After your startup gets its initial funding from their friends and family, the next round begins with Venture Capital funds (VCs). However, many startups go blindly to any of these VCs believing that these funds are willing to write a check right there and then. It is a lot more complicated than that.
First, VC funds are approached by thousands of companies seeking funding and only a small percentage gets any funding. One VC principal stated he gets about 200 business plans a week, or approximately 10,000 a year. And a VC fund will invest in only 8-9 companies in one year. That is less than one percent chance.
Second, VC firms look for high yielding investments because of their limited partners and the high riskiness of the investments. Limited partners invest in VC funds because they believe that the VC firm can provide them with the higher yields not deliverable by the marketplace. These limited partners can purchase high yield bonds, which float anywhere around 10-11% yield. These Limited Partners are generally well heeled investment funds or banks. A typical investment fund could be a $billion endowment being managed for Harvard or Princeton. Or could come from international dungs such as SAGA (Saudi Arabia) or Singapore. Many commercial banks, such as J.P. Morgan, dedicate less than 10% to dispense to VC funds. With over a billion dollars, the ability to invest on high yield bonds is within their reach since the minimum rounds for those bonds is no less than a million dollars. A VC investment should yield higher than a high yield bond, or the limited partner would not have invested its funds in that firm.
Thirdly, the fee structure of the VC firm and the performance of the portfolio forces the hand of any VC firm to demand higher ROIs from the portfolio companies. Once a limited partner provides its investment in the VC firm, the VC charges an additional fee between 2-3% for managing the capital. And that fee increases several percent, about 3-5%, for the allocated investment in that company, whenever the VC firm does invest its capital in a specific company, since the VC firm is actively managing the company by being on the Board. Another factor in determining the ROI is the performance of the portfolio companies. Generally, a third of the portfolio companies lose money, another third perform satisfactorily, and the final third are home runs. To justify the potential risks for loss, the expected yields need to be higher just to compensate for the performance of the portfolio.
Given that high yield bonds pay around 10-11%, and the VC investments have fees charged as much as 5-8%, it is not surprising that a limited partner expects the yields on its investments in VC firms exceed 20-25% annually.
And there are two other aspects to look into approaching any VC firm. Since the funds are finite, the firms will dedicate to investing in industries in which they are familiar. VC firms by nature are run by few individuals. A VC firm does not have the depth and size of expertise found in investment banks. Therefore, depending on the background of the managers, they will only invest in what they know.
Another critical factor in choosing a VC fund is also timing . As mentioned earlier, VC funds are finite. If they have already invested in the preferred industry and most of the funds is already dispensed, then it is unlikely they have additional funds to invest in a stellar company even with the right characteristics. Essentially, the VC firm has exhausted the fund. It behooves any startup to begin in the beginning of the year rather than the latter part since it has a greater chance to get funding.
So this convoluted explanation on VC firms motivation on the expected ROIs clearly demonstrates that any startup attempting to attract VC funding should consider these immutable factors in raising capital from VC firms.