Using Venture-Capital Firms

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Understanding how venture-capital firms are organized

– In this first video on venture capital, I would like to set the scene of how venture capital works from a high level standpoint. I think it’s important to understand who the key stakeholders are and what venture capitalists, also called VC’s, actually do outside of investing capital into startups. A venture capital firm usually operates on a 10-year cycle, during which it will go through five steps. Each fund has a limited lifespan, and successful VC’s raise and run a number of funds over the years.

The first step will be for them to raise capital, just as you will be doing, but lots more of it, with an average fund size of 150 million dollars. Then VC’s will start reviewing and investing in deals, such as potentially yours. The next step is to make sure things go as planned by participating to the management of the companies they invested in, usually as being members of the board.

Then comes the time to harvest the return of their investments by exiting the companies they invested in through the sale of their shares. And the last step is to return the funds with the expected return on investment to the original investors, the ones that provided the original 150 million dollars. Let’s look now at each step in more detail. The first step is when VC’s themselves raise capital to constitute the fund they will be managing during the following 10 years.

The boss of the VC firm is also called the general partner. He is the leader of the firm and will be working with his team to raise capital, exactly the same way you will be doing it. The big difference, though, is that his job is much more difficult, since he’s not raising money on a specific project but rather on his ability and the ability of his team to identify, invest in, and cash out from business deals that should prove, in the future, very rewarding but have not been identified yet.

As you’re probably guessing, one of the key factors is going to be the past experience and achievements of the general partner and his team, which will make that process possible. The general partner and his team will be raising capital from what is called limited partners.Limited partners are usually either very wealthy individuals, corporations, or pension funds, and all of them are looking to make a very big return on investment by investing in the very risky business of venture capital.

They are called limited partners because the loss they can incur, if all fails, is limited to the amount of moneythey have put into the fund, not more. You might rightly say that this is already a huge potential loss, but still, it’s not the same as being responsible for the money and potential liabilities that could arise from the operations of the company you invested in. The fund is constituted on the basis of a number of potential limitations that are contractually agreed with the limited partners, such as the field or industry in which the money will be invested.

The development phase of the projects or companiesinvesting in, for example, in early stage companies or at different maturity levels. The timeframe that the VC firm has to run its operations. For example, it could be set to a total of 10 years, which would require the VC firm to return the capital and the return on investment to the limited partners at the end of a 10-year period,whatever the outcome is.

So, the first year of the life of the firm is dedicated to securing the capital the firm will be managing for them. This tells you as well that VC firms are targetingspecific businesses, and you should, therefore, make sure that you get in contact with those firms that are interested in companies that have the same profile as yours. Once you have identified those VC firms, you can start the process of getting in contact with them.

 

The investment phase

– Once the fund is constituted, comes the project-detection phase which is followed by the investment phase. Those phases are actually happening in that order for each project. But as the fund will be lookingto invest in many projects, it will constantly be reviewing projects and investing in them. As we saw earlier, the VC firms are limited in terms of industry, in which they’re able to invest. So, for example, they could be specialized in clean energy or biotechnology or software development.

The sectors they will be specialized in will usually be related to the experience and knowledge of the general partner and his team. The maturity level of the company is also an important factor and determinesthe risk profile of the VC fund. Which is a reason why it is part of the agreement with the limited partners.When an entrepreneur starts a company, he’s got many ideas but not much to show for. As the company grows, his idea and concepts are proven by hard facts such as customer acquired, revenue generated and profits generated.

So, the idea is backed by the hard facts and therefore, the bigger the company is, the more it has proven its ability to be successful and the less risky it is to invest in. It therefore shows that the earlier you invest in a company, and the riskier it is since there are more ideas in it than hard facts to prove it could be successful in the future. And on the contrary, the bigger it is and the more mature it is and the less risky it is since the company is already on a path and you pretty much know where it’s going.

So, it is only logical that the firm is focused on a certain level of company maturity which defines the level of risk that the limited partners are willing to take. There are therefore, riskier VC firms than others.In addition to those contractual limitations between the VC firm and the limited partners, VCs usually prefer to invest in companies that are geographically close to them. The distance will vary but if you’re usually at more than a two hour flight from their office, it would be too great of an effort to be presenton a regular basis to participate, to the management of the company and would therefore represent a risk for the VC firm.

