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While the investment decision is critical to portfolio performance, VCs spend more than 60% of their time on post-investment activities in order to grow investments for lucrative exits. These activities can be separated into monitoring (protecting the interests of the investor) and value-adding activities (strategic influence, mentorship and access to networks).
It should be noted that because of the many different VC management styles, VC involvement post-investment vary greatly — ranging from informal interaction to stringent control.
Building a Trust Relationship
Let’s face it. If an entrepreneur could do it on his own, he would. It is a major inconvenience having strangers involved in your business that you’ve been conceptualising for ages and nurtured to life. The due diligence exercise is a distant memory, negotiation tactics lead to both parties having to compromise and you’ve gone from sitting on opposite sides of the table to being part of the same team with a vested interest in mutual success. If things work out, the money invested will be of much less importance than the value-adding activities of the VC.
Investment Tranches and Related Milestones
Venture Capital is usually not invested in one go, but split into various tranches, each with a set of milestones to be achieved. These milestones include financial and non-financial measures, and are put in place for risk mitigation and to ensure that the entrepreneur applies the committed funding in line with the agreed strategy. Investment funds for each tranche are disbursed only once the set milestones have been achieved.
To ensure that the founders are incentivised to continue to run their own successful business, the VC usually ends up owning less than 50% of the company. However, the lack of effective voting controls by the VC are negated by building in protective covenants over major company decisions. This will allow the VC to assume control and attempt to rescue the investment if severe financial, operating or marketing issues develop.
Most likely one of the conditions of the investment will be that the target company should maintain adequate financial systems and controls. VCs expect their portfolio companies to provide regular reports on business and financial progress – including cashflow projections, management accounts and audited financial statements. This allows the VC to monitor the portfolio using accurate numbers, and also builds a culture of governance to support the exit strategy of the investment.
VCs are not in the business of assuming control and running a number of high-growth ventures in diverse industries. While operational control will always remain the responsibility of the entrepreneur, the VC will assist in shaping the strategy of the business. This will typically be achieved by appointing a Non-Executive Director to the Board of the company to provide mentorship support and advice to the Executive Directors.
The Startup Genome Report states that the biggest reason startups fail is a result of premature scaling, and because the VC is interested in driving aggressive growth, it could be dangerous for the business if the strategic vision of the VC and the founders are not aligned.
Defined Exit Strategies
A VC won’t invest without a clearly defined exit strategy that is carved out pre-investment – the so-called ‘Divorce before Marriage’ provisions. VCs generally aim to realise capital gains on their investments through a structured exit within five years of their initial investment. But this does not mean running around with a ‘For Sale’ sign on each portfolio investment until it happens. Throughout the life of the investment the VC constantly ensures that the incremental building blocks are put in place to prove business traction; and ultimately ensure that a successful exit becomes a self-fulfilling prophecy.
Venture Capital funding is about enlarging the business pie for all stakeholders involved, while ensuring that the VC’s slice of the pie remains protected in the process. But the entrepreneur needs to be prepared to follow an aggressive growth path with a strategic partner that will ensure that all parties remain on course.