What business model do VCs use?

June 3, 2011 | By More

The goal of many start-ups is an IPO. But what does it mean to get there?

In an earlier post, we discussed about business models. (Read more about What is your business model?)

So one of the most important questions to prepare before meeting with investors, venture capitalists (VCs) and potential shareholders is about your business model. How is your business going to make money? If they like your business proposal, plans and strategies (and of course, business model), they are likely to invest in your company – if that matches with their business strategy.

But have you considered what is their business model?
How do they make their returns? i.e. how do they make money for their investors?

First, let’s understand where they get their money. [ For the sake of brevity, I will oversimplify this explanation. For a fuller one, there is a good post done by Jean-Louis Gassée here. ] Angel investors are the exception as they provide their own funds.

What does this mean?

Institutional and investors typically put their money into a ‘fund’ that is managed by the General Partners in a VC, who use the funds to invest in a portfolio of companies over a defined period, usually 5 years. Because of the higher risk associated with investments in this type of funds (compared with ‘safer’ investment instruments like bank interest bearing accounts or bonds), investors expect a higher return on their investment – typically at least 20% or more, even 35%.

This kind of return cannot be achieved by the dividends generated by the companies. The only way possible is what is commonly known as an “exit”, i.e. Get out of the investment, usually by selling to someone else, of course at a higher price than they paid for it. During the heydays of the dotcom era, it is achieved by an IPO. This is less common these days, but may be coming back into fashion (read more about Bubble 2.0 in the making?)

It is now more likely, if the technology is strong and useful (hint to would be entrepreneurs), the company (heavily lobbied by the VC and their friends) will be acquired by a Cisco, Google, Microsoft, Genentech or some other large corporation who desperately needs the technology instead of building up their own team. Their shares (usually substantial) in your company will be sold to these “LargeCorp” for many times the VC bought you for.

Having the right VC on your team can mean you find a better exit

You now have new shareholders. They may or may not be like your previous shareholders. While the VC and their friends can cash out their loot, sorry equity, it is unlikely that you can. After all, if you, the founders, walked out too, what becomes of the company? So it is unlikely that “LargeCorp” will let you go immediately, at least for a few years.

Of course, not all the companies in the portfolio will be successful. Statistically only one out of 6 will be successful. That means the rare two or three in the portfolio will have to make even big returns with their ‘exit’ to make the VC look good.

A possible exit strategy

So, more often when a VC asks this question: “What’s your exit strategy?”, he or she is simply wondering out loud how she is going to answer to her investors. What it means is: “Who is likely to buy this company?” And “How can I get them to pay lots for it to boost the performance of my portfolio?”

 

Read a very well written article by Jean-Louis Gassée, a veteran of Silicon Valley – The Monday Note

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Category: Managing your business, What's Next?

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About the Author ()

EngTong, pioneer and innovator. Graduated from Imperial College London with an MBA from Cranfield School of Management. Lived in Scotland, England, California, Beijing and led teams in Italy, France, Japan, Taiwan and Malaysia to do the impossible. Now based in Singapore and believes the future is to blend the sophistication of western management practices with the strength of Asian Values. Trained as a Chartered Engineer. Member of IET, Associate of City and Guilds and a certified SixSigma Champion.

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