How does venture capital work? What’s the minimum ROI they are looking for?How long are they willing to wait to see ROI? Can everyone pitch to them? What business models are they typically investing in? How long is the process until funding?This question previously had details. They are now in a comment.
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20 Answers
Fletcher Richman
Fletcher Richman, Partner at a small venture fund
Updated Jan 29, 2016
Originally Answered: Startup Advice and Strategy: How does venture capital work?
There are two parts to this question, each of which I'll answer separately. The first is how a venture capital fund works and what type of returns they look for. The second is how and why VCs choose investments.
1) How does Venture Capital work?
The simplest way to think about venture capital structure is what's often called the "VC Sandwich." The sandwich consists of the Limit Partners, the General Partners, and the portfolio of investments.
General Partners raise a fund from a set of Limited Partners. Then, the General Partners invest the money from that fund into a series of companies. The goal, as with any investment, is for the Venture Capital Fund to return more money than the Limited Partners put into the fund. VC is a particularly risky investment, so investors are looking for large (5-10x+) returns.
There are more intricacies within the fund structure such as management fees, carry, fund term, and others that I would recommend learning about (Amazon.com: Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist (9781118443613): Brad Feld, Jason Mendelson, Dick Costolo: Books is a great resource) , but for the purposes of this question I won't cover them in detail. The key thing to know is that a VC Firm is incentivized to invest in businesses that can have a large return in < 10 year time frame. The returns have to come in the form of some sort of exit for the VC Firm to pay back the Limited Partners. These exits are primarily acquisitions or IPOs.
A VC Firm is what is known as an "Institutional Investor" because of the structure that has to be setup when limited partners are involved. This is different than an "Angel Investor", which is someone who is investing their own money. An angel investor has different incentives and will usually invest at an early stage than an institutional investor.
2) How VCs choose investments
As with any other industry, VC firms have to differentiate themselves from each other. Differentiation is important to convince Limited Partners to invest, as well as to attract the best entrepreneurs to invest in.
The primary way VCs differentiate themselves is through the investments they make. Theoretically, anyone can pitch a VC but there are too many companies for a venture fund to be able to consider every company. VC Firms usually specialize in specific stages, business models, and verticals of companies.
Stage Focus
The startup journey has loosely defined stages that are often earmarked by specific rounds of funding:
Angel Round - usually a $20k-$250k round from friends and family to go from idea to initial prototype
Seed Round - usually a $500k - $2M round from angel investors and a few early stage VC firms to establish product-market fit with a series of initial customers
Series A Round - usually a $3M-$10M round from VC firms to grow the customer base and start to scale
Series B Round - usually a $15M+ round from later stage VC firms to push towards becoming a market leader or expanding overseas
After the Series B, companies will sometimes raise a Series C, D, E, etc., which can be a mix of both later stage VC Firms as well as Private Equity firms (out of scope for this answer, but good to research the difference).
These amounts are not rules, just guidelines that are constantly evolving. Depending on the size of the VC Fund and the amount they typically invest, VCs usually specialize in one or two different stages of funding, allowing them to create milestones and benchmarks to compare various companies. The stage and amount of investment also plays a role in dictating the amount of time it takes to make an investment decision. A general rule of thumb is the amount of due diligence and research increases as a company gets further along, increasing the time it takes to make an investment decision.
Vertical and Business Model Focus
Startups can be categorized into different verticals and business models. Some examples are Consumer, Software as a Services (SaaS), Financial Technology (Fintech), E-Commerce, Internet of Things (IoT), Real Estate Technology, Education Technology (EdTech), Freemium, etc. VC Firms will often specialize in specific verticals and business models, allowing them to become knowledgeable about that industry and helping them attract specific startups.
Venture Capital is sometimes leveraged to invest in companies that have little to no revenue early on and build a user base or audience that they can monetize later. This is especially common with consumer technology startups. Facebook, Twitter, and Snapchat were only possible because of early backing from VCs, they started out with no revenue and only started monetizing later on. However, VC money can also be leveraged to invest in companies that are generating revenue and may already be profitable. The common theme between VC backed companies is they have to have some potential for exponential growth and massive revenue at some point in the business.
