How Does Venture Capital Investing Work? | AWM Insights #108
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Episode Summary
You’ve decided to jump in to private investing. You’ve already asked yourself if you should invest at all and discovered how to participate. Now that you’re ready to invest - how does it actually work? Who is giving money to whom and what are they trying to achieve?
First, you start with a venture capital founder - an entrepreneur that starts a company with an industry-disrupting idea. Think Zoom, Peloton, and Coinbase as recent examples. The company must grow, scale operations, and eventually become profitable to become successful.
Second, the Venture Capital Firm (VC) - a group of people who specialize in finding the next trillion-dollar company before they even have profits - funds the founder with the capital necessary to realize their potential. In exchange, they become equity owners of the business and work in partnership with the founders to increase the chances of success. Some of the most well-known VCs include Accel, Bessemer Venture Partners, Lightspeed, Sequoia, IVP, Benchmark, and a16z.
Third, the investors, like AWM and other family offices, then put money to work with venture capital firms to target the outsized returns.
The ideal end result is an exit (sale) that generates for the investors, VCs, and founders an outsized return. Without the idea and execution, the VCs and investors would not be able to capture this return. Without the capital invested, the company would fail.
In this week’s episode, Brandon and Justin dive deeper into this process on how the venture capital investing works, the different seed and funding rounds, and what to expect throughout as an investor.
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Episode Highlights
(1:15) Who are the players in venture capital? Who are the players in these deals?
(2:03) Venture dates back to post-World War 2 with wealthy families investing in very early companies.
(2:22) The venture capital managers specialize in finding the best new companies. The VC aggregates money from investors and searches for portfolio companies to make investments in.
(2:33) RIAs and family offices, like AWM, deploy capital to these venture capital managers to find outsized returns.
(3:05) The maturity of the company is divided up into seed, early, and growth stages. A company will usually raise money multiple times before it IPOs, is acquired, or fails.
(3:36) The other key player is the entrepreneur. This is the company founder(s) that have a great idea or business model and needs capital to make the business successful.
(5:10) There are different flavors of venture capital managers. They usually specialize in a niche or maturity level of the company.
(5:30) In general, venture capital is high-risk high reward. Most small businesses are not considered venture capital. Venture capitalists are looking for companies to generate outsized returns.
(6:30) The earliest stage of venture capital is angel investing, pre-seed, or friends and family. The next stage is generally called the seed round.
(7:20) After the seed round, they start calling the funding rounds A, B, C, D, and even sometimes E and F.
(8:50) Most venture capital first stays in its sweet spot and focuses on a certain maturity stage of portfolio companies.
(9:02) The investors (VCs) are making a bet that the founders will take the money (capital) and grow the business and sell it in the future for a much higher price.
(9:37) The founder or entrepreneur knows they need the capital to grow and invest in the invested capital in right people and resources to help the company continue to grow.
(10:46) The marketplace is getting more competitive when it comes to how venture capital firms can add value to the founders and help increase the chances of success.
(11:22) The best VC funds knock it out of the park, the worst VC funds do worse for investors than the public market. This is why understanding the dispersion of returns and getting access to the best managers avoids the crap of Silicon Valley.
(12:05) Founders picking VC firms to work with and investors deploying the capital to VC firms know there is persistence or repeatability by the best firms in VC. This makes getting access to the best difficult and competitive.
(13:00) Founders with the best ideas will take capital from many of the best VC firms to gain the diversity of thought and value that can be gained from the VC's expertise.
(13:35) An example is if you are a young cloud company you would want to partner with Byron Deeter and Bessemer Venture Partners because of his expertise and track record.
(14:24) There is a lot of money chasing Venture Capital right now because it is sexy and easy to sell. It is hard to get into the top funds and the top funds are even reducing LPs to maximize their relationships.
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+ Read the Transcript
Brandon Averill (00:05): Hi, everyone. I'm Brandon Averill, one of the partners at AWM. Where we advise people in creating multi-generational flourishing families, so that we can solve that shirtsleeves to shirtsleeves financial epidemic. And this is a front row seat with AWM's Chief Investment Officer, Justin Dyer and myself, as we discuss some of our clients' most pressing financial questions. This is AWM Insights, and let's dive right in.
