Venture Capital:

Investing in Early-
Stage Startups

Kozhanovska Olha
“Venture-capital firms invest in
trends by projecting returns. But
most projections are pretty much
bogus, and research shows that
experts are no better at predicting
the future than dart-throwing
monkeys.”

—Vinod Khosla
Venture capital is a form of financing where capital is invested into a
company, usually a startup or small business, in exchange for equity in
the company. It is also a major subset of a much larger, complex part of
the financial landscape known as the private markets.
Venture capital is early financing for start-ups that are taking an idea and trying to grow it
into a large scale business. The technology and healthcare companies which are typically
backed by venture capital have the potential to change entire industries and have a profound
effect on the way we live our lives.

Typically, at the time of initial investment, a company receiving venture capital backing only
has a few employees and co-founders and potentially a beta version (early prototype) of
their product or service.

Venture capital can allow these companies to increase in scale in an efficient manner,
normally over a period of several years. It can take them from this very early stage to the
point where they can be generating millions, or even billions, of dollars in revenue.
Venture capital firms are a type of investment firm that fund and mentor
startups or other young, often tech-focused companies. Similar to
private equity (PE) firms, VC firms use capital raised from limited
partners to invest in promising private companies. Unlike PE firms, VC
firms often take a minority stake — 50% ownership or less — when
they invest in companies. A firm's array of companies is called its
portfolio, and the businesses themselves, portfolio companies.
Examples of venture capital firms
Sequoia Capital
Headquartered in Menlo Park, CA, Sequoia Capital is a venture capital firm that invests in IT, mobile, internet, energy,
media, retail sectors and more. The firm is an active investor in ghost kitchens, an emerging space tracked by
PitchBook, and it has invested in companies Uber, Bird, DoorDash and 23andMe.

Andreessen Horowitz
Also based in Menlo Park, Andreessen Horowitz is a venture capital firm that has invested in companies like Lime,
Airbnb, Instacart and Foursquare. In June 2021, the firm raised a $2.2 billion crypto fund, the largest vehicle of its
kind and an escalation of VC's bid to back blockchain-focused startups.

DN Capital
London-based DN Capital in an early-stage VC firm that invests in software, fintech, mobile app, digital media, e-
commerce companies and others. Founded in 2000, DN Capital founded such well-known startups as Shazam, Auto1
and Purplebricks.
How the Venture Capital Industry Works

VC firms also protect themselves from risk by

coinvesting with other firms. Typically, there will be
a “lead” investor and several “followers.” It is the
exception, not the rule, for one VC to finance an
individual company entirely. Rather, venture firms
prefer to have two or three groups involved in most
stages of financing. Such relationships provide
further portfolio diversification—that is, the ability
to invest in more deals per dollar of invested capital.
They also decrease the workload of the VC partners
by getting others involved in assessing the risks
during the due diligence period and in managing the
deal. And the presence of several VC firms adds
credibility. In fact, some observers have suggested
that the truly smart fund will always be a follower of
the top-tier firms.
Attractive Returns for the VC

Thus for a typical portfolio—say, $20 million

managed per partner and 30% total appreciation
on the fund—the average annual compensation
per partner will be about $2.4 million per year,
nearly all of which comes from fund
appreciation. And that compensation is
multiplied for partners who manage several
funds. From an investor’s perspective, this
compensation is acceptable because the venture
capitalists have provided a very attractive return
on investment and their incentives are entirely
aligned with making the investment a success.
A typical breakout of portfolio performance per $1,000 invested
is shown below:
Types of venture capital
Private venture capital partnerships are perhaps the largest source of risk capital
and generally look for businesses that have the capability to generate a 30 percent
A return on investment each year. They like to actively participate in the planning and
management of the businesses they finance and have very large capital bases--up to
$500 million--to invest at all stages.

Industrial venture capital pools usually focus on funding firms that have a high
B likelihood of success, like high-tech firms or companies using state-of-the-art
technology in a unique manner.

