Venture Capital is a form of private equity financing, along with additional benefits, that investors provide to early-stage startups that have the potential for immense growth.
Venture Capitalists (VCs) usually invest $X for Y% equity, also known as ownership of the company. As the company grows and its valuation increases, the $X invested becomes several times the initial amount, and the VCs make an exit!
Companies tend to raise multiple rounds of funding over an interval as they grow and meet certain milestones.
Some basic terms:
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Pre-money valuation: The current valuation of the company without any external funding or the latest round of investment.
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Post-money valuation: The valuation of the company after it receives funding.
Post-money valuation = Pre-money valuation + funding received -
Dilution: The percentage of ownership of each shareholder (founders + current investors) will decrease as the company goes for future rounds of funding.
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Capitalization Table: A capitalization table or cap table is a table providing an analysis of a company’s percentages of ownership, equity dilution, and value of equity in each round of investment by founders, investors, and other owners.
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General Partner: A GP at a VC firm is responsible for investment decisions, fundraising, portfolio management, etc.
How Does Venture Capital Work?
Now, imagine that you’re a general partner at Los Pollos Hermanos (LPH) Fund, a VC firm that invests in early-stage startups. You decide to invest $2 million for a 10% equity stake in Grey Matter Tech (GMT), raising their seed round to build a device that can establish non-verbal communication through a network using EEG signals.
GMT’s post-money valuation now becomes $2 million / 10% = $20 million.
GMT’s pre-money valuation = $20 million - $2 million = $18 million.
The cap table for the seed round would be:
| Shares | % | Value | |
|---|---|---|---|
| Founder 1 | 450,000 | 45% | $9,000,000 |
| Founder 2 | 450,000 | 45% | $9,000,000 |
| LPH Fund | 100,000 | 10% | $2,000,000 |
| Total | 1,000,000 | 100% | $20,000,000 |
With the seed fund, GMT has developed a portable prototype that enables users to control their smart home devices with their minds, making it a trending news worldwide. They now aim to expand production for mass manufacturing and have decided to raise Series A funding from Madrigal Capital.
Madrigal Capital invests $30 million at a 15% equity stake.
This means that GMT’s post-money valuation is now $200 million ($30 million / 15%), and
GMT’s pre-money valuation is now $170 million ($200 million - $30 million).
This also means that your share, as well as the founders’ share, will be diluted by 15%
Let’s look at the cap table,
| Shares | % | Value | |
|---|---|---|---|
| Founder 1 | 315,000 | 38.25% | $76,500,000 |
| Founder 2 | 315,000 | 38.25% | $76,500,000 |
| LPH Fund | 70,000 | 8.5% | $17,000,000 |
| Madrigal Capital | 300,000 | 15% | $30,000,000 |
| Total | 1,000,000 | 100% | $200,000,000 |
Now, even though your shares got diluted, the value of your entire share has seen an 8.5x increase!
Similarly, if GMT goes for another round of funding, the value of your shares through LPH fund will see a greater rise as the valuation of Grey Matter Tech increases further!
How do VC firms make money?
Every VC has an exit strategy to cash out their shares. If GMT gets acquired by a big tech company, then the big tech company has to buy the shares of the shareholders so that the company owns the majority of the shares. If the company puts a valuation of $2 billion for GMT, then LPH fund’s share value increases to $170 million - an 85x increase from your initial investment of $2 million.
Other exit strategies include secondary purchase, where you sell your shares to another investor, and Initial Public Offering!
Now, if GMT failed to achieve product-market fit or had failed to raise Series A, GMT would have had to liquidate or shut down, and you would never have received any returns. This is why VC firms have a diverse portfolio of companies so that even if not all companies reach a good valuation, the investment in one or two great companies can provide major returns.
Where do VC firms get the money to invest?
Now you must have wondered how you, as a General Partner at Los Pollos Hermanos Fund, even got $2 million to invest in the first place. No, no, it’s not the blue stuff.
A VC firm also has an equally important stakeholder, the Limited Partners (LP). LPs are the ones who provide capital to the VC fund in the hope of returns. GPs reach out to LPs in their networks and raise funds for the VC firm. GPs then proceed to invest in companies, and once they make returns, it’s usually split 80/20 between LPs and the firm.