VC 101: How, What & Why VCs Do What They Do
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by Andrew Russ, Startup & Venture Capital Business Development, AWS
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VC 101: How, What & Why VCs Do What They Do
- 1. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved VC 101: How, What & Why VCs Do What They Do (and the key things you should know as a Founder) Drew Russ, Startup & Venture Capital, Business Development
- 2. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved About Me
- 3. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved What We are Going to Discuss: • Venture Capital: The Definition, The Theory • Venture Capital Mechanics: Fund Structure, Time as a Factor, How VCs Make Money, Roles and Responsibilities and Deal Sourcing • Venture Capital: The Deal and the Bargain • The Other Flavors of Venture Capital and Corporate VC • A Glimpse of VC 201 • Thanks!
- 4. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved What is Venture Capital: The Definition HigherRiskLowerRisk Lower Return Higher Return Money Market Funds Corporate Bonds Large cap Equities Hedge Fund Private Equity Investing in a restaurant Venture Capital Inherit it • Venture Capital is a form of Private Equity • For private ventures that cannot raise traditional financing (e.g. bank loan, capital markets) • High risk, with potential for a high return in a relatively short timeframe • Non-majority ownership
- 5. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved What is Venture Capital: The Theory I’ve said many times on this blog that our target batting average is “1/3, 1/3, 1/3” which means that we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments. - Fred Wilson, Union Square Ventures
- 6. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved What is Venture Capital: The Theory contd. “Venture capital is not even a home run business. It’s a grand slam business” - Bill Gurley, Founder of Benchmark Capital
- 7. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved Venture Capital Mechanics: Fund Structure Management Company General Partner 1, LLC General Partner 2, LLC I II Fund I, LP Fund II, LP LPs LPs Portfolio Companies Portfolio Companies
- 8. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved Venture Capital Mechanics: Time is a Factor Commitment Period • Typically 5 years • Length of time for Identifying and investing in new companies • Allocate reserves to each investment that can be used in “follow on” rounds • This is why VCs raise a new fund every 3-5 years Investment Period • The length of time a fund can remain active • Typically 10 years (“a 10 year fund”) • Extensions are allowed, but limited • Management of investments goes beyond period, secondary sales occur
- 9. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved Venture Capital Mechanics: How VCs Make Money Management Fees • Typically between 1.5% and 2.5% annually of funds managed • Paid quarterly and independent of investment success • Pays the salaries and “keeps the lights on” • This fee begins to decrease after the end of the “commitment period” Carried Interest • The share of the profit that a VC keeps after returning all capital to LPs • Achieving “carry” is a fund-wide hurdle, but not all members of a firm have equal share • Partners who perform well, can not achieve carry due to poor performance of fund overall
- 10. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved Venture Capital Mechanics: Roles & Responsibilities • Analysts • Associates • Sr. Associates/Principals • Managing Directors / General Partners • Other: EIRs, Venture Partners, Operating Partners…
- 11. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved Venture Capital Mechanics: Sourcing to The Wire
- 12. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved Venture Capital & Time: Why VCs invest at Different Stages Early Stage • Founder focused • Ideation risk and product market/fit • Will own more of the company • Smaller investmetns with potential for higher multiples Mid Stage • “Traditional” VC • Team focused • Traction and scaling risk (sales and marketing) • Its about “pouring gas on the fire” Late Stage • Exit risk • How big can the Market become • IPO windows and acquisition potential • Mix of VCs, PE, Public investors (mutual funds)
- 13. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved A glimpse of VC 201: The Term Sheet and Cap Table Premoney The Valuation of a business prior to any additional investment of capital Postmoney The valuation of the business PLUS additional capital invested after the close of a round of financing
- 14. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved Venture Capital: The Bargain INFLUENCE VCs rarely want control when company is performing against plan LIQUIDATION PREFERENCE Investors typically have rights to get their money out first DILUTION At exit, founders and management will typically own 10-20%
- 15. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved What is Venture Capital: The (other) Flavors of VC • Today we are talking about independent, institutional Venture Capital Investors • But there are other types of investors that a startup founder may encounter: Angel Investors AcceleratorsIncubators Corporate VCs
- 16. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved What is Venture Capital: A bit more on Corporate VCs • Leverage existing businesses • Inspire new products • Access new technology • Identify new markets • (Be cool; extend the brand) Why Challenges • Direct investment • Indirect investment • Incubation / Acceleration How • Fluctuating internal support • Shorter sighted • Slower decision making • Varying value-add • Conflicts of interest Corporate Strategic Non-Strategic
- 17. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved Other Reading Books • Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist • Term Sheets & Valuations: A line by line look at the Intricacies of Term Sheets and Valuations • Blogs & Books Blogs & Newsletters • Dan Primack’s Term Sheet • Mark Suster’s Both Sides of the Table • CB Insights • Product Hunt • The Creator’s Code by Amy Wilkinson Tweets • @awsstartups • @firstround – solid early stage fund, platform • @karaswisher– Re/Code, breaks a lot of news • @benedictevans – A16Z, data hound
- 18. © 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved© 2016, Amazon Web Services, Inc. or its Affiliates. All rights reserved aws.amazon.com/activate Thanks!
