As a serial entrepreneur building venture-style tech companies, I spent the first decade of my career fetishizing venture capital. I’d follow VCs on Twitter like they were celebrities, I’d attend conferences if well-known VCs were speaking, and I’d brag to my fellow founders about pitch meetings at Andreessen and Sequoia and Benchmark. Despite not raising money from any of those firms, I’d naively assumed the simple act of taking a meeting with me was a form of validation for my company.
What I didn’t realize was that I was completely misunderstanding the purpose of venture capital. For a long time, that misunderstanding contributed to my inability to raise capital.
I’m sure I’m not the first or only entrepreneur to misjudge the relationship between venture capital and startups. In a way, new tech entrepreneurs are encouraged to worship at the altar of VC rather than understand it. The confusion starts with the tech press, where funding announcements dominate the headlines as “newsworthy” events. It carries into popular culture, where companies are described by their valuations (i.e. “billion-dollar unicorns”) rather than their impact (i.e. “saved the lives of 10,000 children”). It permeates conferences and events, where the featured speakers are often venture capitalists or entrepreneurs who have successfully raised lots of money from them. And it dominates the life cycles of startups as founders align their strategies to what investors want to see rather than what their customers will most value.
My goal, in this article, is to explain venture capital and venture capitalists in a way I wish someone had explained them to me when I first started building venture-backed tech companies. By doing so, I hope I can help new entrepreneurs understand A) how to engage with venture capitalists; and B) whether they should be pursuing venture capital funding in the first place.
Why venture capital exists
From an entrepreneur’s perspective, it’s tempting to think of the venture capital industry as being in the service of startups. After all, VCs fund startups and support their growth. Seems like they’re trying to help startup founders succeed, right? But assuming that the goal of VCs is to support startups confuses the purpose of venture capital with the outcomes of venture capital.
Venture capital exists to serve as an investment vehicle primarily for people and organizations trying to diversify their investment portfolios. As such, the goal of venture capitalists isn’t to help startup founders realize their entrepreneurial dreams. The goal of venture capitalists is to generate a positive ROI for the people investing in their venture funds. This is important to remember because it underscores the difference between how most entrepreneurs perceive venture capital and how venture capital actually operates.
In order for venture capitalists to succeed, they must invest in companies with a high potential for 1) being worth significantly more than the original investment; and 2) being sold to another company (or on the public market) so the company’s increased value can be returned as cash and disbursed to investors in their fund. This liquidation opportunity is called an “exit event.”
How venture funds are structured
The following is an over-simplification of the venture capital model that I often use to explain VC for my students in a way that articulates the fundamental structure. I realize it’s not perfect, but it’s enough for our purposes here.
Let’s say a venture fund has $10 million. Putting that money in the stock market would return roughly 10%. Not bad money, for sure, but VCs are supposed to do better than that.
The VCs running our hypothetical $10 million venture fund are going to attempt to “beat the market” by investing in fast-growing companies. Our hypothetical VCs are rather unsophisticated, so they’re going to simply divide their $10 million into 10 equal $1 million checks and invest them in 10 different companies.
When those VCs invest in their 10 companies, they do so expecting a full 50% of the companies to never return a penny.
Of the remaining five companies, the VCs expect four of them to ultimately end up returning the initial investment (i.e. $1 million each, $4 million total).
So we’ve started with $10 million and we’ve only gotten back $4 million. Not a great outcome so far, but the VCs still have one more company. That 10th company is their “home run.” It’s going to be so successful it’ll return 10x the initial investment, or $10 million.
Put it all together, and the fund has turned its initial $10 million into $14 million, or a 40% return on investment that it can distribute to fund members. Not bad in theory, right? In practice, it’s a bit more complex.
Ownership, dilution, and follow-on capital
In my above breakdown of a venture fund’s investment, the entire model hinges on one company turning a $1 million investment into $10 million worth of value. It’s a simple enough statement to write, but, if you’ve ever attempted to turn $1 million into $10 million, or even $1 into $10, you know it’s difficult… bordering on magical. After all, there’s a reason we call successful startups “unicorns.”
Returning to our $1 million investment example, for the sake of simplicity, let’s imagine our hypothetical VC was the only investor in the company and, in exchange for it’s $1 million investment, the VC received a 25% stake in the company. (For you VC math geeks out there, that would be a $3 million pre-money valuation, $4 million post-money valuation after receiving the million dollar investment.)
In order to create a 10x return on its investment, the VC needs the company to sell for $40 million. (Again, for you VC math geeks, that would mean 25% of the shares would be worth $10 million, which is 10x the initial $1 million investment.)
Unfortunately for the VCs (and us startup founders), companies valued at $4 million at the time of initial investment don’t usually sell for $40 million without requiring additional funding. Instead, the company is probably going to raise more money ~12 months later at a (hopefully) higher valuation. When it raises more money, everyone who currently owns a percentage of the company will have to give up a portion of their ownership to “make room” for the new investor(s). This is called “dilution.”
