Investment Strategies

Although the roots of private equity can be traced back to the 19th century, it was only after the Second World War, that venture capital grew into a distinct industry and investment strategy. Harvard Business School professor Georges Doriot considered the “Father of Venture Capital”, founded The American Research and Development Corporation in 1946.

With a fund of $3.58 million, this firm focused on investing in companies that developed commercialised technologies during WWII. This foresight bore fruit in 1955 when the company went public and Doriot’s $200,000 investment turned into $1.8 million.

In this chapter, we’re going to dive into the venture capital investment strategy and understand it in detail.

The process is very similar to other PE strategies. First, the entrepreneur(s) looking for funding must lay out a concrete business plan and present it to the venture capital funds or investors. If it catches their attention, then they run thorough due diligence on the business plan.

The due diligence process includes investigating the startup’s business plan, products, management, and operations history, among other factors, as the fund size is usually a few million dollars.

Once the business plan passes the due diligence test, and the terms of the investment are clearly outlined, the fund will invest in the company. The funds may be provided all at once but mainly they are provided in a series of funding rounds.

They don’t usually take majority control of the company, but still play a crucial role in its success.
The investor or the firm actively takes part in mentoring and monitoring the growth progress of the funded company.

Eventually, once the company has scaled and increased its valuation, the VC fund will look for an exit. This may be through selling their stake in the company, initiating a merger & acquisition, or going public with an IPO.

Venture capital firms are investing billions of dollars in businesses that are shaping our future. These firms invest in companies when they’re just starting or when they’re ready to grow, aiming for growth at all costs!

Basics of Venture Capital Investment Strategy

To understand the VC strategy process, let’s look into the investment made by Accel Partners in Facebook in 2005.

In 2012, when Facebook went public, it was estimated that Accel partners’ investment was worth $9 billion even after offloading $500 million worth of shares.

1. Long-Term Investment Horizon

   Venture capital investments are like long-term adventures. They do not offer a quick way out, which means the VC firm faces a high liquidity risk. The success of the funded companies becomes the key to unlocking potential returns.

   Consequently, the strategy offers the investors potentially higher returns which compensates investors for the higher liquidity risks that are associated with the investment.

2. Illiquidity

   Investments made by VC firms are like sowing seeds and waiting for the produce. There is no way to cash in and quickly exit with returns. It’s a game for the patient with less chance of a quick win. The terms of these investments do not fluctuate like the shares traded in the public market.

3. Large Discrepancy between Private and Public Market Valuations

   Understanding how much a company is, without any prior statistics, can be like solving a mystery. As the investments are held by VC funds, it is tricky for individual investors or public market participants to understand the valuations of the funded company.

   On the other hand, the private fund also may not understand how the public market values its investment. This mystery creates a lot of guessing and speculation among investors, from both public and private markets. It’s like trying to guess the price of something that everyone wants but cannot agree upon.

4. Entrepreneurs have Limited Information about the Market

   The VC investments are usually made in innovative projects intended to disrupt the market. These projects come with significant risks, however, the potential returns are huge.

   Both the entrepreneurs and the VC fund operate with some uncertainty as they cannot fully predict how the market would value the project. The uncertainty also comes with the fact that there may be a lack of information about prior statistics on the product or service they want to introduce into the market.

5. Portfolio Diversification

   Venture capital funds do not pool their money in just one place. They usually spread their investment in a bunch of different companies.

   This helps them mitigate risk and increases the chances of a successful investment. It’s like having a team of diverse players, if one does not perform well, there are others to pick up the slump.

6. Network and Connections

   Venture capital funds are well-connected match-makers in the world of business and investments. They know a lot of people and can introduce their funded startups to potential partners, strategic partnerships, customers, and talented individuals. It’s like having an extrovert friend who knows everyone and can open doors for you.

7. Exit Strategy

   Venture capital firms typically invest with the expectation of realising a return on their investment. The exit could be through IPOs (initial public offerings), mergers and acquisitions, stake sale to another strategic investor, or other means.

Venture capital financing either happens in a series of rounds or at different growth stages of a business.

• Pre-Seed/Accelerator Stage Capital

  In this stage of funding, the business is just an idea, a spark waiting to ignite. There are no employees or operations taking place. If the venture capital fund, aka the dream enablers, sees a sparkle in the concept, they invest their money and expertise in the startup.

  It’s a collaboration of wisdom and together they can carve a journey to success. Think of it as entrepreneurs entering a startup boot camp, where they not only get funding but also get a bit of magic from investors to turn their ideas into reality.

• Seed Stage Capital

  Seed stage financing is like giving wings to an idea. It’s the boost a startup needs when it’s just a prototype in the making. Imagine it as the groundwork for turning dreams into products or services.

  This type of funding comes in handy when there’s no money flowing in yet and the business is gearing up for a launch. It is like having a backstage pass that helps entrepreneurs turn their brainchild into reality.

• Early Stage Capital

  Early-stage capital can include either the Series A or Series B funding rounds. It acts like a booster to help set up the basic operation and production processes.

  The capital supports the business to set up shop, produce products, and get the word out. This stage of financing helps in keeping the entrepreneurial spirit running.

• Late Stage Capital

  Imagine a business as a mature tree, with its roots deep and branching out wide. It is not just an idea anymore and it’s alive and thriving. Late-stage capital gives the company’s growth even. This funding isn’t just about the money, but also about boosting growth, enhancing products, and spreading the word about the business.

  It is provided when the company has gotten off the ground, is generating revenue, and is looking to go public or be bought by another company/potential investor. Whether it’s gearing up for an IPO or merging with like-minded partners, this funding stage truly helps the business take flight.

In 2022, Shiprocket, a logistics company, became the 20th firm to become a unicorn in that year. A unicorn is a start-up with a $1 billion or more valuation. VC funds including Temasek, Lightrock India, and others invested close to $32 million increasing the company’s valuation to $1.3 billion.

When it comes to measuring the success of venture capital investments, there are two key metrics that investors use: the internal rate of return (IRR) and the multiple of invested capital (MOIC). These metrics depend on three key factors: the entry valuation, the exit valuation, and the holding period.

The IRR is the annualised percentage return on your investment, while the MOIC is the ratio of the exit value to the invested amount. The higher these numbers are, the better your returns will be. So, how do you achieve high IRR and MOIC numbers?

One key factor is the entry valuation. The lower the entry valuation, the higher your returns are likely to be. This means that it’s important to look for opportunities where you can invest in companies at a low valuation.

Another important factor is the exit valuation. The higher the exit valuation, the higher your returns are likely to be. This means that it’s important to find companies that have the potential for big growth and that can be sold for a high price down the road.

Finally, the holding period is also important. The shorter the holding period, the higher the IRR will be, but not necessarily the MOIC. This means that it’s important to find companies that can be sold quickly, but without sacrificing long-term growth potential.

Risks

• If the VC firm has a major % of stake in the company after their investment, then they would be the controlling partner and dictate the terms
• During decision-making in the company, the management must run them through the investors and get their approval. Thus, limiting the company management’s independence
• The VC firms have a specific period for divestment. If the funded company fails to deliver returns, then the VC firm may pressure the management to generate returns.

Returns

• Provides capital to early-stage companies to bootstrap operations that the companies may not get through traditional banking
• The funded company would not have to worry about sourcing finances for the growth of its business
• The project would have a good reputation and goodwill, attached to the VC firm, and possibly attract other investors.