Often the names of the great unicorns are joined by names that look like lawyers' names, Andreesen Horowitz, Kleiner-Perkins, or that end in the words “Capital,” “Ventures,” or “Partners,” like Ignia Capital, Bessemer Venture Partners, or Accel Partners. These are venture capital funds, companies whose objective is to inject capital into the most promising startups and make them grow until they have an exit.
These are the eight terms you need to know about venture capital to start investing like the big boys.
1. What is a Venture Capital fund in Silicon Valley?
Venture Capital (VC) or "risk capital" is a form of financial operation where capital is allocated to startups and companies with great growth potential and high levels of risk, to obtain a percentage of the company in exchange.
In a venture capital fund, the investment partners, or LPs, of the fund, contribute money to the fund so that a managing partner, or GP, identifies companies in the seed or entrepreneurial capital stage, invests, and contributes to the development of the company.
The most famous funds are Andressen Horowitz, Accel, Benchmark, Index, and Sequoia.
2. Convertible Note: This is a form of short-term debt that is converted into equity, usually in conjunction with a round of future investment. The equity fund invests in a startup and instead of a return in the form of equity plus interest, the investor receives shares of the company after a certain time or when they manage to raise a certain amount of capital. The main advantage of issuing convertible notes is that it does not force the issuer or investors to determine the value of the company when there is really not much to base a valuation on. The notes have a maturity date, interest rate, rules by which an investment is converted into shares, a discount, and generally a "cap", which is the maximum value of the company at which an investment is converted into capital.
3. SAFE: (Simple Agreement for Future Equity). An agreement between an investor and a company that grants the investor rights to future shares in the company similar to a convertible note, except without determining a specific price per share at the time of the initial investment.
The SAFE investor receives the futures shares when a round occurs in which a formal valuation of the company or a liquidation event is made. SAFEs are intended to provide a simpler mechanism than convertible notes for new companies to seek initial funding. The SAFEs we have signed are 3 to 5 sheets and the notes are generally 5 to 10 sheets.
4. What is the valuation CAP? It is when a company's value limit is applied in the event of runaway growth in a period between investment rounds. It limits the maximum valuation for the conversion of the convertible note or a SAFE. Then, investors can benefit from the advantage of their investment as they would with direct capital investment.
If the company has a valuation that exceeds the limit, investors with convertibles or SAFEs will receive the number of shares that correspond to the CAP. This means that they receive a discount on the price of the shares, which both depend on the value of the current company against the cap.
5. PRO RATA: This is a Latin term used to describe a proportional allocation. It basically translates as "in proportion", meaning a process in which everything you allocate will be distributed in proportion to the number of shares or money you invested.
In Venture Capital funds it means the proportional part of the Startup that corresponds to the fund according to the number of shares it has. The term also applies to the investors of an investment fund with respect to their shares with the fund. It also determines what percentage of the capital rounds you are entitled to contribute.
6. (LPs) Limited Partners: The money that Venture Capital funds invest comes from pension funds, universities, foundations, finance companies, family offices, and people with money in general. These investors are called limited partners (LPs). The word "limited" affirms their passive role in the operating activities of a fund. If you invest in a fund, you become an LP, the legal figure in the United States is exactly that, an LP (Limited Partnership).
7. (GPs) General Partners: As Venture Capital fund managers the general partners of the venture capital funds perform functions that depend on the guidelines of each fund. They look for investment opportunities, manage the fund's investments, conduct investor relations, and ultimately generate value for the investments. To these GPs, the LPs pay an administration fee for the investments.
8. Distribution: These are the returns that an investor in a private equity fund receives. It is the income and capital obtained from investments minus expenses. Once the cost of the investment has been returned to an LP, the additional distributions are actual earnings. In the case of Venture Capital, these distributions occur when one of the portfolio companies is sold.
8a. Liquidity Events: It is an event that allows the founders and the first investors of a Startup to receive part or all of their shares. When your company receives money from Venture Capital, the commitment you are making is to generate a liquidity event, that is, to sell your company once certain objectives are achieved. The capital is not for you to achieve a stable operation, it is to grow so much that your company is an attractive asset for other investors, companies, or the public market.
Investments in private companies, either startups or those requiring capital for expansion, are an alternative to traditional investments. Many of the funds and/or companies operate in different markets and some are even counter-cyclical. We have many examples of companies that have grown between 2 and 25 times their value in 2020 because they are largely focused on a niche and when the biggest players in a market get into trouble because of economic crises, startups see the opportunity to take a bigger piece of the market. Why are startups resistant to crises?
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