Morris Esformes | How Venture Capital Works

Like, Morris Esformes, you have probably heard about Venture Capitalists(VC's) and their spending habits toward dot coms. However, after the bubble these so called "VC's" backed away a bit and started having very strict guidelines or prerequisites in order to receive funding. Surprisingly, most people don't know how venture capital works, as if the preseeded money comes from the trees.

VC Money

So where does the money come from? According to Morris Esformes, The VC firm generally gathers money from pension funds, companies, rich individuals, and even universities. However, the firm itself is personally liable for that money. Now that the money portion is cleared we must understand how everyone benefits from this deal. Basically, hungry entrepreneurs are looking for money, lots of them and VC's are looking for not only a great idea but a superb team to invest in. Once these two are aligned they make a deal(called a term sheet) and the entrepreneurs give a percent equity of their company to VC's for the money that they receive.

Getting Rich

So what is the end goal that both the entrepreneur and the VC's want? That's simple they both want to get filthy rich within a couple of years. Morris Esformes says, typically the VC's look for 3x, 5x, etc of its initial investment. Let's say a venture capital firm invests 1million into entrepreneur Joe. Over the next 3 years Joe grows his company and sells for 6million. If the VC firm owed 50% of the company then they get a 3x return. But then the major question comes into how much the company is worth.

How much the company is worth? (Valuation)

Per Morris Esformes, from the start the entrepreneur owns 100% equity, but once he accepts a VC investment he must give part of that equity away. But how do you know how much of equity of give? This depends on the valuation. If the entrepreneur is asking for one million dollars for a 25% stake of the company then the whole company is worth four million (4 x one million)

Morris Esformes on Venture Capital Structure

In a nutshell, the roles within venture capital is a little like a condensed version of corporate structure. Except, in this case VC only has four people. These are the partners, EIR's, principals, and associates.

Partners- You can think of the partners as the CEO's. They make the end decision and are usually the owners of the firms themselves. Many of them have advanced degrees such as MBA's to Engineering degrees as well.

EIR's(Entrepreneur-in-residence) You can think of EIR's as contractors hired by the VC firm. They usually help with a particular expertise such as valuation or can bring in valuable insight into a particular field such as engineering.

Principals- You can think of Principals as the manager. They are general partners in training. They have no decision or authority over investment decisions but do bring key insight and manage the associates.

Associates - You can think of the associates as a white collar "worker" who supports the principals and the general partners. They have no authority over investments and mainly spend their time in research.

The above is essentially how venture capital works in a nutshell. Per our information from Morris Esformes, by knowing where the money comes from, how the deal works in addition to the valuation and the typical venture capital structure you already know more about venture capital than most people.