The world of venture capital (VC) can be pretty opaque and as startup CFOs we’re often asked for advice about how best to navigate VC funds to try and ensure the best outcome for the startups we may be working with.

So with that in mind, we thought it would be helpful to write this guide to how VC firms themselves work, not only to make the ecosystem a little less opaque but also because we’re firm believers that if you have decent knowledge about how they work, it may help you as you navigate your next fundraising round.

What is Venture Capital?

In order to understand how VC firms work, it’s worth understanding what venture capital actually is. VC is a subcategory of Private Equity (PE) which is an alternative class of investment consisting of funds investing in unlisted companies (i.e. companies that have not been listed on a stock exchange).

Whilst PE tends to invest in more stable businesses, often with predictable profitability and cash flow, venture capital tends to invest in the earlier stages of a company’s life cycle when there is much less certainty in the business and its outcomes. This is why it is often referred to as risk capital.

So where do VCs get their money from?

As we said above, investments made into startups and scaleups are made via a fund structure. That is a pool of capital that has been entrusted to the VC or fund manager to deploy into these businesses.

Like a startup, therefore, a VC fund has its own investors, called Limited Partners or LPs. This can consist of one or more individuals or asset managers (such as pension funds or state entities like the British Business Bank) that commit to providing the capital that the VC fund will use to make its investments.

A limited partner, as the name suggests, has limits to its power, voting rights, and say over the day-to-day running of the firm.

OK, then who makes the decisions in a VC firm?

VC funds are set up by General Partners (GP) who, in contrast to LPs do have day to day responsibilities in the running of the firm and also have personal liability for the debts of the VC firm.

Alongside GPs you may have a number of other individuals in the firm, from analysts who do a lot of the low level transactional work, associates who may introduce deals and work with portfolio companies to principals who may serve on portfolio company boards, bring investments to the firm or negotiate deal terms. Beyond the principal role you have partners who take a more specific role in the running of the firm, the decisions around investment opportunities as well as being the outward face of the firm.

Why don’t VCs invest in certain industries, geographies, or company stages?

VCs tend to have an investment thesis that is like a framework that determines what sorts of businesses they will invest in. Some have very detailed theses around specific industry types whilst others may be more general.

An investment thesis may be thought of as

What
Why now
Why us

The “What” is the vertical, geography, or stage they will invest in, the “Why Now” is about why they think there is an opportunity for outsized returns in their choice of What (for example with the push for sustainability right now as well as changing dietary trends it might be the ideal time to invest in plant-based meat alternatives) and the “Why Us” is why the firm thinks that they have a real edge in this space – maybe they have deep connections within the wider industry or maybe they have very strong disciplinary backgrounds in science that can help with some bleeding-edge technology.

Ultimately, if all VCs invested in the same types of businesses and stages, there would be a lack of capital for others so ensure that you do your homework in advance and choose the fund whose thesis fits your business.

Why is there a time limit on when a VC can invest?

As we mentioned earlier, LPs provide the capital that VCs then invest, however, there are two important factors to consider here. Firstly, LPs don’t provide all the capital upfront but rather invest in a series of tranches when VCs trigger a capital call and secondly, LPs expect to get their money back (plus a profit) after a fixed period of time.

Most VCs will have a total fund lifetime of 10 years, often with 1 or 2-year extensions. They will invest a portion of the capital into new businesses over the first 3 or 4 years, reserve some of the capital for what is called follow on rounds (i.e. subsequent fundraising events after their initial investment) for the next 2 – 3 years, and then reserve the rest of the 10 year period to ‘harvest’ their investments, i.e. find a way to sell their shareholding of the company. This may be via a secondary sale (where they sell their shares to a new incoming investor), an exit of the business via sale to another company, or even a PE fund or a public listing via IPO.

Because of this cycle and time frame, there are two other things that follow. Firstly the VCs must be clear about their portfolio construction (which is a fancy way of saying how many businesses they will invest in, over what period, for how much cash, and in return for what level of equity and how much they will reserve for follow on funding) and secondly, that VCs will almost always be raising a new fund whilst they are still deploying from a previous one.

How do VCs make their money?

The bottom line is that whilst we may think that VC is all about funding new innovations or breakthroughs in science and technology, the reality is that this is often a happy byproduct of the real reason VCs exist – and that is to return capital to their LPs and pay the salaries of the partners and individuals involved in the running of the firm.

The way this works is via management fees and carried interest. Management fees are the annual fees that are used to ‘run’ the fund and carried interest being a share of the profits once the portfolio companies have exited. The most traditional structure is a 2 and 20, which means 2% management fees and 20% carried interest.

One thing to note is that the 2% is not just charged as a one-off on the fund, but is an annual figure. So, for a $100m, 10 year fund, the management fee will be 2% x $100m x 10 years = $20m. This means that there is only $80m left to invest in portfolio companies.

Let’s say the VC does relatively well and “3x’s” the fund, this means that after investing in and exiting their portfolio, they are left with $300m, they will then return the first $100m back to their LPs and then split the balance of $200m profit with 80% going to LPs and 20% being split between the partners. In this instance that would be $40m.