In our example where the investor owns 25% of a company valued at $4 million, when the company raises money again, the investor will have to give up 25% of the ownership being given to new investors. For example, if the company raises $2 million at an $8 million pre-money valuation, the company’s new, post-money valuation will be $10 million, the founders will own 60% of the company (down from 75%), the new investors will own 20% of the company, and the original investors will also own 20% of the company (down from 25%). However, their 20% stake in a company valued at $10 million means they’ve doubled the value of their initial investment, making it worth $2 million.
Not bad, right? By giving a company valued at $3 million an additional $1 million in cash, the venture capitalist was able to help it become a company worth $10 million (an increase of $6 million!) while doubling the value of the VC’s initial investment.
Conversely, the VC fund only owns 20% of the company. In order to turn its initial $1 million investment into a $10 million return, it now needs the company to sell for $50 million. That’s $10 million more than when it first invested.
In case you’re wondering, here’s where the concept of “follow-on capital” becomes relevant. While our hypothetical VC invested all of its $10 million fund into 10 companies, a good VC will keep additional capital in reserve to invest more money in its portfolio companies that are doing well in order to maintain (or increase) its original ownership stake.
I won’t bore you with the intricacies of follow-on capital and how VCs can use it to increase returns, but the basic math remains the same: as a company raises more money, the value of the VC’s investment increases, but so does the amount the company needs to sell for in order to achieve the necessary ROI.
The kinds of companies VCs need to invest in
Whether you’ve read every detail of what I’ve written so far or skimmed for the “gist,” I hope you’re recognizing how the venture capital model forces VCs to look for certain kinds of companies. Specifically, VCs need to invest in companies with mechanisms for exponentially increasing value.
Only certain kinds of companies can achieve venture-style growth. Before attempting to raise money from VCs, you need to ask yourself whether your company fits the VC model and whether you, as a founder, have the ability to achieve it. While a million dollars (or tens of millions of dollars) might seem like lots of money, it doesn’t change the basics of the venture capital equation. Each dollar you receive — whether someone writes you a check for $10,000 or $10,000,000 — has to generate multiples of itself.
In the hypothetical investment example I’ve given, $1 million of cash created $6 million of new “value” for the company, meaning every $1 invested produced $6, which is a 600% ROI. Compare that to the stock market’s 10% ROI (10 cents for every dollar invested), and remember that the stock market represents the average result of investing in a collection of the world’s most successful companies ever.
Now do you see how absurd the expectations are for venture-backed startups? The best companies in history increase in value roughly 10% year-over-year, while startup founders are expected to increase the value of their companies exponentially. That’s why so many startups fail. That’s why building a successful startup is so difficult.
VCs are entrepreneurs, too
If you think the expectations for the founders of venture-style tech companies are absurd, think back through what you’ve read and consider the similarly absurd expectations placed on venture capitalists. They have to “beat the market” by predicting which ultra-risky companies have the best chance of succeeding at a nearly impossible task. It’s such difficult work that 50% fail and another 45% barely break-even.
When I first started building venture-style tech companies, I never considered how difficult a VCs job was. Instead, I used to think of venture capitalists as the rockstars of the tech industry. They were the people with the huge purse strings that, on a whim, could give your company millions of dollars and turn you into an overnight success, not entirely unlike how Usher “discovered” Justin Beiber.
In that worldview, I was less like an entrepreneur and more like a performer, and it showed in the ways I interacted with VCs and pitched them my companies. Instead of pitching a business that fit with the demands of their investment model, I was trying to impress them with my pitching skills and make them think my product was cool. But impressing them and/or getting them to like my product never mattered. They weren’t listening to my pitch to be impressed. They were trying to find companies that mapped to their investment model. Why? Because they also had a product they were pitching.
That’s right… all the money VCs invest has to come from somewhere, and that “somewhere” is rarely out of their own pockets. Instead, despite what founders may think, venture capitalists don’t spend all their time talking with founders. Instead, VCs spend enormous amounts of time doing the same thing as the entrepreneurs they support: fundraising. A VC’s product — just like yours — is a high-risk, high-reward venture, and a VC’s success depends on an ability to fundraise, an ability to sell, an ability to build, an ability to manage, an ability to market, and an ability to execute a vision.
From that perspective, venture capitalists aren’t particularly different than entrepreneurs. In fact, many VCs consider themselves entrepreneurs. And that’s what I really wish someone had told me when I was a younger entrepreneur.
Venture capitalists are entrepreneurs, too. Instead of treating them like the “king makers” of the startup world, treat them like fellow founders. Don’t be in awe of them, don’t try to “pitch” them, and don’t try to impress them. Instead, just try to get to know them. When you do, you might discover partnership opportunities that could benefit the ventures each of you are building. But if you aren’t good partners, that’s OK, too. You can still be friends, you can still support each other, and you can still grab a beer together and commiserate about the challenges of building companies.