How a Venture Capital Firm Works
A venture capital firm is usually run by a handful of partners who have raised a large sum of money from a group of limited partners (LPs) to invest on their behalf. The LPs are typically large institutions, like a State Teachers Retirement System or a university who are using the services of the VC to help generate big returns on their money.
The partners then have a window of 7 – 10 years with which to make those investments, and more importantly, generate a big return. Creating a big return in such a short span of time means that VCs must invest in deals that have a giant outcome. These big outcomes not only provide great returns to the fund, they also help cover the losses of the high number of failures that high risk investing attracts.
A Small Number of Investments
Although VCs have large sums of money, they typically invest that capital in a relatively small number of deals. It’s not uncommon for a VC with $100 million of capital to manage less than 30 investments in the entire lifetime of their fund. The reason for this is that once each investment is made, the partners must personally manage that investment for up to 10 years. While money is often plentiful, the VCs time is very limited.
With such a small number of investments to make, VCs tend to be very selective in the type of deals they do, typically placing just a few bets each year. Regardless, they still may see thousands of entrepreneurs in a given year, making the probability that an entrepreneur will be the lucky recipient of a big check pretty small.
The most common check written by a venture capital firm is around $5 million and is considered a “Series A” investment. It’s relatively uncommon for these checks to be the first capital into a startup. Most startups begin with finding money from friends and family, then angel investors, and then a venture capital firm.
Depending on the size of the firm, VCs will write checks as little as $250,000 and as much as $100 million. The smaller checks are typically the domain of angel investors, so VCs will only go into smaller sums when they feel there is a compelling reason to get in early at a startup company.
Venture capitalists also tend to migrate toward certain industries or trends that are more likely to yield a big return. That’s why you see so much venture capital and angel investment activity around technology companies, because they have the potential to be a huge win.
Conversely, other types of industries may yield great businesses, but not giant returns. A landscaping business, for example, may be wildly successful and profitable, but it’s not likely to generate the massive return on investment that a VC needs to make its fund work.
The other reason VCs tend to invest in a few industries is because that is where their domain expertise is the strongest. It would be difficult for anyone to make a multi-million dollar decision on a restaurant if all they have ever known were microchips! When it comes to big dollar investing, VCs tend to go with what they know.
Big Bets, Big Returns
VCs know that for every 20 investments they make, only 1 will likely be a huge win. A win for a VC is either one of two outcomes – the company they invested in goes public or is sold for a large amount.
VCs need these big returns because the other 19 investments they make may be a total loss. The problem of course is that the VCs have no idea which of the 20 investments will be a home run, so they have to bet on companies that all have the potential to be the next Google.
Unlike a bank that takes all interested customers, VCs tend to be far more selective in who they take pitches from. Often these relationships are based on other professionals in their network, such as angel investors who have made smaller investments in the company at an early stage, or entrepreneurs whom they may have funded in the past.
VCs will expect entrepreneurs to be very buttoned up. They are writing big checks to a small number of companies, so they have the luxury of only investing in the well-prepared businesses.
While some VCs will in fact take pitches from an unsolicited source, your best bet by far is going to be finding an introduction through a credible resource. The VCs are the big leagues, so you’ll want to make sure you do everything to make the most of your time in front of them.
Venture capital is hard to come by, make no mistake. The few that are chosen are often picked out of thousands of potential candidates, and even those initial candidates likely faced some sort of screening to get their chance to pitch.
Most companies that have yet to create much traction are not ready to begin talking to venture capital firms just yet and are more ideally suited to talk to smaller sources of capital that would come from an angel investor or similar source.