Investments in Private Capital

Before defining what Venture Capital is, it is crucial to understand the concept of private capital or private equity. There are two main categories of capital investments:

• Public equity: Refers to investments in companies whose shares are open to the public and listed on the stock exchange, allowing anyone to acquire shares.

• Private equity: This type of investment focuses on private companies, whose shares are not available to the general public. Various investment strategies are used.

Within private equity, we find two strategies: Private Equity (PE), which focuses on more established companies, and Venture Capital (VC), which invests in companies in their initial stages, but with great growth potential.

The key difference between the two lies not only in the type of companies, but also in the form of investment. While the PE can invest through debt or equity, the VC focuses exclusively on equity.

Definition of Venture Capital

The term Venture Capital, or Risk Capital in Spanish, refers to capital investments made to acquire a stake in small or medium-sized companies, typically startups. These investments are carried out by specialized VC firms.

What is a Venture Capital firm?

The Venture Capital industry is made up of firms that perform three main functions:

• Search, evaluate and make investment decisions in startups.
• Carry out legal and financial operations to invest the funds.
• Manage the investment portfolio in startups.
• These firms act on behalf of their investors, known as Limited Partners (LPs), who contribute capital to a VC fund managed by the firm. It is important to note that Venture Capital firms also have their own investors.

A fund is made up of the following parts:

• The Fund (Limited Partnership (LP)): This is the legal entity through which venture capital investments are made. It is made up of LPs and GPs.
• Limited Partners (LPs): LPs are partners who contribute capital to the fund.
• General Partners (GP): The GPs are the partners in charge of directing the venture capital firm that manages the fund and invests in startups.
• Portfolio Companies: These are the startups that receive financing from the Fund in exchange for shares.

With these terms defined, we can delve deeper into the relationships between each of the parties.

How do Venture Capital funds work?

Before establishing a Venture Capital fund, GPs present (similar to how a startup would do with them) their new Fund to potential LPs. LPs are institutional investors, such as pension funds, corporations or wealthy families, who trust their money in the experience of GPs, with the expectation of obtaining the best possible return.

GPs are usually professionals with extensive investment experience, with operational experience in technology companies or successful entrepreneurs. Notable examples of GPs in Latin America include Nicolás Szekasy of Kaszek Ventures, Eric Acher of Monashees and Diego Serebrisky of Dalus Capital.

A Venture Capital firm can manage several funds, each being an independent legal entity. Each fund is governed by a Partners Agreement that establishes the terms that govern the relationship between GPs and LPs, addressing aspects such as:

• Remuneration of GPs.
• Investment returns that LPs will receive.
• How the fund money will be invested.
• Duration of the fund.

The firm is run by the GPs, who are also owners, and usually has:

• Investment Team: Professionals in charge of carrying out the search, evaluation and administration tasks of investments, in collaboration with the GPs.
• Management Team: Includes accountants, financiers, lawyers and other specialists who support administrative and legal operations.

How do Venture Capital funds make money?

The standard model in the industry is known as the "2/20."

• 2% Management Fee: This annual commission covers the firm's operating expenses, such as rent, salaries, computer tools, etc. It is equivalent to 2% of the managed capital.

• 20% Carried Interest: Represents the participation in the returns that the GPs receive. These returns are calculated as the money returned to LPs that exceeds the principal of their investment.

Example:

Let's assume that a Fund manages US$ 10 million and has a duration of 10 years. After paying the management fees (US$ 200 thousand annually), there are effectively US$ 8 million left to invest. If the firm invests US$ 1 million in 8 startups, of which 7 fail and 1 is sold for 30 times its initial investment, the Fund would receive US$ 30 million. After returning the US$10 million (the principal capital) to the LPs, the excess returns would be distributed 80% (US$16 million) to the LPs and the remaining 20% ​​(US$4 million) to the GPs.

Why would a startup in Latin America want to seek Venture Capital investment?

Startups are private companies with a short operating history, generally 2 years or less. This differentiates them from more consolidated companies in several aspects:

• First phase of development: Its products, operations and management teams are still in formation.

• Brief History: They have little sales and cash flows, and sometimes even no sales and negative cash flows.

• Reduced tangible assets: They do not have machinery, properties, etc., since their investment is focused on technology (intangible assets) whose market value is still uncertain.

These characteristics generate high uncertainty about the ability to generate cash flows in the future. Therefore, it is often almost impossible for startups to access financing from more traditional capital sources, such as banks or public stock markets.

It is in this context where an alternative source of capital arises: Venture Capital. In exchange for the investment necessary to boost the business, startups offer a percentage of ownership of the company.

Why do VCs invest in startups?

Investments in startups involve high risk, but this risk is offset by the possibility of obtaining a much higher than average return, if the company successfully executes its plans.

However, because the cash flows of startups are usually negative in their first years, there is often a risk of losing the entire investment contributed.

Given the early stage of development of startups, the investment is considered illiquid and requires investors to keep their capital tied up for at least 5 to 10 years before having the possibility of selling their stake to a third party, in an event known as exit or exit.

At each stage, startups must meet certain criteria that give the investor enough confidence to believe in their high potential. For this reason, there are investors with different risk profiles depending on the maturity of a startup.

For example, an accelerator, an angel investor or a seed investor could be interested in investing in a startup in a pre-revenue stage, that is, with a product but no sales. On the other hand, a Venture Capital firm is less likely to invest in such early stages.