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Borislav Agapiev
Borislav Agapiev, Search Entrepreneur
Answered Sep 1, 2016
This is a great question and there are several good answers here that describe how it all functions, from the outward perspective.
I am going to focus on the back view, how it all works behind the curtains, so to speak, because I think that is the key to understanding the industry:
There are several essential things always on the mind of a venture capitalist:
Limited Partners - which is true no. 1 as venture capitalists invest other people’s money. VC’s investors are called limited partners and they are absolutely key to venture capitalists success and very existence. The ability to impress and convince limited partners to invest huge sums of money with relatively small partnerships, which is how VC firms are organized, is what separates the wheat from the chaff. And it is impressing at the personal level that is of utmost importance, as there are really no objective ways to try to measure and predict future VC success. One might think track record is such an indicator, and indeed limited partners will stay with successful VCs, but there are many examples where newer entrants broke out with huge successes, e.g. Andreessen-Horowitz more recently.
Crowding Instincts - VCs run in packs that gather around perceived successful rising ‘deals’, which are startups garnering the most early buzz, hype and attention. Such a strategy may appear shortsighted at first, but it is actually a smart form of arbitrage where VCs know early access to deals will give them great valuations for the best companies. Such valuations are absolutely key for the biggest home run successes, which is how the largest VC fortunes are made. The risks of them being wrong, which is always a possibility, are further mitigated by increasing chances to exit from such deals by acquisitions based on earlier buzz.
Keen Sense of Markets - is of tremendous importance as rising tides lift all boats. Notwithstanding all kinds of protestations to the contrary, when markets are rising and capital is cheap and plentiful, everybody looks like a genius having picked an unicorn. It is kind of amazing that not many are willing to admit this key link, insisting on ‘resilience’ of VCs and their funds during market downturns. One should ask entrepreneurs about such views, which will be rather different. A great example of this crucial link is periodic periods appearing seemingly out of nowhere, where all of a sudden the VC chatter turns to the need to be prudent and preserve precious capital, as opposed to going for growth no matter what. It is never mentioned why the change all of a sudden, as if it was a abrupt discovery or realization of great and obvious importance.
Great Sense of People - this the most important picking ability and one of the sources of most popular confusion. The outward projection of VC industry portrays a picture of detailed analysis of business plans, projections, scrutinizing of ideas and plans etc. In reality, nobody really knows, including the smartest VCs and entrepreneurs, what will turn out to be a spectacular success. A good team can always pivot, should the original idea turn out not to work, while a bad team will screw up even the best of ideas and plans.
For entrepreneurs, the last point is of special importance as it is crucial to grasp that the investors will be judging and evaluating you and and your team, as opposed to your ideas, plans, projection and technology. VCs will make their decision during the first ten minutes of a meeting and any subsequent delays, postponements, requests for other lead investors etc. are just ways of avoiding to say ‘NO’.
Make sure you understand this completely as any unwillingness to do so by you will result in a guaranteed emotional roller-coaster of dashed hopes and crushed expectations. For early and less experienced entrepreneurs, resist the siren song at the back of your head, screaming that this is your best and only chance. Instead, make an early decision yourself about the investor and move on quickly to others.
Venture Capital is largely about arbitraging markets. It is much easier to appear ingenious during bouts of irrational exuberance, to paraphrase Alan Greenspan, than to defend results during downturns. The key is to deflect as much responsibility as possible during bad times as general market conditions which are objectively unavoidable.
People who master triangulation of limited partners, great market conditions and times to pick and choose companies are the ones who go on to be successful venture capitalists.
https://www.quora.com/How-does-venture-capital-work-What%E2%80%99s-the-minimum-ROI-they-are-looking-for-How-long-are-they-willing-to-wait-to-see-ROI-Can-everyone-pitch-to-them-What-business-models-are-they-typically-investing-in-How-long-is-the-process-until-funding
