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The traditional investor’s guide to Venture Capital

Photo by Icons8 team on Unsplash

If you’re reading this, two things are likely: you’re into VC, or you aren’t. My appeal as the title may suggest lies with the latter group, but stick along you might learn something.

At Orion Startups, we often face difficulty when raising money for the fund due to a generalized misunderstanding of what we’ve come to call “traditional investors”, to the point that on every financing, most of the work is actually on the mindset and simply evangelizing about the venture world.

So, let us begin by the basics.

What is investing?

Investing on its simplest form is putting money places to get a return over a specified period of time.

Why does it work? Because in the world there are people who need money to build things, and often these things they build end up being really, really valuable, so an opportunity for financial symbiosis exists, where these people exchange a partial ownership of their business — or whatever thing they’re gonna do — for the money the need to build it, with the premise (promise?) that the wealth they will create on the long-run will be a net positive for the investor and for them. If the investor agrees, they will invest.

An investment is successful in relation to its return, that is wether the ownership that was transferred to you for that money is worth substantially more than the money you put in exchange to it. This is called Return on Investment, commonly abbreviated by ROI, and it is defined as:

Net Profit / Amount Invested

where Net Profit is defined as:

Total Holdings Value — Amount Invested

The potential return of any given investment is — generally — proportional to the risk of the investment, and that shouldn’t come as a surprise.

An investment is said to be risky to the extent that one cannot predict how it will play out. This is a very important distinction to make: you don’t call an investment risky according to how much money you could loose or win, but by how much you could be caught off guard. It is not just a matter of range, but a matter of distribution.

[ nerd notes:
Speaking mathematically, risk is just a more human-readable way of talking about Standard Deviation, that is, how much the values in any given data diverge from the expected results. A set where every value is equally probable has no Standard Deviation, while a set where very few of the values are extremely, disproportionally probable is a set where Standard Deviation is king, and where talking about averages really makes no sense in any practical way.
]

What is Venture Capital?

Venture capital simply is the world of investing in startups; the very young and highly tech-based companies, or any company that expects to grow well above their market, usually over 100% YoY with the earliest and 50% YoY with the latter.

Investing in this sorts of companies is very risky, because most of them will die, giving an ROI of -1, while the few that are to be successful will do so big-time, giving you double-digit ROI’s.

This simple condition of the startup world means lots of things for Venture Capital, making it inherently different to traditional investing, in four key ways:

  1. Growth
  2. Timing
  3. Liquidity
  4. Risk

Growth: Linear vs Exponential

Linear growth works very differently from exponential growth. Why? Because it is hard for us to wrap our heads around it. We are used to thinking in systems were the rate of change of constant, not itself changing, and that often means a challenge from the start.

Graph made with Desmos

The blue line shows a curve with exponential growth, while the purple one does of linear growth. Pretty regular, huh? Well what’s important to showcase of these to graphs is their origin.

Just a matter of perspective

Notice how at the origin both graphs appear to be growing at exactly the same rate. And this is something that people often miss when “thinking exponential”. Simply put, they overshoot and think that exponential means lots from the start, but nothing further from the truth. Actually, most of the times linearly-growing businesses outperform their exponential counterparts on their first few months or even years. The reason is easy: developing technology is hard and expensive, but distributing is easy and cheap. When a business doesn’t develop technology, it can start selling much faster, but since their distribution costs and durations scales proportionally to their revenue, their business scales linearly.

Most business scale linearly; restaurants, real estate, candy stores, notebook manufacturers, but with technology there is a positive mismatch between revenue and unitary costs that allow for a very scalabe business. The issue? There’s no guarantee what the companies ends up building becomes successful or doesn’t get outcompeted by a faster or bigger player. All this in contrast to, say, a restaurant which can sell food and variabilize costs quickly and find itself a very comfy niche either by location or type of food.

What makes tech very sexy and profitable is what also makes it very risky: digital distribution and network effects.

