In Silicon Valley, we’re so often mired in jargon that we forget to ask the most basic questions about how venture capital works.

Christine Herron, director at Intel Capital and a venture advisor at 500Startups and StartX (a Stanford-affiliated nonprofit accelerator), addressed an intimate audience of investors of entrepreneurs this afternoon at Startup Monthly’s Smart Money conference.

She answered questions like: ” What are capital calls?” “Where does money come from?” “How does  a venture capital fund work?” She also offered her personal perspective on investing — bear in mind that there may be some discrepancies among venture capitalists.

There is no shame in brushing up on the basics! Herron’s ultimate advice for entrepreneurs: “Never be ashamed to ask questions.”

Venture capital: How does money go in?

Venture capitalists get 99 percent of total funding from limited partners: endowments, public venture funds, hedge funds, pension funds, and so on. Only one percent is from the general partners themselves (for tax reasons and to make the limited partners feel like there is “some skin in the game.”) For this reason, general partners who haven’t made money yet have small funds. Sometimes, however, a juinor partner gets brought in and the firm will give them a loan.

In many ways, venture capitalists are answerable to their limited partners: for instance, they can’t do investing in year one they haven’t set expectations for.

What is a capital call?

Also known as a “draw down”, this is a legal right of a firm to demand a portion of the money promised to it by its investors. In rough economic times, it is harder for some investors to come up with the cash they promised to invest in venture capital funds. Read more about defaulting limited partners here. 

How is the profit shared?

Venture capital is repaid to limited partners before any profit is shared. Typically, 80 percent will go tot he limited partners; 20 percent of the profit goes to the general partners. An individual venture capitalists share of the total general partner profit is called “carried interest.” New funds might offer a better split.

Tips for entrepreneurs

• Get to know the firm: According to Herron, it helps to follow the firm on Twitter and read their blogs.
• Ask questions if you’re a startup that is on the funding hunt: Entrepreneurs need to know if the firm hasn’t made an investment in six months. They may be having difficulties  – specifically ask, “when did you close your last fund?” Also worth asking about their average investment size, the amount of boards a partner currently serves on, and how their process works. “Your job is to optimize low number of VC coffees with high dollar raises,” said Herron.
• Entrepreneurs should know which partners work well together: “An entrepreneur-friendly VC would always share who else would be good,” said Herron. “They are looking ahead and saying who else should be at that board table making the company successful.”
• Pick your angel investors wisely: Choose angel investors that can bring in venture capitalists to join them in the round.
• Demonstrate your passion for the idea: VC’s want rainbows and unicorns. “I get so excited that you’re trying to change the world,” Herron joked.

Fund cycles and staying in business

Most venture capital funds have a fixed life of 10 years and the investing cycle for most funds is about three to five years — it’s a model that was pioneered by Silicon Valley firms int he 1980s.

After raising a fund, venture capital firms will spend three or four years seeding new companies, and then they will trickle down and stop. Around that time (the three or four year mark in the fund cycle), they’ll begin looking to raise the next fund. “They need to always be in the market writing cheques,” Herron explained. Venture capitalists should have the second fund teed up and ready to go once you’re no longer able to allocate from their current fund.

Got an innovative, albiet risky, idea? Early in the fund’s cycle, venture capitalists are far more prone to making gut-calls. By the third year, they will be more conservative with deals in order to hedge the risk.

What if the market sucks? If it’s a down market, venture capitalists might sit and flood the market at a later date. Firms can stop making new investments; they simply won’t start the clock. It doesn’t start until they make a capital call. “By the fourth year, they start to get itchy,” said Herron. “For this reason, during the height of the recession I would often advise startups to hold on until 2010.”

Common mistakes entrepreneurs will make

• Term sheets are non-binding! Herron makes an important distinction between two types of due diligence: Some venture capitalists will give you a term sheet and will do due diligence (call your customers and your references, for instance) to back up a decision that’s already been made. Other investors will present a term sheet, perform due diligence and change their mind. It’s important to know if there is diligence happening after the term-sheet, and whether there will likely be significant changes.
• Be clear on expectations: Find out if there will be a partner on your board. Will they spend one or one time with you?
• NEVER shop between partners! Here’s how the process should work: The entrepreneur will meet with an associate or partner. If they think it’s exciting, the entrepreneurs may be invited to talk to a few people. If all goes well, they will be invited to a partner meeting and pitch everyone.

In gold-rush times, here’s how VC trends affect you

• Expect higher venture capital valuations
• There will be more copy-cat ideas that turn into acquires,  and as a result, the bar for writing a check is a little lower.
• The minimum funding amount per investment will typically grow.

Whether or not the market is going down, according to Herron, venture capital money still has to be invested. But be cognizant of the state of the industry — you’ll need to step up your game in shrinking funding markets.

Top image // courtesy of Jesse Martinez

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