Investment banking firms traditionally provide expansion capital by selling a

company's stock to public and private equity investors. Some also have formed
C their own venture capital divisions to provide risk capital for expansion and early-
stage financing.
Form of the venture capital investment
Through a convertible promissory note. The investor is issued a note by the company, convertible into company stock in its
next round of financing. The note will have a maturity date (often 12 months from the date of issuance) and will bear interest
(4% to 8% is common). No valuation is set for the company at this time. The investors will usually ask for the right to convert

1 their notes into the stock issued in the next round of financing at a discount to the price paid in the next round valuation (a
20% discount is common), sometimes with a “cap” on the valuation of the company for purposes of the conversion rate (e.g.,
a $10 million cap). Convertible note financings are much quicker and easier to document than the typical convertible
preferred stock alternative discussed below. Convertible notes are often seen in seed rounds.

Through a SAFE (Simple Agreement for Future Equity), first developed by Y Combinator. SAFEs are intended to be an
alternative to convertible notes, but they are not debt instruments—unlike a note, a SAFE has no maturity and does not bear
2 interest. The SAFE investor makes a cash investment in the company that converts into stock of the company in the next round
of financing. Just as with notes, SAFEs can convert at discounts and/or at capped valuations. (Read a good primer on SAFEs
here.) Institutional investors, such as VCs, are less likely to invest in SAFEs, but they can be useful for companies at a very
early stage.

5
Through a convertible preferred stock investment, with rights, preferences and privileges set forth in the company’s certificate of
incorporation (sometime referred to as the “charter”) and several other financing documents. The preferred stock gives the
investors a preference over common shareholders on a sale of the company. Preferred stock also has the upside potential of being
3 able to convert to common stock of the company. Most Series A financing rounds are done as convertible preferred stock. There
is a strong benefit to the company in issuing preferred stock to investors—it allows the company to issue stock options (options
to buy common stock, which does not enjoy preferred preferences) to prospective employees at a significantly reduced exercise
price than that paid by the investors. This can provide a meaningful incentive to attract and retain the management team and
employees.
Venture Funding Rounds
Pre-Seed / Seed Stage Series A

The pre-seed and seed-stage round consists of close friends

and family of the entrepreneurs as well as angel investors. The Series A round includes early-stage investment firms and
More seed-stage VC firms have emerged in recent years, but represents the first time institutional investors provide
the area remains niche and is typically for unique situations financing. Here, the startup’s focus is on optimizing its
(e.g. founders with previous exits, preexisting relationships product offering(s) and business model.
with the firm, former employees of the firm).

Series B/C Series D

The Series B and C rounds represent the “expansion” stage

The Series D round represents the growth equity stage in
and comprise predominantly of early-stage venture capital
which new investors provide capital under the impression that
firms. At this point, the startup has likely gained tangible
the company can have a large exit (e.g. undergo an IPO) in the
traction and shown adequate progress towards scalability for
near term.
success to seem achievable (i.e. proven product/market fit).
Two main ways to invest in early-
stage startups

Investing in a priced equity round

Investors purchase shares in a startup at a fixed
price

Investing in convertible securities

The investment amount eventually “converts” into
equity (thus the name)

Seed and early-stage investors often invest in startups via convertible securities,
such as convertible notes and Y Combinator’s SAFE documents. Investors in later-
stage startups (Series A or later) will more commonly invest in priced equity rounds.
Obtaining venture capital
financing

To understand the process of obtaining venture financing for startups, it is

important to know that venture capitalists typically focus their investment efforts
using one or more of the following criteria:

■ Specific industry sectors (software, digital media, semiconductor, mobile,

SaaS, biotech, mobile devices, etc.)
■ Stage of company (early-stage seed or Series A rounds, or later stage rounds
with companies that have achieved meaningful revenues and traction)
■ Geography (e.g., San Francisco/Silicon Valley, New York, etc.)
Venture Capital Due Diligence: Management
Team

The first key point of diligence is assessing the management team in charge of
the company. Throughout this diligence phase, numerous qualitative topics
need to be addressed regarding each member of the leadership team to learn
more about their:

1. Domain Expertise
2. Total Experience Level (and Relevance)
3. Individual Value Contribution
Collectively, the management team
must have:
Management
The management cohesion suggests
team must hold a the skills of the
long-term view founders
regarding the complement each
direction the other, and the team
company will be Long-Term Management can delegate tasks
steered. Vision Cohesion and collaborate
efficiently.

