A Startup Founder’s Primer to VC

Getting exposed as a rookie is often the deepest of cuts. Take the scene in the movie The Big Short where Jamie and Charlie from Brownfield Fund go to JP Morgan to get an agreement to make riskier trades. Instead of meeting in the office, an associate comes down to the lobby and informs them that they are $1.47 billion under the capital requirement for an “ISDA” agreement.

As the associate looks on, Jamie and Charlie reel from the embarrassment of not knowing an obvious requirement. They realized just then how underqualified they were to be playing in the big-leagues of the trading world.

When I was out raising capital for my startup, I had many Jamie and Charlie moments. I did not know how Venture Capital (VC) worked, who we needed to talk to, or what they expected from founders. We just stumbled from one embarrassing moment to the next.

Back then, sources of quality information on the VC industry were few and far between. I leaned on the few blogs that existed about VC from Fred Wilson, Brad Feld & Mark Suster. After my startup, I started building more relationships with VCs, which gave me a much clearer view into how VC operates.

Today there are numerous sources to learn about VC. There are podcasts like Full Ratchet & Venture Unlocked, books from Mastering the VC Game to Venture Deals, media such as TechCrunch & Venture Beat, and sites like GoingVC, Kauffman Fellows & StrictlyVC with a wealth of resources. There are free courses from edX, Coursera, and colleges. Also, many VCs share over social media about the VC world.

The downside of this deluge of information is that it’s a lot to take in. To make it super simple for you to get the fundamentals, we put together this condensed overview of VC so that you are more informed as you go out to raise capital for your startup.

What is Venture Capital?

Venture Capital (VC) is a form of financing provided to high-growth startups in exchange for equity with the expectation of generating significant returns.

What is the difference between a VC firm and a VC fund?

A VC firm is a limited partnership company that manages and invests capital in startups and typically manages multiple VC funds over its lifetime. A VC fund, on the other hand, is a pool of capital raised and managed by the VC firm for investing in a portfolio of startups. Each fund has a defined investment thesis and lifespan, usually 10 years, which includes a period for making new investments (first 3-5 years) followed by managing those investments and seeking exits to return capital to the investors.

What is an investment thesis?

A thesis guides VCs in their investment decisions and is built upon market insights, technology trends, business models, industry sectors, societal shifts, and talent insights. The thesis also informs stage of investment and portfolio construction. This enables a VC to differentiate themselves when raising capital for their fund and providing guidance on investments decisions.

Are there different types of VC firms?

Yes, VC firms can generally be categorized by domain and / or fund size. Along domain, VCs can either be generalist or specialist firms. Generalists invest in a wide range of startups as long as they adhere to thesis, whereas specialist firms have a narrower range but deeper focus in a particular industry (fintech, biotech), sector (consumer, SaaS), impact (sustainability, diversity), or geography. VCs may also be categorized by fund size from Micro / Seed Stage / Early-Stage VCs that focus on pre-seed to Series B and Growth Stage VCs that typically invest in post-Series B startups. There are also Corporate VCs (CVCs) that operate within a company, angel and syndicate groups that in some ways interact with startups in a similar way to VCs, and accelerator / incubator programs that also invest in a portion of the startups that graduate through their cohorts.

What are the types of roles within a VC firm?

The number and types of roles in a VC firm will vary based on the size of fund being managed and thesis, but most VC firms will have the following roles.

1. Associate - Entry-level members in a VC firm responsible for market research, screening investments, and supporting due diligence. They are often the first person a startup engages at the VC firm.

2. Senior Associate / Principal – More senior than associates, they identify and vet investment deals, lead deal execution, and sometimes manage relationships with portfolio companies.

3. Partner / General Partner (GPs) - The senior-most members with decision-making authority in a VC firm. They set strategic direction, secure capital, make final investment decisions, and lead relationships with the firm’s most important portfolio companies, often taking board seats.

4. Operating Partner – Usually as part of a Portfolio Support or Platform team, these are experts in a domain and help portfolio companies by providing guidance and operational expertise.

5. Limited Partners (LPs) - Investors who provide capital to a VC fund managed by the firm. While they contribute capital, they have no role managing the firm or making investment decisions.

Depending on fund size, a VC firm may have interns / analysts (junior to associates), operations to support firm functions (finance, HR, recruiting & communications), and venture partners / scouts / entrepreneurs-in-residence to help source, evaluate deals, and advise portfolio companies, but are not full-time.

