Are you about raising startup funds from VCs and want to increase your chances? If YES, here’s exactly how venture capitalists work and make investment choices.
What is a Venture Capitalist?
A venture capitalist is an investor who either provides capital to startup ventures or supports small companies that wish to expand but do not have access to capital or equity funding.
Venture capitalists are risk takers because they provide the capital to run a business or expand it without asking for collateral. This is regardless of the fact that the new business may collapse at any time and take their monies with it. Because of this, venture capitalists are very strict with who they give out their dollars to.
It’s also worth noting that venture capital funds have a fixed life of about 10 years, thus establishing investing cycles that last for about three to five years. At the lapse of this term, the investors will work alongside the startups and founders to scale the business and seek an exit, so that they can move on with their lives.
Despite facing enormous risks, VCs do shovel out millions of dollars every year to untested ventures, and sometimes tested ventures, with the hope that they will eventually transform into the next big thing. Considering how risky investing in startups and untested businesses can be, venture capitalists do consider a lot of things before investing in a business.
Venture capitalists are businessmen and they expect every single investment they make to make good yields for them because they have a lot at stake, and they would not compromise on this fact. Before an entrepreneur can start seeking out a venture capitalist to invest in his or her startup idea or business, such a person has to know these facts about VCs so as to know what they are getting into.
6 Hard Facts You Must Know About VCs
- They want profits: just like every businessman, profits are mostly what drive venture capitalists. For a VC to invest in any business, such business must have a clearly defined route of making profit. This in fact is the only way to convince investors to part with their hard earned cash. So, if you want to get a venture capitalist to partner with you, ensure that your business can generate profits.
- They take calculated risks. Unlike banks that have a low tolerance for risk (which is why they ask for collateral), venture capitalists look for businesses that have the potential for rapid growth. Since they give cash in return for a share of profits, high growth is the only way that they can make a return on their investment.
Yes, they make risky investments, but they don’t invest blindly. This is the sole reason why VCs conduct due diligence on companies they choose to invest in. Their aim is to get to know the company’s trading and operational history, know how cash is managed and understand the full potentials of the business. This is one of the reasons why VCs are seen as being very mean, heartless and remorseless.
- VC firms invest money on behalf of others: VCs raise multiple funds over the course of years from which they can invest. And the majority of capital for each fund comes from either institutional investors like endowments and pension funds or from wealthy individuals.
- Participation in management: Besides providing finance, venture capitalists may also provide technical, marketing and strategic support. To safeguard their investment, companies may also at times expect VCs to participate in their management.
- They invest for a fixed period of time: Venture capitalists do not form partnerships to last a business’s life time. If they do that, they would not have funds to fund other businesses because their liquid capital would be tied down. Before investing in any company, a contract is usually drawn up on the duration of the foray which is usually for a period of 3 to 7 years.
- They need an escape route: Venture capitalists aim to invest in a business, take their cash after a while and move on to another business or pay off their investors. The shareholding agreement sets out the conditions of this exit sale and the expected interest rate that applies. As such, any business that expects a VC investment must have a clearly laid down exit strategy.
How Venture Capitalists Work and Make Money
Venture capitalist investors are firms or companies that pool money from groups of investors into a combined fund to invest in emerging businesses. Their primary business goal is to obtain the greatest possible financial return by eventually selling the company they invested in maybe through mergers and acquisitions, or by holding an initial public offering (IPO).
How a typical venture capital firm works is by getting income from wealthy people who want to grow their wealth but they do not know how to go about it. They take this money and use it to invest in more risky businesses that may find it difficult to gain funding from other sources.
Because the investments are generally risky, the venture capital firm in order to compensate would then charge a higher interest rate for the money it gives out to the business. The interest rate may prove too high for the business, but it is either that, or the business stays without funding.
When a venture capital firm invests the funds of its clients in a business or businesses, they expect that the investment would mature in around three to seven years so that they can pay back their clients with interest.
This money is repaid either when the venture capital firm takes their invested businesses public and start selling stocks and bonds, or when the company is acquired by another company. The money is then paid back to the venture capital firm, with interest.
Sometimes, the money is repaid through shares of stocks in the company. Once all of the money in a particular fund is returned, the money, with the interest earned, is then sent back to the investors. Of course, the venture capital firm takes a portion of the money as a fee for their troubles.
How Venture Capitalists Make Investment Choices
The bottom line for equity investor decision making is that they need to believe the company is capable of growth and that the presented plans will produce the profits they need in order to exit after a few years. But what are the criteria investors consider before choosing to invest in a particular company? Let’s consider some of them.
