Venture Capital demystified – how it all works

Venture capital funds are behind the success of some of the largest and best-known companies in the world – from Apple [NASDAQ:AAPL] and Google [NASDAQ:GOOGL], to Spotify [NYSE:SPOT] and AirBnB [NASDAQ:ABNB]. Venture capital is investment provided to start-ups and emerging companies with strong growth potential. 

But what is VC? What do VC managers do? Jonny Blausten, founder and CEO of Sprout, a Venture Capital fund platform, helps demystify the asset class.

VC funds raise large pools of money, which they invest into the most exciting companies. Fund managers typically build up a diversified portfolio across tens of businesses, which spreads the risk and improves the chances of successful investment returns. When businesses sell, or list publicly (via an initial public offering, or IPO), the returns from these ‘exits’ are then distributed to those who invested in the VC fund.

Identifying opportunities

VC funds screen hundreds or thousands of opportunities each year. They will assess each of these based on a range of criteria, then conduct more detailed due diligence on the businesses that interest them most. Some considerations include: market size and opportunity; competitive positioning; revenue model and commercial viability; strength of team and growth trajectory; historical performance; and defensibility (in other words, how hard it is to copy).

Once comfortable with the decision, funds then negotiate on valuation and other commercial terms to improve their chances of success and manage their downside risk. This discipline allows top funds to go from looking at 1,000 or more investment opportunities a year, to investing in six to ten situations.

Understanding the numbers

VC funds are not always very hands-on. It will depend on the fund, the stage, and how much hand-holding the business needs. Some funds explicitly sell themselves on the value they add, whether through operational experience or a network of partners they can bring to the company they invest in.

When it comes to fundraising, the size of the raise is typically set by the company that’s raising funding, and this goes up the more mature a company is  – namely, seed rounds are smaller than Series B rounds.

Some VC funds will ‘lead’ rounds, and write the largest cheque, whereas others ‘follow’, and prefer to have someone else lead the round. On average, each fundraise will typically give away around 20% equity in a business – although this can vary from as little as 10% up to around 35% – which will be divided between the different funds and individuals investing.

Fuelling growth

When a company raises funds, they will typically have a driving motivation, with a plan for how to spend that money. This could be anything from product development to hiring more staff, or marketing.

Venture capital exists to fund growth. In many venture-backed companies, this investment provides the cash a company needs to grow, because it is either loss-making, for example pre-product, developing something that requires investment up-front; or more mature but in need of significant capital to embark on its next stage of growth, such as international expansion, M&A, aggressive customer acquisition.

If this is successful, companies may then raise further funding in order to keep investing in growth, or to embark on a new strategy.

Some venture-backed companies will continue to raise money, to fund even more revenue growth, even whilst not yet profitable. This is seen by some as an acceptable trade-off, as long as there is a route to profitability down the line once the business has established itself as a market leader. Examples in case include Uber [NYSE:UBER] and Amazon [NASDAQ:AMZN]. More recently, given the wider macroeconomic conditions, funds have placed more importance on reaching profitability sooner.

Knowing when to exit

The more equity a VC fund holds in a business, the more influence they’re likely to have over the decisions around liquidity events or exit. The size and type of exit will be determined by the progress the business has made, its rate of growth, and its strategic importance to industry incumbents. The most common exits include:

• Trade exit: This is where another (often larger) business buys a company. These can be horizontal (a competitor, or closely adjacent business), or vertical (a company buying a software company whose product they use daily). These are typically strategic deals. Trade buyers see additional value beyond just what the company does (synergies) and will often be able to justify paying a higher price than a purely financially motivated investor.
• IPO: This is a public listing on a stock market. This will provide greater liquidity for investors and can generate outsized returns if market appetite for shares is high enough. Public listings also come with increased burdens on companies in terms of reporting and other scrutiny.
• Private equity: Private investment funds that typically buy majority stakes (less than 50%) in businesses. Private equity firms will buy VC-backed companies that are perhaps growing too slowly for an immediate IPO, or those that need more support to reposition or restructure. Whilst a VC-backed company exiting to Private Equity can be a very successful exit for everyone involved, it is not typically the target outcome when VC funds invest.

Managing failure

A common misconception around VC is that all the companies they invest in are small or early stage. This is the case with some VC backed companies, particularly those funds that focus on pre-seed or seed investing. However, there are a number of ‘growth’ investors that are focused on businesses that have significant revenues, sometimes in the tens of millions, and therefore have a different risk profile.

It is, however, an inevitable reality that some start-ups fail. The best way for any investor to protect against this risk is to build a diversified portfolio. Well-constructed venture portfolios are of a sufficient size that they expect a certain number of businesses to fail, but the businesses within a portfolio that succeed will pay out enough to cover those losses many times over. VC investing, particularly in early-stage businesses, is a game of upside – the downside of any investment is limited to 1x invested capital, whilst the upside can be as high as 100x or more.

Additionally, VC funds will typically invest on terms that protect their downside when investing – for example guaranteeing themselves preferential terms in the event a company sells or raises further funding at a reduced valuation. This often means that VC funds will come out of a failed investment in better health than a private investor, who would often be unable to dictate similar terms.

As this overview shows, venture capital can offer investors a wealth of opportunities – it all starts with awareness and understanding.

The opinions expressed in this article are that of the author. This article does not purport to reflect the opinions or views of Sprout. Nothing contained in this article constitutes investment advice. It is not intended to be relied on to make investment decisions. Eligible investors only. Capital at risk.