But, we will be discussing further on risks in generaland the parts they play in the VC mindset.

The investment phase

– Once the fund is constituted, comes the project-detection phase which is followed by the investment phase. Those phases are actually happening in that order for each project. But as the fund will be lookingto invest in many projects, it will constantly be reviewing projects and investing in them. As we saw earlier, the VC firms are limited in terms of industry, in which they’re able to invest. So, for example, they could be specialized in clean energy or biotechnology or software development.

The sectors they will be specialized in will usually be related to the experience and knowledge of the general partner and his team. The maturity level of the company is also an important factor and determinesthe risk profile of the VC fund. Which is a reason why it is part of the agreement with the limited partners.When an entrepreneur starts a company, he’s got many ideas but not much to show for. As the company grows, his idea and concepts are proven by hard facts such as customer acquired, revenue generated and profits generated.

So, the idea is backed by the hard facts and therefore, the bigger the company is, the more it has proven its ability to be successful and the less risky it is to invest in. It therefore shows that the earlier you invest in a company, and the riskier it is since there are more ideas in it than hard facts to prove it could be successful in the future. And on the contrary, the bigger it is and the more mature it is and the less risky it is since the company is already on a path and you pretty much know where it’s going.

So, it is only logical that the firm is focused on a certain level of company maturity which defines the level of risk that the limited partners are willing to take. There are therefore, riskier VC firms than others.In addition to those contractual limitations between the VC firm and the limited partners, VCs usually prefer to invest in companies that are geographically close to them. The distance will vary but if you’re usually at more than a two hour flight from their office, it would be too great of an effort to be presenton a regular basis to participate, to the management of the company and would therefore represent a risk for the VC firm.

But, we will be discussing further on risks in generaland the parts they play in the VC mindset.

Cashing out

– The last two steps of the VC firm cycle are about getting the results of the hard work that has been deployed for the many years spent investing and managing start-up companies. Of those two steps, the first one is about exiting the companies the firm invested in. Contrary to the entrepreneur, who is leading the company which company could be the project of a lifetime, for the VC firm, it’€™s only an investment. And since the beginning, howeversuccessful or groundbreaking the company was, the VC firm planned on selling its shares at the back end of the cycle, probably when the company reached a significant milestone.

There are typically two ways for a VC firm to exit a company which are through an IPO or through a mergers and acquisitions deal. Just to give you the short story on the two exit strategies. M & A stands for mergers and acquisitions and is relating to when two companies decide to either merge to form a single company or in the same logic, when a companydecides to acquire another one. Companies acquire one another usually to either form a stronger group to be more successful, to acquire technology that will make it more successful, or complement its product portfolio by choosing to acquire a successful company in its field, or in short, not to reinvent the wheel when you can just buy it.

Expand into a new geographical area such as Europe, for example, or Southern America. The second typical exit strategy is through an IPO. IPO stands for initial public offering and is about a company being traded on the stock market. Companies are privately held for a certain period of time and can sometimes decide to open their capital to individual investors such as you and me and start trading it publicly on the stock market.

Those are two ways for VC firms to trade their shares of the company and cash in their returns. But they can also sell their shares to another VC firm if there is an additional round of funding. The last step then is to return to the limited partners the result of this entire 10 year cycle of operations. If the firm has been successful, the limited partners get their capital and a handsome return on investment that covers the risks they have taken and the time they have waited.

The VC mindset

– One thing we all need to realize is that the job of the VC is very different from most of our jobs, in one sense at least. Their job is very visible and super risky,and if things don’t go as planned, and if the firm does not generate the expected return for its limited partners, a general partner and some of his teammight not be able to raise another fund. Most of us can live with blunders in our careers. Those are not communicated publicly, and chances are they’ll just be a small bump in our history, but for VC’s it’s quite different.

VC’s play their career with each fund they run, and few people will remember past successes when a big failure comes. So, why is it so important to understand that when raising capital through venture capitalists?Well, simply because there is not much room for error on the VC side, while at the same time, they play a very risky game. VC’s invest in companies that are expected to be game changers in their field through technology, drug development, and so on.

Game-changing companies are, therefore, alone in their field, since not every company can be groundbreaking. Most companies follow the herd, and one of a kind, every few years, will come with a great new concept or technology and change the game for everyone else. That means that VC’s usually review and invest in companies that propose new products and services and that those same VC’s need to be ableto make the difference between the idea that will not succeed, the one that will barely succeed, and the one that will be really game changing for its industry.