Digital distribution means that anyone anywhere can buy you, or stop buying you.

Network effects mean that you can either get all the users, or none of them.

Timing

Another thing lots of people get wrong about exponential growth is that when you get to choose between exponential and linear growth you’re choosing between an extremely exponential graph that breaks off from the start, and a linear graph that barely grows, but in reality, the choice is between a decent-growth linear graph, and an exponential one where the breaking off happens well into the life of the company.

TL;DR: yeah, it will grow exponentially, but it ain’t showing from the start. See below.

No need to clarify which one is which

[ nerd notes:
The cool thing about the graph above is that the x axis could be taken as literal in terms of months, since we’ve seen that it often takes companies two years to become cash-flow positive, but the one’s that make it… oh boy.
]

All this translates into something very simple: Like in the mirror dimension, time works very differently in the startup world. And this becomes important when it comes to returns.

We often have investors surprised that they will not see any return on their investment for10 years. Part of this is because tech companies take time to start becoming very successful (we invest in the earliest stages), and also we cannot simply turn our equity into cash overnight.

A general rule of investing is that you should be able to loose all the money you invest without a meaningul compromise to your quality of life. So it follows you should be able to say goodbye to it for a couple of years. Getting rich ain’t easy.

Liquidity

And you might ask: why can’t I just turn my shares into money in a snap like I can in Wall Street? Well, it’s easy; because in a private company the cycle of buying and selling ownership is different. There are four liquidity events where your shares might turn into cash (from worst to best):

1. Bankruptcy

When a company dies, all your shares are automatically translated into cash, usually at the value of $0 dollars per share, but depending on the financing terms you might still get some money out of it.

2. Selling equity on a later round

Another way in which your shares can turn into money you can spend is when someone wants to buy them from you. This usually happens to the early series investors when the company raises late-stage rounds. But what are rounds anyways?

Startups raise money by stages, called Series; Series Seed, Series A, Series B, Serie C, Serie D, etc. Many companies will raise money before the Series Seed, these are called Pre-Seed Series. The name of the series is a decision of the company, and they usually go by the growth period of the Startup.

  • Pre-Seed: Need money to build the team or research to pre-product building.
  • Seed: Need money to build the product.
  • A: Need money to scale the team, the product, and the sales strategy.
  • B: Need money to expand and scale into other markets or product categories.
  • C and above: Need money to further achieve world domination.

A Startup will only raise money so often, and even then you will not find people who want your shares for lots of these rounds, specially in the start.

3. Merger / Acquisition

When a big company buys or merges with a company in which you own shares, usually investors are paid in cash for their ownership, or in shares of the new company, which most likely is a public companies whose shares can be sold easily.

4. IPO

When a company becomes public (their ownership is traded in the stock market) your assets become very much liquid, since you can sell your shares at the speed of Wall Street — which is very fast.

For a Seed or Pre-seed investment, you can expect any of the liquidity events above to come — at least — in 5 years time. So yeah, you cannot dispose of your assets quickly.

Risk

Investing in a tech startup is one of the riskiest ways of investing, still there are ways in which you can manage the risk of your investment.

Going collective

Investing with a bunch of other investors enables you to invest in lots of companies, and the more you put your money across lots of companies, the more your ROI will approach the average, cancelling the factor of Standard Deviation, effectively vanishing risk.

Later rounds

The older the companies you invest in, the you can expect your ROI will be predictable and your investment approach that of a public company.

Smart money

Investing in a company might be a good idea, if they are successful. A way in which you can help your investment be successful, is by helping the company become successful throughout its life, either by personal mentorship, or using part of your investment to buy them an acceleration or incubation program which will increase its odds of success.

Investing in Startups is not for everyone, but rather a select few that not only have the resources but the passion and ability to withstand uncertainty to invest in a startup, knowing it could either be the next Apple, or the next Juicero.

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Felipe Acosta

Felipe Acosta

Writing stories; code, literature.