When a new venture arises, it is important for the entrepreneur to have different types of support, particularly on the financial side, especially when it shows a high potential within the market in which it is venturing. One of the most common forms of financing is venture capital or Venture Capital (VC).
In general terms, VC is an investment in the form of financing that an institution provides to a Startup while it is in its growth stage. Once the Startup reaches a stable point of development, the investor can withdraw with its respective monetary benefit.
Although, as its name suggests, it is a risky investment, investors are usually reassured because, by purchasing a Startup's asset, they have a voice in the decisions made in the growing Startup and can help steer it to success.
Venture capital seeks to help startups that are innovating to offer citizens a series of products and services of the highest quality and, of course, functionality. But it not only helps the entrepreneur and gives profits to the investor. These types of funds are of great help in various types of economic and commercial situations.
In addition to channeling investments to high-potential businesses, promoting entrepreneurship greatly supports the local economy. They also finance innovation in various economic and labor sectors, the development of new products, technologies, and business processes, and create jobs through the various employment opportunities that the promoted startups can offer, all of which directly and positively influence the economy of the countries.
An example of what a VC can do for a country's economy occurred after the Covid-19 crisis in Spain, where new operations have already been carried out with venture capital in sectors such as the hotel industry, where they are financing companies in difficulty that the banks are denying credit; they do so with direct loans or with the purchase of assets. The President of the Spanish Association of Capital, Growth, and Investment (ASCRI), Aquilino Peña, and the CEO José Zudaire defend that "private capital has tried to maintain the staffs that make up its investee Startups, providing them with liquidity and the necessary instruments to be able to weather the recession."
Along with the role of alternative financing, venture capital has been key in helping to professionalize startups. According to ASCRI data, Startups participating in these funds increased their sales by 17.1 million euros in the three years following the investment and Ebitda (gross operating profit) at an annual rate of 7%.
Most of the world's largest startups, and those considered game changers, are VC-backed. A research paper published in 2012 evidenced that VC firms tend to focus on certain industries and regions for reasons such as capital capacity and local legislation. However, that is changing; many VC investors have expanded, and others have also emerged over the past eight years, especially in the MENA (Middle East and North Africa) region, following the global digital transformation movement and Vision 2030.
VC’s and Global Challenges
The Sustainable Development Goals (SDG’s) were approved by all the countries of the United Nations in 2015 to eradicate poverty, hunger, child labor, achieve full gender equality, decent work, energy transition, and the reduction of pollution emissions.
These are seventeen goals with 169 measurable and quantifiable targets that would transform the world by 2030. Even with internal contradictions, their fulfillment would be a revolution, but we must work for it, although there are still some aspects to be resolved to achieve the goals set. One of them is financing.
Before the establishment of the SDG’s, there was a discussion on their financing (Addis Ababa Conference 2015) by the member states because, without adequate financing, the best intentions of the international community expressed in the SDG’s would remain only good intentions.
A study conducted in 2019 by several UN agencies presented an in-depth analysis of how countries and the international community were mobilizing the necessary financing. It also recognized that the financing needs are not small. Annual spending by 2030 could be $2.6 trillion in emerging markets and low-income countries to provide education, health, energy, roads, water, and sanitation within the framework of the most important SDGs. to a growing population.
This is where civil society and entrepreneurs have the opportunity, through venture capital, whether their own or not, to support some of the SDG’s while making significant profits.
The Integration of a VC
Integrating a venture capital fund takes work. The most difficult thing is to know where to start, as there is a lot of information on the web about, for example, how to structure financial models, search for startups, etc. Still, all the information is scattered and can be confusing and lead to wrong and costly decisions.
There are some things to consider, for example, that today's fund managers compete on speed and, when building a fund, it is important to take into account the small details, as their costs can be immense.
Having a systematization process simplifies the learning curve, increases speed, and the impact is exponential, which means transforming VC into a force for good in the world.
Some organizations have experience and are of great help to Startups seeking transformation. One of them is VC Lab, a venture capital accelerator led by Adeo Ressi and Mike Suprovici that provides a structure of fund creation, proven advice, mentoring, and peer-to-peer support to reduce the barriers to entry into the low-transparency, high-cost venture capital world.
