How Venture Capital Works

VC funds have investors in large institutions like pension funds, insurance companies and financial giants. They place only a small fraction of their funds into startups and high-risk investments.

More than good people or good ideas, VCs look for good industries to invest in.

The initial period in a company’s life cycle in a profitable industry is a time of accelerated growth, except for the concept stocks that are experimental and require a lot of burning capital.

By investing in areas with high growth rates, VCs allocate their risks to the ability of the company’s management to execute. VC investments in high-growth segments are likely to have exit opportunities because investment bankers are continually looking for innovative high-growth issues to bring to the market.

Any basic deal structure has the same logic: Giving the investors in the VC fund both ample downside protection and a favourable position for additional investment if the company proves to be a winner.

The venture capital industry has four main players: entrepreneurs who need funding; investors who want high returns; investment bankers who need companies to sell; and venture capitalists who make money for themselves by making a market for the other three.

The VC firms protect themselves from risk by investing with other firms, enabling portfolio diversification.

Funds are structured to guarantee partners a comfortable income while they work to generate those returns. 

The venture capital partners agree to return all of the investors’ capital before sharing in the upside. However, the fund typically pays for the investors’ annual operating budget—2% to 3% of the pool’s total capital—which they take as a management fee regardless of the fund’s results.

The real upside lies in the appreciation of the portfolio. The investors get 70% to 80% of the gains; the venture capitalists get the remaining 20% to 30%.

Assuming that each partner has a typical portfolio of ten companies and a 2,000-hour work year, the amount of time spent on each company with each activity is relatively small. 

If the total time spent with portfolio companies serving as directors and acting as consultants is 40%, then partners spend 800 hours per year with portfolio companies. 

This allows the VCs only 80 hours per year per company—less than 2 hours per week.

Venture-funded companies attract talented people by appealing to a “lottery” mentality. Despite the high risk of failure in new ventures, engineers and businesspeople leave their jobs because they are unable or unwilling to perceive how risky a start-up can be. 

Their situation may be compared to that of hopeful high school basketball players, devoting hours to their sport despite the overwhelming odds against turning professional and earning million-dollar incomes.

By understanding how venture capital actually works, astute entrepreneurs can mitigate their risks and increase their potential rewards. Many entrepreneurs make the mistake of thinking that venture capitalists are looking for good ideas when, in fact, they are looking for good managers in particular industry segments.

The value of any individual to a VC is a function of the following conditions:

• the number of people within the high-growth industry that are qualified for the position;
• the position itself (CEO, CFO, VP of R&D, technician);
• the match of the person’s skills, reputation, and incentives to the VC firm;
• the willingness to take risks; and
• the ability to sell oneself.