(K) or other retirement plans. Those firms pool capital, called fundraising, from various sources including from individual retirement plans like yours or mine, and invest such pooled capital to buy public company shares, corporate, federal, municipal or other bonds (debt), sometimes real assets like gold, farmland, timber, and real estate, with an explicit goal to generate at or above market returns. To drive at-market returns is usually considered passive investing and to generate above market returns typically entails active investing. Similarly, venture capital also pools capital from various sources (you often hear about raising a venture capital fund), and venture capitalists invest such pooled capital into private company shares and private company shares only.
Three things are important to note:
Because venture capital invests in private companies and such a share is not liquid (meaning you cannot sell a private company share easily as you can in public markets), it is expected to generate above-market returns that involves active investing. In fact, venture capitalists’ main job is to turn capital raised from its investors (called limited partners) into more money through sourcing and selecting the best private companies and helping such companies grow.
Venture capital differs from private equity in that venture capital is almost always minority investors, meaning they cannot tell how a founder or operator should run the company. In comparison, private equity tends to take majority ownership and has a much higher degree of control over how a private company is run and even who should be on its management team. There has been a growing number of growth equity firms where traditional venture capital or private equity firms (usually noticeably big funds) would start with taking less than 50% ownership of a company and may gradually grow its stakes into majority ownership through more investments or buying out existing owners. This trend reflects how funds are responding to market conditions when more funds are competing for investment opportunities and some of them are trying to make themselves more appealing to founders/operators by becoming a minority capital partner first.
Venture capitalists are professional money managers, meaning they manage money, mostly other people’s money (again, called limited partners) for a living. In contrast, angel investors or organized angel groups are usually wealthy individuals who invest their own money and do not typically do that on a full-time basis. In recent years, there has been more interest from family offices (typically super wealthy individuals) who would hire professional money managers to invest directly into private companies that venture capital would typically invest in. There has also been a rise in fundless sponsors where professionals would scout out interesting venture capital investment opportunities first and then go out to their investor base and try to raise investment dollars for those specific opportunities. Overall, such industry dynamics give founders/operators more capital options and is a net positive for the overall venture community.
A venture capital firm has four main buckets of activities: fundraising, investing, portfolio management and finally fund administration and investor relations.
Venture capitalists need to raise capital from their investor base first before they have money to invest in private companies. Fundraising is the process venture capitalists go through to raise a fund (pooled capital from various sources). Investors in venture capital funds can be pensions, endowments, corporations, state entities, foundations, or individuals. Like startup founders, venture capitalists need to produce a compelling sales pitch and successfully sell to their investors to raise funds. Once a fund is raised, investors usually are committed to the fund for at least 10 years (sometimes 12 years or longer), hence the illiquid nature of such investment compared to buying or selling shares in public markets.
Once a fund (a committed pool of capital is raised), venture capitalists typically have 3-7 years to make investments. As mentioned before, this is where the bulk of a venture capitalist’s job takes place. It involves marketing, brand building, active deal sourcing through attending events and building relationships with other organizations in the startup community, and many conversations with a startup founder/operator and existing or potential co-investment partner (typically other venture capital firms) to get an investment over the finish line. This is where I used to spend most of my time on.
Once an investment in a private company is made, such company becomes a portfolio company of the venture capital fund. Depending on a fund’s investment strategy, a fund can have a dozen to quite a few dozen portfolio companies. Most venture capital firms are allocating more time and personnel capacity towards helping portfolio companies grow as its portfolio gets bigger, since how much portfolio companies can generate value would determine how much money a fund can generate and return to its investors. Such fund return performance, typically called the track record, would also drive how many more funds venture capitalists can raise down the road. Not surprising, VCs who made a lot of money for their investors in the past would have a much easier time convincing investors to invest in their future funds.
This is an essential back-office function where a venture fund’s accounting and tax work is done, and any reporting due to its investors is managed. To further relationship building with its investors, venture capital firms also have limited partner advisory committee (LPAC) to help with fund governance items, and host semi-annual or annual investor meetings to share portfolio news and fund progress.
A venture capital fund typically charges a percentage off its committed capital to hire professionals to manage these activities. That’s called management fee. 2-2.5% management fee is pretty standard. A $100M fund (committed pool of capital) for instance, would incur $2M a year in management fee at a 2% fee structure. That can amount to up to $20M over the 10-year life of the fund and leaves only $80M available capital to actual venture capital investments. $2M a year would cover operating expenses like personnel, rent & lease, marketing, technology infrastructure, and legal & other professional fees. Obviously, the bigger the fund, the more management fee a venture capital firm can generate to hire more professionals. In addition to management fee, a venture capital fund typically let venture capitalists participate in a fund’s upside called the carried interest – the theory being: the more money venture capitalists can make for their investors and themselves, the more motivated they would be to generate such bigger returns. Carried interest, typically 20% above a certain fund performance threshold, is a financial incentive for venture capitalists to drive better fund performance, very much akin to performance-based bonus.
