Follow me @samirkaji for my always random, sometimes relevant thoughts on the world of venture capital and technology.
Building a great company requires many different facets. Most importantly, it requires a talented team with great conviction to build toward an incredible vision. Of course, building a company requires capital.
Capital can come from many areas ranging from angels, friends and family, cash flow from operations (yes, it does happen on occasion), and from VC’s.
While many entrepreneurs seem to have a love/hate relationship with VC’s, most resign themselves to the fact that they will have to jump on the venture treadmill at some point. A logical conclusion given that almost every major technology company founded over the past couple of decades has been venture backed.
With that said, I frequently meet entrepreneurs that refer to the VC community with some level of derision. The complaints range from a view that VC’s don’t seem to take enough risk at the earliest stages to concerns around economic and strategic misalignment.
While many of the anxieties I hear are certainly valid, a truly symbiotic entrepreneur-VC relationship can serve as an incredible accelerant for a business. For this to occur however, it’s important that entrepreneurs understand the VC business as much as VC’s understand theirs. Doing so will help determine both whether VC is an appropriate fit for your business, but will also provide the best opportunity of building a synergistic relationship with your investor.
First, the truth of the matter is that very few startups are truly venture fundable. That’s not meant as an indictment. Many companies that never go on to raise venture money provide wildly successful educational and financial outcomes for their founders. They simply aren’t conducive to venture capital funding. To illustrate why, let’s dig a little deeper into venture math.
Through advances in areas like cloud computing/hosting, companies today in 2015 can get off the ground at 1/100th of what it would have taken back in 1999. These cost efficiencies have created a world where ~10,000-20,000 companiesare formed every single year. Of these:
-Approximately 1000 get venture funding
-Approximately 50-100 encounter decent exits ($50MM+)
-Perhaps 5-10 have bellwether exits (>$500MM). These 5-10 drive 90%+ of the returns within venture.
Looking at this in another way, the power law of returns evidenced above makes the venture capital game really, really difficult. Every year, only about 10%-20% of funds provide risk-adjusted returns consistent with Limited Partner expectations.
To take this to a more granular level, let’s do an exercise to examine a hypothetical $25MM Micro-VC fund with a fairly common expected return distribution model:
*$2MM for fund admin costs, assuming no recycling
The above example would be considered a pretty successful fund, likely falling within the top quartile of the fund’s vintage year. However without the “big win” referenced above, this is a fund that would just marginally provide a return over the total capital committed by investors. While it may not seem apparent, this would be terrible outcome for the fund’s Limited Partners when illiquidity, risk, and opportunity cost are taken into account.
As such, most fund managers view prospective investments through the lens of whether a potential investment can become a “fund maker”. This is where a single company returns at least 100% of the fund to make up for the losses incurred by the majority of the portfolio.
This math is often what creates a level of economic misalignment between investors and founders at the early stages. Investors must invest in companies they believe can be home runs. And once an investment is made, a small acquihire outcome, while potentially very impactful for the founding team, is not going to be very appealing for the VC (although the best investors grasp the nuances of supporting founders even during times of economic misalignment).
With this said, as an entrepreneur it’s critical to objectively think through whether your personal and business objectives are aligned with the realities of venture investing prior to leaping onto the venture treadmill. Venture Capital is certainly the most likely path to enabling a big business, but it’s important to fully appreciate the perspective of the other side. You’ll save a ton of time, frustration, and friction if you do.
Because once you take that leap onto the venture, casually jumping off simply isn’t an option.