Brandon Averill (00:34): Well, Justin, welcome back. Welcome everybody.
Justin Dyer (00:37): Look at this.
Brandon Averill (00:37): Those of you watching, we've got kind of a professional setup here. Hopefully somebody's watching. So if this is audio only, do us a favor, hop over to YouTube, check out the new setup. Maybe we'll come up with something for the wall here soon. But yeah, it's fun to be back. We're diving deep. We're going to dive deep into venture capital. We introduced the topic last week. The week before, we introduced private markets. So yeah, I'm excited to jump in, take this journey.
Brandon Averill (01:08): What we're going to cover today is really, venture capital at a high level. Who are the players? What are we even talking about when we talk about venture capital? And then how do those players within the space actually interact with one another as we get a deal done? So maybe we'll start there, Justin. I would love for you to just jump in, super high level. When we talk about a venture capital deal getting done, who's giving money to who? And who's taking the money? And let's run through that a bit.
Justin Dyer (01:36): Sure. Like with anything there's a lot of history here and things have changed over time. So I will say that we're going to focus more on the present day, I think with this conversation. And talk about the players that really exist today, which again has changed over time, not drastically over the relatively short term, last 20, 30, 40 years. But going back, venture really actually dates back to the post-World War II era, and traditionally was led by big family money. So think about the Rockefellers, Vanderbilts, et cetera.
Justin Dyer (02:13): Families are still a big part of it today. They invest with venture capital firms. But largely speaking, call it a consolidated industry where venture capitalists, those that are providing capital, are almost intermediaries between institutions, families like we just talked about, going back into time. RIAs like ourselves, registered investment advisors that is, and we deploy capital to a venture capitalist fund company or a manager. And then they are then in turn making investments directly into companies.
Justin Dyer (02:48): So the venture capital, the VC, is typically a firm set up to aggregate money from various investors and then go and search for what they call portfolio companies to make investments in. We touched a little bit about the maturity of the companies that they are then investing, in early stage to growth stage. Actually just got an email today from a fund we're invested in about an investment they just made and can use that as a great example. Won't go into specifics. We're not supposed to there, but it's a great example just using the general structure of what just happened to give a sense of really what we're getting into today.
Brandon Averill (03:31): I think that's great. And the one key other person involved in this is the entrepreneur. So at the heart of all of this is somebody that came up, maybe it's just an idea, it's still in the garage and they're still banging around what the idea is and trying to figure out if there's product market fit or other reasons for them to be able to grow a big company. And then you hit on funds quite a bit, but the venture capitalists their whole point in coming in is that entrepreneur needs capital in order to make that idea come to fruition. And so venture capital is another term, I guess for entering into a little bit more of a risky proposition.
Brandon Averill (04:15): Typically at least, and we'll get into the stages and we hit on it before, but as we start out there is somebody with capital to invest that is going to ultimately believe in the entrepreneur's idea. And so as we start to work through that, I think it's really important to start to flush out some of this terminology we've been using. But okay, we've got the early idea, the entrepreneur that has just an idea, we've got an entrepreneur that maybe has a little bit of sales and we've got the entrepreneur that hopefully is approaching profitability and scale throughout those times though. There's probably, and there are leading question, but different people. Different venture capitalists, different flavors that are going to be coming in at different stages. Is that accurate to say and maybe cover kind of what that looks like at least historically, because now it's all blending together.
Justin Dyer (05:10): Yeah. Like anything things change over time, like I said at the very beginning, but no your spot on. I will even say that not all founders starting a company need venture capital, capital being the key term there. Where venture capital comes into play is really high risk, high reward type investments. And maybe you can control the risk, if you will, and then there's probably some critique you can make on that comment. But in general high risk, high reward type investments. Whereas a lot of small businesses are not necessarily high risk, high reward. And so that's something to keep in mind.
