The Business of Venture Capital

1. Venture capital is a high-risk, high-reward asset class driven by relationships and performance

"LPs come to venture capital for sex and blood—it's that dark alley—everyone is intrigued and wants in—the curiosity and interest level is very high, but very few LPs know what truly goes on."

High risk, high reward: Venture capital is a small but alluring asset class within the alternative investment universe. It attracts institutional investors seeking outsized returns, but comes with significant risks. Only a small subset of VC firms consistently outperform, making access to top-quartile managers crucial.

Relationship-driven: Success in venture capital hinges on building strong networks and relationships. This applies to both fundraising from limited partners and sourcing deals with entrepreneurs. Top-performing VCs often have privileged access to the best deals through their reputations and connections.

Performance is paramount: While relationships matter, ultimately VC firms live and die by their returns. LPs scrutinize past performance when deciding whether to invest, looking for consistent outperformance across economic cycles. This creates a "rich get richer" dynamic where top firms attract more capital to reinvest.

2. Limited partners (LPs) are the primary source of capital for venture funds

"If public markets are like an ocean—multi-trillions of dollars at work—and private equity is a bath tub … say $300 billion a year … venture capital is like a small sink."

Diverse LP landscape: The main sources of capital for venture funds include:

• Pension funds
• University endowments
• Foundations
• Family offices
• High-net-worth individuals
• Fund-of-funds

Asset allocation considerations: For most institutional investors, venture capital represents a small portion of their overall portfolio, typically 1-5% of assets. This is due to the illiquid nature and higher risk profile of VC investments.

LP motivations: Different types of LPs have varying goals and constraints:

• Pension funds seek long-term returns to meet future obligations
• Endowments can take more risk due to their perpetual time horizon
• Family offices may be more focused on accessing innovation and emerging technologies

3. Due diligence is critical for both LPs evaluating funds and VCs assessing startups

"If it takes $10 million to make a good VC, that $10 million better come from the LP next door."

LP due diligence on funds:

• Track record and attribution
• Team stability and expertise
• Investment strategy and thesis
• Fund size and portfolio construction
• Alignment of interests (GP commitments, fee structures)

VC due diligence on startups:

• Team capabilities and background
• Market opportunity and competitive landscape
• Product/technology differentiation
• Business model and unit economics
• Financial projections and capital needs

Importance of references: Both LPs and VCs rely heavily on reference checks to validate claims and uncover potential issues. This includes speaking with entrepreneurs, co-investors, and industry experts.

4. Fund structure and governance set the foundation for VC operations

"Style and Structure are the essence … great ideas are hogwash."

Key fund entities:

• Limited partnership (LP) - the investment vehicle
• General partner (GP) - the management entity
• Management company - handles operations and employs staff

Economic arrangements:

• Management fees (typically 2% of committed capital)
• Carried interest (usually 20% of profits)
• GP commitment (1-5% of fund size)

Governance considerations:

• Investment committee structure
• Decision-making processes
• Conflict of interest policies
• Reporting and transparency requirements

5. Sourcing quality deals is an art that relies on networks and industry expertise

"Good GPs and funds magnetize good entrepreneurs. I have found sourcing to be a differentiator, a huge advantage, much more than what I was trained to see."

Key sourcing strategies:

• Leveraging personal and professional networks
• Building relationships with entrepreneurs and angel investors
• Attending industry conferences and events
• Developing sector-specific expertise
• Cultivating relationships with universities and research institutions

Competitive advantage: Top firms often have privileged access to deals through their reputation and connections. This creates a virtuous cycle where success begets more success.

Volume game: VCs typically review hundreds or thousands of opportunities to make a handful of investments. Developing efficient screening processes is crucial.

6. Valuation methods balance art and science in early-stage investing

"Sounds about right" is often an expression used by practitioners when numbers are tossed around.

Common valuation approaches:

• Comparable company analysis
• Discounted cash flow (less relevant for early-stage)
• Venture capital method (working backwards from exit)

Key valuation drivers:

• Market size and growth potential
• Team quality and track record
• Technology/product differentiation
• Traction and customer validation
• Competitive landscape

Balancing act: Early-stage valuations involve significant uncertainty. VCs must weigh the potential upside against the risk of overvaluing and missing future rounds.

7. Term sheets define the economic and control aspects of VC investments

"Terms are important but seldom the primary drivers of investment decisions. As they say, terms never make a poor firm look good nor make a good firm unattractive."

Key economic terms:

• Valuation (pre-money and post-money)
• Liquidation preference
• Anti-dilution protection
• Option pool

Key control terms:

• Board composition
• Protective provisions
• Information rights
• Right of first refusal / Co-sale rights

Negotiation dynamics: While terms are important, the overall quality of the company and team typically drive investment decisions. Top companies often command more favorable terms.

8. Effective board membership is crucial for guiding portfolio companies to success

"No school teaches a venture capitalist how to be a good board member."

Key board responsibilities:

• Setting strategic direction
• Monitoring financial performance
• Hiring and evaluating the CEO
• Ensuring good governance practices

Value-add opportunities:

• Leveraging industry connections
• Advising on fundraising and M&A
• Providing operational expertise
• Helping with recruitment

Challenges: Balancing the dual roles of supportive partner and fiduciary oversight can be difficult. VCs must navigate potential conflicts of interest and know when to step back.

9. Acquisitions are the primary exit strategy for venture-backed companies

"Companies are always bought, never sold."

Acquisition advantages:

• More frequent and accessible than IPOs
• Can provide faster liquidity for investors
• Often preferred by acquirers for talent and technology

Key considerations:

• Strategic fit with acquirer
• Valuation and deal structure
• Integration planning
• Employee retention and incentives

Process overview:

1. Preparation and valuation
2. Identifying potential acquirers
3. Initial outreach and NDAs
4. Due diligence
5. Negotiation and definitive agreements
6. Closing and integration

10. IPOs, while prestigious, face significant regulatory and market challenges

"For I must tell you friendly in your ear, Sell when you can, you are not for all markets."

IPO advantages:

• Potentially higher valuations
• Increased visibility and credibility
• Access to public capital markets
• Liquidity for early investors

Key challenges:

• Regulatory burdens (e.g., Sarbanes-Oxley compliance)
• High costs of going and staying public
• Pressure to meet quarterly expectations
• Loss of control and flexibility

IPO process overview:

1. Selecting underwriters
2. Due diligence and SEC filings
3. Roadshow and book building
4. Pricing and allocation
5. First day of trading
6. Post-IPO lockup period

Last updated: August 17, 2024