I thought there is generally somewhat of a misunderstanding on what a venture capitalist (or VC in short) actually does. In order to explain the activities that happen in venture capital and to highlight the differences between an angel investor and a venture capitalist, I wrote this article for you.
I’m a fan of a solid and stable income, but as soon as your expenses are covered, I also like to find ways to increase my personal capital in order to account for things like an own home or have enough money for my retirement age.
There are many ways to invest money. Years ago, I was spending some time in CFD trading, and that worked out well. The side effect of that was the requirement for permanent attention to the markets. I liked the feeling, but then I found it hard to find rest at night. It was not the right thing for me in the long run.
Later I tried to invest venture capital in startup companies in the seed stage. You can start doing so even with a small amount of money on seed-stage crowdfunding platforms. Unlike popular platforms for crowdfunding, such as Kickstarter and Indiegogo, this type of investment is done only for the sake of gaining capital return, larger than the initially invested sum, after a couple of years. You’re buying into the company, and you’re not buying their products.
Diversification
For both CFD and VC portfolio management, I can recommend putting your investment capital never all in a single pot. You should diversify and prepare to hedge it if need be. You can significantly reduce the risk of a total loss by investing in 10 different things. Don’t put your investment capital in a single gig, no matter how disruptive and promising the business model might seem.
Also, you should never touch your normal savings account, or even worse, your retirement funds in order to back a company with your money. Be smart about investing but brace for loss. This can’t be what you use or will use for normal living.
In the figure above, you can see how the ROI could be distributed across ten different investments within one portfolio. There will be losers, and there will be investments doing just “okay,” but the VC is in for the, no I won’t say “unicorn,” they are in for the company, which positively stands out the most.
What does a venture capitalist actually do?
A venture capitalist usually acts on behalf of a VC organization. They are on the lookout for promising companies in the seed stage, which have or are soon going to have disruptive technology and prospects to buy. They are not investing their own money into the deal but manage larger funds with the capital of several parties. Some senior VCs also have the option to invest personal capital into their portfolio too.
The VC who completes funding with the CEO of a company will most likely join their board as well and have a stake in strategic decisions. The VC will do their best to make the company grow fast and share connections in their professional network. They are usually trying to make the company interesting for a merger, an acquisition, or prepare it for an IPO.
The net gain, which is yielded after such events occur, is the primary objective and is to be achieved within a couple of years. A negative outcome would be if the company fails and returns nothing, or the equity is liquidated and returns less than the invested money.
The portfolio of a single VC of currently active investments could be around ten companies, give and take a few.
What is an angel investor?
The difference between an angel investor and a venture capitalist is that the angel uses personal money to invest in a company, and the VC will invest the money of others into a company. I would, however, never call myself an angel investor. I suppose that the term personal investor or personal venture capital investor would be more appropriate.
The term “angel investor” also sounds somewhat braggy. I don’t want to profile myself as an angel of any kind. That’s maybe something others could call you if you helped them, but this isn’t something you put on your business card yourself.
Also, there is a huge myth around what angel investors do. They are not donating their capital to a company. They are investing in the company in exchange for convertible debt or ownership equity. Some would say the angel investor is the opposite of a VC, but both of them want the company to grow fast and succeed, and both will help the company to achieve even beyond the financial funding.
Why would a company choose to be VC-funded?
VC funding is not a lifeline and not credit from your local SMB-friendly bank. If you are not in an optimal financial state, no VC will consider you for their portfolio. If you want to keep control of your company, keep it alive for generations, and grow is slowly, VC funding definitely is not for you.
But why would a company be interested in a VC acceleration? With the additional capital, they can hire key staff on all levels of the organization. You can also increase your marketing budget to extend the brand awareness and exposure of your (hopefully) disruptive product or service.
The owner of a company basically gives up some of the control in order to have access to the professional network of the VC and pursues to also make a profit in case of an M&A activity or IPO.
How does a VC make money?
So how do they make money if they just manage the portfolio for others? From the percentage, it doesn’t look nice but considering fund volumes of $100m+ they start to work out. The outcome isn’t always the same, but here is a realistic example for you. The ROI after exit is split into four parts, from which the first two parts are directed to the VC. The figure on the right side shows a pie chart of where the money goes when an exit occurs.
Carried Interest
The carried interest at the exit, or just “carry” in the lingua franca, is usually around 20 percent of the net profit once the exit activities are through. The higher the overall net profit is, the better the carry will look. From the investor’s point of view, this ensures that the VC always acts in their best interest to grow the company’s in the portfolio and helps to make them successful.
Management Fee
The VC will usually charge a two percent fund management fee, which compensates for the time used to prepare the deals, screening companies, doing due diligence, serving the company’s boards, coaching the CEOs, and later prepare the exit.
Summary
So now you know what a VC does and even how it differentiates from an angel investor. You know what objectives the VC pursues and what activities are engaged in order to achieve them. Do you feel something was off? Do you have questions or spotted something, which you can’t agree with? Please add your feedback below in the comment section. I would love to hear what you think about this. Many thanks for reading!
Photo credit: Erica Breetoe / Daniele Falciola / Thomas Bayer / Steven Depolo
