Venture capital firms are without a doubt the muscle behind innovation, as they support the company they may invest in, from the early stages all the way to IPO—especially those with larger funds that have billions of dollars under management.
In this chapter I would like to walk you through the logistics of venture capital firms so that you are able to understand fully how they operate.
VC firms have different types of individuals working at the firm. The most junior people want to be analysts. These people are either MBA students in an internship or people that just graduated from school.
The main role of analysts is to go to conferences and to scout deals that might be within the investment strategy of the fund that the VC firm is investing out of. Analysts are not able to make decisions, but they could be a good way to get your foot in the door and to have them introduce you to someone more senior within the firm. However, analysts are for the most part conducting research of the market and studying you and your competitors, so be careful about educating them too much.
The most immediate position after the analyst is the associate. An associate could be either junior or senior. Associates tend to be people with a financial background and with powerful skills in building relationships. Associates do not make decisions in a firm but they can definitely warm up an introduction with individuals involved in the decision making.
Over associates, you will be able to find principals. They are senior people who can make decisions when it comes to investments but they do not have full power in the execution of the overall strategy of the firm. A principal can get you inside the door and be your lead to help bring you through the entire process of receiving funding. Principals are those individuals who are close to making partner. They have power within the firm but cannot be considered the most senior within the firm.
The most senior people within a VC firm are above principals, and are called partners. Partners could be general partners or managing partners. The difference in the title varies depending on whether the individual has only a say in investment decisions or also has a voice in operational decision making. In addition to investments, partners are accountable for raising capital for the funds with which the firm will be investing. Last, venture partners are not involved in the day-to-day operations or investment decisions of the firm. Venture partners have a strategic role with the firm, mainly involving bringing new deal flow that they refer to other partners of the firm. Venture partners tend to be compensated via carried interest, which is a percentage of the returns that funds make once they cash out of investment opportunities.
Another figure in a VC firm is the entrepreneur in residence (EIR). EIRs are mainly individuals that have a good relationship with the VC and perhaps have given the VC an exit, helping them earn cash. EIRs generally work for a year or so with the firm, helping them to analyze deals that come in the door. Ultimately the goal of an EIR is to launch another startup for positive investment. 1
Investors of VC firms are called limited partners (LPs). LPs are the institutional or individual investors who have invested capital in the funds of the VC firm with which they are investing. LPs include endowments, corporate pension funds, sovereign wealth funds, wealthy families, and funds of funds.
As I've mentioned previously in this book, first and foremost, identify the VC that might be investing within your vertical. There are plenty of tools you can use to identify who might be a fit. (You can use Crunchbase, Mattermark, CB Insights, or Venture Deal.)
Once you have your list of targets, you will need to see who you have in common and close to you who would be in a position to make an introduction. The best introductions come from entrepreneurs who have given good returns to the VC. VCs use these introductions as social proof and the stamp of approval on the relationship. The better the introduction, the better the chance you have of getting funded.
As a next step to receiving the introduction, and in the event there is a genuine show of interest from the VC, you will have a call. Ideally you would want to go straight to the partner to save time, or the goal would be to get an introduction to the partner ASAP. If you are already in communication with the partner after the first call, he or she will ask you to send a presentation if the call goes well and there is interest.
After the partner has reviewed the presentation, she will get back to you (or perhaps her assistant) in order to coordinate a time for you to go to the office and to meet face to face. During this meeting, you'll want to connect on a personal level and to see if you have things in common. The partner will ask questions (which have already been covered in previous chapters). If you are able to address every concern well and the partner is satisfied, then you will be invited to present to the other partners.
The partners meeting is the last step to getting to the term sheet. All the decision-making partners will be in the same room with you. Ideally the partner you have been in communication with has spoken highly of you, unless there have been issues (which you've hopefully resolved by this time).
