What are Venture Investments and How Do They Work?

May 7th 2021

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Venture capital is a financial instrument that allows you to earn on investments in high-risk technology companies. The basic principle of VC is the same for everyone: the fund distributes capital among dozens of promising projects, recognizing that most will be unsuccessful.

But those who succeed, can more than cover the losses, but bring the investor a profit of х10 or more. Nevertheless, the volume of investment, company valuation, and preferred stages can vary greatly from region to region.

Features

Such capital is attracted by startups. Such companies have no history or collateral for a loan, so venture is becoming one of the few options for raising funds. The purpose of such investments is to leave the company by selling its stake and at the same time making a significant profit. An ideal option for an investor is the company’s (matured start-up) IPO, but it is difficult.

Another way is to sell your stake to another investor at a price much higher than the initial investment or sell to a strategic investor. Venture capital is illiquid, and such investments are always very risky. The ROI (return on investment) will have to wait for 3–5 years, sometimes longer. However, with the successful selection of companies for financing, the income will be significant, which is why investors invest in such high-risk assets. Most venture capital funds are created in the form of a limited partnership. The fund has a general (managing) partner and limited partners — investors who invested their funds directly in the fund. The general partner establishes a VC firm and subsequently manages the entire operations of the fund (as a managing partner).

He personally decides what projects to invest in, organizes the investment and exits from it. But limited partners are passive investors — do not participate in such decisions, but can influence the general partner through participation in the supervisory board. The general partner shares risks with other partners and investors, investing, as a rule, from 1% to 5% of the total investment. For his managerial and investor participation, he receives two types of remuneration:

· The first is a management fee. Most often, this is 2% per year of the total fund, sometimes 2.5%, in superfunds — 3%. These funds cover the operating expenses of the VC firm

· The second type of remuneration is participation directly in the fund’s profit (carried interest). Most often, it is 20%. First, you need to return the funds to all partners who have invested in the fund, and only then, the profit is divided between the general partner and limited partners.

An investor invests in a fund, but this happens in stages. Typically, funds are received in parts, depending on the volume of the investor’s share in the fund. With this share, he participates in investments in a specific project.

The general partner informs how much and when to transfer, to which project these funds will be directed, and then the investor completes the transaction. This is called capital calls. The life of the fund (and, accordingly, the period of ROI) can be 5–7 years, 10 years. In some cases, it is extended for 1–2 years more. It all depends on what the focus of the investment fund is and at what stages of the development of the company it invests.

There is a category of “evergreen” funds (evergreen). Such a VC fund uses the profit received from investments, reinvestment in new projects. The task of the general partner is to find such investment projects that can provide a profit 10 times higher than the investment in volume (10X). Not all companies really will.

Usually, 3–4 out of ten projects fail; another 3–4 brings small profits and allows investors to return funds. Only 1–2 projects out of ten become successful, and it is they that give the massive bulk of the profit. In general, an average ratio of 2.5–3X is considered a good indicator of the profitability of the fund, 5X is a successful fund. Some funds show results in 10X or more. Another important indicator is annual profitability. It is calculated based on the volume of income and terms of investment. A good annual return of 25–30% is considered. There is an example when one project brought the fund a return of 914% per annum.

Investment stages

The earliest stage of investing is pre-seed, but venture funds usually do not invest at this stage. Early-focused funds often start with series seed. This is the stage when the team works on creating a prototype and launches MVP (minimum viable product), begins to make initial sales. The average round size is $ 1–2.5 million. Series A investments are aimed at achieving product/market fit. This means that the startup already has a product, there are active sales. The average size of a series A round is $ 13 million. These are the two highest risk stages, but there are great opportunities for investor earnings.

The following are series B, C, D — business scaling, IPO. These are large rounds with less risk and less return on investment. To find promising projects for investment, the partners of the fund are actively building a network of contacts.

Networking is based on attending a large number of specialized events. It is customary for venture capitalists to share contacts and projects. The fund always has information about good projects that for some reason are not suitable for it (for example, the fund does not work with a specific market or company line of business). In this case, partners can recommend the project to other participants in the venture capital market.

The more active and competent the fund is building the network, the better its reputation, the more “passive” offers it will receive. Such a fund does not invest in projects that came from outside. Financing is received by companies that the partners of the fund have found on their own or those who are interested in any of the familiar investors or those who came to them on recommendations from their circle of contacts.

