Having spent a day or two being part of the STEV team, I have come to realise that there were many key terms & terminologies that I’m not proficient within the VC industry. Further, if I am to expedite my learning process through the meetings that I’m attending, its for the best to get down into learning out what is important in the talks of the VC realm. As a result, I decided to get back to reading Venture Deals by Brad Feld & Jason Mendelson , a book that was rotting in my read list for quite some time. I actually did browse through it occasionally but most of the terminologies turned me off since on hindsight, I did not have exposure to such meetings that involved buzzwords, hence not allowing me to relate to the book pretty well. However, I have grown to develop better insights on the book and certain basic concepts that an entry level hire will need to understand, so let me do my best to put up a summary for the benefit of everyone! In this chapter of a multi-part series, I will be covering:
- How a Venture Capital fund works
- Capitalisation Table
Structure of a VC fund
Figure 1 shows a typical structure of how a VC operates. What we mainly see in light of many VC firms out there, play the role of a General Partner(GP). These are the individuals that make up the whole firm, where they conduct their fund raising, deal funnelling and all relevant due diligence that ends up in eventual investment management of the funds that they have raised.
On the flipside, Limited Partners(LP) comprises of the investors whom GPs have raised funds from. They comprise of a non-exhaustive list ranging from pension funds, bunds, institutional investors, ultra high net worth individuals/angels investors(UHNW), fund-of-funds and the list goes on. These LPs represent an ownership stake towards the VC fund, which in turn allows them to reap the fruits of the investment made and managed by the GPs. Collectively, they form a Limited Partnership — the birth of a fresh venture capital fund.
In more detail,
- Management of a limited partnership will lie on the onus of the GP, who also bears the brunt/liability of the company’s debt and obligations.
- The limited partnership does allow for additional LPs, whose liability is only limited to the amount of investment made in the company. This is what we see as the different LPs I have mentioned above that contribute to the fund-raising process conducted by the GP.
- The limited partners here generally have no voting power or control over the daily operations of the VC, but they do make their respective investments(indirectly) and are a valuable source of capital in a business structure.
In more layman words, I believe that we can view LPs as investors that pool sums of money to a fund manager which represents the GP here. The fund manager will conduct its own form of due diligence in undertaking specific investments be it in equities/fixed income/forex , so on and forth. In this context, it will be under the VC world.
Furthermore, we can see that in the grander scheme of things, the multiple GPs that are involved will form the larger management company, an overall bird’s eye view of the VC’s operations and everything else liable to the company (Figure 2). This is only of importance when the issue of “commitment/investment period” is involved. However, for simplicity sake of the layman, I feel that understanding of up to GP level and how its function is merged with the LPs is sufficient.
So… How do VCs make their money ?
To understand how VCs make their money and cash in that big boy money everyone ponders on, let’s break it down into tinier portions of information.
VCs primarily obtain their income from management fees, which is a fixed percentage of the total funds raised during a specific round(1.5–2.5%). These fees are typically taken annually and then paid out quarterly or semi-annually. For example, if the fund raised was $100 million with a management fee of 2%, the VC would receive $2 million in management fees! Although that sounds like a hefty sum, bulk of it is used to pay for staff expenses, daily operations, rent… and the list goes on. The nuance comes in when VCs typically raise money over multiple rounds, where they still obtain a percentage of the fund raised as management fees. Assuming that the first fund raised was $100 million and the second one being $200 million, with a 2% management fees, the VC has effectively earned $6 million in management fees :)
** It is to note that if the VC is prudent with its cash consumption, they are able to recycle the management fee as part of the fund in the early stage process, so as to optimise the use of their funds raised. For example, over the course of 10 years with a $100 million fund and averaging a 15% management fee, the VC can strategically be prudent with the $15 million and actively invest it in their portfolio of companies. Afterall, it is in the best interest of themselves to make the money work for them that has a possibility of compounding that dream unicorn of multiple returns.
Carry fees/interest are the fees that contribute to a substantial amount of the raw potential earnings of the VC. In other words, carried interest is the subsequent profit that the VC keeps after returning the base amount raised from the fund raising process. For example, if a VC were to raise $100 million and manages to provide a 5x return of $500 million, the first $100 million will go back to the LPs. The remaining $400 million will then be split between the VC and the LPs, with the percentages being dictated before hand. A rough ballpark figure that is common in the industry will be about 20%. As such, the VC firm receives $80 million with the LPs receiving the remaining $320 million and every stakeholder involved will be laughing their way to the bank to reap that sweet Lamborghini money, haha.
Understanding fund activity
VC fund agreements generally embodies two key concepts.
