How does Venture Capital work?

VC (called general partner, GP, responsible for investing the fund and managing portfolio companies) typically raise money from high-net-worth individuals, institutional investors (called limited partner, LP – doesn’t get involved in day-to-day operations) etc for a fixed-life venture fund.
Suppose a VC raise $100 million fund with a life of 10 years. Typically VC would invest that fund in a number of early stage ventures for a period of 4-6 years. Once VC gets back his money though IPO, M&A or selling his stake in his portfolio companies to some other entity, he would 1st return $100 million to the investors (i.e. LP). After that, whatever amount remains, i.e. profit, VC would keep 20%-30% of that amount and return rest to the investors. Bigger and established VCs would keep 30% of the profit whereas smaller or newer VCs would keep 20% of the profit with the rest of the VCs falling in-between. So this is how a VC makes money.

Because of the higher failure rate of startups (8-9 failures out of 10), a VC expects a return of at least 10x on his investments. Once a startup fails, VC has to write-off that investment. At times, he may be able to find someone who still sees value in the venture that this VC thinks as a failure (or not going anywhere) and he may be able to sell his stake for 2x or 3x, whatever he is able to negotiate.
Given the risk involved and his responsibilities towards the investors, big financial return (at least 10x return) is the prime motive of a VC’s investment in a venture. Since a VC would have to return the money to the investors, all his investments must have a clear exit opportunity.

For example, if there is some venture that is valued at Rs 5 crore today and becomes Rs 30 crore at the end of 5 years, it won’t be of an interest to a VC since he won’t be able to get at least 10x return on his investment, even if he owns 100% of the start-up, which itself is impractical.

Similarly, suppose there is a venture with 50% profitability at the revenue of Rs 20 crore year-on-year (assuming no growth). Though this is a great business, such a venture is of no interest to a VC because there is no clear exit opportunity for him.

Hence, for a venture to be interesting to a VC, it should be in a fast-growing potentially large market with a very few players. Such a venture would not only present an opportunity for big financial return (priority 1 for a VC) but also have clear exit opportunity (priority 2 for a VC) through IPO or M&A or some other means.

By looking at a proposal, a VC would be able to figure out the potential gain from the investment or the exit scenarios. But that is the single most important thing that could risk an investment? That is the quality of the entrepreneurs a VC is banking on. No wonder, you would hear VCs saying that they are investing in the entrepreneurs and that if they are not comfortable with the entrepreneurs, there won’t be any deal, whatever be the potential of the business idea.

To minimize his risk further, a VC may insist on some revenue traction or some customer of the product or service of the venture. He would feel more comfortable if there are some other VCs lined up to fund that particular idea. He may further add some protective clauses in the agreement.