Side note on power law

VC funds and distributions tend to follow a power law, i.e. that the majority of value is returned across a small number of portfolio companies.

This is why VCs are always looking to back so-called Unicorns (companies whose exit value exceeds $1bn) because they need each potential investment to be able to ‘return the fund’.

Confused? Let’s walk through an example:

Let’s say that a $100m fund has the luxury of not needing to charge management fees and so deploys the full $100m with 50% as initial investments and 50% for follow on.

At seed, that likely means investing in around 25 companies at $2m per investment for a target ownership of 10% (i.e. a post-money valuation of $20m).

As some of those businesses start building value, they may need to follow on into subsequent fundraising rounds to maintain their ownership stake at 10% (as new investments will otherwise dilute or reduce their shareholding).

Now, we all know the stats around startup success, so let’s be generous and say only 70% of these businesses fail completely – that’s 18 where the investment has to be written off. Of the balance 7, it’s likely that 5 may have an exit where they either pay back the investment the VC has made or a bit more. Let’s say that those 5 exit for anywhere between $50m and $100m. On the assumption that the VC still holds 10% (i.e. followed on and didn’t get diluted), that means that they will make anywhere between $25m and $50m back from those businesses (highly unlikely but let’s play along).

On that basis, the fund would at most have returned 50% of the fund, it’ll be pretty hard to raise the next one if they haven’t at least returned the initial $100m that LPs invested.

So everything is riding on the last 2 investments and why they need to be unicorns. If one exits for $1bn, then at their 10% ownership, the VC receives $100m (and breathes a sigh of relief as has returned the fund) which means that the $50m from the 17 ok exits is now profit in which they can participate (but only 20% remember!), so it’s hugely important that the last investment also exits for a decent amount in order to really be something worth talking about.

Let’s say that it does well, but not quite unicorn status and exits for $500m, this means that the fund will receive $50m from that investment giving them a total of $200m: $50m from the ok returns, $100m from the unicorn and $50m from the last exit.

This would mean that they have 2x’d the fund and will receive $20m in carried interest.

Simple right?!

Dealflow

All VCs rely on dealflow, which is basically their ability to see as many relevant businesses that are fundraising and that match their thesis as possible. As a rule of thumb, VCs may only invest in around 1% of the deals they see – and they see a lot of deals.

This means that the average time they spend looking at a deck is low, and there has to be something in there that grabs their attention enough to want to move it through their process.

Even then there are no guarantees, we’ve had deals make it through 5 weeks of the process including multiple partner meetings only to be turned down for any number of reasons.

What happens if I get a term sheet?

A term sheet is a non-binding offer to invest in your venture. It will set out the terms of the investment including things like:

• Amount to be invested
• Pre and Post Money Valuations
• Any preference rights the investor may receive
• Any board or observer seat the VC may want
• Any restricted matters such as founder shareholding, package, or new investment that may require investor consent.

This is a non-exhaustive list and it is worth paying attention to what a VC may ask for; many founders focus on the valuation when the control aspects may be more important.

But, once you have a term sheet in hand, it means you’re a large step closer to getting in the investment, there are really only two additional steps beyond that – due diligence and long-form legals.

Due Diligence and legals

Due diligence (DD) is the process whereby a VC firm does a fair amount of work to metaphorically kick the tyres of the business. They’ll look at the contracts in place with founders, whether there is a shareholder agreement, how much equity has been reserved for employees as part of an option pool, whether the financials that have been put in the pitch materials marry up to reality and other matters around incorporation, commercial and employment contracts and anything they may wish to see around the product or tech stack.

This DD can be quite time-consuming on both the VC and the founder side and a red flag for a VC would be where materials haven’t been provided in a timely manner.

If the DD has been successfully completed, the firm will then move on to the longer form legal documents that form the share purchase agreement. This is a continuation of the term sheet and formalises the investment.

Once these documents have been completed and signed by all parties, the fund will then deploy its investment.

So how does this all help me as a founder?

There are several takeaways from this that are worth paying attention to:

• VCs invest in certain sectors, geographies, and stages. Do your homework and don’t go to a Series A, US, SaaS VC for investment in a UK-based, seed stage consumer product business.
• Depending on where a particular fund is in its own lifecycle, it may not be the right time for them to invest in you (or for you to take investment from them). The last thing you want is to take investment from a fund towards the end of its deployment phase who will therefore be looking to exit their position sooner rather than later.
• Give yourself plenty of time to execute a fundraising round. It can be relatively slow and you may have multiple conversations happening simultaneously. Some of the things you can do to prepare are ensuring your pitch deck is snappy and well designed, that you have a financial model in place that matches the narrative of your pitch and that you have a data room ready to go for the due diligence phase.
• Remember that VC funds are driven primarily by financial returns and that these returns tend to follow the power law. You may be building the best online marketplace for shops on your high street, but that isn’t going to get their attention.
• VCs are people. Build relationships early and make sure they aren’t transactional. If you are looking for funding in the future (and even if you’re not), they can be massive advocates for you and your business.

So there we have it, how VCs work and how to use that knowledge as a founder.