"VCs aren’t unintelligent. Nor are VCs evil (not all of them anyway). They’re not even necessarily misaligned with you. What they are doing is optimizing for a very specific outcome. Share that alignment, or don’t take their money."
If you understand what the VC wants and you want that too, then you are aligned. If you don't then you are making a mistake.
That almost gets you there, but founders who misunderstand what VCs want will still take the investment. That sounds like a nitpick, except that, in my experience, lots of entrepreneurs misunderstand what VCs want, thinking that 7 - 8 digit exits are what VCs aim for.
I think he is suggesting VCs want much larger exits than the average founder (at higher risk). Isn't most of Y combinator's success from just a couple massive paydays (airbnb and dropbox etc)? Whereas an exit like reddit in the 15 - 20 MM range is considered a big win for the founders, but quite "meh" for the investors. VCs need big wins to be really successful.
I'm not a VC, but if $5MM (7-digits) is raised and the exit is only $20MM (8-digits), that's an okay return, but it's probably not what the people who put money in were hoping for. 4x seems good until you consider the tremendous risk the investors exposed themselves to.
If the VC firm is taking 15% of your company for $15m, then you've got a valuation of $100m. As far as I know, the "We all know that nine out of ten startups fail" applies to all startups, not the ones that are being valued at $100m. Also, I think very few VCs are investing $15m into a company that they expect to have a 90% chance of failure. You're looking at more of a 3-5x on some of the deals to carry the consistent 1-2x that the rest of the portfolio is returning.
I don't disagree with a lot of the points in the article, but saying that a VC firm with a $150m fund is betting the farm on one $15m investment exiting at $3bn should raise some eyebrows.
Just looking at YCs returns, the vast majority of the wealth appears to be concentrated into 3 of 600+ starts (Dropbox, AirBnB, and Stripe). Even a Heroku sale for 200M+ is a drop in the bucket compared to $10B private market valuation, say it out loud and it will sound weird. "Dropbox is worth 50 Herokus"
Betting the farm implies that they have no other options, which is not the case with VCs, and it's impossible to know which will be their "super unicorns" when they write the checks, so they write lots of checks.
There's not much reason to believe YC is unlike other angel groups, individuals, or VC firms, and their data should back up that the majority of their returns is 1 or 2 companies every so often with huge wins.
The difference is that YC isn't investing $15m into companies, they're investing $20k. The corresponding valuations for the companies that they invest in is $1m on the high end (20k / 2%), not $100m. The risk profile for different check sizes is vastly different.
The risk profile as you seem to be thinking of it is an irrelevant metric when you're only interested in the return profile. They're optimizing for dollars returned, not % of companies sold for greater than money put in.
Consider a "soft landing" (VC gets their money back), vs complete death (VC gets no money back). When put alongside a $3B acquisition they're both completely irrelevant, even if on paper the 1x money back is not considered a "failure".
Check size doesn't appear to matter, the data for YC and for VC that I've seen suggests a similar power-law-ish distribution of returns.
Nitpick: VCs are optimizing for % return, not on an dollar return basis.
I would say that the risk profile is not irrelevant: if you're betting that 1/10 of your investments are returning your fund, then just one miss is the difference between a good year and "I don't have a VC firm anymore". Compare that to betting that half of your investments are returning your fund: one miss is the difference between a good year and an "ehh" year.[0]
That's true; when you compare both of them to a 30x, the difference between a 1x and 0x is small. But what I'm saying is that at a $15m investment, very few VCs expect to see a 30x, and when you compare it vs. a 3x or a 5x acquisition, the difference between no money back and your 1x liquidation pref paying out is much larger, proportionally.
The same power law may apply, but you see more of the tails in when you have a much larger sample size. If there were just as many $15m investments happening as $20k investments, you'd see the same result, but there aren't.
Off-topic: are you the same Scott Klein I talked to over the summer re: statuspage.io?
[0] Of course, that glosses over different probabilities of success and failure, but what I'm trying to say is that VCs are risk averse.
> if you're betting that 1/10 of your investments are returning your fund, then just one miss is the difference between a good year and "I don't have a VC firm anymore"
To add to this, the top 10 VC firms make up around 85% of all of the returns of VC firms combined, and the top 15 VC firms make up around 95%. (don't quote me on those specific numbers, but I believe they are roughly accurate based on a report from a16z).
Long story short - very very few VC funds see worthwhile returns. The one's that do are absolutely killing it.
The best VCs have basically created a self-fulfilling prophecy: many of these firms do well BECAUSE the top VC firms invested in them. If a16z or KPCB invests in you, it makes it a lot easier to get press and additional rounds of funding from other VCs because one of the top firms "blessed" you.
I get the feeling that YC (and similar incubators) are less about making a profit and more about connecting successful entrepreneurs with up-and-coming entrepreneurs. This isn't bad; it gives the YC partners (most of whom never need to work another day in their lives) a way to give back to their community, and I suspect many of them enjoy it.
