Venture capital investing has become prominent with the emergence of startups in the tech industry. Start-ups who demonstrate they have the technology and capacity to drive innovation typically raise funding from venture capital investors to scale the operations of their startups. This funding is usually in form of equity with conditional terms. Venture capital investors may exit these investments when new equity investors buy them out at a later stage in the company’s life cycle or when the company lists publicly on a stock exchange.
Venture Capital Funds
Given its structure, VC investing is pricey and high risk. Most startups do not survive their first 5 years of existence, and this exposes venture capital investors to a lot of risk. One of the ways investors mitigate this risk is to work with venture capital funds. Venture Capital (VC) funds pool funds from multiple qualified investors or institutions to invest in private equity stakes in startups or SMEs with high growth potential.
These VC funds are managed by fund managers who are familiar with how startups work. They do the hard work of reviewing pitch documents and shortlisting the startups to fund. Some VC funds get involved in the active management of the startups in their portfolio. They bring their wealth of experience to the table and guide startups in scaling their businesses by taking a board position or acting in an advisory capacity.
Venture capital funds invest based on an investment thesis. The investment thesis outlines what the fund considers in making investment decisions. Some VC funds are tailored to invest in specific types of startups. E.g., African- focused startups, women-led startups, startups operating in the blockchain sector etc.
How VC funds work
VC funds are managed by fund managers. These fund managers are called General Partners (GP). The general partner raises funds from qualified investors, invest based on the investment thesis and manage the other aspects of the fund. Investors in the fund are called Limited Partners (LP). These investors are usually high net worth individuals and institutional investors who are qualified to invest in a VC fund.
VC funds invest in startups with the general expectation that 80% of the start-ups they invest in might fail and 20% might return significant returns to cover for losses from the 80%. VC investing is long term and not so liquid. When Investors exit a VC funds, it is defined as a liquidity event. A liquidity event happens when a portfolio company is acquired or does an initial public offering (IPO) and gets listed on a stock exchange. The average investment period for most VC funds is 7 – 10 years after investing in the fund.
Funds from the exit are paid to LPs on a pro rata basis. Pro rata implies the LP had the opportunity to invest in more than one round of funding. Therefore, at exit, investors are paid based on their total equity from different rounds of funding.
Returns from VC investing are said to follow a power law distribution. This means a hit at the bull’s eye on one portfolio company can generate enough returns for the entire fund. VC funds ride on this by investing in multiple startups expecting that a few large exits will make the fund.
Data from AngelList (a U.S. website for startups, angel investors, and jobseekers looking to work at startups) shows venture backed early-stage startups have a 2.5% chance of becoming a unicorn. This highlights the risk that comes with venture capital investing. The high return potential however compensates for the risk VC investors take on.
There are different stages of VC investment. It ranges from Pre-Seed to Series D, the average amount raised at each stage of investment varies. A fund’s investment thesis will specify the financing round the VC fund prefers to participate in. While some VC funds prefer to invest large amounts in later financing rounds, other funds prefer to invest in small amounts in early-stage startups.
Who can invest in a VC fund?
Venture capital investing is specifically for accredited or qualified investors. While it is not clear what the guidelines are for accredited investors or qualified investors in Nigeria, an accredited investor in the US must satisfy the following criteria:
- Individual or joint net worth in excess of $1M (not including the value of a primary residence)
- Individual income in excess of $200k or joint income in excess of $300k for the two most recent years, with a reasonable expectation of reaching this level in the current year; or
- Individual holding a Series 7, 62, or 65 license (i.e., financial securities licenses).
- When a group of investors do not meet these criteria, they form a syndicate to invest in the fund. To guarantee the credibility of these syndicates, investors can introduce trustees to the transaction to hold the investment in a trust or act as custodians of the fund.
What are the key things to consider before I invest in a VC fund?
Investing in a VC fund is a better approach to VC investing than being an angel investor who invests in start-ups directly as it spreads the risk of investing across multiple startups. A VC fund is also likely to have stringent requirements for short-listing the start-up or SMEs they consider for investment. This will improve the likelihood of investing in companies that end up being successful.
In making a decision on which VC fund(s) to work with, do an independent assessment on the profile of the general partner i.e., the fund manager. Assess the fund manager’s profile for experience and qualifications. Ask for the VC fund’s track record, the companies they have invested in, an analysis on the performance of these companies and a performance report on the all the funds the fund manager has created or managed. You should also make enquiries about how the VC fund makes investment decisions, who the other LPs in the fund are. Asking the right questions help.
Don’t get carried away with the publicized jaw-dropping returns reported by VC funds. A lot of VC funds also earn wild losses. This notwithstanding, VC investing plays a vital role in the growth of startups and the economy at large. They provide the funds needed to fund the infrastructure/technology businesses require to grow. Your goal is to build a good understanding of how VC investing works and make a decision on if it works with your current or long-term investment goals.