Venture capital remains a niche industry, even after a decade of market boom. Although there are several thousand funds that have been raised during this boom, a typical venture capital firm would try to raise and manage multiple funds and through that, cumulative management fees across multiple funds start to provide some operational scale for the firm. Normally, professionals working at a venture capital firm would carry responsibilities across multiple funds. Because to succeed in this industry requires strong critical thinking and relationship management skills and such skills tend to get honed through doing, career progression in venture capital tends to function like an apprenticeship model. The other typical entry into the industry is through raising your own funds, and these are typically carried out by founders or operators with successful track record in generating venture returns for their investors. Again, since venture capital is essentially money management, returns are very black-and-white – either you made it, or you didn’t. It is the only determinant to how successful a venture capital is and whether he or she can continue to raise funds and manage money for a living.
A typical venture capital firm will start with a founder or founders. These are partners or managing partners. Based on the fund size and management fee available, they recruit other professionals to help manage the four main bucket of activities outlined above:
Fundraising, investing but mostly through participating in investment committee decision-making and portfolio management in terms of serving on portfolio boards
These are usually venture capital professionals who have had 5-7 years in direct VC experience, with oversight responsibilities in deal sourcing, due diligence and portfolio monitoring. They also start to get exposure to fundraising for the firm and are typically positioned for promotion to become partners, often associated with new funds raised.
The difference in title usually signals levels of experience, but not responsibilities. Analyst usually has 0-2 years in industry experience or can be right out of college or graduate school, whereas Associate comes with more and is usually considered a step above Analyst. That said, both roles are focused on learning the basics, usually under the oversight of a Principal or Partner. They tend to spend most of their time sourcing deals through travel to events, talking to startups, and on generating diligence or portfolio reports through primary and secondary research and compiling and synthesizing information. It is through such repeated deal sourcing and due diligence activities that an associate or analyst starts to hone their critical thinking and relationship management skills.
These are venture capital professionals primarily focused on portfolio management. The rise of platform VCs is yet another outcome of change in industry dynamics. As capital becomes more available and VCs seek to further differentiate themselves from other VCs, having dedicated professionals who try to add value in addition to boards to portfolio companies is a strong market signal. These value-adding activities can entail customer, talent, product or capital. In a way, the recent rise of the venture studio model is an extreme case of platform VCs where venture studios would employ a team of product, marketing or talent professionals to essentially provide substantial amount of operational support to its portfolio companies.
This is an important back-office function that often gets overlooked. Venture capital firms that generate sufficient management fees tend to build in-house accounting and fund administration capabilities. Portfolio monitoring particularly around valuation that goes into a fund’s audited financial statements would fall under this bucket of activities. Smaller firms can easily outsource to third-party vendors for a reasonable cost.
In a way, venture capital is no different than a typical business. A team of professionals need to put together a set of products and/or services, find customers and try to sell such products and services for a profit with an appropriate level of financial management and support. The services venture capital is selling are essentially skills to turn money (fund) into more money (return) and they package such services and skills into a fund (product) and sell the fund to its customers (investors or limited partners in the fund). No different than startups pitching to VCs, VCs need to pitch to their customers how their fund (product) is going to make money – that entails team, market opportunity, competitive differentiation, go-to-market, and customer success. Once a fund is raised, a VC would need to find another set of customers (startups founders or operators) who would take VC money. That’s more or less the same set of pitch around VC team, market opportunity or market understanding, competitive differentiation (why take money from my fund instead of other funds), and finally how I can help you (founders & operators) become most successful. All require a high level of critical thinking and relationship management skill sets.
A term used by venture capitalists to describe their investment opportunity pipeline, or said differently, how VCs find the best founder/operators to partner with and the best startups to invest in. As capital becomes more readily available, access to the best startups (deal flow) becomes one of the most important factors in determining a VC success. That’s why more and more VCs use active marketing strategies for brand and awareness building including being open book about how they do business, all for the purpose of better deal flow (investment opportunity pipeline).
This is a several-page document that memorializes the general investment parameters. Most VCs have already done quite of homework around a startup before issuing a term sheet. The National Venture Capital Association has a standard set of term sheet here.
This usually happens after a term sheet has been fully negotiated and executed. This typically involves VCs validating the information they were given to make sure they are in fact real. Most due diligence is confirmatory. For example, VCs would typically conduct management or customer references to validate what they thought the leadership traits or customer value proposition were. If a startup claims to have $1M in revenue, they would request customer contracts to back those up. Analysts, associates and principals are typically running such detailed validation work that would lead to final diligence report or investment memo for the final investment decision to be made. Unless some major red flag pops up such as a founder went to prison for theft and did not bring it ahead of time, most investment opportunities would move forward. VCs have inherent incentives to make such deals move forward because money uninvested does not generate value and substantial VC time and effort have been spent on the deal work at this stage; a deal not done is resources wasted.
