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Explaining venture capital

It is quite common for conferences to have a ‘venture capital panel’ with a collection of VCs, angels and maybe advisors who typically discuss what it is that VCs are looking for and how entrepreneurs might go about getting themselves funded, often with a sector focus.  I was on such a venture capital panel yesterday at the Develop games conference in Brighton with Carlos Espinal of Doughty Hanson, Ian Baverstock of Tenshi Ventures, and Tim Merel of IBIS Capital which was ably hosted by Paul Flanagan of Ariadne.  I participate in these panels to help entrepreneurs and would be entrepreneurs understand more about how venture capital works and how they might successfully approach us in the hope of encouraging more people to start businesses and of making the process of raising money more efficient for everyone.  As the panel ended yesterday I thought we had collectively done a pretty good job of doing exactly that in the context of the games industry.

However, I subsequently learned that for at least one member of the audience we had assumed too great a baseline of knowledge about venture capital.  Reflecting on that piece of feedback subsequently I recalled a number of other situations where I have made the same mistake, including with some quite experienced entrepreneurs.

All of which prompted this post, in which I’m going to try something of an experiment. 

In the final section of this post I will write a high level description of the venture capital process and the most important facts pertaining to raising capital.  I would like you to poke holes, ask questions, and suggest areas where an expanded explanation would be helpful.  My hope is that through the comments and maybe subsequent posts we will generate a picture of which parts of the venture industry and process are widely understood (if any) and which parts deserve to be explained more often and more thoroughly.  This picture will help me and any VCs who read this blog set the baseline well when they are at conferences and in any blog posts and other communications they produce, and will hopefully be a resource in its own right.

Many of you are very knowledgeable about the venture industry already, and as well as shining a light into corners of the industry that remain dark for you I’m keen to provide something useful for people who are new to the VC industry, so if you have a good understanding of this area feel free to cast your mind back to when you didn’t, and also to forward this post to friends who are looking to get up the learning curve.

I will endeavour to answer any and all questions that you have.  The only questions that I can think of right now that I won’t be able to answer are those relating to confidential information about specific funds or their portfolio companies, or anything that would require me to criticise someone else’s business.

There are of course many good resources on the web describing venture capital not least the wikipedia article and there isn’t any value in repeating what you can find elsewhere, so I have tried to take a different perspective below and have also focused the description below on the things I find myself most often explaining to people.

An introduction to venture capital

The venture capital industry is a small segment (maybe 1-3%) of the wider fund management industry.  At one level it exists to give pension funds, insurance companies and other large asset managers access to investments in high risk and potentially high return investments in technology startups.  At another level the venture capital industry exists to provide equity financing to startups so they can continue to innovate and to grow quickly thereby creating employment and delivering a host of other benefits to the economy.

As you can see, professionals in the venture capital industry are middlemen between the entrepreneurs/startups in which we invest and the asset managers who provide the cash that makes up our funds (Limited Partners or LPs in the industry jargon).  Unsurprisingly the most successful VCs are the ones that provide the best service to both sets of partners.  With LPs it is pretty simple – they want the biggest possible return in the timeframe over the 5-10 year life of the fund.  With startups it is also simple, at least at a high level – firstly they want money, and after investment they want any assistance that helps grow their business or otherwise accelerates value creation.

Breaking that down to the next level on the LP side; to generate great returns VCs need to make investments in businesses that will grow fast and exit for a good multiple of the entry valuation. As I’ve written here before, a good model for a successful venture fund is to have one third winners with 5-10x returns, one third that more or less return the investment and one third losers.  Unfortunately, having a large percentage of losers is endemic to the business of investing in startups, and that means the good ones need to be very good if the averages are going to work out.  That covers the LP requirement for big returns.  Their other LP requirement is that we invest their money in a timely fashion – as this helps them manage their own cash flows.  This need for timeliness puts pressure on VCs to make regular investments and you will often see VCs who have not made an investment for a while have a sudden push and make several investments in a short period of time in order to catch up.

Breaking it down on the startup side; the first thing that VCs can do to help entrepreneurs is have an efficient investment process.  That means being clear about the chances of discussions reaching a successful conclusion, being clear about their investment criteria (both with themselves and the startup), and getting to a decision as quickly as possible.  Post investment the trick is to provide help where it is wanted or needed and not where it isn’t.  All these things are easily said, but complicated in practice.  The varied nature of venture capital investing and the need to find the new new thing is in constant tension with the need for efficiency in the investment process, and the high failure rate within our portfolios requires that we sometimes take action to to help improve a company’s performance even if the executive is against it – a requirement that puts tension in the relationship between VC and entrepreneur.  The best way to navigate these potentially troubled waters is to find a VC who you like and trust, who understands your business well and who you think will want to jump the same way as you if there is a need to deviate from plan.

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  • http://twitter.com/johnbelo Joao Belo

    Good intro – the more startups understand VC concerns, the easier it is for them to fine-tune their pitches. Startups should be aware that only a small fraction of businesses are a good fit for venture capital – you need to grow significantly fast over a 5-7 year period and that requires an easy-to-scale business, a large market opportunity, efficient mechanisms to ward off competitors (e.g. IP, lock-in, etc.), a great value proposition, significant exit opportunities and, above all, an excellent, complementary team capable of executing and adjusting strategy as they move along. The more you can prove you have a successful business plan by gaining relevant market traction pre-funding, the more likely it is you'll get funded.

