There are many reasons why entrepreneurs should know about venture capital.
First and foremost, venture capital can provide the funding necessary to get a startup off the ground. They can offer valuable advice and mentorship to entrepreneurs. Additionally, they can help you navigate the often-complex world of startup funding and provide guidance on how to grow your businesses. They can also serve as a valuable networking resource. They often have extensive networks of contacts that can help you connect with potential customers, partners, and investors.
Venture capitalists are professionals who invest in the equity issued by fledgling startup companies.
In most cases, start-ups are not immediately profitable, but rather in the red. Moreover, it is not clear whether they will be able to make a profit in the future. In general, banks are reluctant to lend money to companies with such an uncertain future. Startups are also reluctant to take on debt that must be repaid on a regular basis or by a certain date when they do not know what will happen to their business.
Startups raise money for their business by issuing stock and selling a portion of their equity in the company. The VC buys this equity. The funds raised by the startup from the sale of equity do not have to be repaid.
Most startups that exit and sell their shares disappear without making a profit, their value is reduced to zero, or they are acquired by some other company at a lower price. Some grow explosively and eventually list their shares in an IPO (Initial Public Offering), i.e., on the public market. Public markets include NASDAQ, the New York Stock Exchange, and The Borsa Istanbul (BIST) where a variety of investors buy and sell shares on a daily basis.
Even if a company does not go public, it may be acquired by a large company at a high price through M&A (Mergers and Acquisitions). For example, Trendyol, one of the largest online marketplaces in Turkey, was acquired by Alibaba Group (a Chinese multinational technology company) for $728m in 2018. VCs sell their holdings in such mergers and acquisitions. Selling shares in an IPO or M&A to lock in a profit is called an "exit".
As a general rule of thumb, VC firms hold onto their shares for 5 to 10 years between investment and exit. At the time of exit, the portfolio company's annual sales are in the hundreds of millions of dollars and the total market value of its shares is in the billions of dollars. In Turkey, VC firms generally invest in startups that have the potential to generate millions of USD in sales and tens of millions of USD in market capitalization.
VC firms determine whether an investment has good growth potential and provide various types of support to the company they invested in. The former is the same as for investors in listed stocks, but they need to make very specialized judgments, given the limited track record of performance compared to investors in listed stocks. The latter is a characteristic that investors in listed stocks do not have. They are deeply involved in the management of the company, such as being members of the board of directors.
Various Forms of Investors
When a VC raises money from investors, it is called fundraising. The investors who put money into the fund are called limited partners (LPs). Investors who become LPs include;
- Financial Institutions
Collects money from multiple investors to create a fund from which to invest in a VC.
- Pension Funds
Corporate pension funds, Social Security Institution pension funds (SGK in Turkey), etc. invest the accumulated premiums and invest part of them in VC funds.
- Insurance Companies
Invests a portion of accumulated life insurance premiums and other funds in VC funds.
- Operating Companies
Invests a portion of its own money to increase profits, sometimes with the expectation of a business return, such as a partnership with the company invested.
Other LPs include university endowments, family offices that manage the money of wealthy individuals such as the founders of large companies, and government-affiliated investment funds that manage public funds.
Roles and Responsibilities
An LP, as the name implies, plays a "limited" role in the fund. In other words, they do not have the right to dictate specific investment targets or timing. Of course, LPs are provided with investment criteria in advance, but within those criteria, VCs can arbitrarily decide where and when to invest.
It also has limited liability and does not have any liability beyond whether or not it loses the invested funds. For example, you will not be sued and held liable in any way by the startups in which you invest. To put it in a clear way, once an LP entrusts its investment capital to a VC, it simply waits for the VC to increase its value, without telling what to do or being forced to take on any responsibility.
So far, I've called it VC, but more, strictly speaking, the entity (a person or a group) that manages the fund is called the General Partner (GP). It is the GP's responsibility to decide how much of the funds collected from LPs will be allocated to what companies and to execute the investments. GPs have unlimited liability and assume full responsibility for their operations.
Corporate Venture Capital (CVC)
CVC is a general term for the act of an operating company making its own venture investments. It can take many forms and may not be in the form of a fund, but simply investing in startups with company funds.
Most operating companies pull investment capital from their own balance sheets. This is the easiest way to start an investment and also the easiest way to stop. Generally, since there is no entity dedicated to the investment, the members of the investment team follow the traditional internal approval process. For example, for investments of 1 million USD or less, the general manager has decision-making authority; for investments of 10 million USD or less, the president; and for investments above that, the board of directors must pass a resolution, and so on.
Since CVC has a very low barrier to entry, it may not be easy to say whether the company is committed to investing in startups on a long-term basis. Because organizational priorities are constantly changing, it is possible that after two years the top management may decide that investing in startups is no longer important and disband the investment team. After all, for an operating company, investment is not its core business, but merely one of the means to complement the organization's overall strategy.
Problems with Corporate Venture Capital
- The amount of investment is small and easily influenced by the parent company's intentions, making it difficult to expect stable follow-on investment.
- Business development of the invested company is restricted by synergies with the core business of the CVC's parent company, thus narrowing the scope for growth.
- Employees of the parent company who do not necessarily have specialized skills are assigned to the CVC through personnel transfers. There is no personnel to carry out the minimum necessary functions.
- The parent company's focus is on synergies with the parent company's core business and other non-economic returns, making it difficult to accumulate know-how as a professional investor.
- The result is a repetition of small investments and exits with no accumulation of know-how.
In the next post, I'll write more about how VCs evaluate companies and make decisions.