The Business of Venture Capital
Those aspiring to raise a fund, pursue a career in venture capital, or simply understand the art of investing can benefit from The Business of Venture Capital, Second Edition . The companion website offers various tools such as GP Fund Due Diligence Checklist, Investment Due Diligence Checklist, and more, as well as external links to industry white papers and other industry guidelines. MAHENDRA RAMSINGHANI has over a decade of experience in fostering the growth of early-stage technology businesses. As Director-Venture Capital Initiatives for Michigan Economic Development Corporation (MEDC), Mahendra led the legislation for two Fund-of-Fund programs that deploy $200+ million in VC funds in Michigan. For his economic contributions, his US Citizenship was approved under “National Interest,” a category reserved for less than 1% of the applicants. He is also the co-author of Startup Boards (Wiley, 2014) with VC and author Brad Feld. His articles have appeared in Forbes and MIT Technology Review . Mahendra’s background includes a Bachelor’s in Electronics Engineering and MBA with a major in Marketing & Finance. He lives in San Francisco, CA.
The Business of Venture Capital
"The key to making great investments is to assume that the past is wrong, and to do something that's not part of the past, to do something entirely differently."
- Donald Valentine, Founder, Sequoia Capital 1
A day in venture capitalist's (VC's) life is like that of an entrepreneur - venture capitalists have to pitch a thousand pitches to institutional investors to raise their fund and execute a predetermined plan. If the plan goes well, rewards are distributed; egos are stroked and champagne flows. The partners then go back and raise another fund. If the plan goes really well, which is rare, the partners retire, join local nonprofit boards, or spend time aboard a fancy yacht. A VC's profession is driven by three primary functions: raise the venture fund, find investment opportunities, and generate financial returns.
RAISE THE VENTURE FUND
VCs raise money from financial institutions (called limited partners, or LPs in industry jargon) such as pension funds, foundations, family offices, and high net-worth individuals. (See Figure 1.1 .) Investment professionals or general partners (GPs) develop an investment strategy. Based upon this thesis, its timeliness and robustness, investors commit capital to the venture fund. Investors or limited partners seek a blend of strong investment expertise, a compelling investment strategy, and supportive market conditions. Target returns for investors are typically in the range of 20 percent or more on an annualized basis.
FIGURE 1.1 Limited partners (LPs) in a venture fund.
The fund-raising process can be long and arduous, taking as much as 18 months, and is often compared to an uphill crawl on broken glass. Many a VC is humbled in this process and can empathize better with entrepreneurs when financial institutions do not return their calls, do not ask them to pitch their fund strategy in seven minutes, offer no feedback, and go dark.
A venture fund is a close-ended fund. Once the target amount is raised or the fund is subscribed, no new investors are admitted. The life of such a fund is typically 10 years. 2 The fund is dissolved after the 10th year or when all portfolio investments have been liquidated.
Successful firms do not necessarily wait until liquidation of the previous fund; they raise their next fund as soon as the majority of the capital of the current fund is invested or designated as reserved for existing portfolio companies. Leading venture firms raise a fund every three to five years. Typically, funds are labeled with Roman numerals, such as ABC Ventures Fund I, II, III, IV, and so on. Roman numerals are a soft indicator of a venture fund's ability to survive and to generate returns across the various economic cycles. A firm's true measure of success is its ability to generate consistent returns over multiple economic cycles.
FIND THE RIGHT INVESTMENT OPPORTUNITIES
Once the fund-raising process is complete, VCs are under pressure to deploy the capital. During this investment period, as seen in Figure 1.2 , any fund actively seeks Facebook-like opportunities to generate target returns. Investment periods can be three years to five years. In this period, the start-ups come in - the mating dance begins. The pitch deck, term sheets, valuations, and boards are negotiated. A venture fund has to build a portfolio of companies that promise strong returns. Each portfolio company should demonstrate the potential to generate a return that equals a multiple of 8 to 10 times the capital invested. On a portfolio-wide basis, venture funds target a 20 percent annualized rate of return or a minimum of two to three times the invested capital.
FIGURE 1.2 The J curve of venture fund investments.
A typical portfolio size fo