Startup general interestVenture Capital

Explaining venture capital

By July 14, 2010 14 Comments

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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