Justin Dyer (05:46): Venture capitalists are looking for risk, they're looking for that outside return. And so generally speaking, if you're a founder and you're starting a company you're like, "Wow, I have a great idea. We can scale this thing and really attack this market. But I need a lot of outside capital to do that." They're not going to necessarily, what they say, bootstrap that company themselves.
Justin Dyer (06:06): So just a quick tangent there, but getting into your question specifically. The needs of a company are different depending on how mature they are. I think we've touched on this a little bit, but just to dive into it even more. Where at the outset you have an idea, keep it plain and simple. You have an idea. Maybe there's somewhat of a product or a service that's been developed. But there's an idea and something that investors can understand. Certain investors are going to be a better fit for consumer oriented companies. Certain investors are going to be a better fit for enterprise software or FinTech, et cetera. But generally speaking on the earlier side, it's more or less an idea. Maybe there's a little bit of traction you've gained in the marketplace, but it's very early on. And there's a venture capital firm that is comfortable with that. Again, going back-
Brandon Averill (06:59): Or even potentially right at that stage a lot of times people may be familiar with a friends and family round or an angel. Right?
Justin Dyer (07:07): Right. Yeah. You could say that's even a little bit on the earlier side, but in general, this early stage seed, pre-seed, angel investing all comes into this same category we're discussing. Where it's early.
Brandon Averill (07:20): Yeah.
Justin Dyer (07:20): An idea more or less that people are backing. And then as a company starts to get traction, you start to get into what are called series A, series B, series C, series D you can even see E F, I don't know if I've ever seen a G I'm sure it exists. But as the company matures, generally speaking, there's a reason why they haven't had a liquidity event. They've haven't gone public but they still want to take on some internal financing or private financing. And there's a reason for that. It's totally dependent on the company. And going back to this example that I hit on, just received today, fund were invested in, it was a series D financing round where this company has a substantial amount of revenue.
Justin Dyer (08:07): It's a proven business model, but really at this point it's just trying to increase the scalability of that business model. Introduce different service lines, et cetera. So it's a series D round. The company's valued at actually over a billion dollars, which is not all that uncommon for a company at that stage, but it's a much different company than it was at its pre-seed or maybe it took on some angel capital, et cetera. They look completely different and investors are better suited to one of those stages or the other. There are firms out there that try and play in a wide range of different companies or series of investing different company maturity stages, but generally speaking venture capital firms try and stick with what they're comfortable with. Their sweet spot so to speak.
Brandon Averill (08:58): And basically what's happening when this venture capitalist comes in and invests in the company. Let's just keep it really simple is they're turning over a certain dollar amount. They're raising, let's say $10 million and in exchange for that $10 million they're gaining ownership in that company. So the bet from the venture capitalist perspective is, "Hey, I'm willing to forgo my cash for you. And my expectation is you take that cash, you're going to grow the company. At some point, we're going to sell this company to another investor. And in that instance, then hopefully I'm handsomely rewarded." On the flip side, it's the entrepreneur that sits there and goes, "I need the capital to actually grow this. I can't just take the idea," and you used the term bootstrapping, that only goes so far until you need money to fulfill orders, buy equipment, hire people, all these different types of things.
Brandon Averill (09:52): And so the other interesting thing is you start to evolve along this and we'll get into this I think in future weeks, but it's not only always a money transaction and that's where some of the specialty comes in. Like why you would want somebody that's really good at, let's say series A investing is because they've seen a lot of companies in that stage and they can give a lot of advice. So the capital is one thing, but as capitals become more plentiful, even in this relationship between the venture capitalist and entrepreneur, that value of experience, advice, et cetera. we talk about it a lot of times on the investor, the LP side, why are we a valuable, limited partner, but that relationship also exists with the company and the venture capitalist.
Justin Dyer (10:41): Oh yeah, no doubt. And that dynamic, I think, is getting more and more competitive as more and more venture funds are launched more and more people are throwing their hat in the ring. The marketplace is getting more and more competitive, but I think the thing to keep in mind, I mean we could have a whole conversation probably on that, the thing to keep in mind there is the people who are starting companies and I'm talking really top tier companies, companies that are backed by top tier firms. We've touched on it I think in the episodes leading up to this, the dispersion of returns in venture is substantial. And we were actually at an annual meeting earlier this week and hearing a VC firm speak. And I think he used the term something along the lines of, there's a lot of crap or a lot of shit I think is the term he used.
