Dale Wood, founder and CEO of Dale Ventures, says, “Being an industry insider, I know how hard it is for budding entrepreneurs to secure funding from VCs.”
This article explains the inner workings and behind-the-scenes structure of the venture capital (VC) industry to help simplify the complex topic of how VCs function and make decisions. Hopefully, it will help entrepreneurs find a valuable partner in a VC.
We use sage advice from industry leaders to explain how a VC firm is structured, operates, and makes investment decisions.
What is a VC Firm?
Venture Capital Firms or Venture Capital Funds invest money (aka venture capital) in fledgling companies for a part of their equity. It is a private equity investment because the public equity markets do not provide access to these companies for investors.
Why are VC Firms needed?
Most modern startups operate with a high-growth mindset, which is capital intensive but at the same time lacks material assets to act as physical collateral. But banks and traditional sources of capital consider such a loan a high-risk investment. VC firms provide money to fill this void.
Economics of the VC industry
The economics of the venture capital industry hinges on facilitating capital infusion into inherently high-risk investments.
Dale W. Wood says, “A Venture Fund draws in talented entrepreneurs, buys equity by investing money from private equity funds and its participants, nurtures these companies until they have grown sufficiently, and exits the investment with the help of investment bankers.”
Therefore, the principal entities in the VC ecosystem are Entrepreneurs, Venture Capitalists, Private Investors, and Investment Bankers.
Structure of Venture Capital Firms
The average VC fund has about 14 employees and five investment managers. And most Venture Capital Firms operate on the partnership model. They usually have two types of partners: general partners and limited partners.
Type of partners in VC Funds
A venture capital firm raises funds to invest in companies by inviting commitments from participants. These participants, who supply the capital to invest, are known as limited partners.
General partners are also called Venture Capitalists. They are the fund managers who take care of operating the venture fund. General partners actively seek out investment opportunities for the fund and raise additional capital for the venture fund.
Investment profiles of VC Funds
It is common for a VC firm to invest in a deal alongside other VC firms. Spreading investments across companies provides easy diversification of investment. As opposed to putting all its funds in any single company, spreading funds across different companies helps VC firms reduce downside risk to assets.
Who invests in VC Funds?
The reputation of the VC fund plays a significant role in attracting capital to VC firms. Money in VCs tends to come from large institutional investors, like insurance companies, pension funds, private equity funds, sovereign funds, etc.
These limited partners allocate a small portion of their funds to VC funds. Since the investment typically represents only a tiny portion of their portfolio and the expected rate of returns is 25%-35% per year, their risks are justified.
How Venture Capital Firms Invest
VC Firms invest a large portion of their capital in companies that have begun commercializing their innovation and only a tiny amount in early-stage startups.
The reason is that during this adolescent phase of a company’s lifecycle, the financial situation and growth rate of eventual winners and losers are indistinguishable.
Understanding where VCs come from
A VC aims to meet its investor expectations of returns at an acceptable risk level.
To do this, VCs tend to avoid allocating capital to industries still in their infancy; i.e., industries where market demand for a product is unknown and the technology has not matured. Neither do VCs invest in established, low-growth industries, where industry down cycles and consolidation is inevitable.
Instead, VCs look to invest in industries that allow more room for error in picking winners – industry segments with exponentially high growth, where the market has not matured enough for the industry to focus on scaling production in the medium term. In such breakout industry segments, most companies appear to do well.
High growth rate industries then let the VCs isolate risks to their investment to the management’s ability to deliver, rather than technology adoption or market fundamentals.
Understanding an entrepreneur’s position
Entrepreneurs must understand that VCs want to invest in proven, successful people.
This idea is counter-intuitive because VCs seek to invest in promising industries, not the right ideas or people.
Since they provide a form of capital that entrepreneurs would not have access to otherwise, VCs usually hold the negotiating power in a business deal. Entrepreneurs must understand that being a good manager who can deal with high levels of uncertainty, effectively scale the company, and consistently perform in a high-risk environment are factors that VCs look for in entrepreneurs.
As Ben Horowitz of VC firm Andreessen Horowitz points out about managers, “Management turns out to be really dynamic and situational and personal and emotional. So it’s pretty hard to write a formula or instruction book on it.”
An entrepreneur needs to understand that their leverage in a deal arises from the fact that when a VC Firm invests in high-growth industries, it can restrict significant risk to its investment by focusing on picking the right management team capable of delivering the product.
How does the firm make investment decisions?
The final investment decision is a balance between mitigating risks and maximizing returns.
According to Harvard business review, in a recent survey of Venture Capitalists, 95% said they consider the management team or founding team as an important factor in choosing to invest in a company.
“When we consider making an investment, we run a bunch of social analytics reports on the company,” says Fred Wilson of Union Square Ventures
Quantifying the value of a management team or a manager depends on these broad factors: the availability of qualified people in that specific industry segment and the skills and reputation of the individuals.
A proven business track record, especially in a successful IPO, convinces a VC that an investment is a prudent risk.
In conclusion, while looking for funding sources, entrepreneurs should rely on the leverage that proven, astute entrepreneurs command in a highly competitive ecosystem.
Investor Dale Wood provides the perfect summary: “At Dale Ventures, I advocate a value-added investment approach. Being the CEO and founder of Dale Ventures, I only believe in undertaking partnerships in which Dale Ventures can add tremendous value to organizations. Otherwise, I think the partnership cannot live up to its potential, diluting the return on investment – both in terms of material and human capital investment – for all stakeholders.”
