How Venture Capital works…

Newton’s beginners guide to venture capital jargon… written by a beginner

When I first started at Newton Venture Program in May 2021, I knew very little about venture capital.
 
I had heard of it, sure. I had many start-up clients proudly announce they had closed their funding rounds A, B, C etc. To which I would smile, say congratulations and hope that was the correct response.
 
When our previous Executive Director first mentioned that Newton works across the whole ecosystem from LPs to TTOs, I was far too embarrassed to admit I had no idea what that meant. So I did what anyone does in that position and started googling various terms. 
 
After 9 months at Newton, I’ve learned a fair amount. So this is my definitive guide to what I wish I had known before starting at Newton.
 
Before that…..there is a lot of specific jargon in venture capital. Fintech? Case in point. I’ll be explaining each point as we go.

So how does this all start? Who is looking for funding?

 

Fintech = financial tech, healthtech = healthcare + tech, insuretech=insurance + tech – you get it! And all across the globe, they’re all speaking about one thing: funding. 

 

Why? Let’s say a small company has a great idea, maybe even a product, but not enough money or market share to make its product better, market their product or hire staff. Entrepreneurs turn to several institutions which help fuel the global innovation ecosystem.

 

The most typical: venture capital.

 

What is venture capital?

 

In a nutshell: venture capital (VC) is money/funding given to a small company.
And in exchange, they get equity – a per cent ownership of the company.

 

The company does well, VCs make money. The company doesn’t do well, and VCs lose money. High risk, high reward.

 

And that’s the real essence of VC: making many high-risk investments.

 

And how many companies do well? Unicorns (privately held start-up companies valued at over £1 billion +) are very rare, hence the name. But typically you would expect 10% of your companies to achieve success.

 

The major players in VC: What are LPs & GPs?

 

LPs are Limited Partners– they provide the capital for the VC fund – VCs have to fundraise too. Usually they are university endowments, pension funds, insurance companies, and other institutions. Although independent VCs are on the rise.

 

GPs (not to be confused with General Practitioners) are General Partners– the investors who make decisions. Typically there is a small number of them in a VC fund because it’s a long term goal so GPs stay at their VC fund for many years. Again, solo GPs are also on the rise. 
 
Every ‘fund’ they raise from LPs,  they ‘deploy’ to different companies. 

 

NB/ people who don’t invest in the start-ups, but work at the start-ups – in VC land, are called operators.
 
Image source (below)
Why do LPs get involved? Because LPs make large returns off these companies too. 
 
When do they come in? Usually around seed level – when a company is in its very early stages. Most founders find angel investors; few have access to family and friends investment. 
 
There are also pre-seed funds – even earlier stages than seed – such as Rarebreed VC, which are becoming increasingly popular in the ecosystem.
Angel Investors: an individual who can give financial backing to entrepreneurs in exchange for ownership. Usually, they are independently wealthy. MVP: this term will pop-up loads. A minimum viable product is essentially a product good enough to use. Early customer feedback on the MVP is crucial to making iterations and improvements. Product-market fit: will your target customer buy your product? And will you sell enough to grow and be profitable? For VCs, it’s key that founders prove this. How do you prove it? That’s a whole other article in itself.

Pre-seed vs Seed rounds: what’s the difference?  

 
Pre-seed funding is very, very early. They don’t have a fully formed product and will be working on their minimum viable product. They usually haven’t gone to market yet but know there is potential. They probably don’t have a team – think two founders in their kitchen. Whereas, seed funding: they will have an MVP, have proved product fit, and have a small team.
 
 

What do all those funding letters represent?

 
Typically funding goes up from Pre-seed to Seed to Series A-F. As the company grows, they look to the next round of funding, which unlocks another level of growth.
 
There used to be much clearer ideas of what a round meant in terms of money. But seemingly the book has been thrown out, with fundraise rounds breaking records, such as Gorillas recently raise of USD 1 billion in Series C funding – the largest European round in its sector ever.
 
 

What about other forms of funding?

 
Accelerators – a program that helps businesses ‘accelerate’ their growth by giving them a relatively small amount of investment and support as the company grows their partner and customer networks. This usually operates over a limited time frame.
 
Incubators: Very similar to accelerators, incubators tend to work with founders at the idea stage, without a fixed amount of time. A lot of the incubator process is around market fit and refining their product. Like accelerators, they provide very hands-on support. Some are independent, whilst others are run by investors, government entities and major corporations. 
 
Angel Investors: …. Already forgotten?
 
Tech transfer – The UK has world-class universities, but a mixed record in terms of commercialising scientific discoveries. It attracts large amounts of venture capital for start-ups but has a mixed record when it comes to scaling and sustaining success. This can be improved by more Tech Transfer Offices. Luckily we created a page just for this topic! 


Welcome to the VC ecosystem!

 
The global innovation ecosystem is interconnected in a complex way – see very rudimentary diagram (right).

 

Image source below.

Why do we reference the ecosystem as opposed to just VCs? 