Through a simple 16-week online program in which participants complete a closing with Limited Partners (LP’s) in 6 months or less, this organization helps talented and motivated venture capitalists launch Venture Studios, Pre-Seed, Seed, and Series A funds around the world.
This is a program for the next generation of committed venture capitalists. The curriculum is based on the experience of launching 14 funds at Founder Institute and is constantly updated with new ideas from the community and ecosystem.
Benefits for next-generation managers include speed to successful closings in a maximum of six months. Thanks to a proven methodology that avoids common and costly mistakes; weekly activities to plan and build a fund with instructions, guidelines, and documents to ensure its success; strong relationships with cohort members that allow you to generate competitive deals while accelerating the fundraising process; engaging deal flow to make the fund compelling to limited partners: resources that save valuable time by accessing the best templates for everything from pitch deck to legal agreements.
From the work carried out by VC Lab, some lessons have been learned to design a Venture Capital that, through a systematization process, has simplified the learning curve, allowing to exponentially increase the speed and impact, which implies transforming VC into a force for the good of the world.
Let's look at some of what we have learned:
A small but important detail is determining whether the fund will be incorporated under the U.S. Securities and Exchange Commission (SEC) Regulation 506b or 506c, as the former allows advertising the fund and meeting new potential investors through social media, while the latter prohibits advertising of any kind, which means no fundraising through social media.
It is usually recommended to raise publicly, beyond the network of personal contacts, to proactively reach out to a specific group of accredited high-net-worth individuals who would be willing to be limited partners in an emerging fund. However, these LPs often prefer funds that do not raise publicly because they might otherwise have to share personal documents to prove they are accredited investors.
Like the first page of Google search results, the first-degree connections of LPs' networks play an important role in deciding who gets funded. However, that is far from an efficient system for allocating capital to the best ideas, Startups, and entrepreneurs, which could come from anywhere.
According to Samir Kaji, CEO of Allocate, "We consistently saw that LPs invest in emerging managers based solely on feel, first-degree network introductions (thus limiting the supply pool), and not having enough diversification among managers."
Emerging venture funds are now overwhelmingly raising publicly and leveraging their large social media following to raise awareness of their fund among an audience of accredited investors, i.e., individuals who earned an annual income of at least $200,000 in the previous two years with the intention of generating equal or greater annual income in the current year. It is estimated that more than 65% of successfully closed funds were raised publicly in recent years.
The Fundamentals of Integrating a VC
Starting a venture capital fund can be complicated if you don't have the right guidance or tools. Regardless of the advice that can be obtained, there are some critical steps that must be taken to launch a lasting venture capital fund.
The first step is to develop a winning thesis, which is important for attracting limited partners. The thesis provides important information that an LP needs to know, such as the fund's size, stage, geography, and focus areas. In addition, a strong thesis emphasizes how the fund manager(s) are uniquely qualified to launch a venture capital fund in a specific industry and geography by showing the relevant track record.
Second, keep in mind that limited partners look for domain expertise and a strong track record as part of their process for evaluating investment in a fund. A strong track record can be built anytime through angel investing or by starting advisory work with high-quality, fast-growing startups. The ideal track record can be quantified with metrics, and a rank-ordered list of metrics that LPs consider important include:
1. Total exit value of a previous investment portfolio.
2. Margins, IRR (Internal Rate of Return), or MOIC (Multiple Over Invested Capital) of a previous investment portfolio.
3. Total funding raised for an advisory or investment portfolio.
4. Measurable sales increases from an advisory or investment portfolio.
5. Fame or notable exposure that can be quantified.
6. Number of Startups helped or advisory programs executed.
7. Quantifiable network size or access to the network
8. Years of experience
After the thesis, the most important fundraising tool for an emerging manager is the fund presentation. To be attractive, you should have no more than 15 slides with a white background, clear titles, and fewer than 50 words per slide. Emerging managers should also have a brief two-page written fund overview, a fund model, and a data room with supporting information, such as biographies.
