Venture capitalists are in the business of funding extreme outliers: companies that can become unicorns (valued at $1B or more) in a short amount of time (typically 7-10 years).
Venture capital (VC) is a unique asset class, which has played a key role in helping to create some of the largest and most successful modern companies. Correspondingly, it receives a large amount of media attention. Therefore, it comes as a surprise to many to hear that VC is actually relatively small and certainly very niche when compared to other asset classes.
Consider: in 2020, US VC dollars invested were $130B. That’s a lot of money and the pie keeps growing, but it’s still relatively small compared to other asset classes. For example, US private equity dry powder was $2.9T according to Statista. That’s T as in trillion.
From the perspective of a fundraising founder, the key thing to know about VC is that it is a business of extreme outliers.
Brief Primer on How Venture Capital Works
VC firms are created and managed by General Partners (GPs). GPs contribute their own capital to the firm’s funds. But that’s a small portion of the fund size. Most of the money comes from so called Limited Partners (LPs). LPs include entities such as pension funds, university endowments, high-net-worth individuals, and corporations.
LPs invest in venture capital firms in order to maximize their returns and diversify their portfolio. Therefore, venture capital is ultimately assessed in comparison to investing in other assets. A good rule of thumb is that for a VC fund to be competitive, they need to return 3x their fund size over the typical fund lifetime, which is 10 years. Returns are realized when a portfolio company gets acquired in an M&A or IPOs on a stock exchange.
The GPs go out and hopefully raise a new fund from LPs every 2-3 years. For a typical fund:
- 30% goes into new investments in the first 3-5 years of the fund. Early-stage VCs have a 10-20% ownership target when they invest.
- 60% goes into reserves, which are used to maintain ownership stakes in fund winners by doing follow-on investments.
- 10% goes towards fees. Note that GPs typically get paid with the so-called 2 / 20 model - 2% annual management fee on assets under management and 20% of profits made above a certain benchmark.
The above description is quite generalized - there are a lot of details and exceptions I have omitted since this guide is not focused on VC but on fundraising from VCs. For those curious, there are plenty of great resources a Google search away, which do a fantastic job of expanding on the details of how the VC model works.
Early-stage VC is Very Power Law-Driven
Imagine you are running a $100M VC fund. Using the rough numbers above, you plan to invest $30M to buy 10% stakes in a few companies and have to return $300M 10 years later.
Amounts raised in a round are a moving target, but for the purposes of this example let’s assume that our hypothetical VC firm is investing in seed rounds that average $3M with the founder selling 20%. Since you want to buy 10% stakes you have to take half the seed round, or $1.5M, which gives you 20 investments. Those 20 investments have to generate $3B in outcomes for you to make $300M via your 10%.
Of course, you’d very much like to have all companies succeed, but history shows that most companies fail. Indeed, it is not uncommon in venture capital to have 30% of your portfolio fail outright and another 30% return 2-3x (which is not enough to make an overall compelling fund return as per calculations above). And those statistics might even be worse in real life.
That means it’s all about the top third of your portfolio. And in real life it is actually often about the top 1-2-3 companies that your hypothetical fund invested in. A very simple way to think about it is that, to have a successful VC fund, your top investment should return the entire fund by itself. That is why VCs need those top companies to grow very large very quickly. Otherwise, the math simply doesn’t pan out and the VCs themselves are out of business.
This power law extends to VCs themselves. At least half of VCs don’t beat the market. While the top 10-20 VCs consistently generate superior returns.
The dynamics described above have a number of implications for fundraising, which I explore in Phase II - Fundraising.
Choose Your Fundraising Strategy Wisely
Internet forums are full of stories of disappointed founders, who ran into all sorts of issues with their VC investors. While there are definitely plenty of bad actors out there, in many instances the issue boils down to fundamental lack of compatibility.
As described above, VCs are forced due to their own business fundamentals to look for companies that can turn out to be extreme outliers. VCs are looking for diamonds in the rough, which they boost with unthinkable amounts of capital, in order to reach the coveted unicorn status. It’s okay for most bets to not work out - as long as a few make it very big. If you are aligned with such a goal - despite all the risks and challenges - then by all means go partner with a VC.
But if the VC model isn’t right for you or your startup, then don’t do it. You are simply setting yourself up for failure, frustration, and disappointment. And there are alternatives, including bootstrapping with salary / savings / consulting revenue, crowdfunding, government grants, loans, and more. VC is definitely not the only, let alone the “right” way. As a founder, it is your responsibility to decide which path to pursue and how to navigate its pros and cons.