It is important to note that taking venture capital is not the only way to build successful startups. In fact, most small businesses or startups do not have venture capital investment. A venture-backed or VC-backed startup takes on a specific high-growth trajectory, as VCs hope to generate 10X their investment within 5-10 years. That means if a VC invested $2M in a startup, he or she would work towards generating $20 million in return. In simplistic math, if this startup is valued at $10M when such investment is made, it needs to be sold for at least $100M in cash value for the VC to get $20M back. This is the most simplistic math and most VC investments have multiple rounds at different valuation points which makes the final return scenario analysis a lot more complex. Suffice to say – the types of startups VCs look to invest in can generate significant value, at least 10X, in a short amount of time 5-10 years.
Startups who opted not to take venture capital or potentially any capital at all, and instead would try to grow through reinvesting cash generated from operations and potentially at a slower pace than the explosive growth expected for venture-backed startups.
These are typically VC investments made to support product development and initial go-to-market (finding customers) activities. The risk profile is extremely high since nobody knows for sure whether the product would work, or the customer would be interested in buying. VCs are betting on the founder team’s ability to figure it out.
These are investments made to further prove out and scale up customer acquisition activities. Startups would often hear VCs using phrases like scalable or repeatable. That essentially means if a product and/or services can be sold to hundreds, thousands or millions of customers, and if such sales can be made through a sales mechanism that’s beyond the initial founders, whether that’s through a professional sales team or viral effect through marketing efforts. At this stage of a company development, numbers and metrics become the driving force for company operations, since they are critical for future rounds or liquidity events/exits. VCs also tend to pay a lot of attention to team and culture, including whether the original founders have the necessary leadership traits to grow the company. What makes startup founders superb in ideation and selling often times do not lend itself to building execution disciplines needed for scaling large operations. This is where VCs tend to spend a lot of time coaching and monitoring founders, and also work with other board members to put contingency management plan in place. During my 13-year tenure, very few founders were able to make this transition from a founder or co-founder to a CEO of a team of a hundred people or more. That’s consistent with the general industry trends.
This is also where growth equity or early-stage private equity firms would start to become interested in sizable investments, with the goal of eventually becoming majority owners over time. This is where a lot can happen in market conditions that can impact a company’s development trajectory. An economic recession, for instance, can slow down a company’s growth, making it challenging to raise new rounds of capital. If a company has raised previous rounds at a super high valuation and changes in investor appetite leads to a decreased valuation, this is when a down round would occur. Down is a very accurate term to describe the decrease in valuation and in that scenario, all existing shareholders will likely experience a decrease in ownership, called dilution. Down rounds are demoralizing to the management team and very tough to navigate through the Board and the existing shareholders due to fear of shareholder lawsuits. Most companies would try to avoid down downsides as much as they can, which lead to alternative outcomes like exits.
Exit usually means any transaction that would lead to a change in control and that the majority ownership has changed. Exit usually takes place through selling the company outright or listing the company in a public market which makes selling company shares in the public market feasible. In either scenario, both are expected to generate cash back to VCs and their investors, hence, it is called liquidity event – providing cash back to the investors. The most common form of exit is through acquisition by another company. To list a company in a public market entails lengthy and onerous regulatory and compliance requirements. It also subjects the company to potential share prices swings. It is a different way of operating a company than a private company where the share price is less obvious and is less determined by market or company changes like missing quarterly numbers of key personnel departure.
Despite the steady pace of venture capital investments since the banner year of 2021, it is important to remember that not all venture capital funds are created equal. Funds that come most frequently to mind are typically successful venture capitalists with a long track record and able to raise big funds. Bigger funds mean that they need to make even more money than smaller funds, and thus tend to look for startups who are going to grow in valuation in hundreds of millions or even billions. There are, however, hundreds of smaller funds with less than $100M in fund size that have been raised in the last decade. Their investment targets do not necessarily need to grow into billion-dollar valuation. Many of those funds, often raised by first-time venture capitalists, are in regions between the coasts. They can be good long-term capital partners to startups who tend to run more capital-efficient business models or in an environment where capital efficiency is perceived as a premium, compared to growing at all costs.
Venture capital is a long game. A typical investment takes 5-10 years from the time investment is made to the time the investment return is realized. Just as venture capital is conducting diligence on startups, startups should do the same. Asking upfront on process and/or timeline and next steps and then observing how VCs follow up are necessary. Inquiring about how VCs think about the market opportunity and company-building strategy opens up the dialogue to potentially align long-term growth philosophy. Doing portfolio references on VCs is a good way to gauge how VCs behave after an investment is made. Really skilled VCs often would offer these up without being asked, because they know they are partnering with founders/operators for a long time, and it is their job to win over the best founders/operators in the world. Happy hunting!
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