Show notes
In this episode, we deep dive into the process of Venture Capital - how does it actually all work? - and what the future of VC holds. The end of our 2 part episode on the Evolution of Venture Capital.
Navigation:
Intro (01:33)
Section 1: The Process of VC (01:59)
Section 2: Stats on VC (19:03)
Section 3: The Future of VC (27:31)
Conclusion (38:40)
Our co-hosts:
Bertrand Schmitt, Entrepreneur in Residence at Red River West, co-founder of App Annie / Data.ai, business angel, advisor to startups and VC funds, @bschmitt
Nuno Goncalves Pedro, Investor, Managing Partner, Founder at Chamaeleon, @ngpedro
Our show: Tech DECIPHERED brings you the Entrepreneur and Investor views on Big Tech, VC and Start-up news, opinion pieces and research. We decipher their meaning, and add inside knowledge and context. Being nerds, we also discuss the latest gadgets and pop culture news
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Intro (01:34)
Bertrand
Welcome to Tech DECIPHERED episode 42. After our first episode, episode 41, sharing the history of venture capital as well as the business of VC, and we are starting episode 42 with the process of VC, as well as some statistics around VC and we will finish with the future of venture capital. Nuno, good to see you again.
Section 1: The Process of VC - (01:59)
Nuno
Nice to see you, and let's start with the process of venture capital. At its essence, the process of venture capital is we're funnel managers. We're not just fund managers, we're funnel managers. We manage a funnel. It's about how healthy that funnel is that a fund can return a lot of capital or not.
Nuno
So it's all about really two extreme positions in the funnel, the beginning of the end being deal sourcing, the quality of the deals you see in the market and the market is essentially—we'll come back to that later—has been very inbound driven. It's about people that come to you. That's why you needed to create a brand, people need to know that you existed, et cetera. I suggest that's about to change and that's we'll talk about in the future of venture capital.
Nuno
But it's about the quality of the deal flow that you have, your proprietary networks, your access to key entrepreneurs that bring you other entrepreneurs, your access to scouts, your access to the market and the quality of those deals.
Nuno
And then at the other extreme is selling the asset at the right time. And really normally you sell an asset either because the company is bought by someone else, or the company IPOs, and at some point you can sell it as public equity or the company fails miserably.
Nuno
I think in the last few years it's very obvious there is maybe a fourth mechanism for you to exit, which is secondary. Someone wants to buy your participation in that company and you can sell it to that other entity, be it an investor, be it a company, be it someone else. But maybe minority sale or selling just your stock rather than anything else.
Nuno
Also important to highlight in the business of venture capital, venture capital firms are minority shareholders. They're not majority shareholders, they're minority shareholders. They're just protected by special provisions because when they buy into the company, they buy into preferred shares. Their shares are paid higher than they should be, but then they get special rights. And then if that VC gets someone on the board, the board member also gets special rights in terms of approval, minority protections, et cetera.
Nuno
So it's not that VCs are dumbasses or stupid and they only want to have minority protection, no, we don't run your businesses, we don't want to own it. But we do want to have protections on your businesses to make sure that we are well represented, either because we're on the board or because we're a lead investor or we're a significant investor in the company.
Nuno
Two pieces of the funnel are top-end deal sourcing, top of funnel, bottom end of the funnel, end of the funnel, you liquidate the asset in some way or the other. There is a loss ratio. Companies will fail. This is high risk. Loss ratios vary a lot, the industry seems to have different mechanisms to figure out what the loss ratio is.
Nuno
Some people a loss ratio is below 1X, so you get cents on the dollar on a company is already a loss. Some say would be 50, 60, 70% of a portfolio, others would say maybe a little bit less. In this day and age, you can always get some money back. So maybe the loss ratio is a little bit lower than that.
Nuno
You will hear a lot about power law, that most of your returns will come from 2 or 3 companies in a portfolio that might be 25 to 35. There's this magic number of 20 to 30 companies per fund, which seems to be around. It has to do also with a number of partners and the positions you're in. It could vary a bit more. Obviously, if you're an incubator and accelerator, you will do hundreds of companies. But if you're like a classic VC firm, you might do 20, 30, 25 to 35 and all of that.
