Tech Word for The Week is a weekly series where we look to explain commonly used words in the tech ecosystem in a simple, engaging way.
Venture Capital is a kind of financing (and expert support) investors provide for young startups who have an innovative product or service and high growth potential. Investors provide technical support and finance in exchange for equity in the startups.
The investors could be individuals (high networth individuals) or an institutional investor (endowments, investment banks, corporate pension funds, sovereign wealth funds, wealthy families).
Innovation and technology are the major drivers of economic growth, but they often come with a lot of uncertainty. Venture Capital firms are the knights in shining armour for potential high growth startups. They invest where banks and other financial institutions will never invest. This is because startups are highly risky and cost intensive.
Catch the drift? Probably not. Let’s examine the term again by engaging our imagination without all of the technical jargon.
During the ages where wars were fought to broker peace and enforce the dominance of an empire or kingdom, going to battle comes with a lot of unpredictability. A whole army can be wiped out or it could return victorious. There was no guarantee.
Nevertheless, if the army was going to stand a chance it needed powerful allies. These allies will provide backup resources and reinforcements such as food supplies, weapons, backup soldiers, etc. Before going into the war, smart war generals find these allies who can provide these resources. Are you following? Good.
Anyone who will provide these resources will do it with the full understanding that things could go downhill (making them lose all their investments) or the army can come back victorious. If the army wins the war, the spoils of the war will be shared with their allies.
Now back to reality. Army commanders are startups, their allies are venture capitals. The resources the venture capitals provide are finance, expert management advice, professional and rich network. The spoils of the war are equity offered to the venture capital firm. Losing the war is when the startup fails.
In Nigeria, popular venture capital firms include Future Africa led by Iyinoluwa Aboyeji; Greentree Investment Africa led by Olabode Agusto; Venture Platform chaired by Kola Aina; EchoVC Partners led by Eghosa Omoigui; Ingressive Capital by Maya Horgan Famodu, Voltron Capital by Olumide Soyombo. Read more on others here
On the global stage popular venture capitalists are Peter Theil, the co-founder of PayPal and first investor in Facebook, Naval Ravikant, an early investor in Uber and Twitter, Jeremy Levine, the biggest investor in Pinterest, Jim Breyer, an early investor in Facebook.
How a Venture Capital Firm Works
A venture capital works like a partnership. High networth individuals, trust funds, insurance companies, foundations, university endowment funds, etc, come together to pool their resources together under the firm called a venture capital firm. The individual and institutional investors are limited partners while the executives appointed to manage the venture capital firm are the general partners.
These executives are appointed to manage the venture capital investments and offer full support to the startups in their portfolio. They control where the funds are invested and provide active managerial support to ensure the startups scale and become profitable.
Profits are often shared 20:80 in venture capital firms. 20% go to the general partners as performance reward and 80% go to the limited partners. The general partners also do receive a 2% annual management fee of total capital invested.
How Venture Capital Selects Startups
If a startup wants the backing of a venture capital they submit their business plan and proposal. If the venture capital is interested they'll carry out a due diligence on the startup's product, product market fit, business model, business viability, operating history, management, etc. The research stage is very critical and will ascertain the compatibility of the venture capital and startup and the alignment of their values.
After the investigation is complete and all metrics have been satisfied, the firm or capitalist will pledge an investment of capital in exchange for equity in the startup. Funds may be provided in rounds or at once. They are usually made in dollars.
Going forward, the investor takes an active role in the startup by providing support in managerial expertise, marketing, professional network, etc. Most venture capital exits the startup when it scales by initiating a merger, acquisition or initial public offering.
Most Venture capital professionals and executives have had prior experience as equity research analysts, Master in Business Administration, former founders or partners, etc. They also tend to specialise in specific industries which gives them enough expertise to select and support the startups.
Startups require venture capital firms who can bank on them and give them the support they need to scale their businesses. The returns on profitable venture capital projects are massive if the investment is profitable but the chance of experiencing failure is also quite high. Innovations drive civilisation but they come at great risk.
VCs are willing to risk investing in such companies because they can earn a massive return on their investments if these companies are a success. VCs also experience high rates of failure due to the uncertainty that is involved with new and unproven companies. They however provide a good source of finance for startups who would never get funding from traditional financial institutions.