How Venture Capital Works. Part 2: Business Model
How your investors make money from your startup
We have discussed the least exposed side of Venture Capital in the previous article. Now we will focus more on its business model. Understanding the other side’s goal and methodology is an important requirement for you to be able to successfully raise fund.
During my time as a VC associate, I found out a lot of founders don’t even know how VCs will make a return on their investment. Hint: It’s NOT from your profit (Dividend). When a VC invests in your startup for 20% ownership, most founders always assume someone will come at the end of the year and ask for 20% of the earnings.
For an early-stage startup, the profit will be petty compared to the investment deployed and definitely will not be sufficient to cover the firm’s day to day expenses. However, most startup will not be profitable, and as an investor, they would prefer to keep the retained earnings within the company to fuel growth and expansion instead.
P.S. Find the previous article: How Venture Capital Works. Part 1: The Less Exposed Side in this link.
Part 2: The Business Model of a Venture Capital
Management Fee: To Cover Operating Expense
Running a business is costly. How much does it cost to run your startup? Rent, salary, transportation, you name it. VC firm needs to pay those fees as well. Let’s say the cost is $5,000 monthly. Your startup dividend, if any, would not be able to cover that cost yet.
How do VCs pay their bill then? They get the money from their Limited Partners (LPs). Operating expense for the firm (and sometimes for the fund) is usually already stipulated in the Limited Partnership Agreement (LPA) agreed between LPs and General Partners (GPs). It’s usually a fixed percentage to the fund size. Usually 1–2% per year during the active deployment phase and will decrease after the fund is fully deployed. A fund usually has around 8–10 years of active life where half is spent for investment/deployment and the remaining half for divestment/exit.
A 100-billion-dollar fund like Softbank’s Vision Fund could receive $1B management fee per year. Interesting isn’t it? If the LPs are willing to pay Softbank $1B per year for their service, they will definitely expect Softbank to generate more return for their managed assets. I will tell you more about VC’s life cycle and target return in my future articles.
Beside the fixed Management Fee, VC firm will also collect another fee based on its performance. This is called the Carry.
Carry Fee: To Generate Return to LPs
Understanding Capital Gain
VC is just another asset class in the eyes of the LPs. LPs could invest in any financial product. VC is a tool for them to diversify their portfolio. In another word; VC return needs to beat the market return. The only way to achieve this requirement is to invest in highly volatile products such as early-stage companies stock and aim for a “Massive” Capital Gain (Buy low, sell high). Aiming for dividend will only generate a better than average market return at best and nowhere close to “Massive”.
In 2014, Alibaba sold $22B of stock in what was, and still is, the biggest IPO on record. Fourteen years earlier in 2000, Japanese telecom giant SoftBank had invested $20M for 34% of Alibaba. The IPO gave Alibaba a market cap of $231B — and valued SoftBank’s stake in the company at well over $60B (CBinsights, 2019). Get it now? $20M to $60B, that’s 3,000x Multiple on Invested Capital (MOIC) in 14 years. That’s “Massive”.
P.S. You could follow this link to read more about the most successful VC exit.
“If you do the math around our goal of returning the fund with our high impact companies, you will notice that we need these companies to exit at a billion dollars or more,” he wrote. “Exit is the important word. Getting valued at a billion or more does nothing for our model.”
However, VCs cannot achieve home runs all the time. Most of the time, they missed, but it’s all part of the game. This is what distinguishes a good from a regular GP; the ability to scout the next home run.
In venture capital, returns follow the Pareto principle — 80% of the wins come from 20% of the deals. Great venture capitalists invest knowing they’re going to take a lot of losses in order to hit those wins (CBinsights, 2019).
Rewarding GPs through Carry
A good GP could detect the next home run and they would like to be rewarded for that. In the LPA, this reward would be displayed through the “Carry” Fee clause. According to Investopedia:
Carried interest is a share of any profits that the general partners of private equity and hedge funds receive as compensation regardless of whether they contribute any initial funds. Because carried interest acts as a type of performance fee, it acts to motivate the fund’s overall performance. However, carried interest is often only paid if the fund’s returns meet a certain threshold. (Chen, 2020)
This is where a VC firm could make the real money. This is a year-end bonus for the GPs and will be paid at the end of the fund life. There are some calculations involved (it needs to pass a hurdle rate and calculated on the fund level), but usually around 20% of the excess return for the GPs. Simplified example using Alibaba’s case, $20M investment to $60B return will yield $59.8B x 20% = $11.96B in Carry for Softbank.
The “So What” for startup founders
During the meeting, VC associates will always ask a detailed question regarding your startup business model, but do you know theirs? I hope this article could provide an insight to you. Their business model is the reason why they value growth over profitability. Pay attention to their fund life, they need to exit their position at the end of the fund life. Their attention span will be anchored to the fund life. Will your startup get acquired within that period, or should they sell their ownership instead?
Thank you for reading! In the next series, I will write about the “Investment Thesis”. You should use it to gauge the VC interest in your company and industry in general. Happy to hear your thoughts! Let me know your comment and please share if you find this article useful. You could connect with me at linkedin.com/in/erikhormein/.
Next article: How Venture Capital Works. Part 3: Investment thesis in this link.