After that, the average new or emerging manager's fund requires more than 250 LP pitches to close, so it can take months or years to accomplish. At this point, gathering a vast network of potential investors and partners is important to find the right LPs for the fund. In this step, the first thing to focus on is building and improving the network by attending events and contacting friends and family.
To ensure success, it is necessary to practice presenting with close confidants and engage those who are useful connectors. As success begins, it is necessary to develop an archetype for LPs committed to investing and targeting more LPs in the archetype.
Once you have secured more than 10% validated LP interest, initiate a quick closing process. There is no need to waste time recruiting vendors, hiring lawyers, or thinking about domiciles until you have real, quantified LP interest, as this common mistake is costly and distracting. When real interest is obtained, the critical thing is to move quickly to close.
A closing process has the following high-level steps. It can take a couple of months to complete as it demands secure formation providers: engage committed limited partners, review closing materials, set up Entities and Bank Accounts, secure limited partner signatures, and initiate the First Capital Call.
Following these steps in order means you are in a solid position to launch a venture capital fund. The most common mistakes new and emerging managers make is doing things out of order, which wastes time and money. For example, if you create a fund presentation without finalizing a solid thesis, you will need to change the deck regularly as you refine the Thesis. In another example, if you hire a law firm before you have any real LP interest, you are paying fees long before you need the service.
Long-Term LP’s Base
What does it mean to have a long-term LP base?
1. If an LP exceeds 20% of a fund, it is likely to impose special conditions, insist on control provisions, and may prevent other LPs from investing. Ideally, a fund's largest LPs should be between 7-10%.
2. Prioritize LPs with their internal capital source to reduce risks during fundraising from other LPs.
3. Focus on LPs that have demonstrated a long-term commitment to the private equity asset class. For example, funds of funds (FoFs) are typically formed to invest in private equity, so their tendency is to keep investing as long as the investment fund continues to perform. On the other hand, one should be wary of LPs that are "new to the private equity industry." At this stage of the market, there are many tourists.
Successfully navigating these three points means having a diversified LP base that can withstand the peaks and valleys of the VC industry. The simple analogy is a software company selling across many verticals to insulate itself from the economic cycles of any particular sector. Believe it or not, LPs do not act as a single herd; different types of LPs will enter or exit VC at different times.
Creating a financial model for a venture capital fund is difficult, given the speculative nature of forecasting investment results. It is then considered important to create a forecast, as it allows, among other things, outlining to potential limited partners the fund's expenses, its fees for operating the fund, and its expected capital calls; projecting the investment strategy, mainly in terms of check size, trailing reserves and investment deployment timelines; and ensuring that its strategy reflects reasonable benchmarks and expectations.
According to the lessons learned, the main important components for building a risk fund model include:
1. Determine whether you want to model the fund in general or whether you want to add modeling of cash flows over time. Adding the notion of the timing of significant events in the portfolio (redemptions, unrealized gains from investment price increases, income from exits) provides a greater level of detail for understanding cash flows over time. When it comes time to start making investments, you will want to have a model that captures cash flows over time so you can properly budget and plan your investments, set aside capital for succession if that is part of your strategy, and start planning for the future of your fund.
2. Budget capital to determine how much money can be invested. The budget can be created just for the total amount invested or to show the budget for multiple periods over time (by year, by quarter, by month) if you are modeling cash flows over time.
3. Build the portfolio by determining check sizes, tracking reserves, and expectations around valuations, ownership, and dilution over time. There are many right ways to approach portfolio construction. The "best" way to forecast a portfolio depends on your specific needs.
Going through VC Lab is a must as it has the vision to transform venture capital into a force for good in the world and has a mission to launch and grow 1,000 lasting VC companies worldwide by 2025. Since VC Lab began in March 2020, the accelerator has launched more than 200 VC companies.
Who says that venture capital is exclusive to the corporate world? Have you ever imagined that some of the SDGs proposed by the UN could be achieved through venture capital? What global problem would you invest venture capital in?
You probably have more doubts than certainties today, which is why you will need experienced experts to create venture capital.
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