Guest Contributions

Venture Capital: Whaling In The Digital Age

Daven Talwar, an investment associate at REV Venture Partners, explains the nature and evolution of venture capital.

This article covers the evolution of venture capital and describes its core features.

What is Venture Capital 

Venture Capital (VC) involves investors providing financing to private start-ups with the aim of helping them expand and unlock their long-term growth potential. Unlike other forms of private funding, such as buyout funds, the risk appetite of VC investors is considerably higher with the understanding that successful returns will far surpass those possible from other investments. Over the past 20 years, and especially over the last 10, the appeal of VC as an asset class has grown substantially. Total global funding into VC backed companies per year has grown from $56bn in 2010 to $341bn in 2020 with 2021 figures set to eclipse $400bn. Indeed, some of the world’s most significant and important companies, including Google, Facebook, Uber, Twitter and Airbnb, have VC funding to thank for allowing them to scale to their lofty heights. Creating a start-up and nurturing it to grow into one of these globally significant enterprises requires a tremendous amount of resilience, courage and intellect. The capital which backs these companies needs to not only understand these traits but also to embody them. This is fundamentally the largest difference between VC and other forms of financing. VC investments are patient, long term and embrace high risk – putting vast amounts of capital on the line in order to seek out the highest returns possible.  

History of VC And VC Philosophy 

The early roots of VC can be traced back to pioneer times when high risk ventures required the backing of a financial sponsor with considerable risk appetite. These sponsors would typically be industrial families with amassed wealth, looking to now diversify investments with a project that they believe in. An early example can be found with whaling ships in the mid 19th century. During the 1800s sperm whales were a prized asset with the meat, fat, skin and bones all having utility. A single successful voyage could bring in the equivalent of $3m, however there was no guarantee of voyages being successful. Launching a voyage was costly with ships and crews being sent to sea for an average of 3 years, and the chances of them returning empty handed, having been unsuccessful in securing a whale, was high. Unsurprisingly, the prospect of an investment being completely written off made some traditional investors and debt providers balk, so alternative means of funding were required. The solution came in the form of wealthy individuals and families with the risk tolerance to take their chances on financing a voyage. 

Successful voyages increased the number of willing investors and the first precursors to modern VC funds were created – whaling agents. Whaling agents helped to mitigate risk through pooling money from wealthy investors and deploying them across several different voyages. The agents also conducted the diligence of the voyages, deciding which ones to back based on their knowledge of the space and assessing their likelihood of success. The agents operated on the basis that not all voyages would necessarily need to be successful in order for returns to be made by investors – even if some should fail completely, all it would take would be for one or two successful voyages to payback the invested capital and returns on top of it. In return for their services, agents would be rewarded with carried interest (carry) – a percentage share of profits made by the voyages once initial capital had been paid to investors, and named so because voyage captains, who also received carry, were remunerated by means of a percentage of the profits produced by the goods that were ‘carried’ on their ships. 

The whaling industry shares much in practice with modern-day VC funds. A VC fund typically takes the form of a partnership where investors, also called General Partners (GPs), invest capital provided by a wide variety of individuals and institutions with a high-risk tolerance who seek strong returns – these investors are called Limited Partners (LPs). LPs can include high net-worth individuals, pension funds, university endowments and corporates. Like their whaling agent predecessors, VCs will also look to mitigate risk through spreading capital across a wide range of investments. As a rule, the earlier stage a company is, the riskier the investment will be, and it is not uncommon for VCs with a focus on very early companies to invest in 50-100 companies within a given fund. The understanding is that not all of these investments will prove to be successful, but it would take only one or two breakaway successes to generate enough returns to cover the whole fund, and any successes on top of this would constitute upside/profit (the US National Venture Capital Association estimates that approx. 30% of venture backed business fail completely, and this does not account for the large proportion of companies that are sold in a distressed state at a discount such that investors do not get back their invested capital). Again, like with the whalers, carried interest is the prevalent form of remuneration for VC investors which ensures that the GPs’ focus is aligned to that of the LP’s – it is in the interest of all parties to deliver the best possible returns.

The selection criteria for which whaling voyages were financed are similar to the criteria a modern-day VC investor considers – the capabilities of the captain and their crew, their planned strategy for capturing a whale, their knowledge of hunting grounds, and the economic factors in play which incentivise the crew and also reward the investor. This overall structure and philosophy still dominates the funding landscape, and has proved to be as successful now as it was for the whalers. Whilst there are variations to this, such as publicly listed funds, single LP funds and corporates making venture style investments off their balance sheets, the core principle of high risk, high return investing is still what separates VC from the other asset classes. 

The VC Process 

VCs look to make a lot of investments. The exact number of companies invested in varies per fund and depends on a range of factors including how large the fund is, if the fund has a specific or agnostic industry focus, and the stage the fund looks to invest at. ‘Stages’ refers to how early or how mature a company has to be for a particular VC to consider investing in them. At the very earliest a company might be pre-revenue and exist solely as an idea within the head of an entrepreneur, at the latest a company might already have raised billions of dollars, have hundreds of millions of revenue, and be looking to IPO in the imminent future. Some funds would look to invest at any point in a company’s lifecycle, however it is common for most funds to have a particular sweet spot where they might look solely at companies that have a minimum/maximum amount of revenue. 

