The more conversations I have, the more I realize everybody wants to get a job in Venture Capital.

Founders can’t wait to sit on the other side of the table and have all the power.

Graduates dream of becoming investors and get all the fame, glory and money.

Today we dive into the world of Venture Capital and by the end you’ll know more than 99% of people.

Let’s begin!

Venture capitalists (or VCs) are investors who invest money on behalf of their investors, called Limited Partners (or LPs).

LPs range from large pension funds and endowments to high-net-worth individuals and family offices. They usually invest in venture capital funds as part of a broader portfolio that includes different asset classes (from stocks, and bonds to real estate).

While VCs gain from being known and outspoken (you’ll see why below), LPs are the ultimate source of money in any startup ecosystem and they are usually much harder to identify and even harder to access.

The Venture Capital model

VC funds earn money in 2 ways:

• Management fees: guaranteed yearly fees to pay for salaries, offices and other firm expenses

• Profit share (called carried interest or carry): a percentage of the money the fund makes after returning the principal to LPs

The most common structure is a 2-20: 2% management fees (based on the fund size) and 20% of carry.

This structure is negotiable and the most successful VC firms can even change 3% management fees and 30% carry.

If a fund returns less than the initial investment, there will be no carry for the investors and under certain circumstances they might even be asked to return the management fees they have already collected.

Types of Venture Capital firms:

• Generalists: invest across industries and geographies. Mainly rely on their network and super-connectors. Example: Founder Funds

• Thesis-driven specialists: identify a gap/need/opportunity and invest in companies addressing that. The timing of the thesis is essential. Example: USV

• Thematic investors: most VC firms fall into this category. They focus on specific sub-sectors that match the investor’s expertise, with room for only a few opportunistic investments

Main roles in a venture capital firm

• Managing Partners - they have equity in the management company and are involved in strategic decisions, LPs relationships, investments across multiple funds and promoting/hiring partners

• Partners - they oversee and manage the entire deal flow and portfolio of specific funds and report to the Managing Partners

• Principals - senior investment professionals who are responsible for sourcing new deals, performing due diligence and supporting companies alongside Partners

• Venture Partners - senior professionals who collaborate with the firm on a part-time basis and support partners in strategic, investment, operational and fundraising topics. They are usually not compensated with a salary but with a portion of the fund’s carry

• Associates and Analysts - they do the majority of the detailed work, including research, model, and analysis. These roles range from entry-level roles (junior analysts) to professionals with 3-5 years of experience (senior associates)

Venture Capital firms are usually very small and team members operate independently from each other, especially at a senior level.

Other roles that depend on the firm’s strategy and investment approach are interns/fellows, scouts, finance professionals and a wide range of former operators/executives who provide specific services to portfolio companies.

The life of a Venture Capital deal

Sourcing

• Inbound

• Outbound

• Referrals

• Proprietary deal flow (for example with an in-house accelerator or venture studio)

Great inbound deals are surprisingly rare in venture capital as they require a strong brand.

Good founders have options and venture capitalists sell the most commoditized good of all time, money.

VC firms often invest in having a strong media platform to amplify the companies they invest in, help with intros/hiring, build a reputation as experts in their space and attract better opportunities.

In partners-led firms, such as Benchmark, sourcing is done by the partners.

In most cases, analysts and associates screen deals before presenting them to partners. They are usually specialists in certain verticals so they can rapidly assess the validity of startups and rule out opportunities in case of any red flags.

Investment decisions

What VC firms do before investing:

• Founders’ diligence: reaching out to people who have worked with them previously (keeping in mind that what makes a good employee is not what makes a good founder). Especially in pre-seed/investing, making sure the co-founding team is the right one is essential

• Expert advice: reaching out to investment advisers that are experts in the field and can validate or challenge specific aspects of the startup

• Founder-market fit: do founders have an edge in this field? Do they have the right attitude for this kind of business? (e.g. consumer vs enterprise sales)

• Customer diligence: making sure the problem is big enough and urgent that customers are (or they will be) willing to pay

• Due Diligence: going through financials, legal documents, governance practices and compensation schemes to make sure there are no red flags

How VC make decisions

A deal champion (usually a partner but in rare cases could also be a junior investor), puts together an investment memo with the main reasons why a startup could be a good investment, some answers to key questions already discussed with founders, potential risks with mitigation plan and deal terms.

This is shared with all the partners (or investment committee) in advance of the Partners Meeting.

This is a common practice in every firm and usually, the person writing it benefits the most from writing the memo as a way to clarify their thoughts.

The other partners will only spend a few minutes on it and usually prefer to discuss specific aspects altogether during the meeting

During the Partners Meeting, the startup will present for 30-45 minutes. The deal champion usually takes a back role and does not influence the conversation (they already shared they believe in it) where the other partners will ask questions before moving on.

Common voting mechanisms:

• Majority (open or blind)

• Unanimously

• Silver bullet (a member can push the investment through even if everybody else is against it - usually very limited)

• Veto (one or more members have the right to stop any investments)

If the deal is approved, a term sheet is shared with the company.

In short, a Term Sheet is a non-binding blueprint of an investment.

