How venture capital works ?

Venture capital funds are operated by the General Partners who raise money from Limited Partners (insurance, pension funds, etc) who trust them to use that money to invest in companies that will grow fast and able to deliver a good return of investment within 3-10 years.  The VCs main duty is to find the investment target, select it and structure a deal at the beginning while later provide ongoing advice and guidance to the investment. In other words LPs are betting that the VC will be capable of finding the most promising companies, structure the deal and help them to grow until getting succeeded.

The current online trends have tremendous effects on the VC industry as there is more and more venture money in the market while it is getting cheaper and cheaper to set up a new company.  Social media and online tools allow frequent and fast communication between entrepenuers and investors (including the potential in knowledge sharing) and the added value through the business support is getting the most important criteria of selecting a VC.

“Black swans” sustain the industry

Venture Capital is like hunting the “black swan”.  Around half of the venture backed companies fail and around one third of the companies are able to bring the money back for the investors. 1 out of 10 companies will be a real success story according to thumb rules of the industry.  The black swans generating huge profit for the investors after a successful exit or going public with the company.

Here are the latest trends in the industry. Let me know in a comment if you would like to add and feel free to argue with my points as well. 

Sign at the entrance of Startup city, Washington

1. Founding a company getting cheaper, that changes the role of VCs

Starting-up a company costs much less in the era of cloud computing, virtualisation, co-working spaces and online networks. Around 15 years ago while starting a company you have had much more setup cost by buying hardwares, expensive softwares, leasing office etc. Now the main expense item of a startup is human related. In the past the marketing spendings were very hard to measure, nowadays Google Adwords and Facebook/Linkedin Ads are having transparent click through rates therefore we can calculate much easier the user acquisition costs. From the VC perspective that means that the initial funding need is less, that means more latitude for entrepreneurs  to do bootstrapping and reach higher valuation by sweat equity. By selecting the VCs entrepreneurs prefer the highest added value services (partnership, business development support, etc.) as the money becoming a commodity in the industry, but “smart money” is still rare.

2. Platformization – money becomes commodity

As money becomes a commodity this is a great opportunity for the growing online (investment) platforms. According to Fred Wilson, VCs may not have any assets under management in 25 years from now.  According to Wilson,  ’the venture capital market,  wouldn’t be a need for VCs to ever have funds’. VCs primary value provided is sourcing and structuring the deal and  provide ongoing advice and guidance to help the companies grow.‘Storing Limited Partner money in their bank account, just waiting to invest it is inefficient for VCs. Instead, VCs should be able to submit, on a platform like AngelList, the investment terms, company overview, and personal commitments. Once it’s up, we can easily let the market provide the money ad hoc.’ told Fred Wilson. (Read the full article in this link)

3. Fund batches with less risk at pre-seed stage -The Y Combinator like model

Instead of funding early stage companies one by one and providing them ongoing support that is pretty risky on the investment side and time consuming on the coaching and mentoring side there is a new funding/education model emerging. There is a shift from Incubators to accelerators that puts emphasize on professional support, mentorship and value added services compared to the facility based approach  conveyed by incubators. Companies in batches get seed money and those who could create the most value within a short mentorship driven program could get follow-on funding from VCs attending the demo day.  Accelerators get equity for the initial money and support provided and they will have a return after a successful exit. The investment size in case of accelerators is usually pre-seed, that let the founders allow to deal with the startup full time. (To learn more about business accelerators here is my latest research on the topic)

The growing number of accelerators cause that a lot of seed stage companies are funded, but only a certain part of them (the ones with the most remarkable traction) will be able to secure a Series A afterwards. That is called the “Series A crunch”.

4. Unbundling the advice, control and money,

Venture Capital in the past was the bundle of Advice, Control, and Money but this phenomenon is changing fundamentally. Entrepreneurs want money for growing their ventures and ask for it, but in case of VC it has traditionally came with control as the invested amounts were large enough to create a need of monitoring if its managed properly and if not VCs could react accordingly.

Now, at the time of the decraising information asymmetry thanks to growing number of venture capital / startup portals entrepreneurs are able to educate themselves and understand the control layer. According to Naval Ravikant, CEO and co-founder of AngelList  ”Y Combinator and other seed incubators have essentially helped “union-ize” the startup workforce, and via reputation and standardized documents, reduce the control that VCs have over startups. Lower capital requirements have opened up the playing field of investors, and reduced the need or even the ability of early-stage investors to do active portfolio management.” (Read his thoughts here)

“The fact that start-ups need less money means founders will increasingly have the upper hand over investors,” Graham said. “You still need just as much of their energy and imagination, but they don’t need as much of your money. Because founders have the upper hand, they’ll retain an increasingly large share of the stock in, and control of, their companies. Which means investors will get less stock and less control.” told Paul Graham in an interview on CNBC As a result of this trend, angels are investors who leave out the control. They essentially bundle just Advice and Money.

5. VCs becoming the friends of entrepreneurs

While in the past VCs aimed to maintain the exclusivity this is not the case any more as they are also competing on agreeing with the most promising entrepreneurs. They are becoming the friends of entrepreneurs by supporting them, attending startup competitions, giving them frequent feedback, help them improving their ventures and communicating with them both face-to-face and online. Some of the well respected VCs are blogging, like Mark SusterFred Wilson, or Tomasz Tunguz and finding companies through online channels and get the most out of content marketing.

Venture capitalists are started to hire full-time public relations experts to share their progress, investment news with bloggers and reporters.  They ‘broadcast’ their actions and thoughts on Facebook, LinkedIn, Twitter and in blog posts.

According to the New York Times’ article: ‘In the last year, several top firms have hired people to handle marketing, branding and public relations full time. Among them: Kleiner Perkins Caufield & Byers, Lightspeed Venture Partners and True Ventures. Many others, like Benchmark Capital, New Enterprise Associates and Greylock Partners, keep public relations firms on retainer.’

Conclusion

As Alex Farcet the founder of StartupBootcamp, expert of the European early stage VC market said after asking him about how does the VC industry changing: ‘VC returns on the aggregate are still extremely low, only the top quartile at best are returning interesting results to their LPs.  So on the one hand they’re under pressure and it’s getting harder to raise funds, on the other they’re being crowded out by platforms and the proliferation of angels.  So, yes, they better differentiate themselves in a big way’

Balazs Szabo

Follow me on Twitter: @szbalazs87

(Disclosure: This article was published also on www.balazsszabo.com)

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