To do so, VC’s will look into every aspect of their workto reduce their risks as much as possible in the hope of maximizing their chances of delivering the promised returns to the limited partners. To do so, they will focus on industries where they have extensive experience and understand what it takes to be successful, what problems are latent and require new technology, and they understand where the market is going.

Then, most of them will invest in companies that have attained a certain level of maturity and will have proven their ability to generate revenue and sometimes lots of it. Sometimes, the maturity factor will not be the revenue generated, but when there’s a big problem in an industry and the company is planning on bringing a solution. The big uncertainty will be in their ability to develop the product.

Then the factor that will determine the maturity levelwill be the level of development of the product, and if, for example, the biggest hurdles have been passed successfully. They will look as well for massive markets,where the company has a lot of room to grow. They will look at business models that scale, which means that once those businesses have passed the time of initial investment, their revenue will grow much fasterthan their cost of operations.

And outside of reducing their risks, VC’s are also pragmatic people. They are not dreamers, and they not only take into consideration the odds of success of companies, they actually factor it in their model.They understand that 80 percent of all startups fail,and so that despite all of their efforts, knowledge, experience, and methodology, they will most likely be wrong 80 percent of the time or maybe just 70 percent of the time, thanks to all the things they do to beat the odds.

So, they know that out of 10 companies they will invest in, only a small portion will be successful. They go even further and assume that out of 10 companies,four will be an utter disaster and just go bankrupt and on which they will lose all their capital and their expected return on investment. Another three will barely survive and generate enough money to pay for its expenses or, at best, be profitable but in a much smaller market than expected and, therefore, with no potential to be a big success.

And here again, they might get back their capital but definitely not generate any return. Then, about two companies should be successful, be well positioned in a big market, and make up for the losses of the other seven companies. And last, they hope they will haveone super successful company, the likes of Google or Facebook, in their portfolio, which could have them be way more successful than they originally planned. That also means that, as we’ve just seen, out of 10 investments VC’s make, they really expect only three of them to be successful and make up for all the losses of the other seven companies they invested in.

The issue is that at the time of the investment they have no idea which one is which. The rule is then, therefore, simple. Each company they invest in should yield a potential success and, therefore, be expectedto generate a return that will make up for all the failures of the other companies. And so, when people would usually expect 20 percent or 30 percent or even 50 percent return on investment, VC’s will expect a 10x to 30x factor.

That means that they invest in companies that they believe can be worth, after five to seven years, from 10 times to 30 times their original value. That’s 10 times to 30 times. That means they’re not looking for good companies, not for potential successful companies.They are looking for potential Googles or Facebooksin every project they review, because it’s only by doing that and being wrong seven times out of 10, that they will be able to deliver on their commitments to the limited partners.

Where to go from here: Using venture-capital firms

– In short, the venture capitalists you will meet will be looking for a certain number of things before they even consider investing in your business. First, you’ll have to be solving a big problem in a big market, in a growing market. A big problem means something that people cannot live with and are eager for you to solve.The question is: can people live with the problem? If the answer is yes, then that means there might be difficulties selling your product as people will not have the urgency and could be reluctant to change their habits.

Then, you’ll have to be well on your way either from a revenue standpoint, customer acquisition standpoint,or product development standpoint with a great number of uncertainties lifted as to the potential success of your company. You’ll have to know the VC process like the back of your hand. Know what a term sheet is. What it contains. What are due diligence materials? There are great books out there that detail all the specifics which you need to know even before you start speaking with VCs.

The VC will be looking for a strong team. Everyone knows that the team makes the success of the company, not the rest. It may seem a bit extreme, but it’s the truth. There are countless examples wherecompanies with similar products have had very different successes with some of them becoming market leaders and others disappearing altogether.And even companies deemed unsuccessful who were turned completely around by a great team. So, the team is what makes the difference.

It is the people who will be able to fix problems and turn them into opportunities. As mentioned earlier, you will have to demonstrate your ability to multiplyby at least tenfold the value of your company over the five years after the investment is made. And last, but not least, you need to be very clear up front on your exit strategy and how the VC will turn his stakes in your company into a massive return. If that’s true in acquisition, you should already know who are the top five companies you expect to be acquired by.

 

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