Investing in Venture Capital

By: Scott Sadler, CFA in Educational Content September 1, 2020

Investing in Venture Capital

Similar to private equity (PE), venture capital (VC) investments are both focused on taking ownership stakes in private companies. The difference between the two lies in where the target companies fall in their lifecycle.  Simply put, venture investments are made at an earlier stage of a company’s development.  Investors are attracted to this asset class for its potentially high financial returns and the hope of investing in the next Amazon or the next Facebook.  Venture capital, therefore, plays an important role in being catalysts for growth — bringing risk-tolerant capital to promising companies along their road to maturity.

Investors who wish to participate in early stage investing can, of course, invest directly in a private company that they discover in their city or town.  It is far more common, however, for investors to deploy their capital through a specialist – a venture capital fund that specializes in early stage investing. Such funds may focus on companies in an industry, or industries, where they have specific expertise.  Or they may focus on a particular stage of a company’s development.  In each case, the VC manager uses their expertise to narrow down a vast list of potential investments into a far smaller number of portfolio holdings that can deliver the growth (and returns) that investors expect.

Stages of Venture Investment

Private companies who seek external capital typically follow a well-defined process in order to attract the funding that they need.  The youngest companies initially seek funds from “friends and family”.  These investors may also be accompanied by what are termed angel investors – often wealthy individuals, or groups of investors, who are willing to take substantial risks on companies well in advance of profitability, or sometimes even in advance of revenue.  A relatively recent development called “crowdfunding” allows companies to raise capital online, or in vary small increments.

Professional venture capital funds tend to focus their attention on slightly more mature stages of a company’s investment process.  At the seed round, a company typically is generating revenue, but substantial risks remain regarding product, market size and how to scale up to address it.  At this stage, the focus is on the founder and their history of prior ventures. Funds that address this stage of development typically have far smaller position sizes, spreading the risk among far more ventures.  Such funds may also reserve capital for “follow on” (additional) investments in their most successful holdings.

After a successful seed round of financing, and with progress towards building the firm’s competitive position, a company may need capital in order to add capabilities, talent and resources that will permit it exploit the opportunities in front of it.  These successive capital raises are often referred to by letter – Series A, Series B, etc.  These stages are the core of where VC funds participate.  Substantial risks remain, however, and experienced fund managers often refer to the rule of “1/3, 1/3, 1/3”.  One third of their investments will fail.  One third will essentially break even.  And the best third will provide the bulk of their returns.

Late stage venture investing is characterized by companies preparing for an “exit” – either an initial public offering (IPO) or sale to a larger entity.  At this stage, risks are considerably lessened, and potential returns are commensurate with this lower level of uncertainty.  Many companies remain private, however, and still need additional capital.  And a venture firm might not have the capacity, or desire, to participate in later rounds. They may, instead, choose to sell their stake to a private equity firm who will provide additional “growth equity” to further accelerate the company’s growth.  At this stage, the line between VC and private equity become blurred, so it is up to each manager to define their target investment type in accordance with their management approach.

Expected Returns and Risk

As mentioned earlier, investors in venture capital funds generally do so for the for large financial return potential. According to Cambridge Associates, twenty-year returns for the US Venture Capital Index (through 9/30/19) exceeded the returns for the S&P500 by almost five percent per annum. More recent periods show a narrowing of that spread, but over most periods, VC appears to have delivered the returns that investors expect, giving the higher level of risk that they are taking.

Venture Fund Operations

Again, like private equity, venture capital funds are organized as a limited partnership where the fund’s managers are the general partner (GP) and investors are limited partners (LPs).  The GP will typically charge an annual management fee of 1-2% (to “keep the light on”) while they research acquisition candidates and oversee/engage portfolio companies.  They also earn a performance-based fee at the fund’s conclusion, earning a share of the profits (often 20% of them.)

The GP initially asks investors to make a binding capital commitment (i.e., the size of the investment the investor will ultimately have in the fund.)  Over the next two to three years, the managers will “call” capital from investors in periodic increments, the size of each driven by their success in finding attractive opportunities at valuation multiples that they deem reasonable.  Most VC funds have a stated life of ten years (often with the option to extend for a one or two more).

In the final three years of a fund’s expected life, the managers will be looking for an exit from their positions, knowing that their investors have granted them a finite, albeit lengthy, period to execute their strategy.

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