How Venture Capital Works

On a typical day, venture capital firms invest close to half a billion dollars in U.S.-based startups, according to TechCrunch. And while most of the 35 checks signed on that hypothetical day are for late-stage investments and contain many zeros and commas, more and more money is being funneled toward new, bootstrapping projects. According to the National Venture Capital Association, if the current pace holds up, venture capitalists will fund $14 billion in angel and seed rounds in 2021. That might be minuscule in Silicon Valley terms, but it'll certainly move a few garage-based operations into a WeWorks somewhere. 

So it naturally follows that every founder who knows somebody who can do a PowerPoint deck wants to chase that money. So let’s deconstruct the process of how VCs find money and decide whom to dole it out to. 

Follow the money 

It might help if we started with a flow chart, then filled in the blanks. 

Caption: The venture capital process. Credit:  Jonno Southam, Amazon Web Services

It all starts with the venture capitalists themselves. They are the general partners; that is, they are the ones whose day job it is to keep this wheel turning. The investors are limited partners, meaning that they strictly invest money in the VCs' funds as financial backers. 

Still, the relationship is a little more complicated than "Shut up and take my money!" VCs establish different funds for different sets of opportunities, usually by geography, industry, stage of development, or any combination of the three. 

So who are these deep-pocketed limited partners? Generally speaking, they are either institutional investors or wealthy individuals. Still, this is something of a moving target. 

 "[A] noteworthy trend is the increasing number of deals with nontraditional VC investors, such as mutual funds, hedge funds, corporate investors, and crossover investors," according to the most recent PitchBook-NVCA Venture Monitor. "Pronounced nontraditional investor (NTI) participation in VC deals is a relatively new phenomenon that took flight in 2018 when deals with NTI participation broke $100 billion for the first time, nearly double the previous high of $59.1 billion in 2015 and the first of four consecutive years with such high levels of participation." 

We should also note that some firms don’t have to fundraise at all. They’re the in-house VC operations of major corporations looking for strategic opportunities to acqui-hire innovative teams. According to CB Insights, Google, Salesforce, and Intel are among the most prominent players in this space. 

The larger independent VC shops are becoming almost as widely recognized: Bessemer Venture, Kleiner Perkins, Sequoia Capital - there are a whole bunch. 

Find the talent 

The next step in VC operations is evaluation and investment. VC firms don't typically find projects to fund; the projects come to the VCs. The trick is to determine which of the thousands of prospects are the most likely to profit for the firm (more on that in a minute). But this is where the magic happens. Yes, there are empirical metrics that guide VCs at this point, but earnings projections are not what VC analysts look at first. Much of the selection process has more to do with the individual unicorn hunter's knowledge and experience. "Hunch" is not a word that is in vogue. Still, it is fair to say that these decisions are primarily based on confidence in the startup's management team. This is often a reflection of the founders' talent, experience, adaptability, and, not inconsequentially, passion. 

The general partner then offers successful candidates a term sheet outlining valuation, investor rights, voting rights, board seats, option pool, liquidation preferences, and other vital points which need to be accepted by the entrepreneur. 

VCs studiously avoid buying the whole startup company, or even half of it. In almost all cases, a significant minority stake is acquired. The general partners can't overrule the management team, which, presumably, still has majority control, but neither can the VCs be ignored. And if founders want to get through the next gate of funding - and take in more money than they just did - they're well advised to achieve the goals that the VC firm set for them. 

We should also note that the general partners know they won't make money on 10 out of 10 ventures they fund. They're happy with one or two out of 10. But they presume that those founders who didn't quite make it into the next round of funding might still have the requisite talent, experience, adaptability, and passion, so they might be more amenable to adding those entrepreneurs' next pitches to their list of portfolio companies. 

Cash out 

It's good advice always to start a project with the end in mind, and VC is based entirely on that premise. 

Even before they enter, VCs look for the exits. They want to know that they will get at least 10x their money back. They're less picky about whether that comes from an IPO, from a purchase by a corporation looking to make a strategic acquisition, or from a private equity firm that holds stakes in more mature companies than VCs typically do. 

 The goal is to distribute the gains to the limited partners. The general partners then charge management fees and performance fees. Traditionally the "2-and-20 rule" entitles the general partner to an annual 2% of the total value of a fund's portfolio companies plus 20% of all profits from investing. Again, all venture capitalists know that most of what they invest in will end up as dry wells, but gushers are frequent enough to keep the game in play. 

Be prepared 

All this raises the question: How does an entrepreneur attract VC attention and grab that check? 

 There's no one answer to that, but UpCounsel - it's TaskRabbit for lawyers - offers these suggestions, abbreviated here: 

• Set your business up as a Delaware C-corporation; VCs won’t even look at an LLC. 
• Patent your intellectual property. 
• Build a team of advisors. The proper names attached to your project can add a great deal of credibility and make all the difference when the analysts are considering your project. 
• Have these documents ready to share a pitch deck, which you’ve also boiled down to an elevator pitch, as well as a business plan, which you’ve also boiled down to an executive summary. Oh, and don’t bring a non-disclosure agreement to a pitch meeting. It’s off-putting. 
• Be prepared for due diligence. Just because you haven't told the VC firm something doesn't mean that someone there doesn't want to know it. While you're at it, you should perform some due diligence on whoever is willing to give you money. 

• Most importantly - as far as we're concerned, at least - don't rush into a VC agreement. You might be able to raise all the money you need and maintain far more independence by going to friends and family first, then to crowdfunding sites, then possibly angel investors.