Starting a company the “easy” way, is to get clients, get people do the work and try to make some margin. If you are good and a little lucky you don’t need a lot of money to invest.
But if you want to start a scalable product from day one, often you may need to invest first in the product and in the market before you make enough money to pay the bills. If you have an excellent founding team and preferable some traction you may consider to look for serious capital with Venture Capital, in particular in the early stage funds.
Brad Feld and Jason Mendelson wrote an excellent book from the perspective of the entrepreneur
Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist
As each new generation of entrepreneurs emerges, there is a renewed interest in how venture capital deals come together. Yet there is little reliable information focused on venture capital deals. Nobody understands this better than authors Brad Feld and Jason Mendelson. For more than twenty years, they’ve been involved in hundreds of venture capital financings, and now, with the Second Edition of Venture Deals, they continue to share their experiences in this field with you.
In general, it’s important to understand what drives your current and future business partners, namely your VCs, as their motivations will impact your business.
Summarized Venture Capitalist are organized in a Management Company with various partners. The Management Company executes the work for the funds the manage. A General Partner (GP) from the Management Company is responsible for the fund in which the Limited Partners (LP’s) invest 95-95% and the GP 1-5% himself.
The Management Company receives a management fee from 1,5-2,5% which will be recalculated with the Carried Interest which is usually 20% cash-on-cash for the final income of the fund.
Before you start looking for venture capital it is recommended to understand How Venture Capital Funds Works? Better is to read the whole book and do more research if this is the direction you would like to go with your company.
Below some interesting quotes from the book:
Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist
The most senior person in the firm is usually called a managing director (MD) or a general partner (GP). In some cases, these titles have an additional prefix—such as executive managing director or founding general partner—to signify even more seniority over the other managing directors or general partners. These VCs make the final investment decisions and sit on the boards of directors of the companies they invest in.
Principals, or directors, are usually next in line. These are junior deal partners—they are working their way up the ladder to managing director. Principals usually have some deal responsibility, but they almost always require support from a managing director to move a deal through the VC firm. So, while the principal has some power, he probably can’t make a final decision.
Associates are typically not deal partners. Instead, they work directly for one or more deal partners, usually a managing director. Associates do a wide variety of things, including scouting for new deals, helping with due diligence on existing deals, and writing up endless internal memos about prospective investments. They are also likely to be the person in the firm who spends the most time with the capitalization table (also known as a cap table), which is the spreadsheet that defines the economics of the deal. Many firms have an associate program, usually lasting two years, after which time the associate leaves the firm to go work for a portfolio company, to go to business school, or to start up a company. Occasionally the star associates go on to become principals.
Analysts are at the bottom of the ladder. These are very junior people, usually recently graduated from college, who sit in a room with no windows down the hall from everyone else, crunch numbers, and write memos. In some firms, analysts and associates play similar roles and have similar functions; in others, the associates are more deal-centric. Regardless, analysts are generally smart people who are usually very limited in power and responsibility. Some firms, especially larger ones, have a variety of venture partners or operating partners. These are usually experienced entrepreneurs who have a part-time relationship with the VC firm. While they have the ability to sponsor a deal, they often need explicit support of one of the managing directors just as a principal would, in order to get a deal done. In some firms, operating partners don’t sponsor deals, but take an active role in managing the investment as a chairman or board member.
Entrepreneurs in residence (EIRs) are another type of part-time member of the VC firm. EIRs are experienced entrepreneurs who park themselves at a VC firm while they are working on figuring out their next company. They often help the VC with introductions, due diligence, and networking during the three- to 12-month period that they are an EIR. Some VCs pay their EIRs; others simply provide them with free office space and an implicit agreement to invest in their next company.
VCs raise money from a variety of entities, including government and corporate pension funds, large corporations, banks, professional institutional investors, educational endowments, high-net-worth individuals, funds of funds, charitable organizations, and insurance companies. The arrangement between the VCs and their investors is subject to a long, complicated contract known as the limited partnership agreement (LPA) that makes one thing clear: VCs have bosses also—their investors, also known as their LPs.
The VC firm normally keeps very little cash on hand and must ask its LPs every time it wants money to make an investment. This is known as a capital call, and it typically takes two weeks from the moment the money is requested until it arrives.
Management Fees VCs’ salaries come from their funds’ management fees. The management fee is a percentage (typically between 1.5 percent and 2.5 percent) of the total amount of money committed to a fund.
There’s a slight nuance, which is the fee paid during and after the commitment period, or the period of time when the fund can make new investments—usually the first five years. This fee, which is usually 2 to 2.5 percent, begins to decrease after the end of the commitment period.
The VC firm gets this management fee completely independently of its investing success. Over the long term, the only consequence of investment success on the fee is the ability of the firm to raise additional funds.
Carried Interest Even though the management fees can be substantial, in a success case the real money that a VC makes, known as the carried interest, or carry, should dwarf the management fee. Carry is the profit that VCs get after returning money to their investors (the LPs). If we use our $100 million fund example, VCs receive their carry after they’ve returned $100 million to their LPs. Most VCs get 20 percent of the profits after returning capital (a 20 percent carry), although some long-standing or extremely successful funds take up to 30 percent of the profits.
All LPs should favor recycling, as their goal is generally cash-on-cash return. Getting more money to work, namely the full $100 million instead of only $85 million, enhances the total return.
The GP commitment historically was 1 percent but has floated up over time and is occasionally as high as 5 percent.
Reimbursement for Expenses There is one other small income stream that VCs receive: reimbursements from the companies they invest in for expenses associated with board meetings.
Over time the media picked up on this dynamic and started referring to these firms as the “walking dead”—zombie-like VCs who were still acting like VCs, earning management fees from their old funds and actively managing their old portfolios, but not making new investments.
..secondary sale in which someone else takes over managing the portfolio through the liquidation of the companies. In these cases, the people the entrepreneurs are dealing with, including their board members, can change completely.
Reserves are the amount of investment capital that is allocated to each company that a VC invests in.
Remember that the capital raised by a venture firm can be used for investments in companies, management fees, and expenses of the fund, which include paying accountants for an annual audit and tax filings and paying lawyers for any litigation issues. Also remember that LPs want their VCs to invest 100 percent of the fund in companies.
..however, there are also cases where firms will fund out of two completely separate funds, say VC Fund III and VC Fund IV. These are called cross-fund investments.
Fiduciary Duties VCs owe fiduciary duties, concurrently and on the same importance level, to their management company, to the GP, to the LP, and to each board that they serve on.