Before investing in a “liked” project, the fund conducts an internal analysis and consults with experts from its network. The ability to consult with more experienced (in a particular issue) specialists is an important advantage of a developed network of contacts. Fund partners can receive a response from them within one to two days. In addition, this additionally insures against the risks of all participants in the fund.

Activity and exit from an investment

All investors can be divided into two types:

1) Passive investors. They help the company only with money and then take a passive pending attitude.

2) Active investors providing smart money. They are actively involved in the operations of the company. If this is the leading investor in the round, he gets a seat on the board of directors of the project.

To attract quickly large investments, partners collect a pool of relevant investors, which can contain dozens of names. Fund partners know how to interest each specific investor. The start-up company founders usually do not have such information, so it is difficult for them to attract investments on their own: even if the founders are ready to look for all the necessary information, they may just not have enough time, the company will go bankrupt.

The last important question is the exit from the investment. Funds are constantly looking for exit opportunities; the main thing for them is less time and more profit. You need to know not only other investors but also potential participants (organizers) of the public offering (IPO), advisers that working in certain areas.

There are, for example, generic brokers; there are those who specialize in e-commerce, and so on. In each direction, you need to have contacts. You can’t just find a suitable company on the Internet, write a letter and get an IPO. Only a personal approach works here. Moreover, for this we need contacts. The built-up network of contacts is the main “superpower” of the fund. Networking determines the success of each stage, from searching and evaluating a project to overcoming crises and successfully exiting a project. Choosing a fund with a good reputation is the path to success for both startups and investors

Venture capital: USA

North America as a whole is the hottest technology market in the world. There are more than one and a half thousand-venture funds here: in 2017, the National Venture Capital Association counted 1,562 existing funds. Funds can be classified by investment volumes and investment stages. So, large venture capital funds are invested in projects that go to IPO. The US is characterized by checks of $ 100–500 million at this stage.

Larger transactions are also encountered, more often with the simultaneous participation of several funds. Among the funds aimed at financing in the later stages are General Atlantic, Silver Lake Partners, and others. Another type is funds investing at the same stages, but with an average check of $ 10–30 million. This segment has a high potential for growth in returns, but volumes are more affordable. And there are a lot such funds. The most famous names like Sequoia Capital, Andreessen Horowitz and Khosla Ventures work in this segment. Large funds can invest in earlier stages.

However, there are institutions that focus specifically on seed rounds and series A. This is Benchmark, First Round Capital. Separately, it should be noted the famous accelerators (Y Combinator, 500 Startups), at the level of which there are associations of business angels and angel funds. The ecosystem itself is the most active in the world. There is more capital in the US market than in other regions.

At each stage, there are dozens, if not hundreds, of funds competing for promising deals. For this reason, project evaluation is usually higher. Even a project that does not yet have a finished MVP can cost $ 15–20 million due to a “star” team and a promising idea. Due to the liveliness, the market is faster. On average, an American fund spends less time on one transaction than, for example, a European one.

Venture Capital: EUROPA

The main difference between the European market and the American is that there are no participants in this market who invest $100–500 million or more. Most well-known funds work with an average check of $10–20 million and focus on series A round. Many successful seed funds as well. Each country has regional funds, but there are those who work in several countries at once or in Europe as a whole.

For example, the Coparion Foundation operates exclusively in Germany. But Global Founders Capital, DN Capital, Lakestar, Holtzbrinck Ventures, and Point Nine Capital are international funds operating in Europe as well. A characteristic feature of the European venture capital market is the wider distribution of private clubs for investors, who usually work on the basis of venture capital funds. Most of these clubs are in Switzerland, Germany, and Italy. Such a club allows novice investors who do not have large sums and specialized knowledge in investing in technological projects to take part in the round.

Participants invest together with the founding fund. If investing in a fund usually requires at least $1 million, then for club members the entry threshold is reduced to $ 10–25 thousand. The European venture capital market is less developed than the American one. So, according to the MoneyTree Report for the first three months of 2019 from PwC and CB Insights, in the first quarter, 1298 transactions worth $21.9 billion were concluded in North America (almost half of the world volume), and 593 transactions closed at $4,8 billion in Europe.

