All You Need to Know About “Venture” Capital for 2016

23 May

Very few investors are honest about the transition taking place in startup financial markets. I saw the first real candor in Joe Dwyer’s blog post in 2014. It’s long, but if you really want to understand what’s happening you cannot spend a better 15 minutes of your day. The most recent piece, by Rob Go at NextView Ventures, is also visually insightful, though less analytical.

Here’s how we got here.

When the financial markets crashed in 2008, some people thought printing a lot of money would be a great idea. The allure of loaning money via credit instruments faded as governments around the world dropped interest rates. So if you wanted to earn a return, you sought the equity markets.

Large limited partners (institutionals that provide investor groups their funds) realized that credit instruments were no longer useful for their portfolio. Seeking returns, they needed to focus on higher risk investment strategies like private equity.

Private equity is a catch-all term for investing private money in return for equity ownership. Upstream is venture capital, who seeds money into crazy ideas that offer chances at big returns. Midstream are conventional growth funds who might take a company earning $20M in revenue and find a way to leverage debt to earn a 2-3x return over a relatively short period of time. On the far end of downstream are buyout funds, whose job is to spend a lot of money buying companies and earn a 50% return over their time horizon. Because the capital invested is so large, returns are measured on a cash-on-cash basis. I’ve generated a pitiful graphic to show you how this looks.

With a glut of limited partner investor dollars flooding the private equity markets, many venture capital firms increased their fund sizes remarkably. I’m pretty lazy (if you couldn’t tell from the umbrella graphic) so I grabbed a chart from GSV Capital. The underlying data comes from the National Venture Capital Association. What should be immediately evident – though a few years stale – is that the size of the average venture fund has ballooned beyond 1990′s levels.

Now let’s discuss how venture capital funds work. When a venture firm raises a fund they earn a flat management fee on the amounts raised and carried interest on the profits.  So if a fund is $100M, let’s say, the venture firm might earn $2M no matter what happens. If a deal makes money, the venture firm might earn 20% of the profits. If it loses money, that’s someone else’s problem.

A venture fund is around for 10 years; the limited partner investors in venture funds cannot pull their money out until the fund sunsets. So regardless of fund performance, venture capital partners can still play unlimited rounds of golf late into year nine. Not too shabby, eh?

A venture firm will deploy a percentage of its fund in new deals the first few years. The remaining money is retained to make follow-on investments in existing investments, letting an investor double down on the good ones. Partners at the venture fund sponsor each investment. In essence you have a small number of people debating where the limited dollars get placed.

When venture firms raised large funds they didn’t take on a proportionate number of new partners. The net result is that the number of investments stays the same. Well if you need to deploy 10x the amount of capital over the same period of time without increasing the number of deals, what do you do? You increase the average investment by 10x.

This has left us with private equity creep: venture capital, by the nature of their check size, is getting into traditional growth equity. And it’s not as if growth equity isn’t already a competitive asset class. Thus in order for the venture firms to win deals over conventional growth equity, they have to go above and beyond competing funds. Easiest option? Increase the valuation on the investment round to impress the founders.

In this way venture capital is putting their larger funds to work. Check size is increasing, and “venture” risk is nowhere to be found. In most cases by the time a founder can raise money, there’s no reason to! You’ve had to bootstrap your startup to profitability and millions in revenue to get anyone’s attention. As Jason Lemkin pointed out, today’s “venture” investors think you should be going from $1M to $10M in annual revenue in fewer than five quarters. Organically.

What’s not discussed are the terms of these high-flying venture rounds. We see large numbers floating around and the market gets frenzied. But there’s a reason founders have been pretty quiet on terms. I’m willing to bet that there are aggressive ratchets and liquidation preferences in place should the startup miss a certain milestone within a short period of time. This is what happened to Square’s IPO. A similar arrangement bumped Zenefits’ founder out the door as well. Fenwick and West published a very recent survey with some specifics.

The only people raising true venture money are celebrity founders. Everyone else is required to build a profitable business churning out millions in revenue, or scaling millions of users a month. I’ve made a flow chart to help you understand raising money as a startup.

If this is feeling a lot like the Little Red Hen, you’d be right. Why don’t venture capitalists admit this? Because they want to see every possible deal. This helps investors hone future investment theses and perform cheap competitive diligence on existing investments. One could argue the startup gets valuable feedback, but venture firms rarely tell a startup the truth so they can preserve optionality down the road. This isn’t meant to be so much of a critique as it is a reality check, and founders should be aware going in.

If you’re thinking about changing the world with a really big idea, you might want to consider notching a few billion-dollar wins first. Focus on building a sustainable business without venture money. Yes, this means the really big, transformational ideas will only be started by celebrity founders who can raise money to build prototypes. But unless you’re able to convince 50 people to work free of charge for years on a transformational startup, you had better focus on a smaller endeavor.