This article is part of a series on venture investments. You can find the first part of the series below:
Venture Capital is filled with more than a handful of buzzwords. For a start, you have to know what CAC, LTV, TAM, KPI, B2C, B2B, WoW, MoM, YoY, ROI, GMV, GTM, ARR, MRR, GP, LP, and a hundred others mean.
The plethora of buzzwords give people the impression that VC is an invite-only club and its activities are shrouded in mystery. This piece offers you a start by letting you in on key figures that run the show in venture capital.
General Partner (GP)
General partners play an active role in the VC outfit. The general partner usually bears unlimited liabilities of the VC outfit. The active status of the GP requires such partners to be proactive about sourcing funds from Limited Partners (LP).
Limited Partner (LP)
Unlike General Partners, LPs may play a passive role in the VC outfit. Limited Partners - whether an individual or institution - provide funds for VC firms. The LPs always have limited liability.
Board of Directors
If a Venture Capitalist is putting in an amount of Capital, they want a seat at the board to make decisions. Most times, it starts at priced financing rounds where it's a three-person seat board (founders, main investor, and independent seat). At larger rounds, the seats expand to accommodate more investors. This board of directors makes the CEOs accountable, and it enables protective provisions which allow the Board to oversee and manage things like capital and strategic hirings.
Technical terms in a VC Deal
- Right of First Refusal: It is around the terms of secondary shares. Investors aim at purchasing secondary shares of a company before it gets out to other individuals outside the company. Sometimes, there is a chain for the rights as it will include first the investors, then the funders, then angels and then, the external parties.
- Pro-rata means in-proportion: This minimises dilution. As new money comes into companies, founders get dilution of ownership. With pro-rata however, you have the right to keep investing at the new valuations to maintain your ownerships. Pro-rata is simply the rights of an investor, and it's at their discretion.
- Drag Along: Lead investors make vital decisions for the company. This term cuts downtime and is an avenue for multiple consultations between lead investors and angels. It means you drag all small cheque holders along when making decisions.
- Employee Stock Pool: It’s a simple way for employees to get the upside and an option stock pool when they join companies. Entrepreneurs prefer the model is created after the financing round, so you dilute the founders and investors, not just the founders.
Decision making process for VCs
The way investment decisions are made vary according to the VC. Some firms might have an investment committee in which they will have a majority voting process - maybe three to five partners - and majority votes make deals go through. Other firms are casual and believe in consensus. As long as no one objects, the deals will go through.
In corporate VC, there is general voting. However, one man makes the decisions.
When you raise a fund, you start by being strategic and deploying capital based on your thesis. In the middle, good opportunities that target outliers come up; but they don’t always go with your thesis. Towards the end of the fund, you are careful about your closing investments because they would primarily affect how you raise funds in future.
Major things GPs look for:
- Rights over investment decisions.
- Ability to make final decisions on agreed terms (carry, team set-up, and hiring)
Exciting deals that meet fund criteria are rare. These kind of deals give target ownership within target valuation and the prospects of a billion-dollar exit. Analysts, associates and principals immediately go to partners to get feedback because a VC firm is structured as a partnership. Deals are approved on a consensus. VC firms are always sourcing deals, and funds are as good as their deal flows. There always has to be a balance between convincing the partners and the founders. There is a term sheet, due-diligence stage, background and reference stage. Term sheets are usually a page or two. Deals are closed when money is wired.
In the VC space, many times, it's about optimising ownerships and getting the required ownerships in portfolio companies. It is a reciprocatory ring for co-investments. If you help an amazing company get funds, they will make up space for you in similar scenarios. Great companies are competitive; and there are more dollars looking to get into great companies than what the companies can absorb. Strategic investments from market leaders is another tussle for companies when choosing board seats. Companies don't want to give strategic investors sit on boards because they have access to the diversity of information from competitors, and with them, there is high internal information evaporating.
Founders lookout for strategic principals and associates to place on board. The best entrepreneurs look for the best person to sit on boards and work with them long term.
Venture/growth funds have duties to three stakeholder groups: their LPs, who give them money to invest; founders, who let them invest in their companies; and their own General Partners/Managers, who they want to make rich(er).
- A fund’s duty to LPs is to generate acceptable returns, i.e. investment returns that meet the LP’s target benchmarks/expectations. This results in the LP happily investing in subsequent funds.
- A fund’s duty to founders is to offer them an attractive enough “product” such that Founders choose to exchange equity in their businesses for the fund’s cash over other competing funds’ cash.
- A fund’s duty to its own Partners/Managers is to maximize their profits via carry dollars.