  • http://twitter.com/deburca James Burke

    Where the VC is working with an LP that is government funded/backed (eg JEREMIE funds that are part government part European Investment Bank (EIB) loan – http://www.placenorthwest.co.uk/news/archive/64… & http://www.northeastfinancelimited.co.uk/) what effect does this have on the VC, eg are there other “pressures” or considerations that they have such as retention of businesses and growth in their region and what, if any, are the additional incentives for these VCs in terms of their monetary return where a fixed management fee has already been contracted?

  • http://www.theequitykicker.com brisbourne

    Hi James – the only pressure I have heard about from governments is to invest more in their region/country.

    Anything beyond that would undermine the performance of the fund and would be resisted by any GP worth their salt, not to mention other LPs in the fund.

    I haven't come across any additional incentives of the type you mention (or any other type).

  • http://www.nanodome.com/ Nick Pelling

    Hi Nic,

    May I also ask to what degree you agree with Fred Destin’s assertions earlier this year that the VC industry had “not made much money at all in the last 10 years”, that the age of billion-dollar funds is over, and that the industry’s “social contract with entrepreneurs… is broken”?
    http://www.telegraph.co.uk/finance/yourbusiness/7073081/Britain-faces-venture-capital-success-gap-not-equity-gap.html

    Also, I’ve seen figures elsewhere estimating the overall rate of return for the VC asset class at around 10% (and that was arguably in better times than now, so the current figure may be lower), and I find that hard to reconcile with the needs of VC funds’ backers. For the level of volatility and risk involved, I would have thought that the industry would need to have a significantly higher rate of return – if there is indeed a mismatch here, where ultimately does it lie?

    Best regards, ….Nick Pelling…. // Nanodome Ltd

  • http://www.nanodome.com/ Nick Pelling

    Hi Nic,

    I have to say that the bit about VC funds I don't understand is the tension between high growth, high returns, early investment and timing. For an investment to yield the mythical 10x, you surely have to invest fairly early in the investee company's lifecycle – but the number of early stage UK opportunities that come along per year that genuinely require (say) £2m to 'go big' YET can happily leave their wheels spinning for 6+ months while they go through due diligence must surely be countable on the fingers of one hand. Combine that with VC funds' need to invest precisely when they are opening rather than closing, and it's hard for me to see how such funds ever manage to make a single investment that isn't purely because it fits their profile rather than because it is a good idea.

    In general, though, the whole idea of venture capitalism seems predicated on plucking the ripest cherries from an enormous dealflow… which no longer seems to exist. Hence the impression I get is that the sweet spot in the business cycle for VC funds was about a decade ago, so I'm struggling to see where VCs fit into the current climate in anything beyond a purely marginal position. Am I missing something?

    As an aside, I've been raising (very modest) investment for my security design / manufacturing company, but my understanding is that not one UK VC currently has manufacturing in its portfolio (nor is likely to in the near future). For an industry that likes to pride itself on leading through contrarian risk-taking, it does seem to have become both narrowly-focused and risk-averse – if so, where did it all go so wrong? :-)

    Cheers, ….Nick Pelling…. // Nanodome Ltd

  • http://www.theequitykicker.com brisbourne

    Hi Nick – thanks for the comment. Taking your questions in turn:

    1) You are right that only a small percentage of companies fit the criteria for investment and get funded, but there are enough opportunities to go round for the size of the venture industry here in Europe, more than enough at the moment. Remember also that venture has been a real industry at large scale in Silicon Valley for four decades now and continues to be so, albeit smaller than a couple of years back. We will get there eventually, but it takes time.

    2) Something like 5-10% of our investments are in manufacturing companies (current ones include Tagsys, ZBD, Intense and Metalysis) and the same is true of at least some other funds. These are typically difficult investments to make though as in addition to the usual market and product technology risk you have manufacturing and working capital issues to deal with.

    Best,
    Nic

  • http://www.theequitykicker.com brisbourne

    Thanks Joao. Some good points here.

  • http://www.gamesbrief.com Nicholas Lovell

    Nic,

    I think that this is a great idea, but you're approach is still too complicated. Many entrepreneurs that I meet (particularly in games) run big businesses (revenues of £3m +) with rudimentary financial knowledge.

    Simple things like the use of the word “portfolio” is a very financ-y thing to say. I think we need to make it much more simple: Maybe show the life cycle of a fund in a series of posts. Raising money (lots of bullet points), investing money, managing the portfolio, the nature of exits…

    Maybe I'll consider doing something on GAMESbrief too.

  • http://www.theequitykicker.com brisbourne

    That sounds like a good approach.

    What do you think about the idea of doing something together?

  • http://www.theequitykicker.com brisbourne

    Hi Nick – you are right that returns have been poor in Europe for ten years, and also in the US for a while (not quite as long though) and as a result money has left the asset class.

    Venture is a very cyclical industry though and Silicon Valley has seen this 3-4 times before. That said the current generation of funds in Europe needs to deliver if we are to have any size of startup ecosystem here in any reasonable time frame.

    I think the fundamentals are in good shape though, so hopefully we will be ok.

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