New VC game

Finweek English Edition - - ENTREPRENEUR -

Ven­ture cap­i­tal isn’t easy and has many chal­lenges. As a very brief primer, ven­ture cap­i­tal ( VC) f unds raise money from in­vestors (typ­i­cally called ‘lim­ited part­ners’ or LPs) and in­vest this money into busi­nesses that they be­lieve have very high growth po­ten­tial. The VC man­age­ment team takes about 2% of the funds it’s raised and spends it on ex­penses. The team makes real money when the fund does well, typ­i­cally mak­ing 20% of the re­turns above a hur­dle rate (which varies but is gen­er­ally above 15%). So when a fund makes an an­nu­alised re­turn of 40% and the hur­dle rate is 20%, then the VCs would make 20% of the ‘ex­cess’ 20% – i.e. they’d make 4%. This can be sub­stan­tial when com­pounded and be­comes a large num­ber when the fund per­forms well. It’s very hard to spot win­ning com­pa­nies, es­pe­cially early in their lives when they’re at their most risky. So typ­i­cally VCs ex­pect that for ev­ery 10 in­vest­ments they make, one or two suc­cess­ful in­vest­ments will re­turn their en­tire fund value, another three or so in­vest­ments will pro­duce mod­er­ate re­turns and the rest will fail. In this you have a bit of a co­nun­drum – if you want to in­vest in the kind of high-growth op­por­tu­ni­ties where one or two in­vest­ments will make a sub­stan­tial amount of money, then you have to ap­pre­ci­ate the risk (i.e. that you will also have three or four com­plete fail­ures where all cap­i­tal in­vested to date is lost). The trick then is to iden­tify ex­cit­ing com­pa­nies very early on, take a size­able stake and be able to fol­low your rights by in­vest­ing in the firm as it grows and raises more money. LPs like to see fo­cus. So funds have split be­tween be­ing seed and Se­ries A (the ear­li­est two fund­ing rounds for a busi­ness), while oth­ers do the later but much larger rounds. The in­vestors who get in later do so be­cause they are see­ing busi­nesses with a far bet­ter track record, but if the busi­ness is do­ing well then for them to get a mean­ing­ful stake of the ac­tion (im­por­tant to gen­er­at­ing re­turns on their in­vested cap­i­tal) then they will only be able to do so a much higher val­u­a­tion. If you want con­trol and board seat then you need to have a lot of money to buy a mean­ing­ful stake. So there is more cap­i­tal at risk in each later stage deal.

Typ­i­cally, the early-stage funds have a very fine line to walk be­tween be­ing able to in­vest in more at­trac­tive new com­pa­nies ver­sus sup­port­ing their ex­ist­ing

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