Product specialty
Business acumen is
refers to having the
having the right
technical skillset to
Technical team supporting the
create a product
Product Business product
better than any
Specialty Acumen development.
other company.
Product Analysis
There are three fundamental components to the product being offered:

1 Product-Market Fit

2 Product Differentiation

3 Value Proposition
Product-Market Fit (“PMF”)
Achieving product-market fit is the most important element to growth and scalability.

The concept of product-market fit is one of the major determinants of the outcome of an early-stage startup venture.
PMF is defined as the validation of the product concept in the target market, as signified by consistent organic
consumption and word-of-mouth promotion.

Early on, the management team should have a single-minded focus on demonstrating the potential for product-
market fit, as doing so is crucial to raise funding.

PMF is more of a qualitative trait as determining the degree to how a product meets a particular market’s demand
and the extent of how much a product resonates with the market.

Often, PMF is described as one of those attributes that can be recognized from customer engagement and feedback.
The product also begins to “sell itself” as marketing seems to take off on its own.

In addition, PMF suggests the current pricing mechanism and sales & marketing strategy are effective – albeit
improvements to the business model are going to be inevitable.
Product Differentiation

Most industries where VC funding activity is active tend to carry a “winner takes all” aspect, thereby firms pursue
companies that are inherently different.

That said, another important component to assessing a product is the presence of proprietary technology or patents
that make it difficult to replicate, which reduces the external threats to the company.

In short, there should be significant technical barriers that prohibit competitors from replicating their products.

An economic “moat” is a differentiating factor that contributes towards a sustainable, long-term competitive
advantage – as well as protection of its market share and profit margins.
Examples of deterrents that create a barrier against the rest of
the competition are:
Improved cost structures from the increased scale can be a barrier to entry
Economies of Scale that deters competitors, as the existing incumbents have a clear advantage
in profitability and thus have more cash flows to reinvest into the business

The network effect refers to when the value of a product/service increases

Network Effects with each incremental user and increased adoption

Proprietary Technology / Having a differentiated offering that no other company has can cause
Patents competition to be near non-existent, especially if there are patents involved

Unless the new entrant has a significantly better product/service than the
High Switching Costs current offerings, switching costs can serve as a barrier (i.e., the switching
costs outweigh the benefits)

While arguably not as important as the others, premium branding can help
Branding increase pricing power (e.g., Louis Vuitton, Gucci)
Value Proposition

Simply put, the value proposition to customers can be described as the extent to how much the product is needed.

The value of a product/service offering is tied to how essential it is for business continuity.

If the removal of a certain product causes significant disruption to the customer, the product would be categorized as
being “mission-critical”.

There must be a clear explanation as to:

■ Why does the customer need the product(s) of the company?

■ What backs up the belief that the business relationship will continue?

One proxy to determine the value of a product to customers is by looking at past attrition rates and the duration of
existing customer relationships. If a company has constant customer churn and its customer relationships comprise
short-term durations, the product may not offer enough value.
One of the more critical aspects of the business model is how repeatable it is, as this directly pertains to the scalability potential of the
start-up.

For this reason, capital-intensive companies attract far less venture funding relative to asset-light companies. And this also explains
why the software industry receives such a disproportional amount of interest from VCs.

High Operating Leverage Low Operating Leverage

If a company has high variable costs, each

If the company has high operating leverage,
additional dollar of revenue may generate less
each additional dollar of revenue can be
profit as costs proportionally increase
brought in at higher profits once the fixed
alongside increased revenue (i.e., the variable
operating costs are paid
costs offset the additional revenue)

Thus, each marginal unit is sold at a lesser

cost, creating the potential for greater If the revenue of the company were to
profitability since fixed costs such as rent, increase, these costs would rise in tandem (or
and utilities remain the same regardless of vice versa)
output

High operating leverage is not always better and there are scenarios in which this type of business model can
be detrimental to the company
Venture Capital Diligence: Risk
Analysis

1 3
Timing Risk Product Risk

2 4
Execution Risk Regulatory Risk
Timing Risk
Often, being too early to market can result in limited market adoption and ultimately a failed venture
(e.g., Fitbit wearables).