Justin Dyer (11:32): There's a lot of shit out there. And just to put that into context, the top returning funds knock it out of the park, hit home runs. The bottom quartile, they do worse than the public markets.
Brandon Averill (11:45): Correct.
Justin Dyer (11:46): If not substantially worse. And so as a founder you want to align yourself with that top echelon, whatever quartile or decile, whatever it may be. Those firms tend to stay there and repeat. And so from an investment standpoint, that's where you want to be. Also from a founder standpoint, that's where you want to be. These founders that are creating companies that have tremendous amount of upside, they're not dumb. They're incredibly smart people. They want to bring in the right strategic investors. Not only do they need money, yes. But if a venture fund can bring more to the table, which a lot of them can, hey that's a win-win.
Justin Dyer (12:24): And that's another reason why you see, going back to this example we got today, there were six or seven different firms in what's called the syndicate. That's the group of investors that is investing in this particular round. And each one of those investors potentially has a different attribute that they bring to the table I think is the way to think about it. Obviously investors like to diversify, they probably never want to take the entire round if they could. In some cases they do, but it's rare and nor would founders necessarily want them to take the whole thing, because again diversity of thought diversity of value proposition is just generally a win-win from founder perspective.
Brandon Averill (13:06): Yeah. I mean, we've heard that a number of times talking with companies. If you're a founder we've heard, "Hey yeah, I didn't really actually need the money, but I wanted the experience." They have an operator within their venture firm that has walked this walk before and their advice is the value there. So I'm willing to give up ownership and take the money really just to have that venture capitalist on board. We've talked about this with Bessemer in the past, and a gentleman Byron Deider, if you have a cloud company you want Byron to be involved at some level. That's just a huge value add. And so this relationship gets a lot more complex absolutely. It's a noisy market right now and maybe I'll end on this, but we see a lot of capital right now chasing a lot of companies.
Brandon Averill (13:56): And I think it goes back to that venture partner really talking about there's a lot of crap out there right now because it's sexy. This is a pretty easy thing to sell quite frankly. But it's hard to get into that top. He made the comment, they just raised their most recent fund, I think it was like six and a half billion is more than double what their previous fund was. And they did it with 20% fewer investors in their fund.
Justin Dyer (14:21): And the [inaudible 00:14:22] interesting statistic.
Brandon Averill (14:22): Yeah. The point was, yes there's a lot of money out there, but really people, especially at the top end they want to maximize the value of their relationships. You don't want to just kind of throw in people along the lines. So yeah. Anyways, hopefully this was a helpful groundwork for who the players are. Simply the entrepreneur, who's the venture capitalist, what are the roles that they're playing here. In future weeks, we're going to get into, for sure specifically the entrepreneur. What types of things are helpful from the venture capitalist? How does a venture capitalist pick the entrepreneurs because that's the special sauce. And so we'll get into all the details there.
Brandon Averill (15:06): There's some big nuances and then throughout we're going to try to relate it back to you as the investor. Again, when do I participate in this? When should I get access? Hey, I'm being sold access by my wire house broker and I can get in on the next thing and all I got to do is put 25,000 in and you know, yada, yada. We'll dispel all the myths there. You're probably getting less than that market return in the public markets to cut to the chase. So anyways, we want to hear from you, we'd love to hear all your questions that you have on the venture markets. Shoot me a text 602-704-5574. We'll respond right back to you. Comes right to my phone here and would love to hear from you. So I'll give you the number again. It's 602-704-5574. And until next time, own your wealth, make an impact, and always be a pro.
Speaker 4 (16:07): The information in this podcast is educational and general in nature and does not take into consideration the listener's personal circumstances. Therefore, it is not intended to be a substitute for specific individualized, financial, legal, or tax advice. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a final decision.