Editor's Notes
- Been with AWS for three years on the Startup and Venture Capital BD team I partner with top tier VC firms and their portfolio companies to help them build, scale and optimize their businesses Prior to AWS, I was a Principal at Triangle Peak Partners 2009-2013, a multi-stage investment fund based in Palo Alto. Was involved in over 40 equity transactions ranging from Seed to late stage Prior to that I worked in equity research and selection at US. Turst, a subsidiary of Bank of America I am also an advisor to multiple early stage companies
- Professional investors. They get paid to invest. Subset of PE Not all businesses are right for VC. You should always consider other options first depending on your business, your growth plans and your ultimate goals for your business. Can get more into the pros and cons of taking VC dollars later VCs are willing to invest in private businesses with massive growth potential because of the outsized returns that are possible. High Risk, High Growth, High Reward Unlike most PE investments, VC almost never takes a majority (>50%) ownership stake. Typically, a VC will own 15-25% of a company when they initially invest (and more on this later, too).
- MOST STARTUP FAIL The 1/3, 1/3, 1/3 rule Venture Capital is a portfolio of distributed, probalistic outcomes This the broad generalization But what Fred does not go into too much here is the importance, and rarity, of the “bulk of returns” he mentions! Its all about your one or two big winners!
- The reality is most startups fail: most data-based reports this at around 90% of startups Venture investing is a “Grand Slam” model – hits are nice to have, home runs are good, and grand slams keep everyone coming back for more!” Good funds identify focus on home runs. Great funds find the grand slams within the home run hitters and invest heavily.
- There are three basic entities that make up the Fund: the Management Company, the Limited Partnership and the General Partnership Management company is usually owned by the senior partners of the Fund and is the legal entity that employs all the people at the VC Firm. While a VC firm is continuously raising new funds, the Management company remains a constant. And Next is the Limited Partnership. This is the actual Fund, with subsequent funds refered to as Fund I, Fund II, Fund III and so on…when a VC says they have raised “a $300mm fund”, this is the vehicle they are referring to. This is the vehicle that Limited Partners – or investors in the fund – provide capital. The final entity is the General Partnership – and is the legal entity that serves as the General Partner in the Partnership. It is typically also an investor in the Limited Partnership. Realize this can be confusing – the main takeaway is that there is a separation between the management company (or the Franchise) and the actual fund that that Franchise raises from Limited Partners. It is important to understand the basic mechanics as they can impact the motivations of VCs, particularly when it comes to General Partners leaving or joining the Franchise. Lastly, most VC funds raise “draw down” funds. So when a VC announces that they have raised “a $300mm fund”, its not that the capital is just sitting in a bank somewhere. Instead, the receive commitments from their investors (LPs) and when they are looking to make an investment, they request the funds from these investors. This is called a “capital call”. I also highlight this because it highlights something that many founders can forget, which is that VCs also have to fundraise. VCs raise money from a variety of resoruces: Pension Funds, Corporations, banks, other professional institutional investors, high net worth individuals, charitable orgs, and insurance companies.
- Commitment period: After end of commitment period, fund can no longer invest in new companies This is the period of time where VCs invest, and then spend the remaining portion of the fund life supporting companies with capital reserves and managing to an EXIT Investment Period is the total life of the Fund. It is the period of time that LPs have signed up for to provide capital calls. Extensions to investment periods are allowed, but are limited (typically up to two additional years)
- Carried interest: Not everyone has carry at a firm, with the senior partners having the vast majority. Example: $100MM fund that returns 3x its capital, or $300mm. The LPs keep the first $100mm in capital returned. Then after that, each additional dollar of profit is split 80/20 between the LP investors and the 20% to the General Partners (The VC). In this scenario, the GP would make $40mm in carried interest.
