Imagine you are walking back to your dorm from your intermediate accounting class and you realize that you cannot spend 40 years of your life looking at debits and credits. Once this realization kicks in you understand you need to come up with an amazing idea to get you out of the bureaucratic path you are heading towards (no offense to accountants they will always have a good job). BOOM! It hits you, you get an amazing idea to make books that you can plug headphones into and the book will read itself to you. You rush home and you start drawing the prototype for it (let’s assume you just have magical skills, which we all know you don’t) and suddenly 9 months later you have a working prototype. Awesome. Now what? No bank will loan you money because you don’t have any sales, and you are just a broke college student, how are you ever going to scale this idea up into a full fledged money machine? Make a visit to a venture capital fund.
A venture capital fund is a type of private equity fund, which means the companies they invest in are not available to the rest of the public for investment. A normal VC (venture capital) fund will have a vintage year, which is the year they raise capital from LPs (limited partners). These LPs are normally institutional investors or very high net worth individuals. These can include pension funds, endowments, investment banks, etc. The VC firm will go to these LPs and pitch their fund while asking for an investment, and the investment has different ranges in amount depending on the size of the fund. Some funds have billions in AUM (assets under management) and some funds have in the low tens of millions. After the initial investment process is over it is the fund’s turn to invest the money into companies. There are different stages of the VC process, starting with seed funding, which is what somebody like the broke college kid with one prototype would need, to late stage investing which is when a company already has a solid revenue with an established line of business.
Venture capitalism is an extremely risky business with the prospect of great returns. Companies like Youtube and Facebook started out with VC funding and have produced returns hundreds to even thousands of times over. However, for every Youtube and Facebook there are 1000 companies that burn to the ground before they are ever profitable. Back in 2012 the Wall Street Journal conducted a study on VC firm’s investments and Mr. Ghosh concluded, “If failure is defined as failing to see the projected return on investment—say, a specific revenue growth rate or date to break even on cash flow—then more than 95% of start-ups fail” (WSJ, Gage). Of course, this is an extremely harsh critique of failure, just because an investment did not hit the target return does not mean the company was actually a failure; it just wasn’t the next Facebook. This statistic does lead to an interesting insight though because it means that a lot of VC firms are not earning the proper return for the amount of risk they are taking. It also means certain firms are probably having high failure rates but are able to become successful from their unicorn investments.
Now that we have an idea of what venture capitalism is, let’s go back to our broke college kid (which in case you forgot, is you in this article) with the potential unicorn investment. Let’s also assume you have a contract to sell your product in bulk to a major company if you can just raise the capital to get them made. Therefore, under these assumptions, you have a potentially great product and a stream of revenue as soon as you can raise the capital. Perfect, right? Not yet, you still have to pitch your idea in front of a bunch of sharks that are waiting to pick your business apart. These people are the difference between you becoming a multimillionaire and you just having a great idea, in other words, the pressure is on.
From the VC’s point of view, they have the priority of making sure they perform their due diligence when it comes to investing. They are entrusting millions of dollars in a start-up company with very little to no track record, in the hopes that you have what it takes to make it to the top. Therefore, they are extremely particular about their investment process, they normally have proprietary qualitative and quantitative models to separate the stars from the scrubs.
For the sake of learning purposes, let’s say you receive a massive investment into your company. Now what? Do you just run your company? Nope. Part of the advantage of getting a VC firm to invest in your company is that they have a vast amount of experienced businessmen and experts in your field that will invest in you and your company. They want to see an amazing return on their investment, therefore, for the next 5 years or so they will actually help manage your company with you (essentially be a very hands-on consultant to your company). The investor will do this until they find an exit strategy, which is your firm either getting acquired by a bigger firm or having an Initial Public Offering (think New York Stock Exchange). The exit strategy is the way VC firms get their money back in order to return it to investors.
The typical payment structure of a VC is taking 2% AUM every year and then 20% of the profits. You may be saying, “Wow, that seems ridiculously high.” While that may be true, there is a solid reason behind the payment structure. Not only does doing VC require specialized skills that should be compensated accordingly, having the VC firm take 20% of the profits is a great thing for you as the investor. Think about it, do you want somebody investing on your behalf that gets nothing whether they succeed or fail? Or, do you want somebody who has a stake in the game? Basically, the fee structure aligns the interests of the VC firm with the investor’s interests which is always a great thing when it comes to money management. Venture capitalism is not for the faint of heart, but these timely investments into start-up/growing companies are what helps us have some of the revolutionary technology companies around today. Just think, without a VC firm taking a chance on some Harvard dropout, you probably would not get to see all the kitties on your Facebook feed.