In the previous chapter, I talked about why it is so important to keep your audience in mind when you are telling a story. In my work with founders, I’m sometimes surprised that even pretty experienced founders occasionally don’t understand how venture capital works. By extension, it’s hard to make the most compelling pitch; without understanding venture capital, it is tricky to know what the driving forces behind your investors’ decisions are.
Who invests in venture capital?
At the most basic level of abstraction, venture capital (VC ) is a financial asset class. Think of an “asset class” as a place where you park your money when you’re not using it. As an individual, you may put your savings in a bank account, the stock market, bonds, or an index fund. You could also invest your savings in property, art, or what have you. As a smart investor, you will probably spread your risk a little. You might make some high-risk investments (say, in the stock market) that may double your money, but that could also go to zero, and you could put some of your money in government bonds or a savings account in a bank.
The same basic principle applies to the people who invest in venture capital funds. They might be high-net-worth individuals, pension funds, university endowments, corporations, or even governments. In venture capital parlance, investors into a fund are usually called limited partners—or LPs.
Much like you, these LPs will have a “risk profile,” depending on the goals they want to accomplish. A university endowment fund might be more risk averse than a high-net individual, for example. In any case, most investors will invest some of their money in low-risk investments that have a low rate of return, just above inflation. In addition, they will attempt to grow their fund, typically by allocating a small proportion of their total assets under management (AUM) to high-risk investments across various asset classes. The difference between conservative and aggressive funds is the proportion of each. For the high-risk, high-reward allocation, they may invest in private equity, which buys, optimizes, and sells existing businesses. They may choose to invest in high-risk emerging market stocks. Or perhaps they decide to invest in another high-risk asset: startups.
When an LP decides to earmark some of its money to startups, they typically don’t have the expertise or the bandwidth to vet and invest in the startups directly. Instead, they deploy the funds into a company—usually a partnership—that can keep an eye out for great investment opportunities, and make the investments. These partnerships—you guessed it—are venture capital firms.
From the LPs’ point of view, they hope that when they invest $10m into a VC fund, one of the investments done out of that fund is the next Facebook, Google, Tesla, or Instagram. If the fund had invested in one of those companies, $10m could turn into $200m. The startup makes a ton of cash. The VC makes a bunch of money. And the LPs stand to get an extraordinary return on their investments.
What’s an investment thesis?
When talking to VCs, you need to know what the firm does and doesn’t invest in. That’s known as the fund’s “thesis.”
When people get together and establish a venture capital firm, they become the general partners (GPs) of the firm. The GPs usually invest some of their own money into the fund, but the critical part of their job is to be the legal, moral, and fiduciary shepherds of the LPs’ money.
The general partners will do a lot of research and create an “investment thesis,” a document that describes how the partnership will invest. The thesis will explain what the VC firm believes is going to happen over the next decade and why it has a fighting chance at giving the limited partners the return they so desire.
You may have heard of “series A” or “seed” funding rounds—usually referred to as the “stage” of the venture funding. The thesis includes the stage where the fund focuses its attention. Some firms focus on startups that don’t have a product or revenue yet (sometimes referred to as pre-seed startups). Other firms will only invest in companies that already have a tremendous amount of money coming in. From an investment point of view, investing earlier is higher risk, but it’s possible to get a more significant piece of the company for less money.
Some investors focus on particular markets; you’ll find VC firms that only invest in virtual reality startups, hardware startups, cryptocurrency startups, medical technology, or self-driving technology startups. Other VCs focus geographically, only investing in sub-Saharan Africa, for example. Some will only invest in startups that spin out of a particular university. Some VCs decide to only invest in women, underrepresented founders, or any number of other investment criteria.
Venture capital firms can be extraordinarily broad (“we invest in all early-stage companies”). It can also be spectacularly narrow (“we only invest $20m or more into hardware companies that are working to combat cancer on the east coast of the United States and only into founders who have PhDs in related fields from a specific university”). There’s no “wrong” thesis for a VC firm, as long as it can find LPs who believe in their vision.
All of these selection criteria will, together, make up the investment thesis. That is important because all of these things will be on your investor’s mind. There are exceptions, of course, but as a general rule, if what you’re pitching doesn’t fit into the thesis, it doesn’t matter how good your pitch is. The LPs won’t be happy if they invested in a fighting-cancer investment prospect, and the venture firm turns around and invests in a dog-walking app aimed at millennials.
It is worth noting that most VC funds have some leeway, and there’s no investor who won’t at least take a look at an incredible, out-of-the-ordinary deal. This is how you sometimes see later-stage funds investing in early-stage startups, or you might experience that specialized funds make investments outside of their core thesis. Exactly how and when this happens could be a whole book all to itself, but the short version is that a lot of investors can be opportunistic, and if an incredible opportunity comes along, they may choose to pick an argument with their limited partners for the right deal.
Not all VCs will be fully open with you what their thesis is—or who their LPs are—but I wouldn’t talk to a VC firm myself without researching the former and asking about the latter. You may not get an answer, but asking the question shows that you understand what’s going on.
