?? How Does VC Work? A Guide for Founders | #13

Good morning, fellow founder! ??

Welcome to another edition of FounderForge. Your Europe-focused startup digest - just because we do things a little differently here! ???????

If you missed our last issue, you can still read it at the link below! ??

?? The Myth of Hypergrowth & How to Define Your Growth Formula | #12

Today we are going to take a deep dive into the world of Venture Capital or simply VC!

We believe it is crucial as a founder to understand the business your investor is in to firstly know what you are getting into and secondly to align interests! So let's dive into today's edition below! ??

???Special Edition: How Does VC Work?

VC is one of the most prominent buzzwords in the startup scene.

They are usually behind hugely successful companies and are always in the news after a big win.

?? Hello survivorship bias ??!

However, the reality is that most of their investments fail! ??

And that is exactly how the system is designed.

Confused yet? ?? Great!

Let's shed some light on the dynamics of a VC and see if it's worth raising money from one of them! ??

The Origins of Venture Capital

The origins of venture capital date back to the early 2000s, when the first internet startups were founded and funded. ??

It was the time of beeping modems and everyone wanted to make the world a better place - one website at a time.

The idea of the capital provided is to invest in the growth of the company until it reaches a certain size where it has enough customers to go public (or at least gets acquired for big $$$). ???

Who is the customer?

The industry as a whole focuses on 4 main players:

Founders (hey, that's you!???), (Private)?Investors, Investment Bankers and Venture Capitalists.

VCs aim to facilitate the market between these players.

?? VC in a nutshell:

• VCs raise money from their limited partners (typically individual investors, family offices or large corporations) - they are the VCs' customers!
• Over the life of the fund (7-10 years), the VC invests in different companies - that’s you, their product!
• The success of VCs is determined by whether a company goes public or is acquired by someone else.

Let’s talk about probabilities!

Typically, VCs aim for a return on investment of around 20-35% per year.

You heard that right, 20-35% p.a.!?

That means you have to go BIG to give them a BIG return! ???

But 0 out of 10 startups fail! You must have heard that somewhere by now...

Let's weigh up the odds! ???

How does a VC do that?

Step 1: Invest in companies with the lowest risk (good market potential, good team, etc.)

Step 2: Make sure the company has enough money to make it. ????

The picture above is a good example of how returns are distributed in VC funds.

To make a decent return, only enough (10-20%) of funded companies need to be real winners.

Fun fact: the entire reputation of the biggest VCs is often built on one or two good investments.

The math behind VCs

What does "enough companies" mean? Let's crunch the numbers a bit! ???

Let's take the lower 20% p.a. that a VC needs to generate per year (to not be classified???) as a starting point.

Let's keep it simple and say the fund has a term of 10 years.

= 10 years * 20% = 200% (let's leave out the compound interest part)

In other words, the fund needs to return 3 times its own capital after 10 years (200% + the initial investment).

And for the VC, only about 5-10% of his investment will yield a return of more than 200%. While the majority is written off or returns the initial investment. ???

An early-stage VC portfolio contains 25-30 companies, of which 2-3 need to return the 200%+ of the fund, where the VC should still own 5-10% of the respective companies.

So from your point of view, your company needs to have an exit potential of 10-20 times the size of the VC fund, so you are substantial for a VC to invest in you!

OpenVC recently released a neat cheatsheet that summarizes the VC game. Check it out below ???

And yes, we strongly encourage you to use this information and adjust your market slide accordingly (it has to be BIG!). ???

Trust us, the VCs will love it ??

Will VCs help you build a big company?

We are a hands-on investor to help you build this company into a success story! ??

- VCs before a deal

Every investor talks about their #valueadd and what they can bring to the table.

The reality is that most of the time you get next to nothing (except the capital ofc). ??♂??

If you look at how VCs spend their time, it is simply not possible to do much more.

Each partner in a VC fund has at least 10 active portfolio companies and about 2.000 hours of work/party/networking/skiing in Switzerland per year. ???

Looking at the graph above, you can see that only about 800 hours per year are spent on the actual portfolio companies.

Or about 2 hours a week - which is the absolute maximum.

So don't count on much #valueadd besides the capital and network. ???

Should you raise venture capital?

If its either go big or crash the whole thing full speed into the wall, then yes. ?????

If its a nice but potentially small business, then no.

Whatever the answer, if you can bootstrap your growth, there is no need for VC in either case.

VC is not just money, but comes with a lot of additional pitfalls, from decision-making rights to simply different interests (remember: you are the PRODUCT, not the CUSTOMER)! ???

And don't make the mistake of thinking VC is cheap. With a typical 1x liquidation preference, it's basically like taking out a loan at 58% p.a. ???

So keep it simple if you can, and keep your company to yourself!

???Founder's Library: Curated Resources

A collection of random reads that the FounderForge team enjoyed.

• A Guide on how you can Fund Your Startup by fastercapital
• Carta’s 2024 Early-Stage Funding Cheat Sheet
• Lessons From My Third Year Running a SAAS by Max Rozen
• How Gamma Acquired 10M+ Users Through Wom by Nicolás Cerdeira
• How Instagram Became LinkedIn for Millennials by Mary Snauffer

???Meme of the Fortnight

Founder: So how much value do you add compared to Sequoia? VC: 6.5 ??

?? Your Thoughts on Today's Edition

• ?? It was great!
• ?? Meh - it was okay.
• ?? Not interesting to me.

That's all for now!

If you find this newsletter valuable, share it with a friend!

Cheers,

The Founders Blacksmith ??

Issue #13 | 07. March 2023