So . . . What is Venture Capital?

Let’s call this a back-to-basics post.

I’ve noticed that with the proliferation of new entrants into the venture capital industry, there seems to be a myriad of definitions of what “VC” actually means.

Let me offer my definition —

Venture Capital — Investing in early-stage technology companies for the sole purpose of extraordinary financial gain on a 5-to-7-year time horizon.

Let me break it down into pieces:

“early-stage”

This might not be as obvious as you may think. I define early stage as either 1) pre-product or 2) pre-product-market-fit or even 3) early-product-market-fit. Most investors would call this the Pre-Seed to Seed Stages of investing. You could also include “A” rounds in this category.

But with the recent influx of capital into the ecosystem, rounds are getting larger and earlier and definitions are getting blurrier.

A Seed Round in 2020 in materially different than a Seed Round in 2010. Furthermore, a Seed Round in Kansas City is materially different than a Seed Round in SF in 2020.

So, it can be tough to nail down what someone means when they say Seed Round and that’s why I stuck with just “Early Stage.”

It used to mean the first round of capital that is not from the founders or their friends and family. But now it really makes more sense to try to define it by product life cycle (like I did above) and financial metrics.

Financially, that usually translates to between $0 in revenue and a couple million dollars in revenue. I’m intentionally fuzzy on that “couple of million” metric because there is some gray area.

Is a 5-year-old company with $5M in revenue a startup?

Probably not. $5M in revenue seems to imply they have figured out some product-market fit. They know what their customer wants and are selling millions of dollars worth of it every year.

What about $3M?

Maybe. Kinda depends on the company and what they are selling. Did they do $3M in Year 1 or in Year 15? Is their product $5 or $500k?

See what I mean about gray area?

Essentially, you are looking for someone who has raised little to no capital and is still working out product-market-fit. That’s an early-stage company.

Notice how that is different than a company with $10M in revenue who has figured out their product-market fit and just needs to scale. By my definition, that’s a company that needs “Growth Equity” and not Venture Capital.

Growth Equity is just private equity (from a fund or Investment Bank) that fuels growth. The key thing to pay attention to here is Deal-Level Expected Return.

At the deal level (meaning on any given company that a VC invests in), a venture capitalist should expect a 10x return on her capital. If not, she should not invest. PERIOD. I’ll get into the math of why you have no choice but to solve for a 10x elsewhere, but for now, just take my word for it.

In contrast, a growth equity investor should expect a 3x return on her capital. Remember, she is investing once a company has already figured out what the market wants and how to price it and deliver it. She is going from $10M in revenue to $20M or $25M to $50M, and so on. That company has plenty of sales and resources. The equity investor is just accelerating the trajectory of those sales.

So you can probably see how it becomes easy to tell VCs from the Growth Equity investors after a few conversations.

They split apart abruptly when you talk about what type of return they expect in a given deal. And you can hopefully see why that necessarily forces VCs to invest in earlier stage companies; there simply isn’t the available growth trajectory for companies that already have $25M in revenue.

“technology companies”

My definition gets a little controversial here.

Young companies and tech startups are not the exact same thing. There are young accounting and law firms. Young restaurants. Many of them need capital.

But the extraordinary thing about technology startups is their speed to scale.

It’s difficult to imagine a young accounting firm going from $0 to $1B in enterprise value in 7 years. (Or 30 years.) They are too “human capital” intensive.

Put another way, to scale revenue at traditional companies you have to hire more people. People are expensive, political, litigious, and time-consuming. (#I’mNotJadedYou’reJaded)

At technology companies you can simply (or at least more simply) engineer more offerings into your tech product or roll out new products with the same (again, more or less) engineering and product team you already have in place.

That’s called “scalable margins”.

Tech has it. Most other industries do not and therefore cannot scale revenue at a pace that would justify a 10x exit in 7 years.

That’s why I balk at companies that are “services” companies.

I see a ton of tech-enabled services companies that have some interesting/cool/noteworthy technology, but at the end of the day they are still just selling a service.

In my world (PropTech), that can be tech-enabled brokerage or property management or appraisal or development. All of those services require the founders to go out and hire a bunch of people to broker or manage or appraise or develop. And, as I said, people don’t scale well. Even when they do, they are hugely expensive.

So I think Venture Capital has to focus on technology companies rather than services companies. Otherwise, you’ll never have the exits necessary to support a VC structure.

“extraordinary financial gain”

This is aimed directly at CVCs and this might be mildly controversial, but . . . if you are investing in startups to help streamline your NOI or EBITDA then you are not a venture capitalist.

You are (probably) a savvy corporate investor and there is certainly a place for that thesis within your M&A group, but it’s not strictly venture capital.

(I’ve written about this before)

VC exists to propel companies that can turn $1 into $10 (or $100) in 5 to 7 years. Not to make brokers or asset managers or developers or anybody else 5% more efficient.

This also speaks to that ever-blurry line between private equity and venture capital. But I have an easy way to filter . . .

It’s the same one I used above.

If you are aiming at a deal-level return of 3x to 5x, you are a private equity investor. If your deal-level threshold is a 10x minimum, then you’re a VC.

Easy enough?

I’ll reiterate that I think investing in tech companies is a savvy and thoughtful corporate finance strategy. I think it should be a part of every company’s financial plan after the lessons we have watched from Blockbuster and Blackberry and that list of dead behemoths that ignored plucky tech startups.

But don’t call it venture capital. Because it’s not.

“5-to-7-year time horizon”

This one is a function of institutional capital and its metrics. For better or worse, institutional LPs like pension funds, endowments, sovereign wealth funds, RIAs, and family offices all measure their portfolio performance via Internal Rate of Return (“IRR” for the uninitiated). It’s a terrible metric, especially for VC, but it’s industry standard and we have to live with it.

Since time-to-exit is a huge factor in IRR, it matters deeply how long it takes an investor to exit a given investment. For those unfamiliar with the math, a 10x return on a company over 24 months is meaningfully different than a 10x return on a 96-month horizon.

And, since most funds have a 10-year life, you can probably see how a fund investing in Years 1 to 3 of the fund has no choice but to solve for companies that can actually return capital to investors within 5 to 7 years.

That’s just the cold, hard math of it.

(Side note — you can argue this has caused some of the growth-at-all-costs troubles we have seen in Silicon Valley lately but that is a topic for another article.)

That definition one more time:

Venture Capital — Investing in early-stage technology companies for the sole purpose of extraordinary financial gain on a 5-to-7-year time horizon.

WHY IT MATTERS

Here’s why this is important . . .

If you have set up an investment entity to invest in startups but your primary goal is to get access to early-stage companies or to help your company stay cutting edge in technology, you’re clever. You’re forward-thinking and probably a market leader.

But you are not a VC.

That doesn’t mean you shouldn’t invest in startups, but it does probably mean you shouldn’t lead rounds and set terms. Leave that to the specialists.

It means you’ll struggle to recruit talented young ladies and gents with pure VC backgrounds. Even if you overpay them in the short run, they’ll eventually leave for the carry they can get in a traditional VC fund if they are actually talented.

So I don’t mind if you call it “My Company Ventures” or something that evokes venture capital. That’s fine. Stay in the game and stay relevant.

But when you think about your strategy and messaging, it needs to center around strategic value to both companies and DO NOT compare yourself to the traditional VCs and their portfolios.

You won’t look good under that microscope and those of us who spend our days thinking about early-stage investing will see you as the dreaded “venture tourist” still learning the landscape.

Think I missed something? Tell me at [email protected]