 
As with most ecosystems, there is a delicate balance. Ensuring more diversity in one area is maximised by ensuring diversity across others. In other words, more diversity at the GP level isn’t enough – we need more representation at every organisation through which capital flows. 
 
From a training perspective: Mixing investors with different functions across the venture ecosystem will help bridge knowledge and network gaps: the goal is to improve the end-to-end journey.
 

How do investors find companies and decide who to invest in?

 
This is the hard part.
 
As companies grow, you can analyse data such as revenue, projections etc. But early-stage companies don’t have much to show. So it has to be blind faith. 
 
Some investors have more conviction if the founder has previous entrepreneurial experience; sometimes they just really believe in the product and the team.
 
VC firms always have a pipeline of potential talent and deal flow (number of opportunities available at that time) who they would consider funding. But herein lies a major problem: 
 
If you could give away £100 to people around you, who would you pick?
 
Think about the people around you. How do you know them? Same school? Same area? Same universities? Same interests? Would you give the money to one of them?
 
OF COURSE. It’s natural – it’s what you know. 
 
‘HOMOPHILY’ birds of a feather flock together. For investors, they typically invest in what they know and who they know: same universities, same investment banking firm etc. 
 
And homophily breeds homogeneity. 
 
Did you know? 20% of VC professionals in London attended either Oxford, Cambridge, Stanford, or Harvard (source: Diversity VC)
 
So it shouldn’t come as a surprise to find out that 43% of funding at seed stage goes to founding teams with at least one member from Oxford, Cambridge, Harvard or Stanford (source: Extend Ventures).
 
And this has major repercussions. Currently, the VC scene in London is currently 71% male and 74% white. The result? Remember: homophily creates homogeneity.
 
Image source below. 
That’s where Newton comes in. Newton will seed the future of venture with more diverse investors – and put typically and structurally overlooked groups into the seats of decision-making power.
 
We represent within each cohort what we’d like the global venture landscape to look like in 10 years’ time.
 
More diverse investors = more diverse investments. And who gets backed determines whose problems in society get solved.
 
Consider how empowered a young black female might be at seeing hair products specifically made for her in a major shop. How would this come to be?
 
In basic terms:
 
  • Someone familiar with the problem wants to solve it
  • They start a company
  • They receive funding 
  • They grow and scale to a point where they sell in a major store
  • The consumer buys the product
 
Seems simple. But look at the result. Empowerment and representation. An unquantifiable victory.
 
Newton aspires to change what’s in the shop window, showcasing the next generation of investors from diverse backgrounds – both visible & invisible markers of diversity.
 

Right, on to the legal stuff

 
 
The investor will first carry out their due diligence (DD) – a review of the business to assess all sorts, including pitch decks, KPIs (key performance indicators), founding teams etc – to support their investment intentions.
 
This usually includes valuation, although there are still a lot of conflicting views on how important valuations are for pre-revenue companies. 
 
(In a VC, you may also hear the term upside instead of valuation; the potential increase in value, measured in monetary or percentage terms, of an investment)
 
Once they’ve decided to fund a company: negotiations begin.
 
Both parties will negotiate a term sheet: an agreement outlining the conditions of an investment. This usually outlines around 8 terms including equity, shares & CEO provisions. 
 
This helps produce the company’s capitalisation table or ‘cap’ table: an analysis of a company’s percentages of ownership by founders, investors, and other owners. 
 

So how do you ensure a diverse deal flow and portfolio?

 
Watch this space for another Newton article… or apply for the Newton Venture Program: VC Fundamentals and hear from the experts!
 

What is the end goal?

 
The end goal for the entrepreneurs can differ from person to person but most people wish for (1) more money and (2) some impact on the world. For everyone to make money, a company must ‘make an exit’ – you’ve probably heard this phrase before but what does it mean?
 
In other words, investors need to cash out. 
 
How? Mergers and acquisitions (M&A) or IPO
 
A merge is pretty rare for smaller companies. It does exactly what it says on the tin; two companies merge to create a super company. Sort of how Dave Grohl (Nirvana, Foo Fighters), Josh Homme (Queens of the Stone Age) and John Paul Jones (Led Zeppelin) set up a band in 2009.
 
An acquisition, however, is much more common and usually entails a larger company buying a smaller one. This is much more common and a great outcome for a start-up. Examples include Apple buying Beats, Microsoft buying Skype, Facebook buying Whatsapp & Salesforce acquiring Slack. The list goes on.
 
This leaves us with IPO (Initial Public Offering)- when a private company starts selling shares to outside investors and it comes ‘public’. IPOs are famously tricky and if you’d like to know more about them, then there is a ton on the internet about them. (some link)
 

Do you have to get funding?

 
Of course not! Many companies are bootstrapped, which means they build up a company from the ground up using personal capital and revenue from sales. Of course, the process is slower but still rewarding.
 
 

Have more questions? Get in touch with the team at hello@newtonprogram.vc to start your venture journey today!

 
 
This article was written by Growth Lead, Lara Pawade.

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