How does Venture Capital Work?
Venture capital (VC) is a type of private equity financing that is provided to startup companies with high growth potential. VC firms raise money from institutional investors, high-net-worth individuals, and family offices, and invest that money into promising startups in exchange for equity in the company. In this blog post, we’ll explore how venture capital works, including finding and sourcing deals, the different types of funding rounds, the value-add that investors offer, liquidity dynamics, and exit strategies.
Finding and sourcing deals
VC firms have a team of investors who are responsible for sourcing and evaluating investment opportunities. They may receive pitches from entrepreneurs directly or through referrals from other investors, lawyers, or business advisors. VC firms also attend startup events and conferences to meet with founders and learn about emerging trends.
Once a potential investment opportunity is identified, the VC firm will conduct due diligence on the company to evaluate its market potential, technology, team, and financials. This process can take several weeks to several months and may involve multiple meetings with the company’s management team.
The difference between a priced round, SAFE, and note
VC firms typically invest in startups through a variety of funding instruments, including priced rounds, Simple Agreements for Future Equity (SAFEs), and convertible notes.
A priced round is a traditional equity financing where the VC firm purchases a specific number of shares in the company at a set price. This price is determined through negotiations between the company and the VC firm and reflects the company’s valuation at the time of the investment.
A SAFE is a financing instrument that allows the investor to receive equity in the company at a future date, typically when the company raises its next round of funding. The terms of the investment are negotiated upfront, and the investor receives a discount on the future price of the shares.
A convertible note is a debt instrument that can be converted into equity in the company at a later date, typically when the company raises its next round of funding. Convertible notes typically have a lower interest rate than traditional debt instruments and include a conversion rate that is determined based on the valuation of the company at the time of the conversion.
The value-add investors offer
VC firms offer more than just capital to their portfolio companies. They provide strategic guidance, industry expertise, and access to their network of contacts to help the company grow and succeed. VC firms may also help the company recruit key employees and executives, provide operational support, and assist with fundraising efforts.
The dynamics of liquidity and how VCs make money at an exit
VC firms typically invest in startups with the expectation of achieving a significant return on their investment within a 5–10 year timeframe. This return is realized through an exit event, such as an acquisition or initial public offering (IPO), where the VC firm sells its equity stake in the company.
When a company is acquired, the acquirer pays a price for the company that includes the value of the equity held by the VC firm. The VC firm receives a portion of the proceeds from the acquisition proportional to its equity stake in the company.
In an IPO, the company goes public and issues shares to the public markets. The VC firm can sell its equity stake in the company on the open market, realizing a return on its investment.
The stats on exits via M&A vs IPO
According to PitchBook data, the majority of VC-backed exits are through acquisitions rather than IPOs. In 2021, there were 2,625 VC-backed exits globally, with 2,179 (83%) being acquisitions and 446 (17%) being IPOs.
Acquisitions tend to be a faster and more certain way for VC firms to achieve liquidity compared to IPOs, which can be a more lengthy and uncertain process. However, IPOs can provide a much more significant upside.