The European market is more conservative and more fragmented. Companies grow slower, but in the process of this growth, they “burn” less money. As a result, they are faster on profitability than American ones. In Europe, funds require adjustments in such a way as to quickly begin to profit from the project.

Venture Capital: ASIA

Asia is a relatively new market: according to Blue Future Partners, 162 funds are active in the region. At the same time, the Internet population, from 260 million in 2016, will grow to 480 million users by 2020. The digital economy market will increase from $ 30 billion in 2016 to $ 200 billion in 2025. Given such an active development and growth prospects, international funds “enter” the region and local venture capitalists start to appear.

Among the players who have come from the global arena or working across Asia are Sequoia, WI Harper Group, IDG Capital. A characteristic feature of the Asian venture capital market is the active participation of the state. For example, there are GIC Private Limited and Temasek Holdings, founded by the Singapore government, the Chinese Innovation Fund For Technology-Based Firms.

Another feature is the active participation of corporate funds: for example, from Alibaba, Tencent, Softbank. In Europe and the USA, corporate venture is much less active. Although there are not so many funds operating in the Asian region, deals are made from time to time on the local market considered very large, even by American standards. So, starting in 2015, Grab closed several multi-million dollar rounds, and in 2017 raised $ 2.5 billion.

The Asian startup and venture market is developing rapidly. At the beginning of the year, the Financial Times reported that the local venture capital market was almost equal in volume to the US market ($ 70.8 billion versus $ 71.9 billion) and would soon overtake it.

2019 Investment Interests: American market

With the constant changing conditions on world capital markets, every year investors meet new challenges. Increasingly, investors are wondering where to invest in order to save capital and not lose it and even better to increase their fortune. Today, the prospects for the global economy are rather vague. Experts point to significant growth potential and the absence of overheating in most markets, which makes a global crisis or recession unlikely in the near future.

Despite this, trade wars between major players, political instability in some regions, fluctuations in oil prices and other destabilizing factors have a negative impact on financial markets as well. Therefore, according to the latest IMF forecasts, the growth of world GDP in 2019 will slow down and will add to 3.5%. The era of stability in the global economy has ended, so investment should be considered more carefully. Now, let’s briefly check the main investment trends and promising areas for investments in 2019.

Investing in the US stock market in 2019 is a risky venture. Over the past year, the main index of the American stock exchange Dow Jones fell by 7.1%, given the global instability, the negative dynamics will most likely prevail on the exchanges. Forbes analysts believe that, despite the fact that the stock market may rise in the first half of 2019 due to favorable economic factors, the high volatility on the exchanges will continue and the sharp jumps in quotes both up and down will continue.

According to the reputable publication in The Economist, investing in giants such as Google, Amazon, Netflix, Facebook, and Tesla is the best investment in the US market in 2019. Such advice is relevant only for the short term, and not for a long term in advance, as the situation often changes with lightning speed.

2019 Investment Interests: European and Asian Market

Yet, most economic analysts agree on the idea that investing in the American or European market is now unprofitable. For the 3rd quarter of 2018, the EU zone economy grew by only 0.2%. This minimum figure for the last 4 years, a similar situation is in the Japanese economy. Experts advise investors to pay attention to developing countries, especially India and China.

The PRC economy grew by 6.6% in 2018, and according to the World Bank forecast, by 2030 this country will become the world economic leader. First, it is worth paying attention to the Chinese IT industry, for the first half of 2018, according to Tech in Asia, the Chinese IT sector attracted investments of $43 billion, and according to preliminary estimates for the whole of 2018, this figure will reach more than $80 billion. India, with its 7.5% GDP growth, overtook China in 2018. The growth of salaries in China has led investors to withdraw their production to regions actively with cheaper labor, as India, the Philippines, Vietnam, Bangladesh and other countries of South Asia.

Investors are actively investing in infrastructure projects and production in these countries. Earlier, in the study “The best countries for the location of production”, which examines the countries that foreign investors are seeking to develop or transfer their production to, these countries are in priorities.

Sergey Golubev (Сергей Голубев)

Also published on: https://coil.com/p/Sergey_Golubev/Venture-Investments-Features-Geography-and-trends-/l3-3TotAV