"Chase the vision, not the money; the money will end up following you" –Tony Hsieh

Article #1 of a 7 Article Series on Raising Venture Capital for Early Stage Startups.

This first article is aimed at sharing with Founders/Entrepreneurs:

How the VC Industry works, what drives and motivates investment decisions.

Why?

• Founders without experience do not have the knowledge and experience of the?Venture Capital Industry.
• First-time entrepreneurs do not understand why a VC invests in an early stage tech startup, which leads them:

Inability to think of your Startup’s attractiveness as an investment from the VC’s point of view.

1.- Some facts about the VC Industry

• The VC industry is not the most transparent.
• Intentions and motivations are therefore not Clear.
• Only motivated by Greed & Fear?
• Therefore there is not a balanced relationship between Founders and VC’s.

2.- Data?on VC backed Startups Performance (Source: Scott Sandell, Co-Managing Partner of NEA)

• 35% go out of business: Cero returns or marginal (fire-sales).
• 45% make modest returns: 2-3/4x.
• 20% make the real big, huge returns, and normally it’s usually 5% which do that, i.e. returns in the 50+x.

3.- How are Venture Capital firms structured:

• General Partners (GP’s/VC’s) manage the funds and invest in Startups.
• Limited Partners (LP’s)?commit a certain Capital to invest in Startups through Venture Capital Funds.
• Duration of a fund is usually 10 years.

4.- Economics of the Venture Capital Fund

Break down of GP/VC & LP Compensation

Management Fees

• The GP’s receives an annual Management Fee, which is a percentage of the Capital Commitment to the Fund.?
• A typical fee is 2.5%. On a $500M fund this would be $12.5M per year.
• The Management Fee is used by the GP’s to operate the business. Salaries of the General Partners, Associates, the Support Staff, etc.

Carried Interest

• The GP/VCs make investments.
• The returns from the investment are split between the LP’s & the GP’s.??

A usual split of the returns is:

• Until the investments return to the LP’s 100% of their capital, the split is 99% for to the LP’s and 1% for to the GP’s/VC’s.
• Anything above the invested capital the split would be 80% to the LP’s & 20% to the GP/VCs.
• The 20% is called the GP’s/VC's “Carried Interest”

A great way to understand why VC’s invest in some startups and not in others is to do:Economics of the Venture Capital Fund

Break down of GP/VC & LP Compensation

Management Fees

• The GP’s receives an annual Management Fee, which is a percentage of the Capital Commitment to the Fund.?
• A typical fee is 2.5%. On a $500M fund this would be $12.5M per year.
• The Management Fee is used by the GP’s to operate the business. Salaries of the General Partners, Associates, the Support Staff, etc.

Carried Interest

• The GP/VCs make investments.
• The returns from the investment are split between the LP’s & the GP’s.??

A usual split of the returns is:

• Until the investments return to the LP’s 100% of their capital, the split is 99% for to the LP’s and 1% for to the GP’s/VC’s.
• Anything above the invested capital the split would be 80% to the LP’s & 20% to the GP/VCs.
• The 20% is called the GP’s/VC's “Carried Interest”

A great way to understand why VC’s invest in some startups and not in others is to do:

5.- Maths on VC compensation.

Assumptions

• Expected returns 3x on a $500mn = $1.5Bn.
• As per NVCA data average exit time in 2015 was 8.5 years

Startup 1

Well that should work, right?

Reality from the VC’s perspective

• $30 million .
• Would return 6% of the $500mn fund & 2% of expected returns ($1.5Bn).

That exit does not move the needle.

Startup 2

Wow, that is amazing, right?

Reality from the VC’s perspective

• $180mn exit.
• Would return 35% of the $500mn fund & 12% of expected returns ($1.5Bn).

Better but...

So how do VC’s make $$?

Startup 3

That is incredible, the startup got bought by one of the “biggies” for $2.5bn

“The VC model is based on huge outcomes”

Reality from the VC’s perspective

• $625mn exit.
• ?Would return 125% of the $500mn fund & 40% of expected returns ($1.5Bn).

As Bill Gurley would say:

“Venture capital is not even a home run business. It’s a grand slam business.”

6.- What are investors looking for in order to take the decision to invest?

According to Paul Graham:

• Investors are looking for startups that will be very successful.
• The big successes are so big they dwarf the rest. And since there are only a handful each year (the conventional wisdom is 15).
• Most are interested in you if you seem like you have a chance, however small, of being one of the 15 big successes, and otherwise not.

You need three things: formidable founders, a promising market, and (usually) some evidence of success so far.

What makes a startup a sufficiently good bet?

• In addition to formidable founders, you need a plausible path to owning a big piece of a big market.
• Your target market has to be big, and it also has to be capturable by you.

“Founders think of startups as ideas, but investors think of them as markets” – Paul Graham

Some takeaways:

• Your Startup should be “worth” investing from the VC’s perspective of “worth”.
• Understand what makes your Startup “worth” investing in.
• Explain that clearly to investors.
• And as every other Startup trying to raise capital have a great Executive Summary and Pitch Deck.

In your experience do you believe first-time Entrepreneurs have a good Understanding of how the Venture Capital World work? Do you think it is an important knowledge for Entrepreneurs to have? Whether your answer is yes or no ????, it would be so valuable to learn from your experience. ??????

???? share your opinions with your networks and drop a comment. Sharing is caring ?????

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20+ Yrs building SMB's |??? |?CEO Advisor at a Global Blockchain Fashion Social MarketPlace |??|?Bringing Venture Capital disciplines to ICO's ????

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