VWV Volumes #14: Associate Amanda Lee'23 gives a crash course in Venture Capital
Because we have a number of new subscribers, many of whom are students interested in learning more about VC, I thought it would be helpful to share a brief crash course. This is a collection of some basic VC concepts written by a student, for fellow students!
What is VC?
Venture capital is a form of private equity provided to a company. When venture capitalists invest in a startup, they buy some stake in the company, operating under the philosophy that they will receive high returns for high risk. The reason why their investment is risky is because startups are prone to failure (a common heuristic is that ~90% ultimately go under). Thus, after investing early and during a period of unpredictability at the company, venture capitalists expect an attractive profit — something like a 10x return over 5 years for financing one year.
Read more on how venture capital works or how VWV operates.
What is a fund?
A VC fund is the pool of capital from which they make investments into startups. A fund’s investment period is around 5 years long, during which they invest in new opportunities. After this time, they only invest in companies they have already invested in. Every 3-5 years, VC firms raise a new fund with larger entities, like endowments, government and corporate pension funds, large corporations, banks, insurance companies, etc, as investors. These are called the Limited Partners (LPs).
A VC makes money from its management fee and the carried interest. A management fee, around 1.5-2.5% of the fund, is used to finance operations of the VC. The carry, on the other hand, is the profit leftover after VCs return money to their LPs.
For example, if the management fee of a $100 million fund is 2%, the VC will receive $2 million in fees. Say this fund is a success, resulting in a 5x return of $500 million. The LPs receive their original $100 million back, and the remaining $400 million is divided 80-20 between the LPs and General Partners at the VC. This means that $2 million (management fee) + $80 million (carry) goes to the VC, and the fund’s LPs get $100 million (original investment) + $320 million (profit).
What is a VC’s investment process?
Analysts and associates source deals, conduct due diligence, and summarize opportunities in memos. Sourcing entails finding companies, often in a specific industry or at a particular stage. If the opportunity is compelling, they begin a more rigorous research process — due diligence (DD).
During the evaluation process, VCs assess the startup’s team, product/service, market size and growth, traction, and financials (such as a customer’s Lifetime Value, Customer Acquisition Cost, the company’s burn rate), to name a few. Each of these criteria could be a series of blog posts on their own, but one key concept is that the most important or telling metrics vary from industry to industry and even from opportunity to opportunity.
Principals or VPs often lead these DD teams, and over several negotiations, the investment terms are discussed and finalized. If the VC decides to invest and the startup accepts, the term sheet is signed, and the VC goes on to be a resource to the company, helping with recruiting, networking, branding, sales, etc.
Check out alternatives to VC funding and more on financial metrics.
More resources
If you’d like to learn more, these are a few of my favorites:
Venture Deals, by Brad Feld and Jason Mendelson: a must-read on how VCs operate, also includes a great breakdown of the term sheet, written by the founders of the VC firm the Foundry Group
#BreakIntoVC: How to Break Into Venture Capital, by Bradley Miles: useful for students considering a career in VC
Paul Graham’s blog: cofounder of Y Combinator (a well-known accelerator), you can find his take on many of the most salient VC- and entrepreneurship- related questions here
20 Minute VC with Harry Stebbings: for those who prefer listening to reading
Please feel free to ping VWV on Instagram, Twitter, or via email with thoughts, reactions, or questions!