I have attended a number of seminars and programs for entrepreneurs aspiring to raise venture capital. As much as these programs cover the basics of approaching a VC, such as preparing a pitch or financial models, I have yet to encounter a topic covering the inner-workings of the industry. As much as good VCs understand and appreciate entrepreneurship, good entrepreneurs should understand and appreciate venture capital.
To that end, I recently read “The Business of Venture Capital” written by Mahendra Ramsinghani. The book is loosely divided into three sections and covers the formation and mechanics of a fund, sourcing and closing of investments, and exits. Although I had a fair understanding of the latter two, the first section of the book was extremely helpful in explaining the tricky dynamics between a firm and its limited partners (i.e. investors). I would strongly recommend the book to every entrepreneur and I believe that it should be required reading in advance of any VC pitch. For those tight-on-time, I have listed the key takeaways that I found insightful:
(i) VC money is a “drop in the bucket” – most entrepreneurs know that venture capitalists source their funds from large endowments, pension plans and family offices. What is lesser known is that the amounts allocated to venture capital from these institutions is typically a very small fraction of their portfolio. The book provides a great analogy in that, if an ocean were to represent the total of invested capital, venture capital would be the size of a bucket.
(ii) VC = 10 x Entrepreneur – as difficult as it is for an entrepreneur to secure an investment from a VC, it is significantly more difficult for VC to raise funds from a limited partner. Whereas an entrepreneur might ask for $1 mil to $10 mil from a VC accompanied by evidence of traction, a set of milestones and an allowance of oversight, a VC might ask a limited partner for $10 – $100 million with little direction as to how they specifically intend to deploy the funds. This entails an entirely different level of trust.
(iii) One percent – as evidence of their commitment, VCs are routinely expected to contribute at least 1% to a fund. Although this might seem small, a $200 million fund managed by four general partners requires an investment of $500,000 each! This is well beyond what most entrepreneurs raise as part of family & friends round.
(iv) 80/20 rule – as a rule of thumb, the majority of capital is raised by the top VC firms, with “zombie firms” on the outside-looking-in. Investors are much more trusting of consistent performers than emerging managers, so everyone is scrambling to prove that they are or will be in the top-quartile. Limited partners are not particularly forgiving of failed VCs. Generally, two failed funds and you’re done! A strong relationship between a VC and its limited partners is a key to longevity.
(v) Paradox of success – most founders envision guiding their start-ups from inception to exit, with few realizing that one of the largest impediments to doing so is VC investment. It is not uncommon for VCs and CEOs to disagree as to the direction of the business, with most disagreements settled in the favour of the VC.
(vi) Good VCs have “it” – I believe that good VCs are able to appraise new businesses, technologies and markets well beyond the capacity of others, as well as coach entrepreneurs to capitalize on opportunities. However, the path to acquire those skills is far from defined. Some argue that successful serial entrepreneurs make the best venture capitalists, in that it takes-one-to-know-one. But, as the book notes, whereas entrepreneurship involves working with one technology at one time, VCs must have a macro understanding of all technologies within their portfolio. Also, it can be difficult for an entrepreneur accustomed to being an operator to transition to a VC expected to serve as a mentor or guide. Alternatively, the path of getting an MBA or advanced degree from a prestigious school, joining a VC firm, and then matriculating to partner is no guarantee of success either. Ultimately, good VCs just have “it”.
Having begun shortly after World War II, venture capital is still very young. As time progresses, the industry will evolve, mature and improve for the benefit of VCs, limited partners and entrepreneurs.