But then, later on, venture funding could rapidly flow into the same area with high-flying Valuation
Multiples and mass consumer adoption just a couple of years later (e.g., Apple Watch).

The takeaway: when it comes to venture capital, timing is everything.

A simple yet important question to ask is: “Why now?”

The venture must be initiated at the inflection point right before mass adoption, which is very
challenging to time precisely. However, there are “signs” when end markets are increasingly showing
frustration in the current market offerings – making the segment ripe for disruption.
Execution Risk
Among the many risks in venture investing, another type of risk is called execution risk, which is the
risk that the start-up will fail to execute its business plan.

For all companies, execution risk is unavoidable to some degree, but for early-stage companies, the most
common root causes are:

 Lack of Product-Market Fit (PMF)

 Increased Competition (i.e., Emergence of Well-Funded Entrants, Incumbents Adapting)
 Internal Organizational Issues (e.g., Conflict Amongst Founders or Existing Investors)

As the company matures and refines its business model and customer acquisition strategy (i.e., Growth
Stage), execution risk tends to increase as the product has now entered the “go-to-market” stage with
increased competitive threats.
Product Risk
Typically the most profound risk for early-stage companies still in the product development stage,
product risk is defined as the chance the product (e.g., system, software) fails to satisfy or fulfill the
expectations of the end customer/user.

The result of this is that the problem that the company identified (and aimed to have its product
solve) was left unfixed.

The capabilities of the product fell short of expectations and failed to deliver on the proposed value that
had originally enabled the start-up to raise capital in the first place.
Regulatory Risk
Another noteworthy risk to look out for is regulatory risk, which is the risk of regulations changing
unfavorably.
To provide two examples of companies impacted by regulatory risk with different end results:

Capsule: The digital pharmacy initially faced significant challenges in having to

navigate regulatory risk related to patient medication confidentiality and comply with
strict HIPAA regulations – however, this barrier was broken down by the
1 normalization of telehealth and digital health companies (with COVID-19 becoming a
major beneficial catalyst)

Juul: The electronic cigarette start-up was once valued near $38bn and received a
minority investment from Altria – but this appeared to be the peak of Juul as its
2 valuation plunged to approximately $10bn following regulatory scrutiny from the
public for marketing towards children/teenagers and nationwide bans on the sale of
most of its top-selling flavors
Pre-Money and Post-Money Valuation Overview

When it comes to evaluating early-stage companies, the Pre-Money Valuation refers to how much
a company’s equity is worth prior to raising capital in an upcoming round of financing.

Once the financing round and terms are finalized, the implied value of the company’s equity rises by
the amount of funding raised, resulting in the Post-Money Valuation.

If a company decides to raise financing, the total amount of new funding is added to the pre-money
valuation to arrive at the post-money valuation.

Pre-Money Valuation Post-Money Valuation

The value of a company’s equity before The value of a company’s equity once the
raising a round of financing. round of financing has occurred.
Therefore, while the pre-money valuation refers to the company’s value before the first (or the next)
financing round, the post-money valuation accounts for the new investment proceeds received.

The post-money valuation is equal to the amount of financing raised plus the pre-money valuation, as
shown below:

But depending on the amount of information readily available on the terms of the funding round, the pre-
money and post-money valuation could also be calculated using an alternative approach.
If the pre-money valuation is unknown, but the financing raised and implied equity ownership is
announced, the post-money valuation can be calculated using the following formula:
“Up Round” vs “Down Round” Financing

Prior to raising capital, the pre-money valuation must be determined by existing shareholders, most
notably the founders.

The difference between the beginning valuation and the ending valuation following the round of
financing determines whether the financing was an “up round” or a “down round.”

