Basics of venture capital

venture capital

What is venture capital?

Entrepreneurs are the lifeblood of fledgling companies. But when the company needs to scale, and scale quickly, significant financing can be required, often beyond what any one individual would be willing to risk. Growth capital at the very early stages of high risk, high growth-potential companies, is frequently provided by venture capital (VC), a type of private financial capital. At this stage of the company, startups are unable to acquire loans from banks because of a lack of cashflow and/or product. Venture capital fills the funding void between early stage seed funding, and product reaching the market place. 

What do they do?

Venture capitalists (also commonly bearing the acronym VCs) invest money into companies that they selectively handpick through an arduous process (often seemingly more arduous to the entrepreneur) as “due diligence”. The reality is that a typical VC receives more than 500 business plans each year (often each Partner in a VC individually triages that number of business plans), and then through a quick screen, followed by a second filter, narrows it down to 20 or so that undergoes further diligence. This funneling process can seem brutal, but often not without reason – VCs typically have a mandate for their fund, and the portfolio of companies may have to fit well in their investment strategy, which may be stage dependent (e.g., Series A and earlier only), or type of life science company (e.g., only medtech). Each investment has to be approved by the VC’s internal Investment Committee.

The pool of investible money comes from their Limited Partners, who often contribute 99% of the value of the fund. That means that VCs themselves have to go through a fundraising cycle, much like entrepreneurs do, to raise the fund, before they have the capital to invest in their portfolio companies. The financing is largely from large funds such as insurance funds, endowments, foundations, public pensions, and large family offices as well.

Once they invest in the companies, they often take control of the company by owning a significant chunk of equity, and sit on boards to steer the company’s growth and direction. At the earliest stage of the company, a hands-on VC may even be an interim CEO.

Because VCs are accountable for someone else's money, they have to eventually return the capital to their Limited Partners, often within a fixed period, known as the fund cycle (around 10 years, often longer if biotech-focused). Although an “exit” at the peak of valuation would ideally align interest of the entrepreneurs and the VC, the compounding factors of fund-cycle timing could lead to the VCs making the decision to look for a liquidity event before valuation peaks. Such liquidity events can come in many forms. A larger company (either big pharma, or a larger competitor) acquires the company, or the company goes public and issues an Initial Public Offering. Once the money comes back to the VC, they first return the initial investment to their Limited Partners. Thereafter, they usually take 20% of the profits (following the 2&20 rule of private equity, where frequently 2% of the initial investment goes towards management fees and 20% of the carried interest, profit which is known as “carry”, goes to the VC firm).

Should you consider VC?

Good VCs are usually value-added and bring more than just capital. They bring with them a wealth of experience and contacts, both of which can be instrumental in helping a fledgling company succeed. Some corporate VCs have product development, or sales and distribution channels that the company could leverage. Hence, the term «smart money» has been coined to reflect the advantages of accepting capital from these investors.

However, there is no one-size-fits-all. VC funding is not for every company. VCs like to invest in home runs and large ideas that promise immense returns. A company that has a business model that focuses on organic growth through reinvesting of profits, and does not require the scale that VC funds may provide, may not necessarily require VC investments. Remember that VCs will often take away control of your company, in return for the expertise and contacts they can provide, as well as the appetite for risk – the question to ask is always, “is this worth it”?

This article is the first in a series on Venture Capital. Click here to read the second article on the VC method for valuation of an early stage company.

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