Where do VC firms get the capital that they invest?

Given the millions (and possibly billions) of dollars VC firms deploy, VCs need to find large enough pools of capital to fuel their investment objectives. More established firms draw upon larger checks from institutions, while smaller VC firms mostly rely upon capital from wealthy individuals and families. Each of these sources is explained below

1. Institutional Investors – The most common source of VC capital covering a broad range of investors including Pension Funds (manage retirement money), Endowments & Foundations (universities & charities), insurance companies, and Fund of Funds (firms that invest in VC funds).

2. Corporate Investors - Some corporations invest directly in VC funds to gain early access to innovative technologies and business models to seek strategic benefits alongside financial returns.

3. Family Offices - Wealthy families often invest through family offices to manage their private wealth.

4. High Net-Worth Individuals (HNWIs) - Individuals with significant personal wealth.

5. Government and Public Agencies - Governments invest in venture capital funds to stimulate economic growth, encourage innovation, and promote job creation within their jurisdictions.

6. Sovereign Wealth Funds - These are state-owned investment funds or entities specifically focused on financial returns.

What process do VCs use to source and manage investment opportunities?

Almost every VC firm globally will follow these steps when investing in startups.

1. Sourcing Deals - VCs find startups to invest in through networking, industry events, and relationship with incubators, accelerators, and other investors, as well as direct pitches or referrals from startups.

2. Screening and Evaluation - Once a potential investment is identified, the VC conducts an initial review to assess the startup's viability, market potential, and alignment with the VCs investment thesis.

3. Due Diligence – For startups that pass initial screening, VCs dive deep into the business, including financial model, legal matters, market research, technology, and operational capabilities.

4. Investment Decision – If a startup passes due diligence, the firm sends the deal to the investment committee (IC) to decide whether to proceed with an investment.

5. Structuring the Deal - The terms of the investment are negotiated and outlined in a term sheet, covering amount of capital to invest, equity stake, governance rights, and other key terms.

6. Legal and Closing - Once the term sheet is agreed upon, legal documents are drafted by both parties’ lawyers to formalize the investment.

7. Portfolio Support - VCs actively manage their portfolio companies through advice, introductions for customers, recruits & future financing rounds, and taking board seats.

8. Exit – VCs make a return on their investments when portfolio companies list an initial public offering (IPO), get acquired, or sell shares to other investors in future rounds or secondary sales.

What is an investment “round”?

VC investments are structured in stages that correspond to the growth stages of the startups receiving capital, providing the capital needed to reach the next significant milestone in the startup’s growth.

1. Friends & Family - The first money in, usually from the founders themselves, friends, family, and possibly angel investors.

2. Pre-Seed and Seed Funding - The first formal equity funding stages when pre-revenue / pre-product startups are refining their concepts and developing a minimally viable product (MVP). Pre-seed is usually founders with an idea whereas seed is for startups with an initial product and customer validation.

3. Series A – Funding is mostly from VC firms when the has shown evidence of user growth, revenue, or significant product development. Funding helps to confirm initial product-market fit thesis.

4. Series B – Startups are well-established with proven market potential and customer revenue. This round generally focuses on market expansion and achieving operational scale.

5. Series C and Beyond – Mostly led by growth stage VC firms and private equity funds for startups that demonstrate long-term viability before IPO or acquisition.

6. Bridge Rounds – Short-term financing led by existing investors to prepare a startup for next round of funding but need extra capital to be better positioned for securing the next round.

7. Debt Financing - Startups sometimes use debt financing to finance their growth without further diluting equity holders, usually starting with post-Series A.

What do VCs look for in startups to invest?

While is varies from firm to firm, generally VCs want to understand the following: Market Potential that the startup addresses a large or rapidly growing market, Innovative Technology or Business Model that provides a competitive and differentiated advantage, Scalability for growth and high margin without a corresponding increase in costs, Team that has passion, experience, agility & resilience, and Traction that shows increasing user acquisition, revenue growth, product value, and market share.

How do VCs make money?