Most Term Sheets have the same format and terms, which are considered industry standards by almost all VCs and this is why it’s not uncommon to have 1-page term sheets.

Here are a few common terms:

• Money raised (minimum amount of money that you have to raise to close the round and finalize the transfer of capital)

• Pre-money valuation (company value before the investment)

• Liquidation preference (investors have preferred shares and priority to get their money back in case of an exit before other shareholders)

• Conversion to common stock (investors have the option to convert their shares into common shares and get paid together with other shareholders in case of an exit)

• Anti-dilution provisions (if the founder sells shares at a lower. valuation than the investor is paying, they will receive additional stock to secure their ownership percentage)

• Pay-to-play (under certain conditions, investors have to invest in future rounds to avoid their preferred stocks converting to common stocks)

• Boardroom makeup (how the Board of Directors will look like after the investor comes in. Usually 2 founders, 2 investors and 1 independent)

• Voting rights (investors have a direct saying in company matters)

If you want to learn more about this, you should read Venture Deals.

This opens a negotiation with a founder. As a founder, pushing back on a few terms makes sense as the investor is not likely to immediately back off from the deal (they have already put their reputation on the line within the firm).

But founders should not overdo it as that person will probably end up on your board and become a trusted advisor so it’s key to preserve a great relationship.

Company building

Early-stage investing is a great way to get involved in the companies within the portfolio and investors get a chance to create real value.

How do VC firms add value:

• Partners’ advice with no major services provided - Kleiner Perkins, Benchmark

• Hands-on services: the high fees from large funds are used to hire world-class operators that can support the portfolio to scale - a16z

• Halo effect from reputed firms - this instantly makes you a hot company to other VCs (consensus investment in future rounds), talent who want to work for a company backed by tier 1 firms and customers that immediately think you are more legit

• Supportive cheerleader: be there when founders need you without a strong advisory or service role - Foundry Group

Board of directors in startups

A lead investor will usually join your board of directors, which is formally structured in quarterly meetings (in person or virtual).

A board has usually two roles:

• Governance (setting and agreeing on high-level company matters, confirming financials and budgets, approving stock options plans, hiring, and firing executives)

• Advising (working with the CEO and management team on key strategic objectives)

These are a few common best practices:

• The CEO sends updates in advance, which are considered read and understood by everyone when the meeting starts

• Length is 3-4 hours with clear agenda and planned breaks

• The list of decision items and discussion items is communicated beforehand and iterated at the beginning of the meeting

• Executive team members are invited to join the meeting and directly engage with board members

• Follow-up items are noted and shared afterwards with the entire group

• Observers and lawyers should only speak when asked

• Board members and executives spend social time together during a meal before or after the board meeting

How fund’s returns drive decision making

Venture Capital is a very illiquid asset class, with LPs money locked up for a decade.

From an LP perspective, a VC firm has to compete (and potentially outperform) other asset classes, such as the broad stock market, which is by definition liquid and compounds at a 7-9% per year.

This means VC firms target a 12% yearly compounding return or a 3x net return over the 10-year lifecycle of a fund.

This is very hard to achieve considering venture capital follows a power law: 65% of VC-backed startups return 0-1x the initial investment, 25% return 1-5x and only 1.5% return over 20x.
(source: Correlation Ventures)

For example, a $100M seed fund aims at returning at least $300M.

Because of the management fees, only a part of that money is actually invested. With a 2:20 model, the fund will invest $80M.

This means that, in order to return 3x the investment to LPs (DPI - Distribution to Paid-In Capital), the fund has to return ~ 4.4x on invested capital (MoIC - Multiple on Invested Capital).

Assuming a large enough portfolio, these investors are looking for 1 successful company that can return at least $400M (or 2 companies that return $200M each).

Considering an ownership percentage of 10% at exit, 1 portfolio company has to exit for $4B (or 2 companies have to exit for $2B).

This is exactly why the size of the market matters A LOT!

Incentives in decision making

Achieving these kinds of returns in a competitive market means investing when there is no consensus and you end up being right in the end.

Younger VCs are incentivized to make consensus bets where companies are hot and there is clear potential for a good markup in the next round.

This way they can rapidly build a good reputation and get promoted.

They have little to no incentive in pushing a deal that no one of the partners believes in because even if they are right and that ends up working, real success is only evident in 5-10 years after the investment so they would only reap the rewards much later on.

On the other hand, if there is no consensus among partners but they still push for investment and things don’t work out, they might be up for a tough conversation in just a few months.

In summary, if the ultimate goal is to return over 3x the fund, consensus bets are risky because they usually do not have that potential but they work great to build a reputation and give you some track record to raise the next fund.

In addition to that, if a company with broad consensus does not work, investors are less likely to be held accountable, because everybody believed it was a good investment.

This is true for Partners dealing with LPs and junior VCs dealing with Partners.

It’s just a safer bet.

This is also why a lot of similar companies are funded by (almost) every VC firm during a hype market (e.g. AI, crypto and so on).

There are also other incentives for choosing consensus deals.

