Founding a startup is always a question of financing. Perhaps you can build your startup from cash flow and at the same time bootstrapping? In many cases, however, founders require larger initial investments. Venture capital financing is often suitable for this. We explain the basics of venture capital financing here. If you have any specific questions, please get in touch with a team member!
This is how a venture capital fund is structured
In most cases, a venture capitalist finances the startup via a venture capital fund. This is an investment company that collects money from various other investors and uses the money collected to invest in a startup. Central to this are the so-called general partners, who manage the future fund, control the investments and are responsible for the fund's performance. General partners usually contribute money to the fund themselves, but also look for other investors for the venture capital fund. These partners or investors are referred to as limited partners (LPs for short). LPs are often institutional investors such as family offices, in the USA primarily pension funds, companies or very wealthy private individuals (high-net-worth individuals). The general partners attract the limited partners' money by offering certain forecasts for the venture capital fund: On the one hand, they state an expected return; on the other hand, they state a fund term. The return is clearly above current interest rate scenarios, because an investment in the venture capital sector, as is very often the case with start-ups, has a high potential to fail. The expectations for the growth of the start-ups are correspondingly high. But more on this later. The investment strategy also plays a major role in attracting limited partners to the fund, as it defines the growth phase a startup should be in and the sectors in which it operates. In the areas of artificial intelligence and sustainability in particular, there are currently funds that want to invest their capital in start-ups, as these markets are growing strongly. Of course, the asset management of limited partners is associated with costs. The so-called management fee covers the expenses of the general partners and is usually dependent on the capital committed by the limited partners. This is often 2% of the committed capital.
The exit as a central element of venture capital financing
The fund ultimately uses the capital collected from the general partners and limited partners to invest in the start-ups in order to generate a return. Not least for this reason, a startup must be sold again after some time. Either strategic investors or follow-on investors with a different investment focus come into consideration as buyers. From the proceeds of the sale, the so-called exit proceeds, around 80% ultimately flow back to the limited partners who have made a purely financial investment. The general partners receive approximately 20% as so-called "carried interest" and thus as a success fee if they were able to achieve a positive return for the investors. As previously mentioned, startup investments are associated with high risks. Accordingly, it is important in the area of venture capital financing that venture capital funds spread their risk and invest in several start-ups. This is where the so-called power law principle comes into play.
The power law principle in venture capital financing
The power-law principle is a mathematical concept that describes how certain phenomena are unequally distributed in many different areas. It is also known as "scale freedom". The principle is based on a mathematical function known as the power law. In the area of venture capital financing, this means that only a few start-ups are likely to achieve a very high return and the majority of investments will fail. Venture capital funds generally expect that around 50% of the investments made will be total losses, around 20-30% of the investments will repay the capital invested in them and around 10-20% of the invested start-ups will be able to multiply the investment. The knowledge of this power-law distribution in the area of venture capital financing has a massive influence on the behaviour of venture capital funds: funds will only invest if there is a particularly high expected return and therefore particularly strong growth of the startup. The size of the market in which a start-up operates is significant, but the degree of innovation of the start-up also plays a decisive role in the investment decision.
What is success? Recognising the 10x potential in venture capital financing
In the area of venture capital financing, this means one thing above all for investors: "Go big or go home!". You may also have heard of the so-called 10x potential? In the context of start-ups and venture capital, "10x" refers to the fact that the exit proceeds generate at least ten times the return on the original investment. This 10x expectation is naturally transferred to the start-ups. Before you conclude venture capital financing with a VC fund, you should therefore ask yourself:
- Is the market in which your startup operates so large that growth of 10x is to be expected?
- Is the valuation of your startup set in such a way that investors can still expect a return of 10x?
- As a founder, are you prepared to take a particularly high risk in order to fulfil this 10x expectation of VC investors? If not, another type of financing may be better suited to your startup.
- Do you have the stamina to see your startup through to an exit over several years? If not, are you prepared to hand over significant shares of your startup to other people who can lead your startup to an exit?
- Can you as a person fulfil the high performance and growth requirements of an investor? Here, for example, a Accelerator programme help.
If you need support in answering these five questions or with other topics relating to your startup, you are welcome to send us your pitch deck and register for our non-binding Open Pitch log in.