Scale up your mind: What is venture capital funding and how does it work?

You might have a startup or even a small business that has got off the ground. You might have the skills and experience, the team and enthusiasm to take it to the next level. But all that could come to nought if you don’t get your financing strategy right.

From the first spark of an idea to setting up a business and making it grow, at various points of the journey, an entrepreneur will consider venture capital funding for his startup to thrive, scale, and go farther, faster. But the process can be daunting for a newbie entrepreneur.

Whom to take money from, when to raise money, what should be the terms? Is the business fundable in the first place? There are many questions to answer, but if you tackle them before going off on a hunt for venture capital, you will save time and improve your chances.

There are thousands of venture capital funds out there now, looking for startups in Asia to fund. But most startups won’t even get a chance to make a pitch to a sought-after investor. Your best bet is to be as well prepared as you can be, and this how-to guide aims to get you started.

First things first: what is venture capital funding?

Pension funds, insurance companies, and wealthy individuals invest in real estate, stocks, and other assets. They allocate around 10 percent of their money into riskier investments with higher returns, a.k.a. startups. They channel those investments through venture capital funds, mostly.

Who runs the venture capital funds?

Ex-entrepreneurs, financial wizards, and the like set up venture capital funds. These general partners or GPs will decide on the size of the fund, where they want to invest it, and come up with an ‘offering memorandum’. Based on this, various investors will commit their money to the venture capital fund, and become limited partners or LPs in the fund, which the GPs will run.

How are the venture capital fund investments made and managed?

Once the money is committed from pension funds and other investors, and the fund is ‘closed’, the GPs will find investment opportunities, or ‘source deals’ as they say. They might look at 50 to 100 opportunities for each one they pick to fund in exchange for equity. GPs will also sit on the boards of directors of these companies to manage the investments.

How do the investors and fund managers make money?

Acquisition of a startup or its IPO (Initial Public Offering) is when the venture capital fund’s partners get their returns. A venture capital fund will be considered to be doing well if one-third of its portfolio companies provide its partners with such an ‘exit’. The usual time-frame for an exit is five to seven years, and the life of a fund is 10 years. The GPs take an annual management fee of two to three percent of the capital committed to the fund, for salaries and expenses. They also get a 20 to 30 percent share of the spoils from exits – usually after the LPs have got their capital back.

So the reward system is such that VCs need to find a few big winners, and find them quickly. “In a business like ours, you starve your losers and give more money to your winners. This is not about those 10 failures or 10 moderates out of the 18. This business is about those four or five companies who succeed and three of the moderates,” explains Parag Dhol, managing director of Inventus (India) Advisors.

What are the progressive stages of venture capital funding?

Venture capitalists or VCs will typically invest a third of the fund in the first three years. Depending on the VC’s preference, the money can be invested anywhere from the seed stage (or early stage) to the growth stage (series A and above). The remaining two-thirds of the fund will go into follow-on late stage rounds for portfolio companies which gain traction and can be positioned for an acquisition or IPO. The rest will more or less be left to their own devices. So a VC-funded startup basically has a three-year window to get going and scale up. The GPs need a few early winners, so that they can go back to the LPs to raise a second fund midway through the lifecycle of the first one. Two funds under management give GPs headroom.

Now that we have seen how venture capital works, we can take up what it takes for an entrepreneur to land venture capital funding. What are the 11 basic questions an entrepreneur needs to ask himself before taking that path? Read Part 2 of the article to find out.

See: How the smart startups get venture capital funding

Sources: The Nuts and Bolts of Business Plans – MIT, Blume Ventures, Kalaari Capital, Inventus Capital Advisors, iSPIRT