Venture capitalists (VCs) make money through management fees and carried interest. Management fees are the source of income for VC firms used to cover firm expenses like salaries, office space, etc. These fees are a percentage of the capital committed to the fund and are paid annually during the life of the fund, but may wind down after the active investment period. Carried interest, or carry, is where VC’s make real money. Carry is the share of the profits generated by the fund from its investments after the original capital contributed by investors has been returned, along with a predetermined "hurdle rate" or minimum rate of return. While the percentages sometimes vary, most VCs earn “2 and 20”, meaning 2% management fees and 20% carried interest.

What do VCs consider a successful investment?

Given the high-risk nature of startups, VCs need significant returns to justify the risk and resources involved in investing in this segment. What success looks like will depend on stage of investments, risk profile, investment thesis, and portfolio construction. Generally speaking, early-stage investors (pre-Series B) want to see a 10x return over 7-10 years while growth-stage investors (Series B and beyond) will target 3x-5x returns.

There are a few key metrics used by VCs to evaluate success. First is Internal Rate of Return (IRR), the annualized compounded return rate of an investment. VCs typically aim for an IRR of 20% to 30%. Second is Distributed to Paid-In (DPI), the ratio of the return on the capital distributed back to LPs relative to the capital originally invested. Early in the life of a fund, DPI will be under 1.0 since the fund has no exits, whereas towards the end a good DPI would be 1.5 or above, depending on stage of fund. The last metric is Total Value to Paid-In (TVPI) which includes both DPI and the Net Asset Value (NAV). TVPI is useful for evaluating current performance and future potential value.

The benchmark for these metrics is driven by the Power Law. Because most startups fail, only a few will achieve significant returns where 1 out of 10 investments return 10x, 2 out of 10 achieve 3x-5x, and the remaining generate no return or fail. Thus, a successful VC doesn’t require every investment to be a hit; one or two significant wins can cover the losses of other investments.

What are the key components of a VC term sheet?

A term sheet is a document that outlines the terms and conditions of a proposed investment between a VC firm and a startup and the basis for formal legal documents if both parties agree to proceed. There are many terms that appear in term sheets, but these are the most common and important ones:

1. Valuation and Investment Amount – This includes Pre-money Valuation (value of the company before the investment), Post-money Valuation (value of the company after the investment plus new capital), and Investment Amount (total amount of capital the VC firm will invest in the startup)

2. Capitalization Table – Also called “cap table” shows the startup’s ownership structure before and after the investment, including the percentage of equity shares held by all parties.

3. Liquidation Preference – Specifies how the proceeds will be distributed in an exit and ensures investors receive their investment back before other shareholders are paid.

4. Participation Rights – Whether investors have the right to the proceeds of an exit after receiving their liquidation preference; full participation (yes), capped (partial), or non-participating (no).

5. Anti-dilution Provisions – Protects investors from future dilution if the company issues new shares at a lower price than the investors previously paid.

6. Voting Rights – Specifies the voting rights attached to the new shares and potentially includes details on votes required for certain types of decisions.

7. Board Composition – Outlines changes to the board of directors' composition post-investment, including how many board seats the VC firm will occupy.

8. Information Rights – Gives investors the right to regular financial and operational updates from the startup, usually including annual, quarterly, and sometimes monthly updates.

9. Founder Vesting – Conditions that might be placed on the founders’ shares, typically requiring that founders earn their shares over time to ensure they remain committed to the startup.

10. Right of First Refusal (ROFR) – Gives existing investors the right to match any new offers in future financing rounds.

11. Exclusivity & Confidentiality – Also called a “No Shop” clause, it prevents the startup from seeking other investors and sharing details of the offer for a specified period during negotiations.

How can you convince VCs to invest in your startup?

Glad you asked! Check out future editions of this newsletter where we will provide more guidance on how to build the case for VCs to fund your startup.

There is much more to explore when it comes to VCs. While this is not meant to be a comprehensive review of the VC industry, this guide gives you a starting point on your research before you go out to raise. By understanding how VC operate, you can be better prepared for a successful raise.

Mark & Basil

P.S. Thanks for your patience as this edition got out later than expected due to the amount of content and editing that went into our VC guide. Since it is a lengthy essay, we are pausing our Commentary and Community sections with week.

BUT we do want to ask our community, that means YOU, our awesome subscribers, to give us your feedback and tips about VC that you think should be included in our guide. Our goal is that this becomes a living document that is current and informative for all founders. You can message us over LinkedIn to share your thoughts. Thanks again and appreciate your support!