Venture capital (VC) can be very positive for startups, especially if you’re interested in prioritizing speed of growth over efficiency. However, if too reliant on VC rather than profitability, it can be a significant detriment to your business model’s long-term sustainability. Sometimes raising funding from VCs can be a shot in the dark if you don’t know what you’re looking for or what’s vital for your business stage. Below is a brief overview of origins, key terms, economics, and investment criteria that founders should determine when raising VC.
The venture capital industry came to fruition by Georges Doriot and his firm American Research and Development Corporation (ARDC) after World War II to encourage business in the private sector. Alums of ARDC would go on to found prominent VC firms like Greylock Partners.
Venture capital is a type of private equity that is generally provided by firms or corporate venture arms. VCs are investing in tech-enabled startups with high growth potential to generate returns despite high risk. The stage of a typical VC investment or first institutional money usually occurs after seed funding in the Series A round. These investments range from early-stage startups to later-stage companies.
The vehicle that the firm uses to invest in startups is the fund. The firm raises the fund from family offices, high-net-worth individuals, public pensions, and endowments, to name a few. These investors in the fund are known as limited partners (LP). LPs expect to see returns based on the investments made by the general partners (GP) and support staff (principal, associates, analysts) of the firm. GP’s are typically paid 2% annually from committed capital to manage the fund and 20% carry, which is where most of their compensation comes from.
A large share of the fund’s returns come from a small percentage of investments, which permeates most VCs’ thoughts. Investor, Michael Dempsey, refers to this as the Return The Fund (RTF) analysis:
Fund Size / % owned at exit = Minimum Viable Exit
Further delving into how VCs think about building their position over time, I’ve provided some quick math below:
VC Firm has a $20M seed fund investing $1M in startup
- $1M/$10M valuation = 10% ownership
- In order to return the fund (not including dilution), the startup must exit for (20/.1) = $200M
If VCs pass on you, then your startup idea might be too small for some VCs. Other metrics VCs use to measure traction and progress include IRR, unrealized gains, and social validation.
VC firms vary in structure as well as in investment thesis. A VC’s investment thesis can help you, the founder, immediately determine if they’d be interested in investing in your startup. Many follow certain parameters and invest in specific business models based on years in the space. Some place a higher emphasis on authentic differentiation to convey their advantage in providing strategic advice to startups. Task Force Capital (TFX) is one example of a VC firm whose investment thesis is investing in veteran-founded businesses.
Established in 2015, TFX is a Veteran-led venture capital firm uniquely focused on investing in high performing, accomplished, and commercially-tested former military leaders building early-stage technology (B2B) and technology-enabled businesses. The firm’s thesis is informed by the team’s personal experiences, beliefs, and observations. Its site states:
“We see the presence of a military veteran on a founding team as a potential source of investment alpha. As veterans ourselves, we have unique access to this community of founders and offer a unique risk management approach via the common bond we share. We can get to moments of trust and transparency rapidly and in a way that many investors cannot.”
For founders considering raising funding from VCs, it’s essential to understand their mathematical motivations, actionable metrics, and criteria revolving around investments. Around .1% of companies who raise venture capital ever actually achieve venture scale. While raising VC is what we mostly consume in headlines and a viable blueprint for a select few to grow their business, it doesn’t mean VC is the track for everyone.