Venture Capitalists (VCs) are professional investors who use pools of other people’s money to invest in private companies (Note: some VCs have a little of their own money in the pool). The Silicon Valley VCs still get a disproportionate share of the headlines, although the VC community in New York, Austin, and Boston can definitely hold their own. Venture Capital is a type of Private Equity.
Understanding the mechanics of venture capital
Most venture capital funds have a fixed life of 10 years. The managers of the fund, the venture capitalists themselves, raise money for the fund by talking to pension funds, university endowments, insurance companies, and very wealthy individuals. The fund makes investments in private companies and when those companies are sold or conduct an initial public offering (IPO), the fund gets a return on the investment. The VCs are often compensated on a “2 and 20” basis, which means they receive a management fee of 2% of the total assets at work in the fund and a 20% “carry,” which is a 20% participation in the profits of the fund.
The venture capital industry is competitive. All funds are targeting 20%-25% annual returns, although there just aren’t enough good deals to go around. Most funds have trouble beating the returns of the public markets and average in the mid to high single digits. Considering all the risk and volatility inherent in investing in young, private companies, these returns are not terribly attractive.
But, the premier funds generate nice returns and are always able to raise new funds. Partly this is due to their excellent deal flow – the premier funds have the first shot at the best of the rising stars. Also, this is partly a self-fulfilling prophecy. When Kleiner Perkins (an iconic, tier-1 Silicon Valley VC firm) invests in a company, that company gets a lot of publicity and attention. People want to work there. Kleiner Perkins opens up its network and makes introductions that help attract partners and customers. It’s still tough to hit it big as a startup, but getting an investment from Kleiner Perkins will help.
It varies depending on who you talk with, but most VCs will tell you that about half of their portfolio companies fail, three or four fall between break-even and moderate success and one is an absolute home-run. While these results are apparently good enough for the venture capital industry, they have led critics to question how great the model is for the portfolio companies. In his insightful TEDx talk, Jon Brilliant coined the term “nurturator” to distinguish his new vision from all the accelerators and incubators out there today that basically operate on a VC-type model (i.e., lots of failed companies and the occasional homerun). Brilliant argues for a new fund model that aims for mostly successes and minimizing portfolio company failures.
What to expect when dealing with VCs
More so than angel investors, venture capitalists target specific industries and, like angels, they generally seek to provide more value than just cutting a check. They have large networks and can be great sources of contacts for partners, beta customer prospects, and other investors. However, VCs will rarely be as hands-on and active as the most engaged angel investors. So, if you are looking for a mentor, you probably want to look to someone other than your venture capitalist.
And, while VCs seek to provide more value than just money, they are primarily driven by the money. Perhaps it’s not fair to say that the venture capitalists themselves are money-driven. But, the nature of the industry, i.e., requiring that you show a competitive return to your investors, requires that money be the driving force in their investments. Therefore, discussions about valuation and legal deal terms like anti-dilution provisions and participating preferences will have you climbing the walls. Stay engaged, though, and press your attorney to understand all those little provisions – as they say, “the devil is in the details.”
You may hear the term “vulture capitalist.” Personally, we don’t think this is a fair label for most VCs we know. They are good people and they genuinely enjoy helping entrepreneurs succeed. But, they are intelligent and they have responsibilities to their investors so they are going to negotiate good deals. But, they understand that value of win-win deals and they want entrepreneurs to have plenty of incentive so, if you’re talking to a VC that doesn’t seem to care at all about you or your company, move on and find another VC – there are plenty of good ones out there who will be firm but fair.
How we can help you navigate the world of venture capital
We have a large network of venture capitalists and we are always happy to introduce them to companies that we know meet their pre-screening criteria.
We are rarely in a position to make these introductions if we haven’t already worked with you in some capacity. Contrary to what you might initially think, we aren’t dangling the introduction just to get some business from you. Yes, we want to do some work with you – that is, after all, how we keep the lights on. However, working with you provides the insight we need to understand you and your company in order to be able to confidently make an introduction to our valued network. Therefore, it’s helpful if you are working with The Cenkus Law Firm or The Startup Shepherd in some capacity, although, again, that is not a prerequisite. One option we encourage you to consider is The Startup Shepherd’s “2&1 Review,” which is a two-hour review of your business plan/pitch deck and pro forma numbers. They also use that time to analyze your industry and competitors. They then spend an hour with you giving you feedback and helping you improve your pitch and documents. We can’t promise you that you will then be a candidate for introduction to our VC network but we can promise you that the time and money will be well-spent. The feedback is solid and given by a former venture capitalist.