Nuno
But just to go back to the funnel, these two elements of top of funnel and bottom of a funnel are the essential ones. And then there's one, that I would add as a corollary, is you need to get into the deal. You can do due diligence or not, you can do whatever, but you need to get in the deal. That's pretty critical as well. So you can identify the company, but if you don't get into the deal, well, great, you identify the company and then what?
Bertrand
You spend a lot of manpower to work and the thing happened, that's not good.
Nuno
And getting it to the deal is more art and science. You need to be well known, you need to have a reputation, people need to want to give you an allocation, even if you're not the lead investor, even if they want to go with someone else to be the lead investment in that round. So getting into the deal is pretty critical here. The two extremes of liquidation and deal sourcing, which in the middle the dealmaking piece, that creates that added value.
Bertrand
Yeah, and as you say also, it's definitely a poor law at work. Some investments are going to generate outsized return, I mean, you could argue that the very definition of being a VC is outsized return on a few investment. The model for most funds of having a fund returner, I mean, one investment might return the whole fund, if not more. And then you have others that are bringing back 5X, 3X, and then you have quite a few 1X and ultimately you have the one who don't return anything.
Bertrand
Another term that I've seen used is a J-curve, where you talk about from deal sourcing to liquidation, that's what happened. You have to start investing money from your fund and usually you have your first four years of investment that are focused on investing in new companies, and the remaining of the term of the fund, as you said, a total of 12 years. So the rest of the duration of the fund is around, potentially some follow-on investment, but also quite a bit of exits, hopefully. And that's where the J-curve come back. Initially, you decrease the amount you have in your fund and step by step you get it back through the exit.
Nuno
Exactly. You can recycle capital and do a variety of things without necessarily always calling capital from your limited partners.
Bertrand
Potentially, yes.
Nuno
The funnel, just to be very clear, this is at least my taxonomy, is about deal sourcing screening. Deal sourcing is really sourcing deals, and screening is really that first conversation that you would have with the company. Then there's a piece around analysis which might be relatively high level and then the deep dive more into hardcore due diligence, data room analysis, looking at a bunch of data, doing outside analysis.
Nuno
If the VC firms normally, if they're hopefully any good, they will do their own analysis. For example, on market, they won't just trust your numbers on market sizing. Then there's dealmaking, negotiation, getting the deal, putting a term sheet in front of someone or getting into a term sheet that's already been signed, getting to an agreement, managing the lawyers as we we're talking before, then portfolio impact and management.
Nuno
So we've already invested in a company, now we need to create impact for our portfolio, help them manage it, be on boards, the ones that we got board seats or board observer rights and really create value to the company through our own selves, through our teams, through our institutional value and the operations that we've created in-house—we'll talk about that in a second—and then finally liquidate.
Nuno
So again, the two edges are sourcing and liquidation, but at the end you need to liquidate. The company needs to go somewhere. It's either it's gone or it's rebought by its partners or it's sold to someone for a lot of money or not a lot of money or IPOs, et cetera, that's the end of the funnel. Well, that's basically what we manage.
Nuno
This funnel is a complex funnel because if you look at it, it requires a lot of different skills, a lot of different elements of skills for you to be really good at. The skills that it takes to negotiate a deal are not the same skills that it takes to assess whether a market is amazing for a specific company or the skills that it takes to assess whether the team is exceptional and is gritty and can take it to the next level. All of these skills are super different. I always call it, it's the ultimate generalist activity that you have a huge unfair advantage if you have some deep spikes where you're really good at.
Bertrand
Yes, it's a complex process. I'm not sure if we have time to go deeper in every one of these steps. But for instance, deal sourcing that has been a lot of change, as you say, from an old boy network, proprietary network, to applying data science at scale and finding companies automatically with automated scraping databases, API access and filtering these machine learning,...
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