Up Round Financing Down Round Financing

A “down round,” in contrast, means the

An “up round” means the valuation of the
company’s valuation has decreased post-
company raising capital has increased in
financing in comparison to the preceding
comparison to the prior valuation received.
round of financing.
Venture Capital Valuation
Estimate the Investment Needed Valuation is perhaps the most important
element negotiated in a VC term sheet.
Forecast Startup Financials
While key valuation methodologies
Determine the Timing of Exit (IPO, like Discounted Cash Flow
M&A, etc.) (DCF) and Comparable Company
Analysis are often used, they also have
Calculate Multiple at Exit (based on limitations for start-ups, namely because of
comps) the lack of positive cash flows or good
comparable companies. Instead, the most
Discount to PV at the Desired Rate of
common VC Valuation approach is called
Return
the Venture Capital Method, developed in
Determine Valuation and Desired 1987 by Bill Sahlman.
Ownership Stake
VC Valuation Example
VC Valuation Example
Historically, deal counts tend to favor earlier stage investments as shown below. In the last few years,
however, there has been a noticeable move towards deals of larger magnitude.
As you would expect, the average deal sizes are significantly larger for later-stage investments, but
early-VC investments have been trending up across the board.
Pros / Cons of Fundraising
From the perspective of an entrepreneur and existing investors, there are several advantages and disadvantages
of raising outside capital.
We have listed some of the most important considerations in the table below.

Pros Cons

Increased valuation if the company performs Time-consuming process to raise

Entrepreneur well, more capital to implement new expansion funds (i.e. takes time away from
plans, access to experienced value-add partners managing the business)

Control mechanisms (go or no-go decision)

Existing Potential for ownership dilution,
with options to double down or hedge risk,
Investors validation of the firm’s investment thesis
less voting power
Venture Capital Timeline
While time to investment can vary from a few weeks to a few years, the venture capital timeline for an
early-stage company has six discrete steps:

Start-up Formation formulation of the idea, core team hiring, intellectual property
filings, MVP

Investor Pitch “roadshow” marketing of start-up, feedback on the idea, the

start of diligence

the continuation of due-diligence, final investor

Investor Decision
pitch, venture partner decision

Term Sheet Negotiation deal terms, valuation, cap table modeling

complete due-diligence, legal

Documentation documentation, government filings

Sign, Close and Fund fund, budget and build

The law of returns of early-stage venture investments states that for every ten Series A investments,
20% (2) will pay, 40% (4) will break even & 40% (4) will fail.
This means that to meet the VC firm’s investor expectations, those who make money on the
investment must make up for those that do not make money (i.e., the winners need to return a
multiple of the fund).

Recent VC Exit Activity

After experiencing a COVID-19 related dip in Q2 2020 deal count, Q3 showed signs of
improvement. As you can see from the figure below, the deal sizes have trended up pre-COVID
despite the drop is deal count.
Moreover, while the vast majority of VCs exit their investments through acquisitions, the dollar
amounts of these exits are derived largely from IPOs, and more recently, from acquisitions.

The recent public listings of Snowflake (SNOW), Palantir (PLTR), Asana (ASAN), and Unity (U)
all helped contribute towards this massive rebound in exit returns in Q3.
Venture capital has generally been less risky
than the broader equity markets
A global opportunity set for venture capital

Although the US has historically

been the largest market for
venture capital and has continued
to expand, the main driver of the
industry’s growth over the past
decade has, in fact, been
elsewhere. Asia, specifically
China, has seen the largest
growth. Europe and the rest of the
world have also expanded in
scale.
Late stage venture capital is at risk of
overheating but the early stage market is better
positioned
In contrast, capital flows for early
stage investments have
remained relatively stable and median
pre-money valuations
across the US, Europe, and Asia have
increased only
modestly. The Schroder Adveq FRI
confirms that early stage
venture capital is better positioned to
deliver strong returns
than the more crowded late stage
market.
Conclusion

Venture capital is an attractive asset class due to the ability to get early access to potential
market leaders of tomorrow, as well as generating strong returns for investors at
comparatively low risk. It is possible to get exposure to both the best venture capital funds
and top venture capital-backed companies, thus providing access to top quartile returns.
Venture capital is also not as cyclical as most investors think, providing consistent strong
returns through market cycles. Within the venture capital market, it is currently best to invest
in the early stage
part of the market.
“The biggest secret in venture
capital is that the best
4
investment in a successful
fund equals or outperforms
the entire rest of the fund
combined.”

— Peter Thiel