What is Venture Capital?
Every business begins as an idea. When executed correctly, and with appropriate financing, that idea could become the next multi-billion pound company. Venture Capital ("VC") focuses on investing in companies that have these high growth characteristics.
VC funds are pools of money, collected from a variety of investors, which invest their capital in startup companies that are high risk, but offer high potential returns.
Get VC right and the returns can be enormous.
Examples of some of the best VC backed companies are all around us
Note: For illustrative purposes only. Actual companies invested in will vary by fund.
WhatsApp decided early on to work only with a single investor, Sequoia Capital, which invested a total of $60M into the company for a massive $3B return.
King Digital Entertainment, maker of mobile game Candy Crush, was acquired for $5.9B, resulting in a huge payout for Apax Partners, which owned 44%.
Alibaba grew alongside the early growth of the internet, helping to make early investor Masayoshi Son, today chairman of Softbank Group, the richest man in Japan and a tech titan in his own right.
Why do Venture Capital Funds exist?
Without VC funds, business and apps that we use on a daily basis would simply not exist. Facebook is a poster child example. After receiving a small angel investment to start, Facebook quickly sought VC funding to scale at the rapid rate that it required.
VCs raise this capital from family offices, institutional investors (pension funds, university endowment funds, sovereign wealth funds, etc), and high net worth individuals (with assets over £1 million), who allow the VC firm to manage their investments.
The size of VC investments in a given startup can vary widely based on the particular investment theory and practices of each firm. The influx of VC cash, along with the additional resources, advice, and connections VCs can provide, often serves to help startups to grow rapidly and dominate their market.
VC firms typically make investments according to a particular thesis – for example, supporting startups in a particular stage, industry, or geographic region.
Venture Capital fills a crucial void
Most early stage companies are not very cash generative. As a result, they are not ideally suited to borrow money and typically need to give away equity in order to grow the company. VC fills this important gap between a business being founded with its product in development and the often costly acquisition of paying customers to generate revenues and, eventually, profits.
Lower risk than you may think
Leading Venture Capital firms rarely invest in ideas. Due to the nature of who they manage money for – sophisticated institutional investors, to whom they hold themselves completely accountable - VC firms are phobic about avoiding losses and tend to invest in business models that have already been proven with a burgeoning customer base in a large market. Investing at a later stage in a company’s growth can reduce the risk.
There are several different stages of financing within Venture Capital as follows:
Note: For illustrative purposes only
What makes a good Venture Capital investor?
There is no set route into becoming a venture capital investor. The best firms are typically a mix of individuals including; tenured industry veterans, successful entrepreneurs with an exit under their belt and a plethora of other bright investors.
In a survey taken across the world’s best 1,500 VCs, a staggering 40% went to either Harvard or Stanford Business School - these are extremely bright individuals looking at building the companies of tomorrow.
Who currently invests in VC funds?
Investors in VC funds are typically very large institutions such as pension funds, financial firms, insurance companies, and university endowments—all of which put a small percentage of their total funds into high-risk investments. They expect to earn a premium return over the lifetime of the investment. These institutions choose to invest in a fund not due to any one prior investment, but the firm’s overall track record, the fund’s “story,” and their confidence in the individuals themselves.
More than just money
Investing in the best companies is highly competitive. An accomplished entrepreneur with a good track record and a strong, scalable business model will often receive multiple offers from numerous VC firms. The very best VCs have evolved their own models to deliver significant value to their portfolio companies above and beyond just a monetary commitment.
Most often, this value-add is centred around the networks and relationships a successful venture capitalist can bring to the company. Be it opening doors with large prospects, helping to negotiate better terms with suppliers or even cross-selling to other portfolio companies; the best VCs will always look to add value in a hands-on, material manner.
Valuations mean nothing. It’s all about exits
Most VCs will aim to ‘return the fund’ with one investment (e.g. have one investment repay all of the investors' capital). Fred Wilson of Union Square Ventures, one of the most esteemed investors in the world wrote; “If you do the math around our goal of returning the fund with our high impact companies, you will notice that we need these companies to exit at a billion dollars or more. Exit is the important word. Getting valued at a billion or more does nothing for our model.”
Selectivity is key. Only invest in the best
Almost more than any other investment asset class, gaining access to the strongest Venture Capital funds is crucial to generating the strongest returns. In a study of 1,000 VC funds undertaken by Wealthfront, they found that the top 20 funds – 2% of those surveyed – generated 95% of the profits across all 1,000 funds in the study.
Source: Wealthfront, Demystifying Venture Capital Economics, September 2014