DFN: Insights into the VC process and mindset.
101 on How VC Industry Works
November 16th, 2009 by Pavan Krishnamurthy, Partner at Ojas Venture Partners
Many first time entrepreneurs may not fully understand how a venture capital fund works and consequently may not fully relate to how VC’s function. This post makes an attempt to provide a generic overview of how a VC fund functions and what it implies for entrepreneurs.
To start with, it would help to understand similarities between VC’s and entrepreneurs. Just as entrepreneurs go through the cycles of opportunity, business plan, fund raising and eventual exit through IPO or M&A, VC’s also follow a similar cycle. VC’s identify the opportunity space in which they want to play and then develop a business plan. The business plan would broadly cover capital deployment strategies, time-frame for investing/exit, types of opportunities that would be considered for investing as well as target returns at the fund level. With this business plan, VC’s approach a set of qualified investors for raising the required funds for starting the VC fund. This fund raising effort is an intense and time consuming effort and closure can take anywhere from 12 months to 24 months depending on the size of the fund, team, past track record, nature of opportunities etc. Just as VC’s perform due diligence on the opportunities, prospective investors who are considering investing into the VC fund also perform detailed diligence on VC’s.
In VC jargon, investors who contribute to the capital of VC fund are called “Limited Partners”(LP’s) and people who raise money and then invest in start-ups are called “ General Partners” ( GP’s). Typically LP’s are high net worth individuals, family offices, pension funds etc and contribute 99% of the fund corpus while GP’s contribute 1% of the fund corpus. Investment into the VC fund by LP’s is generally based on a contribution agreement (Similar to shareholders agreement). This agreement broadly lays down the roles of the parties, governance and other requirements related to investments.
don-corleone and the VC industry
At this stage, it would be good to understand how VC’s make money. General Partners/VC firms receive their compensation in two forms. First they receive an annual management fee that ranges from 2 % to 3% of the fund size for their operating expenses such as salaries, office space etc. Secondly, the GP’s receive a share of profits from the investments made by the fund ranging from 20 % to 30%. However in most cases, GP’s receive their profit share only after repaying the entire fund corpus along with a hurdle rate to their investors. In most fund structures, annual management fee starts declining after year 4 or 5 and if GP’s have not succeeded in raising their second fund by that time, they will not be getting any management fees in subsequent years to support their ongoing expenses. Just as there is a concept of vesting of stocks for founders, GP’s are also subject to a vesting schedule with respect to their profit sharing %. Generally speaking, VC’s raise another fund by the time they are in year 4 and the ability of the VC’s to raise another fund would largely depend on the performance of their investments from the first fund or previous fund.
As a generic model, VC’s assume 3 years as investment horizon during which they will source deals and invest and next 4 years for developing their investments and positioning them for an exit. Through selection of right investments, VC’s hope to generate superior risk adjusted returns typically in excess of 30% at the aggregate fund level. In order to meet the target return expectations, VC’s would have to naturally consider only those opportunities that appear to have high growth and scale potential.
As can seen from above, generic structure of the VC funds and the mandate on which they have been raised impacts how VC’s approach their investment. As entrepreneurs, VC’s need to maximize the value creation and therefore would naturally be biased towards those opportunities that have the potential of rapid growth/scale and exit. Because of these parameters, in many cases, VC’s may turn down investing opportunities which otherwise are profitable but may not rapidly scale from an exit perspective.
At this stage, it would be good talk about two key points of risk and scale. While the general perception about VC’s being providers of pure risk capital is correct, one should realize that VC’s risk taking is always in the context of risk, efforts and reward equation. Unless the potential outcomes are large enough, VC’s are unlikely to support any idea stage opportunities and would rather wait to see business developing traction before they could consider the same seriously. This is very similar to what an entrepreneur would do in his own business. Scarce capital or resources is always allocated to those projects or efforts that have a higher probability of success.
Scale of the opportunity is another issue that is often difficult to qualify apriori. One useful approach to scale would be to consider it from an exit perspective. Assuming that the exit event is primarily in the form of an IPO, what would qualify as a good exit candidate? Typically, a good IPO candidate is expected to have a market cap between 200 crores to 300 crores at the time of IPO . Depending on the nature of business, this could translate into revenues of anywhere from 75 Crores to 150 crores at the time of going for an IPO. With this as the background context, the scale question reduces to the ability of the business to hit revenues of atleast 75 Crores in 5 to 7 years time-frame from inception with reasonable capital infusion. If a business does not have the potential to grow into this size, then it may not be a good candidate for VC investing (technology or IP based exits are of different kind and their valuation may not be based solely on revenues. Different metrics would apply to those cases)
To sum-up, it is important to keep in mind that VC’s are also entrepreneurs with a clear mandate to multiply money and create wealth. In order to achieve this, they take calculated risks within the contours of their business plan/mandate and therefore would consider only those opportunities that fit in with their requirements.