For example, when funds get larger ($500M+), it is a lot riskier to invest in non-consensus deals. LPs are probably ok with safer returns over a shorter period of time (usually these large funds invest in Series B+)

In these cases, getting high ownership of a few consensus deals might be the right strategy to secure good returns and raise a new bigger fund every few years.

This is probably closer to Private Equity than Venture Capital.

Both work but in different circumstances: the key is knowing the game each investor is playing.

After investing

At every round, investors aim to own 10 to 15% of the company, which will of course be diluted in future rounds.

One way to keep good ownership is to follow on with additional investments in future rounds.

At the time of the initial investment, some deals give the investors the right to keep investing in future rounds in order to maintain their ownership percentage (pro-rata rights) or even increase that up to a certain multiple (super pro-rata rights).

Investment follow-ons can be done in 3 main ways:

• By the same fund (many funds have a 50/50 or 60/40 split between initial investments and follow-ons)

• By another fund within the same firm (e.g. later stage or opportunity fund)

• Through SPVs (Special Purpose Vehicles), which are basically syndication of investors, usually led by the existing investor, pulling new investors into the deal

Deciding whether to proceed with a follow-on investment is not as easy as it looks because many times the step up in valuation is bigger than the additional data you have, which means that you are still not sure if the company will be a winner or not.

Given the limited size of a VC fund and the opportunity cost of not investing in a new company, early-stage funds usually have limited capital for follow-ups from the same fund.

Portfolio management

Given the power law of startup success, investors need to be exposed to a high enough number of deals to increase the chances of getting a home run.

LPs are not necessarily fond of huge diversification (especially institutional ones) because they are already diversified by investing in multiple funds.

A concentrated portfolio around a specific theme might work better from their point of view. On the other hand, LPs know that a high enough number of investment allows the Partners to build a good portfolio and maximize success for their own firm and career.

Usually, VC portfolios tend to be between 20 (highly concentrated) to 40 (highly diversified).

Common scenarios of a portfolio startup:

• The company is working - they probably don’t need much help from investors. If there is a strong conviction, investors tend to put more money in before the next round (even before a founder asks) to secure more ownership and wait for an even larger markup at the next round

• The company is kind of working - in this case, the investor’s advice can be very helpful in trying to steer the company, work on a pivot, a restructuring or a different strategy

• The company is not working - everybody knows the company will fail but investors can still help with a soft-landing

The first group is what makes investors successful.
Scenarios #2 and #3 build reputations and help investors get in front of the best deals in the future.

In theory, only companies in bucket 1 should even be considered for follow-on investment.

In practice, this is not the case.

First of all, it’s not always easy to know which group each company belong to.

On top of that, partners (and especially junior VCs) only have a few investments per year and they end up becoming very involved in a small number of companies.

As their reputation (both internally and externally) depends on a few deals, they might be willing to invest in companies that are not performing great, with the hope of turning them around.

This is (almost) always a bad strategy.

Exit scenarios

A company exit means that there is a liquidity event which returns money to the owners of the company based on the shares they own.

This allows VCs to turn their unrealized increase in portfolio valuation into realized gain, distribute money back to LPs and earn a portion of profits.

There are 3 types of exits:

• Acquisition: the company is bought by a larger company in a cash and/or stock deal

• Public event: the company is listed on a public stock exchange

• Secondary transactions: investors sell their shares to existing shareholders or new investors

Being a venture capitalist is easy, right?

Only 5% of VC funds return 3x or more!

Venture Capital is a tough business and it’s a lot harder than it seems (despite the fact that VCs always look successful).

VCs rarely provide the expected returns to their LPs, which means most of them get compensated almost exclusively by management fees.

Founders have a hard time building companies that fit the venture capital model, which requires a path to an outsized outcome from day 1.

It’s an industry in continuous evolution and with the rise of data-driven VCs and micro venture capital funds, there is a lot to be excited about!

This week’s newsletter turned out to be longer than many blog posts so I’ll spare you a scientific deep dive.

… but get ready for a great piece next week!

If you have any feedback, suggestions or thoughts on this issue, let me know.

This week's top reads

1. Discovery and mechanism-guided engineering of BHET hydrolases for improved PET recycling and upcycling (Nature)

2. Human BioMolecular Atlas Program (Nature - data freely available)

3. Seeing colour following gene augmentation therapy in achromatopsia (Cell)

4. Neuronal wiring diagram of an adult brain (BioRxiv)

   FlyWire Dataset 

5. Rewiring cancer drivers to activate apoptosis (Nature)

Latest funding rounds in health & bio

Ready to turn this news into your next career opportunity? Here is how

• thymia raised $2.7M for their AI-powered mental health platform that leads to diagnosis and treatment plans through objective assessment and through gamification 🇬🇧

• Béa Fertility raised £2.5 to pilot its at-home fertility treatment in the UK through a pilot with the NHS 🇬🇧

• CathVision raised $9M to further develop innovative products for cardiac ablation therapy, starting with an AI-powered medical device for intelligent decision support 🇳🇱

• Gaia Tech raised CHF 480,000 to upcycle agricultural sidestreams into bio-compounds and added-value ingredients 🇨🇭

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