So, That’s How Venture Capital Firms Work: VC Demystified

As a rising senior at the University of Southern California, many of my peers are interested in joining a startup when they graduate next year. For me, I’ve always been interested in venture capital, a key component fueling the startup boom. And, while the world of VC is anything but simple to navigate, I’ve been able to gain a deep understanding of venture capital and its inextricable link to the innovation economy throughout my time at USC and particularly during my internship with OpenView, a VC firm based in Boston. While understanding the in's and out's of venture capital might not seem essential, wrapping your head around the basics can be extremely helpful, especially if you plan to someday work at a startup that in all likelihood will at some point raise money from a VC firm.[bctt tweet="So, That's How Venture Capitalism Works, by @SahilKhosla14 @OpenViewLabs"]

For most startups, raising money from a venture capital firm is part of their long-term plan from day one. While some companies choose to "bootstrap it" and forgo traditional VC money, more often than not, young startups -- especially founders and CEOs -- will spend a huge amount of time raising money from venture capital firms. While VC funding is never and should never be the end-all-be-all for a startup, it can be a good indicator of potential and if spent wisely (mostly to build out a stellar team), venture funding can get a young startup to the next level.

These days, venture capital is flowing like never before. If you follow the tech scene, you know that startups regularly pull in millions and millions of dollars from venture capitals firms (and if you don’t, check out CrunchBase, CB Insights or Mattermark to get up to speed). While all this free flowing capital is definitely impressive, even experienced startup employees are often left wondering just who these VCs are and how and why they’re pouring money into tech startup after tech startup.

How venture capital works:

In the simplest terms, venture capital (VC) firms invest in private companies in exchange for equity (or part ownership of the business), but there are several characteristics that distinguish VCs from other kinds of investors.

First and foremost, VCs invest money to help businesses grow rapidly and their goal is to obtain the greatest possible financial return by eventually selling the company (think mergers and acquisitions) or holding an initial public offering (IPO).

But, VCs only invest in a company if they see a compelling opportunity. Good VCs will scrutinize and analyze factors including the strength of the company’s management team, how large and how attractive the market size is, whether the company possesses a unique technical advantage, the financial health of the business, why customers flock to the company’s product over others and many other criteria.[bctt tweet="Good VCs analyze the management team, market, finances, etc., says @SahilKhosla14 @OpenViewLabs"]

While on the surface most VC firms are pretty similar, there are a few things that can distinguish one VC from the next:

For starters, venture capital firms usually specialize in investing in certain stages in the life of a company.

For example, OpenView invests solely in expansion-stage companies—the time when a company has found their product-market fit, but needs that extra push a VC firm can provide to further scale and grow.

While OpenView is an expansion-stage VC, other VC firms invest at the seed, early, growth and late stages (expansion fits in right between early and growth-stage). Still other VCs are stage-agnostic and invest across the board, regardless of stage.

Second, some VCs are thematic, meaning they invest in a specific theme or area that guides their investment thesis.

OpenView invests in business-to-business software-as-a-service companies. While we invest across verticals, all of our portfolio members provide B2B SaaS products. Again, some VCs are agnostic and will invest in both business-to-business and business-to-consumer companies.

Third, VC firms invest money on behalf of others.

VCs raise multiple funds over the course of years from which they can invest. And the majority of capital for each fund comes from either institutional investors like endowments and pension funds or from wealthy individuals.

Fourth, VCs actively monitor, support and advise their portfolio companies.

VCs often take seats on the boards of the companies in which they invest. Doing so gives the VC a voice in the strategic direction of their portfolio companies. These days, some VC firms also offer portfolio companies support services like recruiting, marketing strategy, sales development, market research and more. These firms are called value-add VCs -- you may also hear the term ‘platform’ to describe a firm’s value-added services. OpenView is a huge proponent of this model and we work closely with our portfolio through OpenView Labs, the value-add arm of our firm, to support and grow our portfolio companies’ businesses.[bctt tweet="Four distinguishing features of VC firms from @SahilKhosla14 @OpenViewLabs"]

So, why would a startup raise money from a VC?

Startups use VC funding to invest in areas that will drive growth of the business. Usually, funding goes towards building out sales, marketing and engineering teams or initiatives. So, rather than dipping into revenue (which may be non-existent in the early stages of a company) or worrying about generating revenue just to stay afloat, investment from a VC can help startups cover current and future operating expenses. Therefore, startups can operate at a loss while they work to scale their businesses, make key hires and focus on building long-term sustainable and profitable companies. In other words, venture funding gives startups the runway they need to eventually go public, achieve profitability or be acquired by another company.

How do VCs make money before their portfolio companies exit?

There are two ways VCs make money. The first is a management fee, which is typically 2 to 2.5% of the capital commitments of the fund (as of final closing). The second way is called carried interest —once the firm exits out of an investment, it must repay its limited partners (the VC’s investors) and then any profits made from the exit are split 80:20 between the limited partners and the VC’s managing team. VCs typically look for 3 to 5x the investment they make in a company. Sometimes returns are much higher and sometimes companies miss the mark.[bctt tweet="VCs make money in 2 ways— management fees + carried interest @SahilKhosla14 @OpenViewLabs"]

Understanding venture capital in-depth is definitely not a requirement of working at a startup. But the more you know about how startups are funded, the better picture you’ll gain of the entire startup economy. And, it’s vitally important to remember that while VC funding can be a good vote of confidence that your startup is doing something right, it should never be the end goal.

Photo credit: Pictures of Money via Flickr cc