Here’s What You Should Know About the Finance Behind Venture Capital

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Venture capitalists help startups grow by offering capital in exchange for equity during early stages. Of course, there’s much more to the process than simple siphoning money from VC to startup: often, this capital becomes a lifeline for promising businesses whose roadblocks are almost entirely monetary. Today, VCs play a huge role in the financial landscape of the startup world.

“From 2003 to 2011, an average of 157 new funds were raised each year,” says Eric Feng, who analyzed and pulled his numbers Pitchbook. “But from 2012 onward, that average rose to 223, or an impressive 42% increase. More funds equals more active investors working at those funds.”

That’s just the beginning of what’s happening in the world of venture capital and startups today. Here’s what else you should know about the finance process behind venture capital deals:

Venture Capital: The Numbers
Over the past 15 years, VC firms in the United States have invested 4x more money into startups, amassing $85 billion last year. Prior to 2011, the average amount of money invested in started was around $28 billion annually. And on average, there were 3,800 investment deals between 2003 and 2013, compared to today’s average of 8,700.

When you analyze the numbers, it’s clear to see that venture deals account for a whopping 90% of capital. Even with huge spike in seed funds, traditional venture and growth funds are still powering monetary movement. The math breaks down to roughly 1 venture capital deal every single hour, 365 days of the year.

Behind the Finance: The Venture Capital Process
Before the finance talk even begins, it’s critical for entrepreneurs to understand how venture capitalists are choosing their companies. The process of finding the best venture capital funding isn’t easy. And the more that an entrepreneur understands the process, the better off they’ll be.

“The reality is that entrepreneurs are at a disadvantage when fundraising relative to investors.,” says venture capitalist Lee Jacobs. “Investors do these investments all the time and an entrepreneur often does not have much experience in these transactions, that is why it is really important for entrepreneurs to arm themselves with as much information about the process as possible. ”

Finances & Term Sheets
Term sheets are the documents that detail the entire scope of financial and business involvement that a venture capitalist will have. It includes several important components, like corporate governance, liquidation, and funding.The document should be mutually beneficial to both parties. On the one hand, investors want to protect their investments and have the power to prevent certain actions from taking place that affect those investments.

For example, during early stages, the startup team’s key players are instrumental in the decision making process. Because these initial investments can veer on the risky side, VCs are often counting on specific people, and not necessarily just the product. Therefore, a portion of their time sheet might stipulate the long-term involvement of certain members of the team.

On the startup side of the term sheet, entrepreneurs want to make the most of their capital without giving up too much of their business. Ideally, they don’t to relinquish too much control, but they understand the value that a VC brings the table.

“The term sheet will typically state that it is non-binding, except for certain provisions, such as confidentiality and no shop/exclusivity,” says Forbes writer Richard Harroch. Although it is not binding, the term sheet is by far the most important document to negotiate with investors—almost all of the issues that matter will be covered in the term sheet, leaving smaller issues to be resolved in the financing documents that follow.

Getting a Return on Investments
It’s clear that venture capitalists are busy these days. Investments are the early engine for VCs, but an exit strategy is the end goal. To truly understand the risk that venture capitalists face with each deal, it’s important to understand how those investments translate into returns. Fortunately, the results don’t bode too bad. Over the past 15 years, the number of startup exits is twice as high as it used to be. Furthermore, the value of those exits averages 3x higher than the previous decade and a half.

By Steve Barker

© 2019 Copyright Steve Barker - All Rights Reserved

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