It can't be based on pure charity because that's not a sustainable model, so there's got to be an equity component. But I suspect YC barely breaks even.
Regardless, the way VC measures returns is typically at between 70% and 100% of the life of the fund. If after 7 years, you're getting 1x your money back, that's a pretty big loss considering you could have just put it in an S&P index fund and earned ~7%. Even a 2x return after 10 years isn't that great; you're looking at an equivalent annual interest rate of ~7%. Things don't even get interesting till you start talking 5x or more (~17%). The time component of the equation is very important; the only reason people invest in VC is because it has the potential to provide greater returns than other asset classes if you're patient enough to wait 10 years for the payoff.
YC is seed stage; you expect a higher failure rate and higher returns from your successes.
Basically, you can break VC firms down into categories based on the size and timing of their investment. Typically you have the following:
* Seed / angel funds. <$1M investment, 90-99% failure rate (failure rate is higher the less you invest). Astronomical returns because they buy equity when it is at its cheapest; a "home run" here can net you several thousand times your initial investment. Your founders are often very raw and you have to work with them on basic business fundamentals.
* Series A funds. ~$1-3M investment, 70-90% failure rate (though this is dropping as more funds move from Series A to seed funding.) Probably the riskiest of the bunch since you're placing pretty big bets on a lot of companies; this is typically what people think of when they think "VC". Returns for a "home run" are 10-100x initial investment. Your founders think they know what they're doing but they don't; good VCs will help the founders through their network and by letting them make enough mistakes to learn from.
* Growth funds. $10-25M investment, 50% failure rate. These guys go after companies that have proven a market exists and there's an opportunity for huge growth if only they can scale. Still risky because scaling a business is hard. Returns for a "home run" are closer to 10x, but these guys can pull their funding if things are starting to circle the drain so a "failure" doesn't always mean a loss. Good founders here are starting to realize they are in way over their head and ask their VCs for help.
* Pre-IPO funds. $25M+ investment, very low failure rate. Returns are relatively low but also much safer: investors here are basically funding you pending an inevitable IPO. This is basically your traditional private equity firms at this point. Founders here need guidance on how to take their company public (legal, cultural, etc.) -- hence why PE guys who are often ex-investment bankers play in this space.
Most VC funds do have exit dates and specific life spans (typically 7-10 years). The way it was explained to me that if you have 10 companies in your portfolio, by year 7 you will have:
* 3 total busts. Out of business; zero return on investment.
* 4 "walking dead". Still in business, but just barely breaking even. Might as well be zero return because these investments are not liquid (who wants to buy a 7-year-old risky business with no profit?) Anymore these end up as acqui-hires with the VC getting pennies on the dollar.
* 2 minor successes. Good, profitable companies that will probably never produce a hockey-stick graph. 2x-3x return.
* 1 home run. If you're lucky. 10x return (though usually closer to 5x).
Her example was bad, but it was just an example. VC is a tough industry to actually make any money in. VCs don't pressure founders to do things because they are greedy, it's because they're scared of losing their shirts.
Big changes in approach are inevitable in early-stage companies: things become apparent after 1-2 years that weren't initially. Early stage companies involve so much uncertainty that trying to stick to a plan for the sake of sticking to a plan is folly.
His numbers are in a different context; but I get his point. Venture investing is a portfolio business; you fully expect a high failure rate.
The way I interpreted it was more, failure in VC terms is "not blowing up".
That $15 mil investment might be acquihired, or continue to be unexcitingly profitable, or put up on the chopping block for its patent portfolio. They might not even lose money, but.
I agree, especially in light of the preference structures that she mentions (and that I believe are industry-standard). But these arguments seem to lead to the conclusion that you shouldn't be an LP, not that you shouldn't take venture money. The only way that this becomes an issue is if the VC has enough of a stake to run their own decision making and executing process, and that (as I understand it) is the line between VC and PE.
FYI: The carry distribution schedule mentioned in the article (carry after 3x) is way off market for a VC GP-LP relationship.
The most typical arrangement is 20% after 1x in LP distributions, with some variation in what are called hurdle rates (that is, different percent carried interest at different multiples or IRRs).
>But these arguments seem to lead to the conclusion that you shouldn't be an LP, not that you shouldn't take venture money.
I have a very limited understanding, but the impression I got is that VCs typically have short maturity dates and thus are riskier in nature, whereas PE funds typically have the luxury of biding their time. How this is structured, or why exactly is beyond my ken.
So upside being, VCs are incentivized to encourage larger risk taking than what would be otherwise optimal from the perspective of a bootstrapped founder.
