In my experience, people in tech tend to view venture capitalists in one of two ways. Either VCs are money gods to be revered at all times in case you need their investment in the future, or they’re joyless ‘vulture capitalists’ who will force you to kill everything you love about your company in pursuit of a lucrative payday for themselves.
In reality, venture capital is a fairly innocuous, and endlessly interesting, financial services business model. And it can be incredibly useful to you as a fintech entrepreneur — if you understand it properly.
I was surprised a few years ago to discover that many tech entrepreneurs seek VC investment without taking time to understand what they’re getting into. That’s a bit like spending money on a credit card without understanding the interest rate and repayments: it might turn out fine, or you could get stung badly.
How venture capital works
Before we get to the part where VCs help your business by pumping a load of cash into your bank account, let’s look at a VC’s business model. Only by understanding why VCs invest in certain companies can you decide whether that money is really going to be any real use to you at all. And the first thing to note is that usually, most of the money they invest in your startup isn’t their own.
Venture capital firms are essentially investment managers. They start by raising a fund from wealthy individuals and institutions on the understanding that there’s a chance that money will be returned at a significant multiple, sometimes ten times or more. These investors (‘limited partners’ — or LPs — in the fund) commit money knowing that while the VC firm may invest in lots of startups that fail, they only need a handful of big wins to make a huge profit on their investment.
So for the LPs, investing in a venture capital fund is essentially high-stakes gambling, although usually they wouldn’t present it like that, as LPs are often pension funds, university endowment funds, public investment funders like the British Business Bank, corporations, or wealthy families with their own investment offices. They’re serious people who simply see VC as one way of growing their wealth as part of a portfolio of investments.
Once the VC firm has raised a fund, it takes a small fraction (typically 2%) to pay for salaries and operational costs (the ‘management fee’) across the lifespan of the fund. The rest of the fund is then dedicated to investments in high-growth companies that fit the company’s ‘thesis.’
A thesis is an investment philosophy. It could be as simple as ‘support great companies with high potential in our part of the world’ or it could be a high-concept vision of how a particular technology will transform the world. For example, VC firm 2150 recently launched with a remit to support “businesses that are changing how our cities are designed, constructed and powered, for good. Hunting for Gigacorns – the technology champions of the coming decades with the potential to benefit billions of people, create billions in commercial value and lower gigatons of emissions. And make the world of 2150 one we actually can and want to live in.”
No matter the specific thesis, the companies that a VC firm invests in will have the potential ‘high-growth.’ That’s because it’s only companies that grow big relatively quickly that fit the VC business model and deliver the kind of return a VC’s own investors — the limited partners — require within a defined timespan. The partners in the VC firm will also take a cut for themselves, too. Those management fees alone aren’t much of a financial incentive to get into VC on their own!
When a VC cashes out of the business — be that through selling their shares to a company that acquires it, or on the public markets at an IPO, or to another investor who invests in a later round — they have only really succeeded if they’ve got a decent multiple on the amount they originally put in.
VC is a marketing business
I described VC as a financial service above, but it’s also a marketing business. Through their flashy theses, ‘thought leadership’ blog posts, and hard-won reputations for ‘picking winners’, VCs market their funds as great places for LPs to invest millions of pounds. On the other side, they market themselves to founders as the perfect people to provide ‘rocket fuel for their dreams’ or any number of other clichés.
Those clichés are true though. VC investment can be essential if you’re a founder who wants to build a huge, valuable, globally impactful business. But you need to understand that taking VC investment means working towards some kind of ambitious exit that may result in you running a company that’s traded on the stock market (and all the stresses that entails) or selling out and potentially eventually having to say goodbye to the company you built, albeit hopefully with a nice wad of cash in your pocket.
When an entrepreneur complains that a VC is pushing them to grow faster than they’d like, or is angling in board meetings for them to be replaced by a different CEO, or any number of seemingly objectionable things, it’s likely because the entrepreneur in question didn’t quite understand what they were getting into when they took the investment.
If you don’t want to build your company into a ‘venture-sized’ business, that’s perfectly fine. There are plenty of examples of founders who have built successful tech companies without VC. But it’s best to figure out your ambitions early on and not waste your time courting VCs just because it feels like the thing you should be doing. Believe me, there are plenty of founders who do that!
Beware sharks
As with any other business, VC has sharks. Those sharks, combined with people who enter into VC investment deals without understanding the implications, are what gives the industry a bad name in some quarters. I’ve been told some horrible tales (in confidence!) over the years about VCs screwing startups over with terrible terms or bad boardroom behaviour.
Even if you’re sure you’re ready for venture capital, you should do ‘due diligence’ on your prospective investors, just as they will on you. You’re not auditioning for Simon Cowell, you’re assessing a potential deal that could make or break your business. Talk to the VC’s portfolio companies (and not necessarily just the ones they may introduce you to!) and find out what they’re like to work with. And scour the media for any sniff of past impropriety; at the very least you’ll want to understand the truth behind the stories, just as they would if there were stories about you.
As an easy starting point, Landscape can be a useful tool for reading about what founders who took funding from a particular investor say about them.
Venture capital is an important part of many a fintech startup’s journey, but just make sure you take the time to properly understand what you’re getting into first.