The first concept involves a commitment period which usually last a span of 5 years, which is the timeframe of the VC to identify and invest in new companies. Following which, the fund is only restricted to using the remaining fund to invest in their current portfolio of companies. This explains why we’ll always notice in news that different VCs have raised a new sizeable fund every few years — once they have exhausted the commitment period of their funding, they will require to raise a new fund to stay active as investors for another portfolio of different companies.
The second concept is known as the investment term, which is the length of time that the fund can remain active. New investments can be made only during the commitment period, but follow-on investments can be made subsuequently. This is just so that for example, if you invested in an early stage company that can only potentially seek for M&A/IPO exit in 7–10 years during the last year of the commitment period, you will still have sufficient time to look after a company and see through it till the end of its time. Beyond a standard duration of 12 years, a voting process will happen within LPs to decide if the fund should extend its investment term
A capitalisation table in general, summarises which stakeholder holds a specific percentage in the company before and after financing. Let us support this topic with a relevant example.
In this context, let us presume that James is the sole founder of a new floorball stick company — Innebandy. He employs the use of smart manufacturing and certain Industry 4.0 standards that allows for mass customisation of floorball sticks, something that the current market does not have. James has also reserved 20% of his company for employee stock options, which will be needed for ‘incentive purposes’ as he hires his first batch of talents. With 1million shares issued at his initial valuation of 10million (price per share of $10), he is left with 800,000 shares with employee pool of 200,000 shares.
Entering the Seed round….
As his business idea comes into fruition, he starts hiring his staff and building his start-up, along with requiring extra cash to manage the company’s future burn rate so as to achieve the end goal of being the next market leader in the floorball stick market. He has decided that he will require to raise $5 million in his seed round funding, and starts to pitch to different investor about his company.
Golden Ventures and Seed Ventures have taken an interest to lay a stake in his business. Both have agreed to provide $2.5 million each, although with a different criteria/condition. Golden Ventures will invest the $2.5 million at a 20% discount in the next Series A funding at pre-money valuation, while Seed Ventures will invest the $2.5 million at a $15 million valuation cap on the next pre-money valuation. Money will be wired in to James’ bank account and everyone is happy with the settlement. However, the valuation does not change as of now since the convertible note introduced here will only convert to equity at the next funding round.
Onward to Series A…
The funding has allowed James to created a full profitable company and he starts selling his customisable sticks. He receives loads of traction and his sticks are now widely used by the floorball community. He now requires an additional set of funding that will help him to scale his business to the next level. He now requires another $10 million in cash for creating a new production plant and selling his products globally. With that, Triple Ventures, KinseyMc Capital and Boston Capital have indicated interest to be part of the Series A funding.
- Triple Ventures will lead the Series A round with a $5 million investment
- KinseyMc Capital will follow the round with a $3 million investment
- Boston Capital will end the round with a $2 million investment
This sum of investment will be made through a post-money valuation of $25 million, also meaning that the pre-money valuation will be $15 million. With Series A funding done, we’ll need to issue out equity stakes to all of the stakeholders now.
To recap, Golden Ventures has invested $2.5 million at a 20% discount in the next funding series. With a $15 million pre-money valuation, the Series A share price is $15/share. With a 20% discount, Golden Ventures is able to capture the purchase of share price at $12/share. Along with a $2.5 million total sum, 2,500,000/12 = 208,333 shares will be issued. At its new valuation , the value of Golden Venture’s shares will be at 208,333*15 = $3,124,995.
Seed Ventures has invested $2.5 million too but at a $15 million valuation cap pre-money valuation. This means that Seed Ventures will purchase the shares on its valuation cap, which will be 15,000,000/1,000,000 (total value/number of shares outstanding) at $15/share. Seed Ventures will then purchase 2,500,000/15 = 166,667 shares. The value of Seed Venture’s shares will be at $2.5 million.
For the remaining Series A investors, we do the simple division of their investment made against the price per share valued currently, which will amount to the total shares issues to them.
With that, the final table at post-money valuation can be tabulated as below (Table 2).
We can notice that subsequently, the final valuation is different from the intended post-money valuation as decided at Series A. This is largely due to the action of the convertible note provided during the seed round.
Lastly, we can identify that the 80% stake that James has initially owned eventually diluted to 39%. Although it can seem scary, it is nevertheless better to have a small stake in a highly valued business than to own a company that is valued peanuts. Nevertheless, if James’ venture were to take off and reap that 10x returns, all of the stakeholders involved will be laughing their way to the bank :)
With that, I conclude the current crash course of Venture funding and capitalisation. Stay tuned to the next part of the series!