Are you wondering what a Venture Capital (VC) or Venture Capitalist firm is? In a nutshell, VCs are organizations that raise funds from multiple sources. They use those funds to invest in startup companies..
Most of the time, funds are being raised by VCs from sources such as family offices, sovereign wealth funds, trust funds, university endowments, or from wealthy individuals.
VC investments can range in size from a few million to over hundreds of millions of dollars. Factors influencing this include the investment theory and the risk appetite of each vc firm.
VC cash, along with the market connections, advice, and help offered by the VCs help startups take flight from a small firm, to one that is listed on various stock exchanges. How VC firms make their investments are based on the stage the startup is in, the industry they operate in, or even the market that they target.
An example of a Venture capital firm
Union Square Ventures (USV) is an example of a VC Firm. Their portfolio includes investments in Tumblr, Twitter, and Coinbase being amongst their most noteworthy picks.
Their strategy is focused — they invest in startups or firms with large numbers of engaged users who come together to form a network, and who are fans of that network. They also invest in firms with a good user experience.
Simply put, they are looking for companies with the ability to scale up, that can bring together large numbers of people over a common topic or connect people via a marketplace such as Twitter, or provide a smooth experience to the end-user such as Codeacademy.
What these firms have in common is their ability to thrive off the network effect, which is defined as the value of a product or service increasing when the number of people who use that product or service goes up.
What are VC funds?
Simply put, VC funds are a pooled fund from money given to experienced fund managers hired by the VC firm. The fund managers are then responsible to invest the VC fund into promising startups that have a good chance of success, to maximize the returns on investments.
A single VC fund is worth over $130 million on average, with the capital being shared out over as many as 80 startups. In some cases, the rationale is that by spreading the fund out, there are bound to be one or two startups that hit major success.
Risks With Venture Capital Investments
Investing in Venture Capital Funds is risky. Many businesses fail. Even start up businesses funded by venture capital are not guaranteed to succeed. They are just more likely to have enough funding to overcome issues with growth.
Even a successful startup funded by venture capital may end up being a failure for the fund. This is because the startup may not generate the returns the fund expects. The exit may not be as lucrative or as quickly as hoped.
The expenses of Venture Capital Funds tends to be expensive too. There is often a management fee of around 200 bps a year in addition to a share in the returns. This means the investment needs to perform that much better to overcome the fees.
Venture Capital Lock Up Period
Venture Capital Funds typically have a lock up period. This means that investors are not able to exit their investment in the fund until the lock up period expires. Venture capital funds are highly illiquid.
Returns on VC Funds
Investors in Venture Capital Funds are seeking high absolute returns in exchange for accepting the risk that the businesses fail.
Payout usually occurs when the venture capital fund exits their position in a company that they helped grow. This generally occurs when a startup IPOs is listed on the stock exchanges or are acquired by a larger company.
Venture capital vs Angel Investors
What Is the difference between Angel Investing and Venture Capital Funds? Angel investors are more likely to invest in new businesses without much of a track record. Venture capital funds tend to invest in businesses that are already established. Venture capital funds help businesses scale and grow.
Statistics provided by the National Venture Capital Association, VCs based in the US have in total raised more than $28 billion and deployed well over $60 billion worth of funds to over 4000 startups as of 2015.
In comparison, angel investors (these would be individual investors who make direct investments into startups without the help of a VC firm) raised and deployed a mere $24 billion in 2015, spread over an estimated 70,000 companies.
Why Do Startups Use Venture Capital Funds?
For startups looking to scale, VC funds are a great financing structure given that they are likely to see losses for a significant amount of time before becoming profitable. Starting a new business is expensive.
Venture Capital Firms provide the startup capital needed for businesses to weather the storms of growing pains. Such was the case with some of the biggest names in tech such as Apple, Meta, and Google.
Unlike companies that deal with physical assets such as car dealerships or airlines, startups generally don’t have much to offer as collateral and as such, may not be able to qualify for traditional loans. By raising venture capital, there is no obligation for the startup to repay the money used.
The tradeoff, in this case, is ownership rights. Traditional loans require payment with interest. VCs however are buying some part of the company out from the founders, meaning that the investors are given some percentage of the company’s profits for as long as they remain a shareholder, thereby creating a large potential for huge returns if the company strikes a jackpot.
That was the lowdown on VCs and what you need to know if you’re wondering what this is all about. Venture Capital Funds are a high risk vs high return investment. They are speculative, but can generate out sized returns if their underlying businesses have successful growth.