- They look out for investors with strong entrepreneurial characteristics and a great team
Venture capitalists look out for investors with the requisite experience, ability to deftly execute ideas, and ability to adjust to opportunities and threats. Quite simply, management is by far the most important factor that smart investors take into consideration.
They are not looking for inexperienced managers instead, they are looking for executives who have successfully built businesses that have generated high returns for their investors. Businesses looking for venture capital investment should be able to provide a list of experienced, qualified people who will play central roles in the company’s development. Businesses that lack talented managers should be willing to hire them from outside.
Yes, even though a strong leadership is seen as sacrosanct, but VCs also look out for investors with a strong capable team, because a strong leadership and weak team would only make for disaster, and vice versa. These people could be experienced managers or recent college grads who have skills that complement each other. It could really be anybody, as long as the group has a history of collaboration.
- They seek great products with competitive edge
Products are a dime a dozen, and everybody can decide to manufacture and sell, so VCs typically consider first companies with a product or service that is unique and presents a clear value proposition for its customers. They look for a solution to a real, burning problem that hasn’t been solved before by other companies in the marketplace.
They look for products and services that customers can’t do without – because it’s so much better or because it’s so much cheaper than anything else in the market. They will also look at how the intellectual property is protected and how easy it is for companies to flood the niche and breed competition.
- Competitive advantage
Venture capitalists generally don’t like competition. When they are looking at a potential investment, they want to understand exactly how competitors fit into the picture, what their solutions are, what their market share is, everything to the very last detail. This is why they always look for a competitive advantage in the market. They want their portfolio companies to be able to generate sales and profits before competitors enter the market and reduce profitability.
- They look for a Large or growing market
Venture capitalists want to know that the company they are investing in has large untapped pools of potential customers. For VCs, “large” typically means a market that can generate $1 billion or more in revenue. In order to receive the large returns that they expect from investments, VCs generally want to ensure that their portfolio companies have a chance of growing sales worth hundreds of millions of dollars.
They will be interested to know exactly how each different market segment will be acquired as well as the anticipated rate of growth. In the case of startups, you will need to show exactly why customers will be willing to buy your product or service and preferably be able to back this up with the results of pilot studies.
If you are past the startup stage and are poised for growth, then you will be expected to show that your business has gained traction (that is a good, strong user base) and how this investment will enable you to expand these markets.
- The business must have Existing clients
Venture Capitalists will want to see the size, quality and value of the existing market especially for businesses that already exist and have been running for a while.
- Have good Profit potential
This is invariably the most important aspect because if the company has a high profit margin and also understands how to grow the business and extend their reach, they will feel more confident that they will be able to realize a return on their investment in future. This would guarantee them a sure nod from a venture capitalist.
- They assess risks inherent in the business
Investing in a business is enough risk as it is, and venture capitalists know this, so they would naturally want to know the kind of risks that are involved in any business they are getting into. They expect the business founders to be very sincere on the kind and level of risks the business is likely to be exposed to.
They would want to know if regulatory or legal issues would pop up, if the product or service would still be relevant in 10 years from today, what kind of competition they would be expecting, etc. The ways that VCs measure, evaluate and try to minimize risk can vary depending on the type of fund and the individuals who are making the investment decisions.
- It should be a Scalable business
Scalability means the ability of a business to very rapidly grow and increase its margins. Venture capitalist looks out for businesses that can grow quickly, because the faster the business grows, the faster they can recoup their investments, and the faster they can exit.
- It should have a clear exit strategy
Right at the start of every business relationship, the venture capitalist will want to know that you understand the importance of the exit and the role it plays in building a business. Most equity investors invest for only a few years and then expect to exit. This then means that if your business has no clear cut exit strategy, then you should forget about getting investment from VCs.
Venture capital investors usually decide to sell their investment and exit a company after they have achieved their intended goal with the company. Alternatively, the company’s management can buy the investor out (known as a repurchase). Other exit strategies for investors include; sale of equity to another investor – that is secondary purchase, stock market floatation, and liquidation – that is involuntary exit.
The exit value of a company must be mutually agreed between all parties, and will depend on the type of operation, the number of shares sold, the original valuation of the company and so on.
In conclusion, running a business is very stressful and potentially money guzzling especially if a bad investment is made, and that is why investors are always wary. So, before putting money into an opportunity, venture capitalists spend a lot of time analyzing them and looking for key ingredients of success.
They want to know whether the management is capable enough for the task ahead, they want to know the size of the market and whether the product has what it takes to make money within the required time frame; and most importantly, they want to reduce the risk they would encounter to the barest minimum so that they can exit with enough cash in their pockets for themselves and their clients.