Two factors which are unique to VC style funding are the expectation that companies will undertake multiple rounds of financing, and that there will typically be multiple VCs backing a single company. Funding rounds are called ‘series’ and a typical progression is for a company to raise an initial ‘seed’ round of funding to get started, before then going on to raise a Series A round, a larger Series B round, a larger Series C round, etc. Each series of fundraising is undertaken with the goal to propel the company to the next stage and to attain the next set of business milestones. Typically, this might look like seed capital being used to take a company from an idea to a minimum viable product, Series A capital being used for growth and to expand the headcount, Series B capital being used for international expansion and blitz scaling, and future rounds being used to further the company in all directions, ultimately leading to a successful exit and profitability. Each round is also likely to feature participation from a syndicate of multiple VCs – typically a lead investor will set the terms of investments and contribute the most funding towards the round, and other funds will join them on the same terms. In the case of Uber as an archetypal example of the VC process, the company raised funds from Seed to Series G, as well a number of smaller one-off financings, and there were in excess of 150 separate investors at the time of IPO (when the company listed on the U.S. stock market).

Unlike with public equities, the investments a VC makes are not liquid, meaning that they are typically unable to sell their investments any time they like. Instead, a VC must wait for an exit, typically in the form of an IPO when all shares become liquid, or in an acquisition when the entire company is purchased by a larger corporate or by a private equity fund. Secondary share sales are also growing in popularity, where a VC can transfer their holding to another investor. This means that the lifecycle of a VC investment, particularly one made in early rounds, is typically long and it can be many years before a VC sees a material return on their investments. 

The exact process on how a VC chooses their investments varies per fund, however there are invariably a significant amount of companies that are assessed and spoken to before the investment decision is made. At REV Venture Partners we have invested in approx. 50 companies over the last 21 years, but in this time we have explored 50,000 companies. Even if companies do sit within our sweet spot of having a data and analytics focus and being at around the Series B stage where we like to invest, there is still only a 1 in 1,000 chance we would invest. The process for us involves assessing the size of the opportunity, the capabilities of the founders to execute on their plan, and also whether we believe that the product offering is something truly disruptive that will fundamentally improve industries. Other funds will have their own criteria of assessment, but the role of a VC investor is always as much about building the network of companies as it is analytical. 

Why VC funding 

VC funding has grown to become a necessity for companies looking to scale quickly and go from an initial idea into a market leading solution that makes a fundamental impact on society.  The speed in which companies grow to take over their industries is ever increasing, a recent example being HopIn (virtual events platform) which went from being founded in 2019 to being valued at approx. $5bn in 2021. Growth at this breakneck speed requires significant amounts of capital to be spent and the cash burn rate of these companies far eclipses that which can be generated through organic growth. This is particularly prevalent with technology SaaS (software-as-a-service) companies which might be reliant on irregular cashflows due to subscription billings. The lump sums of cash provided by VC investors allows a company to invest heavily in growth and allows them to scale at a rate that is not organically possible. 

VCs also offer a strategic advantage beyond capital as well. By the nature of their jobs, VC investors are typically seasoned experts within their particular focus industry, and it is in the interest of companies to leverage this industry expertise. Board seats are often given to VC investors in return for their capital commitment and VCs will offer guidance in helping companies navigate their journeys to scale. Indeed, the profiles of many top VCs include being former founders who have successfully exited their own ventures and they are able to play the part of mentor and consultant as well as investor. Taking investment from a VC also allows a company to benefit from a VC’s network. One of a VC’s greatest assets is their network and having a VC backer allows the company to leverage a VC’s black book of useful contacts that can support the company’s growth journey towards a successful exit (when the VCs ‘cash out’ and sell their stake).

What’s Next?

The VC model has been well established now for a number of years. Leading on from the early whalers and industrialists, the modern-day VCs can be traced back to the roots of Silicon Valley in the 1970s where the emergence of the semiconductor and microprocessor industries revitalised the demand for VC style financing. Since then, the VC industry has witnessed many pivotal moments including the birth of the internet, the Dotcom crash of 2000, the financial crisis of 2008 and the subsequent emergence of new global tech players. However, it could be argued that the most significant moment for the industry is currently in process and has been over the past 5-10 years. During this time, global VC funding has skyrocketed and is showing no signs of slowing down. The entire technology industry has evolved to no longer being a singular industry, but instead being that which underpins every single industry. The most valuable companies today are no longer those which grew organically but instead those which grew on the back of VC funding. New VC funds have started and excelled, as LPs are looking to deploy more and more of their capital into VC funds. Indeed, VC style investing is no longer limited to just the traditional VCs as corporates look to also make similar investments and both private and public equity funds are dipping their toes in the water of VC investing. This rapid expansion of the VC world shows one thing for certain – whaling in 2021 has never been more popular.

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Daven Nijran Talwar – 26/07/21 – Investment Associate at REV Venture Partners

Headline image source: https://www.forbes.com/sites/priyashukla/2019/07/28/scientists-are-mining-ship-logs-from-19th-century-whaling-vessels-for-climate-data/

2 comments on “Venture Capital: Whaling In The Digital Age

  1. Good learning, tanks!

    Like

  2. Good learning, thanks!

    Like

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