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Venture Capital Fundamentals Insights

The Venture Industry Explained

A guide to understanding how the venture capital industry works

The venture capital asset class makes up a tiny fraction of the total private investment in the economy. Still, it is un-proportionally responsible for a majority of the innovation and new job creation we see today. In our series exploring the intricacies of venture capital, we demystify the asset class and give a comprehensive breakdown into everything you need to know.

What is Venture Capital?

Venture capital is an asset class aimed explicitly at the sub-sect of private equity, which focuses on startups. To some companies, venture capital is a necessity as most financial institutions and lenders are inadequate in providing funding to startups due to their high-risk profile and failure rate.

Consequently, venture capitalists specialize in analyzing and investing in these technology-backed companies, in exchange for equity. These startups, to some degree, have comparable characteristics and approaches to disrupting traditional industries.

VC Startup Profiles

Venture capitalists back early-stage companies that utilize new technologies and business models. Since most of these companies run at a loss in the early stages, they are deemed undesirable and risky for most lenders. VC-backed companies dominate the news and garner a lot of attention, however, for every success story, there are countless failed companies in the same space. It is the role of venture capitalists to find these companies and nurture them for growth. 

It is costly to develop said technologies and software; however, once created, they are very scalable. Once a product is developed and gaining traction (product-market fit), the race for ‘blitz-scaling‘ and rapid expansion requires significant capital. 

These startups typically enter global winner-take-all markets and to gain a lead on their competitors, usually spend vast sums of money. Tech companies typically prefer growth over profitability in the short term, in an attempt to become market leaders. Therefore, in the venture capital model, investors are betting on the future value the company will attain once it becomes a market leader as it utilizes its competitive advantages. 

Does Venture Capital Work?

Most traditional businesses do not need venture capital funding, and the route of achieving steady growth with a positive balance sheet is the best strategy for these firms. So you might ask yourself, “does venture capital work?” and the short answer is yes, with a select subsect of tech-enabled companies.

There have been many studies aimed at answering this particular question. Ufuk Akcigit, a Professor of Economics at the University of Chicago, claims in a podcast with Freakonomics Radio that there is substantial evidence that shows VC-backed companies do indeed perform better. However, he points out the question, “would those companies have succeeded without venture capital ?”. 

In a recent paper named ‘Synergising Ventures’ where Ufuk is a co-author, the team of economists compares two sets of similar companies in an effort to answer this question. The research shows that VC-backed companies, when compared to alike businesses, do indeed perform better on multiple vectors, one being high-quality patent production, where the quality is measured by the citations it receives and the second being relative employment those companies produce.

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Evolution of average employment before and after initial venture capital fundingEvolution of average quality-adjusted patent stock before and after initial venture capital funding

Source: Synergising Ventures

How VCs Add Value

Venture capitalists, at least the best ones, add value to portfolio companies after investing in them. Most founders seek more than just capital from VCs and so investors which have a unique post-investment value add are at times the crux for the success of a startup. For founders, especially new ones, this is a crucial factor when deciding who to choose as an investor. 

The best venture capitalists are experts in a particular niche. This can be domain expertise, growth hacking, product development, operations, and so on. They will also have a vast network of people who can also provide value to portfolio companies. For example, this may be other investors or experts in hiring, marketing, and PR. Additional help to founders is what separates many venture capitalists and is a significant contributing factor for the success of portfolio companies.

The VC Strategy

In venture capital, fund managers will create a portfolio of companies around their thesis. Some funds are multistage generalist, while others are focused entirely on a particular stage with a strict focus on a domain

Portfolios are created to manage risk as venture capital is a highly risky asset class, which also has the potential to yield high returns. Since startups take time to mature, returns are typically seen far in the future. VC funds returns are not evenly distributed, and a few companies produce the majority of the returns; therefore, VC follows what is known as the ‘power law.’ 

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Source: The Unique Philosophy of Venture Capital – Michael Tan

A large percentage of the startups in the portfolio will go to 0, while several will return their initial investments or provide a moderate level of IRR. However, some of these companies will achieve outsized profits and will go on to return the entire fund and possibly more.

For this reason, venture capitalists only invest in startups and companies that can scale and return the entire fund or more. Often, VCs will look at the total addressable market (TAM) and work backward to see if said company has the potential to do so. The venture capitalists must categorically think that any of the companies within their portfolio can become a leader in that market for the foreseeable future.

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