What is an exit?
A venture fund gives the company money in exchange for shares in the company. Once the investment is made, it means that the money is “locked up,” and it doesn’t free up again until there is a liquidity event—also known as an exit. Exits can play out a few different ways, but the two most obvious exits are an acquisition or initial public offering (IPO).
Acquisitions happen when other companies buy a startup. They do that for a few reasons; perhaps the startup has technology that the more prominent company doesn’t have. Maybe they have a customer base that is hard to replicate. Maybe the startup is bought because they’ve built an incredible brand or perhaps the acquiring company wants to buy the startup just for its team. The latter is usually known as an “acquihire”—short for “acquisition hire”—instead of trying to hire a group of outstanding people individually, a big company might swoop in and buy the whole company. In any case, the company buys all the shares of the company, and the VC gets a payout based on how many stocks in the company they own.
The other exit is a listing on a stock exchange, usually through an initial public offering. In this scenario, the company stops being a private company and instead makes its shares available on a stock exchange. That makes the shares “liquid”—and the VC firm can sell them to stock traders who want to invest in the future of the firm.
If a company doesn’t have an exit, the VCs (and, usually, the founders and staff who own shares or options in the company) won’t see a payout.
How does a VC firm make money?
Most venture capital firms are set up with a “management fee” and a “carried interest” (usually just called a “carry”). The management fee tends to be 2% of the assets under management per year for the duration of the fund. So, if the fund is $100m and deployed over 6 years, the venture capital firm gets $100m × 2% × 6 years = $2m per year, for a total of $12m throughout the fund. The management fee covers the expenses, such as the wages for the staff, legal, accounting, office, travel, and other costs.
San Francisco—and the wider Bay Area—is particularly well-known for venture capital. Don’t be fooled; angel investors and venture capital funds are everywhere, not just in the area south of San Francisco known as “Silicon Valley.”
Much more important than the management fees, however, is the “carry.” This is the cut—usually 20%—of the returns the VC fund gets for deploying the money. Exactly how the carry for the fund works varies a little, but to understand how it works, this simplified explanation works: Imagine the VC firm invests $100m into 50 startups. Some of them fail and make no return. Some return the money (i.e., the VC firm invested $2m and gets $2m back when the company “exits” some years later) or come with a modest return (say, a $3m return on a $2m investment). However, in this fund, the VC was able to invest in a startup that went on to get a huge initial public offering (IPO) on Wall Street. That $2m investment turned into $200m, and across the whole portfolio of investments, the $100m fund returned $400m. From those $400m, the venture firm gets a 20% cut or $80m. This money is divided up among the general partners. Sometimes other staff at the venture firm have some carry as well, which means they also share in those spoils.
All of which is to say, running a venture firm for $2m per year isn’t particularly lucrative. General partners at venture firms are often pretty wealthy already, and they wouldn’t get out of bed for the wages they are paying themselves—if any. Where things get interesting is in the carried interest, that’s where a venture firm makes its real money.
What does the VC need from its investments?
Investing in startups is risky business. The exact benchmarks will depend on the stage and market the VC is investing in, but it isn’t uncommon to have half of the investments fail to make a meaningful impact on the firm’s financial health.
As a startup, your company failing is a terrible ordeal, but from the VC’s perspective, that doesn’t matter: they didn’t take all their money and put it in your company—they have a whole portfolio of investments. Knowing that a lot of the investments will fail is a part of the model.
The result of all this is crucial to understand. You know that the LPs want to see a return on their investment. You also know that a lot of startups fail. The final piece of the puzzle is that if the VC firm wants to raise another fund, they need to get a decent return on the fund. So, if the VC fund wants to get a 3x return across the whole fund, it cannot invest in a company that can, at best, get a 3x return. In other words, if there is no universe where your company can result in a 10x return, it doesn’t make sense for the VC to invest in your company. The big “hits” have to make up for the failures elsewhere in the portfolio.
Should you raise venture capital at all?
You picked up this book because you are interested in raising money for your company. I also feel that I should point out that venture isn’t the only way to run a company.
There are downsides to venture capital-fueled companies—they run at breakneck speed, not least because the investors want to see a return on their investment, typically in a 7–10-year time horizon. Being on the VC treadmill also means that you’ll continue to raise money every 12–18 months until your company either becomes self-sustaining or has an exit. Both the pace and the 7–10-year timeline may be deal-breakers for some startups; in some industries, that’s not enough time to build a robust and sustainable company. And some founding teams prefer a slower, more measured approach than the breakneck venture speed affords.
If venture isn’t the right path for you, it’s possible to “bootstrap” your company. Find a way to get started, optimize for early revenue, and then use the income to reinvest and grow the company. Other avenues may be to seek grants or donations or raise money from angels or special-interest organizations that don’t have the return expectations or time constraints inherent in a lot of venture capital models. Once you have some revenue and a clear path to more, banks and other funding sources may become options for further building and developing the business.