You'll receive a term sheet if you were able to satisfy the concerns put forward at the partners' meeting. Remember that the term sheet is just a promise to give you financing. It does not mean that you will get the capital. It is a nonbinding agreement. Following the term sheet, the due diligence process begins. It will typically take a VC one to three months to complete the due diligence. Unless there are major red flags, you should be good to go and receive the funds in the bank once all the offering documents have been signed and executed.
VCs make money on management fees and on carried interest. Management fees are generally a percentage of the amount of capital that they have under management. Management fees for the VC are typically around 2 percent.
The other side of making money is the carried interest. To understand this concept, carried interest is basically a percentage of the profits. This is normally anywhere between 20 and 25 percent. It is normally in the largest range if the VC is a top-tier firm such as Accel, Sequoia, or Kleiner Perkins.
In order to cash out and receive the carried interest, the VC needs to have the portfolio of each one of the funds making an exit, which means that the company is acquired or will offer an IPO in which investors are able to sell their position.
Normally exits take between five to seven years, if the company has not run out of money or the founders have not run out of energy. Typically VCs want to sell their positions within eight to 10 years, especially if they are early-stage investors.
Startups are a very risky type of asset class and nine out of 10 will end up failing. For that reason, VCs will go for those companies with the potential of giving them a 10x type of return so that it can help them with the losses of other companies inside their portfolios. If you are not able to project these kinds of returns, a VC might not be the route to follow for financing.
VCs would like to have a clear involvement with your company in order to stay close to their investment and to have a say in major decisions that could impact their returns in the long run.
With this in mind, VCs will normally buy in equity between 15 percent to 45 percent of your company. Normally in earlier stage rounds, it tends to be on the higher end but VCs need to be mindful of the stake they leave with the entrepreneur so that they are still motivated enough to stick around and to continue focusing on the execution.
VCs will request board involvement in return for the investment that they are making in your company. There are two types of board levels. One will be the board of director seat in which they participate in major decisions of the company. This is especially important when it comes to future rounds of financing or merger and acquisition (M&A) transactions.
The other level of board involvement is what is known as board observer, as we discuss in the Term Sheets and Terms chapter.
Most VCs say the main reason why an entrepreneur should consider working with a VC is because of the value they can bring to the overall strategy and execution of the business. However, that is far from true.
You will need to do the due diligence in order to really understand if a VC is going to add value in addition to capital. This value can be introductions for potential partnerships, their network of other successful founders, or the infrastructure that the firm brings.
The infrastructure could be the most attractive part. VCs like Andreessen Horowitz or First Round Capital have a dedicated team of marketers, recruiters, and other resources to bring to a company they invest in. Ultimately this helps in fueling the growth of the business.
As a founder you want to ask the right questions, which will help you understand if the VC is truly interested in investing, or what style of partners you will be onboarding to your company after the financing round is closed.
If the VC firm has not invested in more than six months in new companies, that indicates that the VC is having trouble closing their next fund or that they are in fundraising mode. If this is the case, move on to the next VC; otherwise the process will be put on hold. Closing a fund typically can take between 12 and 24 months. You always want to choose to work quickly.
Ask how they typically work with portfolio companies. Ask the VC to make an introduction to a few founders from companies that have gone out of business. These questions can provide a complete picture.
In addition, ask about allocations to the options pool for employees of companies your size. (This should be written out in the deal's terms.) If you see they want to allocate over 20 percent on a seed round, or over 10 percent on a Series A round of financing, this could mean they may eventually want to replace the founding team.
There is confusion about the differences between venture capital and private equity. Venture capital firms tend to work throughout the life cycles of a company, all the way to the liquidity event, when the startup either gets acquired or goes through an IPO.
VCs are also very much involved in the operational structure. However, the main difference is that VCs invest in people with a greater degree of risk than a traditional private equity (PE) firm. PEs will go more for the numbers. They invest in businesses that are already formed, where the outcome is more predictable.
PEs will often invest in growth stages and later rounds, so your startup, if you are in the early stage, will most likely not be a fit. Wait until you are at a Series C or Series D round of financing before seeking funding from private equity.