Venture Capital: The Rocket Fuel of the Startup World
Some founders hugely benefit from raising venture capital, others do far better without. What’s right for you?
On rocket fuel and startups
Just like rocket ships, many startups want to take off. If all goes well, a rocket can not only be an extremely powerful mode of transportation, it can also take you places other modes of transportation cannot. However, building a rocket is very difficult, which is why most rockets never make it to orbit.
Let’s compare venture capital to rocket fuel. Rocket fuel is one of the key components for a successful rocket launch. You need just the right amount at the right time. If you have too little, you might not take off. If you have too much, you might blow up. In addition, you want to know exactly how to operate with rocket fuel. Since we are not rocket scientists, what follows is a crash course in venture capital.
Why is a crash course necessary?
At Sunfish Partners, we believe that the better you as founders understand venture capitalists (VCs) — their interests, motivations, structure, and pain points — the more informed decisions you can make. Starting with the most basic question: Should I raise venture capital at all? (The short answer is that not every startup is a venture case. Some founders hugely benefit from raising venture capital, others do far better without.)
Our crash course will cover the following questions:
- What’s the business model of VCs and how are they incentivized?
- How to get the attention of VCs?
- What should good VCs have to offer?
- How to select which VCs to work with?
- How to negotiate with VCs?
This article will be the first in a series. It will focus on the first question (the business model and incentives of VCs). Future articles will cover the other questions.
Business model of VCs
VCs raise money (so called funds) to invest in a portfolio of startups. The number of startups they invest in varies depending on the fund size. Oftentimes it is somewhere between 10 and 20 startups. The duration of the fund also differs. VCs usually set-up a fund for approximately eight to ten years. They use the first four to five years to make their investments and the later four to five years to exit those investments. For example, an exit event would be a sale or an initial public offering. If a VC does a good job, the cumulative money from all the exits of the startups is higher than its original fund size.
The investors in a VC fund are called limited partners (LPs). They invest in VC funds as they think that VCs can make them money by investing well in startups. The partners that manage a VC fund are called general partners (GPs). GPs also commit some of their own money to the fund to signal that they have skin in the game. VCs charge an annual management fee on the capital commitments of the fund. Oftentimes that management fee is around 2%. For example, the annual fee for a fund of €50 million would be €1 million. VCs use this management fee to cover all their expenses (e.g., salaries, travel, office). The management fee only makes up part of the motivation. There is a second component of how VCs make money: the carry. The carry is a form of profit-sharing. Let’s say the €50m fund in our example returns 3 times its invested capital. This is commonly referred to as a multiple of 3 or a “3x” (€50m * 3 = €150m). The money is then distributed to the LPs and GPs according to a so-called “waterfall”: At first, the LPs get their invested €50m back. Second, the LPs might get back an interest on their invested capital. This is referred to as “hurdle rate”. The hurdle rate insures that the LPs get a minimum return on their investment. (We will neglect this for simplicity reasons here). Third, the remaining money (€100m) is split between the LPs and the GPs. Oftentimes the split is 80% for the LPs and 20% for the GPs. The overall goal of VCs: maximize the multiple because the bigger the pie the more their 20% slice will be worth.
Outliers, outliers, outliers
Most startups fail. Picking and investing in the ones that will succeed is hard. With every investment, VCs try to find a future outlier. Outliers are startups that return the invested capital multiple times over, not just 3 or 5 times but rather 20 or 50 times. So, even if the majority or even all but one of the startups in the portfolio of a VC fail, one outlier can still make the math work.
Are there many outliers? Absolutely not. Look at the graphic below to see how few startups become outliers (and, consequently, how hard it is for VCs to invest in those select few). Only 1.1% of all startups generate a 20–50x return and only 0.4% generate a 50x + return. Those are the Googles and Facebooks of this world.
Remember, the VC is in it for the carry. Hence, the critical question a VC will ask before making any investment: Could this startup potentially become an outlier that returns the whole fund or more? If the answer is no, it would not make sense to invest.
“Show me the incentive and I will show you the outcome”
What does it take to become an outlier? Hard to say, there are too many unknown unknowns. At the very basic level, it’s a combination of market and team. Market: The right market at the right time, which ex-ante is hard to predict, of course. Team: An extremely talented, motivated, and hard-working team that is just right for this specific market. What’s easier to say, though, is that VCs are incentivized to do everything in their power to help the startups in their portfolio become outliers.
Charlie Munger, the brilliant partner of Warren Buffet, said it best: “Show me the incentive and I will show you the outcome”. What does that mean for you as a founder? VCs will help you become as big and relevant as quickly as possible. This can work out perfectly for you. However, it’s a strategy that does not come without risk. Again, building a rocket is tricky and many things can go wrong. Doing so with a lot of speed does not make things easier.
When incentives can be misaligned
Whereas you as a founder try to maximize the value of your startup, the VC tries to maximize the value of its portfolio of startups. The difference is crucial. A VC builds up a portfolio of risky bets in hope that one becomes an outlier. Pushing all of them to their limits has generally proven to be a good strategy for VCs. A fund in which nine out of ten companies fail could still be a great financial success from a VC’s point of view. You as a founder, however, don’t care about a portfolio of startups. You care about just one startup: your own. If your startup succeeds, you are happy. If it doesn’t, you are not. Having your startup pushed can be the winning strategy but it also increases the risk that your rocket never reaches orbit.
To be clear: We are not saying that VCs like to see their startups fail. Quite the opposite. They hate failure. They would love to see all their investments become outliers and, therefore, support them as well as they possibly can. However, it is crucial to understand that they are trying to maximize the value of a portfolio of rockets. Hence, given the diversification, they can absorb more risk. Remember, one successful outlier can turn the entire portfolio into a big success. You, on the other hand, only have one shot.
Summary
Venture capital can be a great resource, but it does not come without pitfalls. Therefore, it’s not for everyone at any time. We hope that this first part of our crash course was helpful to get you started. At Sunfish Partners, we believe that a clear understanding of the business model and incentives of VCs can be a key asset for you as a founder. Such knowledge can help you make mission critical decisions and help maximize the value you get out of your entrepreneurial journey. T-5, T-4, T-3, T-2, T-1, blast off!
Acknowledgements
This article first appeared in infoShare’s Grow with Tech magazine (pages 22, 23).
Thanks to Jessie Stettin, Dennis Zeiler, and everyone at Sunfish Partners for their feedback and edits.
