Welcome to my newsletter, Venture Capital & Alii! Today, I’m back to give you a quick and simple introduction to Venture Capital. It’s a very broad world, and I’ve tried to cover the main elements you need to know. This is based on my personal experience and perspective. I won’t be going into too much detail to keep it accessible for everyone, and I might miss a few elements — feel free to reach out if you need any additional information.
Venture Capital?
What is Venture Capital (VC)? Venture Capital is a branch of Private Equity. By extension, PE is defined as the investment of private capital in non-publicly traded companies. VC follows the same logic.
The principle of VC is simple:
Invest in innovative young companies with high growth potential,
Take minority stakes in these companies,
Achieve a return on investment through an "exit": selling the shares held by the fund.
VC has its origins in the United States. It was pioneered by French General Georges Doriot right after World War II. He is considered the first Venture Capitalist. He founded the American Research and Development Corporation (ARD), the very first VC firm in the world.
“We are a movement, not just a company. A commercial bank lends only on the strength of past successes and proven assets. I want money to do things that have never been done before.” — Georges Doriot
This fund invested $70,000 in DEC, which was later valued at $355 million during its initial public offering (IPO), resulting in an exceptional return on investment. As a side note, Doriot was a distinguished professor at Harvard Business School and one of the founders of INSEAD.
What is the organization of a VC fund?
How is a VC fund structured? An investment fund is a vehicle that offers its subscribers, the Limited Partners (LPs), a return on investment, typically around three times the initial investment, as this type of investment is considered risky.
There are several types of funds:
Traditional venture capital funds: Alven Capital, Idinvest, Partech, Daphni, Ventech, Isai Gestion, XAnge, Iris Capital, among the largest French and European funds.
The largest European Venture Capital funds in 2017 - Source: CB Insights
Funds with a single independent investor: these operate as personal holding companies, such as Kima Ventures, the personal fund of Xavier Niel, founder of Free, and Aglaé Ventures, the fund of the Arnault family, owners of the LVMH group;
Funds that bring together several "small" independent investors known as Business Angels: these primarily form networks united by common beliefs, geographic location, or specific sectors, such as Paris Business Angels, Femmes Business Angels, and Bretagne Sud Angels;
Corporate investment funds, known as Corporate Venture: Orange Ventures, Engie New Ventures, Axa Venture Partners, Arkéa Capital;
And other alternative models such as incubators, excubators, or startup studios that invest in and provide operational support to early-stage companies: The Family in France, eFounders in France and Belgium, and Rocket Internet in Germany are among the most well-known in France.
Funds also differ based on the "size" of the startup. There are seed funds, early-stage funds, Series A, Series B, etc., that invest amounts proportionate to the size of the startup. We will discuss the different sizes and funding stages of startups later.
Typology of a VC Investment Fund
We will focus here on traditional funds. Typically, the Limited Partners (LPs) are banks (Amundi, Crédit Agricole, HSBC, etc.) or corporates (Orange, Engie, Axa, etc.) that provide money to the funds, which will invest this capital in several startups.
Given the high level of risk, these funds have a relatively short duration to allow time for the companies to grow and for the funds to sell their stakes. This duration varies depending on the fund's investment thesis (i.e., the preferred sectors of the fund) but generally ranges from 4 to 5 years.
How are the revenues of a fund distributed? They are divided between "management fees" for the fund managers, known as General Partners (GPs), and "variable revenues."
Management fees correspond to the fund's management expenses: salaries, travel costs, rent, etc. They typically amount to about 2% per year of the funds raised by the fund.
On the other hand, variable revenues include carried interest. This is the incentive paid to GPs if the LPs achieve a minimum internal rate of return (Hurdle Rate). The GP team receives 20% of the generated profits.
The team of a VC fund typically consists of partners, principals, associates, and analysts (often interns and rarely full-time). Unlike pure finance, the team is made up of diverse profiles with relatively different backgrounds. It is not uncommon to find individuals with experience in entrepreneurship, startup operations, or entrepreneurial or technological finance.
The fundraising phase for a startup, from the perspective of a fund
On the startup side, raising funds from VCs is an important step in the company's development. You can see this with Google, Facebook, or Meero and Blablacar; raising funds helps create jobs, generate R&D, and ultimately, potentially create the conditions for going public.
Between the moment a startup seeks to raise funds and the moment it secures them, several steps occur within the fund, which I will briefly outline here.
First, there is a deal flow, a stream of proposals that the fund receives each week, and this deal flow is reduced by at least half.
An important rule in VC is the 100/10/1 rule: for 100 proposals reviewed, only 10 will be selected as potentially profitable, and only 1 will be accepted and receive funding.
A preliminary selection is made, leading to an initial meeting. From there, a more thorough analysis takes place.
Essential Investment Criteria
But it is also necessary to meet the investment criteria! A VC fund will mainly look at several elements that we can break down into four groups:
Team
Market
Product
And finally, everything related to Metrics: ratios, business models, key figures, in order to link them to potential exit opportunities and the Equity Story.
The Team - High-Caliber Profiles with Complementary Skills
The team is the fundamental element in any startup. The founders (I say "the" because it is quite difficult to go it alone) must agree with each other, complement each other (a manager, a tech engineer, a developer, etc.), and have an academic background close to exceptional.
You may find it surprising, but we are in a logic of entrepreneurial elite here: entrepreneurs come from the best business/engineering schools and have had prestigious careers in finance, strategy consulting, or unicorn-level startups.
The Market - Having an "Addressable" Market
Of course, having a market for a company means meeting demand and delivering an appropriate offer. Be careful, it is essential to see an untapped market opportunity within an existing market.
The Product - The Most Important Element
Next comes the product, which "fits" with the market. It doesn't necessarily have to be fully developed but should allow for a business model that is expected to generate revenue for the company.
The Metrics - Measuring the Company’s Potential with Numbers
Finally, the metrics will depend on the maturity of the startup and its business model: revenue, growth ratios, etc.
For example, if I want to invest in a "SaaS" (Software As A Service) startup, I will look at certain key criteria: its recurring revenue, customer acquisition cost, and the "lifetime" of that customer with the company.
We also want to understand the Equity Story and comprehend the company's history, the vision for quantifiable goals, and the ambition of the leaders to successfully execute the company’s long-term strategy.
I mentioned exit opportunities earlier as well: acquisition by a French company? European? American or Chinese? This is a topic that fascinates me greatly and relates to valuation questions, but we will have the opportunity to delve into it a bit later in another article.
The Art of negotiating before closing
After this analysis, the fund knows within 2 or 3 meetings if it wants to proceed further. In this case, it can call upon a strategic expert to confirm its choice, for example. This is followed by the negotiation phase: what amount to allocate for the startup and what percentage of the company will be ceded?
These negotiations are then formalized in a Term Sheet. This is a document signed between the investor and the company in which the investor presents the main terms under which the proposed investment could be made.
After the final financial checks, the shareholders' agreement comes next. This is very important. This contract protects common interests, facilitates the resolution of future disputes, and allows for agreements on certain points, such as the future sale of their shares.
Once all of this is in place, the capital increase takes place in the following weeks, and the contract is signed: the VC fund is now part of the startup's capital!
Thank you for reading this article! What specific topics in VC or regarding software would you be interested in? Feel free to share your feedback 🌐 and give a ❤️ if you enjoyed it!