Introduction to Venture Capital
By: Chelsea Braithwaite, Brian Li, and Wallis Toscarelli
Venture capital firms are an essential part of start-ups and emerging markets, but they can be hard to understand. We are Rocket Fuel Ventures, a collective group of students teaching and learning about VCs. Here, we dive into what a VC is and how they function.
What is Venture Capital?
Venture capital provides financing to start-ups, early-stage, and emerging companies. Essentially, VCs make money by helping new companies grow. Funding comes from angel investors, VC funds, and investment banks (IBs), among other places. VC investments are risky, by nature, because of high uncertainty (90% of start-ups fail). As of late, the most popular start-up industries are IT, Biotech, and clean energy, and some popular VC firms include a16z, Bessemer, Sequoia, Accel, and NEA.
It is important to note the differences between venture capital and private equity (PE).
VCs work throughout the life cycle of a company, up to a liquidity event, and they are very involved in the operational structure. PE firms invest in companies that are mature and already formed, lowering the risk.
What is the Process of Getting Funded and How do VCs Monetize?
VCs offer overall strategy and execution to the business. They have dedicated teams to bring to the company to fuel growth and promote future partnerships, networking, and infrastructure.
So you have an idea for a start-up. What are your next steps? First, create a list of targets of what funds may be a fit. Reach out to VC firms and your network to pitch your idea and gauge interest. Then, set up meetings to further explain your business and what you bring to the table. Next, VCs will send you term sheets! Once the deal is done, you will get to work and learn due diligence.
Above is a table showing the timeline and details of VC funding. It shows what type of investments and for how much you should have at each stage of your start-up from the initial idea until the success of your company.
It’s great that VC firms can help start-ups grow and make a profit, but how do VCs make money themselves? VCs make money through fees like management fees and carried interest. Management fees are generally about 2% of the capital that is held under management, and carried interest is about 20–25% of the profits. It becomes a higher range with a higher tier. VCs also make money by cashing out, however, they need the portfolio of each one of the funds making an exit. This means that the company is being acquired or will get an initial public offering (IPO) where investors are able to sell their position. Exits generally take 5 to 7 years and VCs aim to sell their positions within 8 to 10 years.
Terminology to Know!
There is a lot of terminology to grasp when evaluating and researching companies or reading articles.
Pre-Money Valuation — the value placed on a start-up before an investment round. Serves as a key point of negotiation between founders and investors.
Post-Money Valuation — the value of a start-up after the investment round. Investment Amount + Pre-Money Valuation = Post-Money Valuation
Founder Dilution — the amount of ownership given up by the startup founders, as a percentage.
Investor Dilution — existing investors can also be required to withstand a reduction of ownership, especially in later rounds of funding.
Raise/Round — the process and stage of raising capital.
Priced Round — agreeing with investors on the valuation; the company price per share can be quantified, thus “pricing the company”.
Down Round — when founders accept an equity investment valuation at a lower valuation than was previously established.
Seed Round — any investment used to start the company and create the first products and services.
Series A, Series B, etc. — Series A is the first Venture Capital level investment round, Series B is the second, etc.
Equity — the ownership of the start-up; who owns how much.
