What is Venture Capital and why should you consider it?

What is Venture Capital and why should you consider it?

Firstly I’d like to thank FoundersCatalyst for the opportunity to write this guest blog post for FindVC.co.uk. I realise that this topic might be slightly premature for early stage founders, nevertheless I believe this short blog will give prospective founders a succinct overview on just what venture capital is and how it could possibly help you in the future.

Venture Capital just keeps on getting bigger. The UK venture capital scene raised £11.6bn in 2020! Just look at the consistent growth of deal activity since 2010:

In this blog post, I will cover:

1. What a venture capital firm does
2. What level of returns venture capital funds generate
3. The types of start-ups that are suitable for venture capital
4. Why you should care

Fundamentally venture capital is an asset class. When it comes to venture capital, instead of investing in established publicly traded firms like Coca Cola, venture capitalists invest in small private companies with very high growth potential. Standard investment sizes range from £500k-£5m (but they can get a lot bigger).

What do Venture Capitalists do?

Each venture capital firm is slightly different, but they all conduct the same four fundamental activities:

1) Sourcing high growth start-ups

Venture Capital investors spend a lot of time building networks within their preferred investment sectors. This often includes attending sector focused investment events, networking with new founders and building their credibility through PR events.

2) Screening Potential Deals

Once a Venture Capitalist has access to deal flow (investment opportunities) they dedicate substantial time and resources identifying which opportunities they might want to invest in.

Often different VCs will invest alongside each other (to reduce their exposure to any one single investment), as such they need to comb through not only their own deal flow, but deals referred to them by other venture capitalists.

3) Investing

For a venture capitalist that makes 10 investments per year it is standard for them to screen upwards of 1,000 investment opportunities. Of these 1,000 opportunities, a VC firm might choose to interview 100 founders. From these 100 initial meetings, a VC fund needs to win 10 investment deals. To do this, they might need to compete on 25+ deals, as competition in the industry is high.

Once a founder has agreed to take VC investment, deals can take anywhere from 3 weeks to 3 months to be negotiated and finalised. To learn more about the most terrifying term sheet clauses used by venture capitalists today click here.

4) Assisting Portfolio Companies

The last fundamental activity a venture capitalist conducts is assisting their investments. This includes attending the quarterly board meetings of their portfolio companies (investments) and answering founders when they ask for advice. A venture capital investor is more likely to have been exposed to the problems that come with running very high growth startup than first time founders.

Whether it be building a team that can handle 150% sustained annual growth or making strategic marketing decisions, seasoned venture capitalists have seen numerous founders before you successfully/unsuccessfully handle very similar problems.

This experience is often invaluable, as such foresight can help a founder prepare for events that alone they would not have anticipated.

What returns do VCs generate?

The average 5 year performance of UK venture capital firms in 2019 was 20.1%. For comparison, during the same time period the FTSE 500 had an average performance of 7.5%.

On face value this looks like an incredible performance. However, the devil is in the detail. Professional investors are taught to compare the performance of different assets using a theory called ‘the risk adjusted return on capital’.

This model helps investors compare the performance of assets in different risk classes i.e. venture capital (very risky) vs a heavily diversified portfolio of shares (much less risk).

The risk adjusted return on capital model highlights how the riskier an asset class, the greater the returns it generates needs to be. In contrast, very low risk assets i.e. the FTSE 500 generate a much lower rate of return. Fundamentally the model believes that investors need to be fairly compensated for taking on different levels of risk.

Professional investors spend all their time trying to identify investment opportunities where the risk adjusted return on capital is out of balance. Good investment opportunities are ones where the level of return exceed the level of risk of an asset.

Consequently, most professional investors do not think that the 12.6% gain generated by venture capital (over the FTSE 500) is an adequate return to justify the increased level of risk that is synonymous with venture capital.

If that made little sense, simply remember this last paragraph. Venture Capital is very risky, and consequently it needs to generate a high level of return for its investors. This translates directly into what types of firms VCs choose to invest in.

What types of start-ups are suitable for venture capital?

The benchmark performance of a UK VC fund is 21% annual growth. As such, you could be forgiven for thinking that a VC fund needs to invest in startups that offer this type of return.

However, it is not quite as simple as choosing opportunities that offer this level of growth. Data released by Andreessen Horowitz, one of the best VC investors of all time shows how uneven the distribution of returns are for a VC fund:

Their data shows how 60% of the total returns to their funds come from just 6% of total deals made.

Bear in mind, that these are world class venture capital investors with years of experience and a very high quality deal flow. Despite this, just 6% of deals perform how they were expected to when the VC made their initial investment.

As such, most venture capitalists invest in high growth startups that hold the potential for a VC investor to make at least 5x their money in 10 years (or 50% annual growth). They do this to compensate for the high rate of failure they expect to have with their investment decisions.

Looking at the Andreessen Horowitz data, you can see how reliant the industry is on outliers, with just 6% of all deals made by Andreessen Horowitz contributing 60% of all value made by their fund.

To be attractive to a venture capital investor your company needs to hold the potential to become one of their star performers aka an outlier.

We have all heard of the successful startups that made it, from Facebook (where Peter Thiel invested $500k for 10% equity, worth around $77bn today) to Airbnb (Sequoia invested $585k in 2009, for shares worth +$12bn today).

Understandably, much less publicity is given to the failed startups that VCs invested in. Despite the high failure rate in venture capital, the size of the winners in this industry is so large that everyone believes they will one day be able to find a similar level of success in one of their portfolio companies.

Why you should care

Venture capital is a very unique form of capital for a high growth firms. It typically comes in after an angel investment round, when the sum of money required to reach the next set of strategic objectives exceeds what you can raise from angel investors (circa £500k).

If you are a founder who knows that they need to capture a lot of market share whilst there aren’t many competitors around (like Facebook did) or, even better, you face such high demand that without raising external capital you simply cannot reach customers who are crying out for your product/service, then venture capital could be a perfect solution.

Once a founder has raised all they can from friends and family, they have limited options. Banks deem them to be too risky to lend to. Hence why there is a direct need for venture capital.

To learn more about venture capital try reading some more of our blogs here.

If you take nothing else with you from this blog, please remember this: if you find yourself looking to raise venture capital DO NOT limit yourself.

I founded FindVC to help all founders find their ideal venture capital investors. Too many founders fail to raise venture capital, as they simply don’t know about all the possible VC investors that invest in UK startups.

We want this to stop and have created the most comprehensive and up to date database of venture capital firms currently looking to invest in UK based startups. It will always be 100% free for founders.

Thank you for having me FounderCatalyst – it’s been great!