The term "venture capitalist" has been bannered across all media for years now, but most folks outside that cloistered sub-culture here in Silicon Valley know little about it.
The term “venture capitalist” has been bannered across all media for years now, but most folks outside that cloistered sub-culture here in Silicon Valley know little about it. So I sat down with Mike Kwatinetz, one of the founding partners of a “VC” firm called Azure Capital Partners, to shed some light on who they are and what they do. His insightful blog is “SoundBytes 2.”
To provide some context, the National Venture Capital Association (NVCA) claims VCs are responsible for 11% of all new private sector jobs nationally and that venture-backed firms account for an amazing 21% of the US’ gross domestic product.
As Mike explained, VCs are usually partnerships which seek out new high-risk business ideas to invest in. That is different from private equity partnerships that invest in established businesses in the hope of reorganizing them to a profit. Both have their origin in high-net-worth individuals who were very successful in their previous activities. And some partners come from MBAs who work their way up apprenticing.
VCs look for novel technology (Apple) or a new business model (Uber). They also look for an “impressive,” passionate team that is behind the new idea and have the horsepower to carry it to success.
These early ventures usually can’t get bank loans or issue debt instruments, so they turn to VCs. VCs will take on a project they assess has the high potential for success to balance the inherent high risk of starting from scratch. So they take an equity position, (percentage of ownership) often a big equity position, and they “nurture” the development along with advice, connections, and further funding, when required.
The very first money for such a project is called “seed” money, from under $1 million to perhaps $10 million. This is sometimes done by an “angel,” or high net worth individual. And recently, by the new model of “crowdfunding” through a website open to the public. This start-up stage uses the money to build a product and begin marketing.
The next stage is the so-called “Series A,” or funding for manufacturing and sales for the still-unprofitable sapling company. This is followed by the “second round,” which pours in working capital to maintain growth for the growing newbie.
Next is the expansion, or “mezzanine,” round of funding for the now newly profitable yearling. And lastly, the “bridge” round to finance the expensive process of going public and possibly exiting with the VCs’ and the founders’ early profits. Of course, there is heavy attrition at each step along the way. Only a small percentage make it to the IPO (Initial Public Offering) stage.
There are 2 things to keep in mind. Firstly, these successive rounds are often exponentially larger than the seed round and often are underwritten by a group, or syndicate, of VCs to mitigate risk. These new investors are networked usually from what might drily be called “the usual suspects.” Sand Hill Road in Menlo Park, CA, the epicenter of such goings on, can be quite incestuous. More of “them that has, gets” that I referred to last week plus the old “It’s not (only, in this case) what you know, it’s who you know….”
The second thing to keep in mind is the perhaps surprising context of 98% of start-ups not getting any funding at all. And of the 1,000 inquiries that Kwatinetz says Azure gets every year, they will only want to contact about 1/2, to end the year with perhaps only 5 investments. Overall, the NVCA says that only 600-800 start ups nationally will get funded in a given year by anyone.
And a majority of those will either fail or just struggle along. Many start-ups only intend to get enough notice from the big boys to be acquired for their patent(s), clients, or key employees. At a profit, of course, long before the start-up achieves the will’o’the wisp critical mass for independent long-term operation or a public offering of stock.
So, contrary to the headlines, there are relatively few home runs like Google and Facebook. And the VCs are looking to make at least 40% per year, therefore, on the minority of big hits to justify taking on the risks of even their groomed and fussed-over start-ups that end in failure or a dead end.
And some VC partnerships themselves do fail, such as during the recession, and they do have internal turnover. But just a cursory scan of the Forbes 400 wealthiest American billionaires will show why there is so much interest in venture capital.