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November 14, 2019

What is Venture Capital?

 

Many have heard of venture capital, but not many may know what it entails and all the intricacies involved in venture capital. Venture capital gets headlines for being an incredibly sexy industry which has been involved in bringing startups like Uber, Facebook, Twitter, and many more to market. Venture investing has the incredible opportunity to nurture companies in their infancy that will potentially disrupt entire markets and transform the world.

 

So What is Venture Capital?

Venture capital is a form of private equity and type of financing in which investors provide startup companies capital or financing in exchange for equity (which is an ownership stake in the company) in companies they believe have long-term growth potential. The capital generally comes from wealthy individuals, institutions, or even from publicly traded companies. Venture capital investors also provide their investments, or portfolio companies, guidance in the form of technical or managerial expertise, access to an additional network of investors or business partners, and more. 

Venture capital investing can be incredibly risky for those who fund early stage companies, but investors are potentially rewarded with above average returns. Early stage companies, or those with an operating history of less than two years, rely on venture funding, especially if they lack access to traditional forms of funding. The downside for these early stage founders is the loss of equity and some control in their companies.

Venture funds are the primary investment vehicle used in venture capital investments. Each fund is structured as a limited partnership governed by partnership agreement covenants of finite life that pay out profit sharing through carried interest (generally 20% of the fund’s returns). The image below is for a private equity fund, but the idea is the same.

 

 

The Pieces:

  • General Partner: General Partners (GPs) are the managers of the fund. GPs receive management fees of 2% that are used to pay overhead related to operating the venture firm. GPs also receive carried interest or “carry” that is a share of the fund’s profits, but can be made after Limited Partners or LPs have been repaid. GPs raise and manage venture funds, set and make investment decisions, and help their portfolio companies exit.
  • Limited Partners: Limited Partners (LPs) commit capital to venture funds. LPs are mostly institutional investors like pension funds, endowments, foundations, family offices, and high net worth individuals.
  • Portfolio Companies (Startups): Startups in a venture firm’s portfolio receive financing from venture firms in exchange for shares of preferred equity. Funds realize gains if there is a liquidity event like a merger or acquisition or an IPO upon which these shares can be converted into cash. Venture investment comes in many forms, the most popular of which are convertible notes, a SAFE (Simple Agreement for Future Equity), and straight equity.

Portfolio companies are generally early stage companies that have historically been described as companies in preseed, seed, or Series A, but now may include growth stage companies (Series B, C, D, etc), and pre-IPO companies. Venture funds generally have a specific thesis focused on stage (early, mid/growth, late/pre-IPO), geography, sector expertise, or some combination of the three. 

Venture investing is risky as over 70% of startups fail or die. Additionally, among the survivors a startup may not even exit positively for their GPs and LPs. For some color, this Medium Post stated that 3% of companies exit over $100 million, 0.7% exit above $500 million, 0.2% above $1 billion, and 0.06% above 2 billion. The figure below really illustrates the point as well. The numbers above print a bleak outlook and showcase why venture investing is a high risk, high reward industry where the majority of investments fail and the minority succeed and return the majority of a fund. Venture funds generally have a long lifetime of over 5 years with large portions of funds, or even separate funds run by the same firm, focused on follow-on investments to support existing portfolio companies. Venture firms may have multiple funds running at one time, but some funds are active only for new investments.

*From Pocket Sun’s Medium post

There are numerous dynamics at play in venture, but it’s an incredible opportunity for individuals to partake in a high risk, high reward game where any potential investment can change the face of an entire market. We’ll cover additional topics like the various stages of a company’s life, the type of VCs out there, the various types of financing, and more in future educational pieces!

 

For Further Reading:

https://medium.com/sogal-adventures/venture-capital-101-structure-returns-exit-and-beyond-2048f22247a5

https://www.investopedia.com/terms/v/venturecapital.asp

https://www.forbes.com/sites/allbusiness/2018/03/29/a-guide-to-venture-capital-financings-for-startups/#11cf1d5751c9


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About: Francis vu

An investment professional with a background in private equity and venture capital having spent time conducting investments at VU Venture Partners and Pacific Oak LLC with a finance and management degree from Tulane University.

View Francis vu's articles

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