- Analysts: are generally very smart people with limited power and responsibility. Bottom of the ladder. Usually recent grads from college, and generally do a lot of the important work that no one else wants to do or has the time to do. Basically cruncing numbers and writing memos. Associates: Are typically not deal partners, but rather support one or more deal partners, usually a GP or Managing Director. They have a wide variety of responsibilities including scouting new deals, helping with due diligence, writing internal investment memos. Principles/Sr. Associates: The next generation of Managing Directors. They are junior deal partners. They typically have some limited deal responsibility, but also often require support from a managing director, often not able to make the final decision. This is usually left to the Investment Committee, comprised of GPs and Managing Directors. Managing Directors/GPs: The most senior people in the firm. These folks are the leaders of the firm, approve all investments and sit on the boards of companies. Other: EIRs are experienced entreprenuers who support VC dealflow while also incubating or working on developing a new company. Other: Venture Parnters have a part time relationship with VC firms, who can sponsor deals but need the support of a managing partner to get a deal done. Sometimes they are paid on a deal by deal basis. But not always. One Last note: most VC General Partners and Principals are not generalists, but have areas that they focus on. Such as Security or infrastructure or SaaS. It is important to know the responsibility and area of focus of each member of the firm.
- VCs look at 1000s of deals per year They will invest in somewhere between 1-4% of the opportunities that they review “deal flow” comes from a variety of soruces: inbound, outbound and sourcing Not all VCs are the same in this regard: Some only invest in Entreprenurs they know or in only seasoned enterpreneurs Some will only look at deals that are referred to them by other VCs Some don’t have any restrictions Your first point of contact is important If an Assocaite connects with you, understand it is there job to scour the world for deals and they will likely have little pull in the ultimate decision. Also, your first meeting will likely not include a MD or GP YOU Will go through many calls, meetings, emails and then more meetings. Deal review process ultimately follows these stages: Deal Log Identify best opportunities and include in Deal Pipeline that will be reviewed in the “Monday meeting” If early meetings go well, ultimately will meet with a company with Managing Director who will sponsor deal, or the whole Investment Committee There is still a large chance, they don’t move forward after this final step Still have to undergo customer calls, deep diligence and of course the capitalization table and term sheet negotiation (see VC 201)
- Premoney is the valuation of your business that is found through an agreement between the founder and the investor Valuation is defined as the economic value of your business or asset and is used to calculate the value of each owners share in the enterprise. Post money is the valuation – or the economic value, assets minus liablities and anicpated growth of the business – plus the additional capital (an asset). This distinction is important because of dilution, as well as other factors such as the option pool (covered in VC 201). For example, a $4mm premoney business that receives a $1mm equity investment, is 20% dilutive to the founders.
- Control – minority investors; board members; advisors Liquidation Preference: LIFO, Last money in and first money out! Understand the cap table and the preference stack Dilution: 20% for one VC at the start will winnow to a smaller perctentage by end of various rounds of funding, and management ends with 10-20 percent You also are raising capital from a group that has very specific goals: to return a significant return on capital in a short timeframe. That is what you are signing up for. High growth and an exit that makes everyone a lot of money.
- Angel investors invest early, very often the first round of financing. Typically, an angel may be investing in the founder, rather than the business, given this early stage. But Angel investing has changed quite a bit over the last few years, and now are more similar to VCs in the way they may assess deals. They own common stock and tend to be very entrepreneur friendly – acting as an advisor as much as a provider of captial startup accelerators, are fixed-term, cohort-based programs, that include mentorship and educational components and culminate in a public pitch event or demo day. Incubators With mentorship periods often lasting more than a year and a half, incubators focus less on quick growth and have no specific goal in mind for your company other than to become successful at the right pace. In fact, the goal of some incubators may be to prepare your company for an accelerator program. Incubators take little to no equity in your company, and can afford to because they do not provide upfront capital like accelerators. Some take equity and some don’t. The latter generally funded by Grants. Corporate VC
- Two types: Strategic and non-strategic (but all have an element of strategic investment) Corporate VCs can be valuable partners, but come with unique challenges Such as an inefficient decision making process, potential conflict of interest, and varying internal support Examples include Qualcomm, Samsung, Google Ventures and many others You should consider a thorough benefits analysis before moving down this path…can have huge benefits but potential challenges