Demystifying funding: Understanding the VC business model
Great relationships in business and in life are built on the foundation of trust and understanding.
Bringing on an investor to join your startups journey is a huge commitment — as is often said, they are the people who you can’t fire!
There are lots of great resources to help you do some of the ground work in building up trust with your investors. One example of this is the recent blog post by AirTree investor, Elicia McDonald on the checklist that founders can use to do their own due diligence on potential investors.
However, the focus of this post is on the other element of strong relationships, which is understanding.
I have been a founder myself and I know that it can be hard to understand the motivations and expectations of investors as the world of VC (Venture capital) can often be a little mystifying.
So the purpose of this post is to lift the veil and dive deep into how VC funds operate, how they make money and why VCs look for specific types of companies to build long term relationships with.
Who funds the VC funds?
Like startups, VCs also have to go through a fundraising process themselves. This fundraising is done generally from high net worth individuals and organisations such as Superannuation Funds. The people/organisations who decide to invest into VC funds are known as Limited Partners (or LPs for short).
The VC Monetisation model:
VC Funds make their money in two ways.
The first is a management fee (usually 2% of the fund/year) which helps them to run and manage the fund through hiring team members and having the resources available to pay for other day to day operation of the business.
The second and primary way that funds make money is “carried interest” which is essentially a percentage of the profits made in the event of an exit (acquisitions or IPOs) from their portfolio companies. For most funds this carried interest is usually around the 20% mark, with the remaining 80% being distributed to the LPs.
Working the numbers
Let’s take the example of a $100M fund (let’s call it Fund X) that has a 20% carried interest.
If Fund X returns $100M (or less) from their portfolio of investments, there is no carried interest paid out to the fund — a bad return for them and the LPs!
However, most funds target a minimum of a 3x return on investment. For this result to occur, Fund X needs to return $300M from the $100M invested. This would result in a $200M in profit with Fund X receiving $40M from their 20% carried interest.
However, getting a $300M return is not as simple as one of the portfolio companies selling for $300M! VCs will have a percentage stake in the each business — making sure there is plenty of upside for the founders and employees to reach their long term vision.
Funds who jump in early, will want to double down on their best performing companies through “follow-on” investment into subsequent rounds of funding to minimise dilution.
Let’s assume that Fund X is able to hold a 20% investment in the best performing companies from their portfolio. To get to the magical $300M return number they will need:
- 1 company to exit for $1.5B
- Or 2 companies to exit for $750M each
- Or 3 companies to exit for $500M each
- Or alternatively it will take 15 companies exiting at $100M each to provide the same output
The Risk & Power Law
Startups by nature are a risky asset class and getting VC funding is by no means a guarantee that a particular startup will go on to be successful.
As a result, it can be difficult to predict which startups will go on to become unicorns as the returns from these investments often aren’t realised for another 5–7 years!
What is known however, is that due to the risky nature of investing in startups, the success of a portfolio is not evenly distributed. The majority of the portfolio companies will often provide only a small percentage of the returns, but a limited number of companies will have breakout success and provide a greater than 10X return. This is often referred to as the “power law” of investment as demonstrated by the graph below from Andreesen Horowitz which shows that 6% of VC deals provide 60% of returns and 50% of deals provide 3–4% of returns.
What this means for startups and VCs
Given the amount of information we have covered about the VC structure, I just want to reiterate that the emphasis of a good relationship is finding the right fit between both parties. VCs are looking for very unique sets of businesses with a rare potential exit value, however that does not diminish the importance of other startups.
Building and exiting a $100M startup is also extremely difficult and rare! The significance of reaching this milestone and the life changing effect it can have on the founders, their family and those involved in the business should not be understated. But as shown by the example above, this outcome doesn’t align with the objectives of VC funds and the returns they need to provide to their LPs.
Sometimes founders with great traction and interesting products will pitch to investors and not get offered term sheets. It’s important to note that being rejected by a VC fund doesn’t mean that the startup cannot be successful or go on to build a meaningful exit.
However, it may mean that the potential alignment between the startup, the market it operates in and the dynamics at play (e.g. timing, competition etc) doesn’t match the requirements that the VCs need to pull the trigger on investing capital and resources into that particular startup.
VC funds are often looking for “outliers” — those founders and companies that have a unique set of ambitions, characteristics and superpowers that allow them to not just build successful or great companies, but those companies that will go on to significantly disrupt or create and define their own categories (with huge exits!).
It is only by taking these calculated risks by backing these specific types of founders and startups over the long term, that VC funds have the opportunity to deliver on their own business model.
If you are a founder and looking to raise funding from VCs or Angel Investors, consider applying for the “Investor Connect” event, where we will be bringing 20 of the leading VCs and Angel Investors and matching each of them to 2–3 startups that fit the profile, stage and verticals they are interested in investing in! You can find out more about this event here.
How to get involved:
If you would like to apply to be part of this event, you can apply to through our website (playbookventures.com.au) or fill out the application form which you can find here. Applications are open until 1st August, 2019.
Interested in attending as an investor? Get in touch here!
If you have any further questions about the event, feel free to contact me here.
