Understanding the Venture Capital Business Model: Risks and Rewards

Venture capital (VC) financing is a high-risk, high-reward investment model that fuels start-ups in their later stages. The VC business model is unique in its approach as it seeks to provide funds to start-ups after gaining some traction but before they are ready to go public or be acquired.

In this article, we will explain how a VC business model works, explore examples of successful and unsuccessful funds, and provide tips on how to do due diligence on VC funds and pick your fund. This article helps you gain financial skills for entrepreneurs! For more information, enrol in our Funding Readiness programme.
How Does a VC Business Model Work?
The VC model consists of two key players: General Partners (GPs) and Limited Partners (LPs).

The GPs are the individuals who run the VC fund, make investment decisions, and support portfolio companies. In exchange for their efforts, GPs receive 2% of the fund's capital for operations and 20% of the profits, subject to achieving the minimum rate of return required by the LPs, also known as the hurdle rate.

LPs are the investors who provide the capital for the fund. They invest in the fund and get priority over GPs to recoup the returns. LPs don't run the show, but they bankroll it, making their investment a crucial part of the VC model.

For example, suppose a VC fund has $100 million in capital, with 10% of the capital from the GP and 90% from LPs. In that case, the GP would receive $2 million for operations, and the hurdle rate could be set at 8%, meaning that the GP would only receive 20% of the profits above 8% returns.

VCs face a significant challenge in that 80% of start-ups fail. Therefore, to achieve a profitable overall fund performance, VCs need a few extraordinary winners to bring in 10x returns or more. These mega-successes are crucial for covering losses from failed investments, generating impressive returns for the LPs, attracting more capital for future funds, and maintaining the reputation of the GP.

Examples of Successful And Not-So-Successful Investments

For example, the Sequoia Capital fund invested $60 million in WhatsApp, which was later sold to Facebook for $19 billion, resulting in a return of 316x. Similarly, the SoftBank Vision Fund invested $2.5 billion in Flipkart, an Indian e-commerce company, which was later sold to Walmart for $16 billion, resulting in a return of 6.4x.

On the other hand, some VC funds have not been as successful. For example, the New Enterprise Associates (NEA) fund invested $100 million in Jawbone, a wearable technology company, which ultimately failed to deliver a return, resulting in a total loss for the fund.

Similarly, the Bloodhound Ventures fund invested $200 million in Theranos, a medical technology start-up, which later became embroiled in a scandal, leading to the fund's complete loss.

What Makes Successful Funds?

In addition to these examples, there have been many other successful and unsuccessful VC funds over the years. In general, successful funds tend to have a few key traits.

Firstly, they have a strong investment strategy, often focusing on a particular industry or stage of development. Secondly, they have a strong track record of selecting and supporting successful start-ups, often with a well-established network of connections in the business world. Finally, they tend to have a team of experienced GPs with a range of skills and expertise.

On the other hand, unsuccessful funds tend to lack one or more of these key traits. For example, they may have a weak investment strategy, may lack the necessary connections and expertise to support their portfolio companies, or may have inexperienced GPs leading the fund.

For start-ups, understanding the VC world is key. It is essential to find a VC that not only loves your idea but has a track record of guiding companies to successful exits. This guidance is crucial, as VCs provide not only funding but also expertise and connections to help start -ups grow and succeed.

How to Pick a VC Fund for Your Start-Up?

Start-ups must do their due diligence when choosing a VC fund to partner with, and it is recommended to research a fund's investment history, the experience of their GPs, and their connections within the industry. Additionally, it is essential to understand the terms of the investment, discuss a term sheet, and clarify the expectations of the GP before signing any agreements.

Due diligence is a crucial step for start-ups when choosing a VC fund to partner with. The process involves researching the fund's investment history, its General Partners' (GPs) experience, connections within the industry, and the terms of the investment.

Here are some steps that start-ups can follow when doing due diligence on a VC fund:

1.     Research the fund's investment history:
Start-ups should research the VC fund's investment history to gain insight into their investment strategy, the types of companies they have invested in, and their track record of success. This information can be found on the fund's website, social media accounts, or through online research.

2.     Assess the GPs' experience:
Start-ups should also assess the experience of the GPs in the fund. Look for individuals with a strong background in the industry or sector that your company operates in. Experienced GPs can provide valuable guidance and connections to help your start-up grow and succeed.

3.     Look for industry connections:
Connections within the industry can be a valuable asset for start-ups. Consider researching the fund's network to understand the connections they have within the industry, including connections with potential customers, partners, or acquirers.

4.     Evaluate the terms of the investment:
Start-ups should also evaluate the terms of the investment, including the equity stake the fund will receive and the investment cycle's timing. It is also essential to understand the fund's expectations regarding the exit timeline and the minimum rate of return required to receive the GP's share of the profits.

 In addition to these steps, it is also important to consider the timing of the fund's cycle. VC funds typically raise money in cycles, with a cycle typically lasting between 3 to 5 years. During this time, the fund will invest in new start-ups and support its portfolio companies. After the cycle ends, the fund will typically go through a liquidation process to return capital to the LPs.

Start-ups should consider the timing of the fund's cycle when deciding to partner with a VC fund. If a fund is close to the end of its cycle, it may not be the best option for a start-up, as the fund's attention may be focused on liquidation rather than supporting its portfolio companies.

While the VC model can be lucrative, it is not without its risks. As mentioned, 80% of start-ups fail, and VCs must be prepared for this possibility. VCs must also be prepared for the possibility of a company not performing as expected, which can lead to losses for the fund. In these situations, VCs must be proactive in their approach to managing the investment and ensuring that the company has the necessary support to turn things around.

Overall, the VC business model is a high-stakes game that requires a unique mix of financial expertise, business acumen, and the skills to spot the next big thing. While it is not without its challenges, the rewards for those who succeed can be astronomical. As such, it remains a critical driver of innovation and entrepreneurship in the modern business landscape.

In conclusion, the VC business model is a crucial source of funding for start-ups, providing them with the necessary funds to grow and succeed. The model's success relies on the strong partnerships between GPs and LPs, the identification of high-potential start-ups, and a well-executed investment strategy. Start-ups must do their due diligence when choosing a VC fund to partner with, while VCs must be prepared for the risks and challenges that come with investing in early-stage companies. Ultimately, the VC model thrives on calculated risks and backing companies with sky-high return potential, making it a critical driver of innovation and entrepreneurship in the modern business landscape.    

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