Understanding Venture Capital

Understanding Venture Capitalists

Not all investors are rich. It may feel that way because their infusion of capital into your business can help you grow tremendously, so they do have a lot of leverage. However, VCs are also under a lot of pressure to deliver outsized returns to their Limited Partners. Why are we talking about the incentives of VCs when this module is for founders? Understanding VCs and their incentives makes it more likely that they will invest in you. Maybe you just want to become a VC, then this is for you too.

Limited Partners (the people who invest in a VC fund) are often accountable to high social impact areas like teacher’s retirement funds, so don’t think that all VCs are greedy people. Also, associates at VC funds aren’t necessarily wealthy either, in fact they are making sacrifices too. “Management fees” or the fees that VC funds charge their Limited Partners irrespective of whether the fund is successful, cover the salaries of those in the fund. Associates in the fund often could make much more in corporate careers, so they are working very hard too.

Partners of the VC fund make a percentage of the return on the fund but also need to deliver strong returns to their Limited Partners or they may not be able to raise another fund to invest in startups, so don’t think they’re not under a lot of pressure to find a multi-billion dollar winner out of thousands of startups. If they don’t do well for their Limited Partners they’re out of a job. People are not trying to be rude to founders (for the most part) so don’t feel bad if you don’t get a detailed e-mail on why they passed on your investment. They will also admit they make plenty of mistakes too and miss great opportunities so just because they don’t invest at that moment doesn’t mean you aren’t doing great work.

Early stage investors tend to be highly risk averse, but when one person or fund is in, don’t be surprised if others are suddenly in as well.

Just because they don’t invest doesn’t mean they hate you, it could not be in line with their investment thesis, or they often wait on their other VC friends to invest first.

They usually don’t say no outright, they usually say “no for now” or just ghost you. The reason is because they don’t want to look stupid later when you become a billion dollar company Links to an external site..

Understanding a VC Fund - getting their perspective as people.

In life it’s more likely you’ll get a deal if you understand and can relate to the counterparty so you might as well read a little more to empathize with the investor.

The lifespan of a VC fund is approximately 7 to 10 years. That means they have to invest all their money in around 7 years so they must “deploy capital” (invest) on a regular basis. They must return the money they raised plus a return of approximately 20% to the people they raised money from (the Limited Partners).

They typically take “management fees” which is a percentage of the total fund size to do things like pay the employees of the fund and basic business expenses. They make money off their “carry.” Carry is the percentage that VCs will take on the profit they make.

Investment Thesis:

Venture funds typically invest around a theme otherwise known as an “investment thesis.” Some examples can include funds that invest in “mobile-first startups” (Uber, Instagram, Snapchat, etc.), life sciences (bio science types), marketplaces (Airbnb, Uber, Postmates), education, deep tech (Artificial Intelligence/Machine Learning), and the list goes on.

Founder secret: when they don’t want to invest they say your company doesn’t fit their investment thesis, which may be true. However, they can also not follow the thesis and say “whatever” and write the check.

Stage

“The size of your investment won’t move the needle of our fund”

This is commonly heard, but is it BS? Sort of.

Very important. Depending on the size of the fund, they can typically only invest in certain check sizes so that they generate a return for their Limited Partners (remember VCs have investors too).

Also the size of the fund is very important. For example, if the VC fund raises a $500M Fund and they invest $100M in your company, make 50%, that’s a $50M return. If they invest $500,000 and return 1,000% they make $5M. $5M isn’t enough to “move the needle” of their fund they commonly say. Unfortunately that is right. So get bigger first and revisit them when the time is right, it’s not that they don’t like you. There are always exceptions but very rare.

Syndicates - when a group of investors (VCs, Angels, or both together) each invest in part of the round. This de-risks the investment for each investor since now there are multiple funds in the round, you get the network of each fund, and the social validation from each fund.

For example, you are looking for a $1.5M round: Fund A invests $1M, Fund B invests $300k, Fund C invests $150k, and Angel A invests $50k. Just like that your round is complete.

Evaluating the opportunity

How seriously do people take your financial model?

For seed investing, many VCs do not ask you for a financial model so do not obsess over right away and spend your time executing your business. When they do ask you for your financial model they’re not holding you to your numbers

VCs evaluating your company for investment

Every fund has their own process for finding and evaluating investments, but generally it goes like this:

An analyst or associate at the fund “sources” deals by going to networking events, pitch competitions, accelerator demo days, etc. to find founders like you
If the analyst/associate thinks there is potential in the deal, they make a Partner aware of the investment opportunity and the partner decides whether or not to have a call with the entrepreneur
Partners have their own methodology for investing, but generally if the partners like your company and the terms of the deal they will decide to invest
You and the investors agree to the terms of the investment and you both sign a term sheet. Cap or Valuation needs to be negotiated, generally use standard documents and the number is quite arbitrary. Essentially everyone is just making something up.

Building relationships - show that you have grit, can take feedback, can evolve the business, build traction (gain customer and users).

Just like you are looking to create empathy with your customer when building a product to help you sell better, you should also get inside the perspective of the investor. By having greater empathy and understanding mindsets always increases your chances of success, because we’re all people after all. In fact, bringing on an investor is essentially the same as a B2B sale. How is that? Because an investment is you selling stock in the company, so for those who have a B2B business model this should serve as a somewhat familiar process.

They are looking for deals just as hard as you are looking for investors.

You need proof that people want your product, revenue and users are always best. Ideas are a dime a dozen and great execution is rare, they want you to prove it.

General Partners (GPs) - most often referred to as Partner, they make the final decision on investment decisions at the VC firm

Limited Partners (LPs) - these are people or institutions that invest in Venture Capital funds, provide the capital the GPs use to invest in startups, except LPs do not get to make investment decisions