First in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital. We expect the series to run for a year after which we will collate the posts into a book. You can find the rationale behind the series here, and the list of questions here. We welcome your comments on any and every aspect of what we are doing.
In this first post I’m going to answer the introductory question “What is venture capital?”, which sets the scene for the rest of the Series. Nicholas Lovell will publish his first post in the series today as well answering a similarly introductory question “What exactly is an ‘investor’?”. After that we will each publish in alternate weeks, with me taking the first post next Wednesday.
What is venture capital?
Venture capital is money invested in high risk startups by venture capitalists on behalf of institutional investors with the aim of making outsize returns.
There are five concepts in that definition (in italics) which merit further explanation – I’m going to do that briefly now and then in more detail throughout the series.
- Money – the first venture capital investment into a company is typically £3-5m and if successful that company will on average go on to raise a further £15-25m for a total of £20-30m before it is either acquired or has an IPO. As many of you will be know it is getting cheaper to start and grow companies and these numbers are trending down.
- High risk startup – a small technology company that has the potential to be worth hundreds of millions of dollars, but which also has a significant chance of going bust or being sold for very little. At the time of investment a typical venture backed company will have a talented founder (or two), 10-50 employees and a hot product in a market which is in its formative stages but which the investors and entrepreneurs believe will be huge.
- Venture capitalists (of which I am one) – the people who persuade the institutional investors they should be investing in technology startups, go on to choose which startups to invest in, and then work with the company to help it be successful, and make sure their interests are looked after (which mostly means they make as much money as possible over 3-5 years). Venture capitalists typically work in teams of 3-12 partners who invest pools of money called funds in startups that are collected together into groups which are known as portfolios. A portfolio will have a mix of successful and unsuccessful investments and the idea is that the successful ones more than make up for the unsuccessful ones.
- Institutional investors – typically pension funds, insurance companies, and wealthy institutions who manage billions of pounds that is invested in shares, bonds, emerging markets, property …. and venture capital. Venture capital is typically a very small percentage of their overall portfolio, but an interesting one because it has the potential to deliver much higher returns than most of their other investments (and also much higher losses). In normal times a good venture capital fund should generate returns equivalent to investing in a bank account with a 30% interest rate.
- Outsize returns – for an individual venture capital investment to be considered a success it must compensate for the failed investments that inevitably sit alongside it, and do so to such an extent that the overall return of the fund can achieve the 30% returns its investors are looking for. This is why we say every investment must have ‘home run potential’, or the ‘potential to generate a 10x return’.
In summary, venture capital is an industry of middlemen who channel money from very large fund managers into small companies. It is an exciting industry in which to work both for the thrill of working with great people and exciting companies and because it contributes to some very significant wealth creation. I also think it is an important industry because small companies and innovation are the engine of growth for the larger economy and many of those small companies need venture capital to function effectively.
Venture capital is also a hugely varied industry and doubtless many of you are thinking of examples that fall outside of the parameters I have described above. In this post, and in the others in the series, when we give examples and numbers we will try to capture the middle of the bell curve – if in your experience the industry looks different I would love to know. When we collate the posts to publish them as a book we will draw on the comments with the aim of providing the most comprehensive and accurate guide to venture capital that we can.