I can't speak for the PE side, but VCs aren't investing their own money. They have limited partners (LPs) that provide the money, and expect returns on it. This LP money goes into funds (vehicles to make investments out of). Each fund has a limited lifespan (the company I work for has fund lifetimes of around 8-10 years). This means that all of the money should be returned to investors over that time period. Since VCs can't make all of their investments at the beginning of the fund (for many reasons, chief among them scarcity) they need to show returns in an even shorter timeframe.
The bootstrapped founder, on the other hand, doesn't necessarily need to exit the investment in those 8-10 (or shorter) years. There are, of course, serial entrepreneurs for whom that is their goal, and for them (as the article points out) their incentives are aligned. For "lifestyle company" founders (not meant to be disparaging), an exit may not be necessary at all. The key differences are time horizon and exit.
Maybe the numbers could have been better chosen, but the message is correct: when you raise money, you're raising the bar for what will be called success.
This is especially important now that infrastructure is close to free, it's easier now to bootstrap your company or even start it as a week-end hobby. That wasn't true in the 90s or early 2000s when you had to buy costly servers and hosting just to get started.
So it is very important to know what your goal is. You want to get a slight chance to be the next Google or Facebook? You'd better raise money. You want to build a sustainable company for you and a small number of employees? Maybe raising is not the best thing to do.
What I'm saying is that there are very few VCs that are hoping for a 30x on one investment to make up for 9 failures. It's an order of magnitude difference, which I think is nontrivial.
If it was a general point, it would have been fine, but the difference between a $100m --> $300m company and a $100m --> $3000m company are huge.
Investors sometimes say mean things about these “lifestyle businesses” but you don’t have to care what investors think.
There's nothing wrong with a lifestyle business, as long as it's run like a business. There can be decent exits (purchases by competitors, private equity, etc). But the employees seldom see a big payoff. In return, you usually get a pretty comfortable work experience.
Startups trade salary and benefits now for maybe huge payoff later. The maybe in previous sentence is important, most startups fail.
Some business are build to stay there, grow and earn enough for founders to make them upper middle class/rich for the rest of their lives. It is different then Facebook like success, but most would count that as successful too.
Yeah this is an obvious but oft-overlooked fact. As a VC you can manage the high rate of failure of startups by investing in many of them simultaneously.. that's what the whole model is based on.
As an employee, not so much, you're probably doing 2 fulltime jobs worth of work for one single company very likely to fail.
This is why working for shitty pay in return for non-founder equity is a very -EV financial move (I'll allow that maybe it makes sense for some people as a learning experience or whatever). And this is without even getting into the fact that your company could have a very successful exit and your equity could still evaporate due to dilution or outright clawback of options (ala Zynga's pre-IPO moves), or any number of dick moves from the founders/investors.
The best example of this is when RIM was sued by Minformation. After several offers by RIM to settle for around 60-70 million, one of the RIM attorneys said, "I have no idea why they won't accept our offer. You could give every employee of the company $5 million with what we're offering."
When they finally won (and then lost) that $147 million dollar settlement, how much you think the employees saw of it??
I believe this, coupled with demand, is what is driving the cost of engineer salaries in the market today. Equity allocations mean almost nothing to candidates -- as they should.
That doesn't mean you get a pass on offering equity; you just have to match it with a market salary.
I have often thought that it would make sense for employees of different companies to pool any equity. You already take on enough risk being employed by a startup business without adding on your equity risk too.
More seriously there is a number of ways of doing this. I would imagine the simplest would be to create a trust and have everyone give their equity and options to the trust.
The bigger issue is how to ensure that people don't game the system. The assets being put into the pool need to be accurately valued so people don't put in what they know are worthless assets. Of course there is there is the reverse situation where those already in the pool undervalue new assets.
Most of the effort of this idea needs to go into setting up the rules so that everyone does the right things and everyones interests are aligned. While I think this might be hard, I don't see anything that can't be solved by some smart people.
Derisking makes economic sense, but incentive stock options are mostly nontransferable. You're describing a market for shares of a privately held company, which the SEC doesn't want (except through some very specific protocols like JOBS Act crowdfunding).
The stock or stock options aren't really being sold as such, just given to the pool. I am wondering if the pool members could continue to hold the options, but enter into a secondary agreement to share any gain with their fellow pool members. This would be a derivative of some sort I guess.
The problem is that when a company goes big and someone gets a good exit they personally own that money until they make good on their secondary agreement. It would be easy to rationalize that it was specifically their personal hard work that helped make the company succeed. And since it's their money they have a big enough war chest to fight giving it to the pool. Or they can just skip the country. If the payoff is big enough there are plenty of folks who wouldn't mind trashing their reputation. And then that's the end of the pool.
Don't get me wrong, it seems like an interesting idea. I would love to have some way for my un-diversified work portfolio to get diversified. But short of creating a sweat equity only market/exchange I don't really know how you'd do it.
Even that has problems because people could fake a startup well enough to gain access to the returns creating a free-rider problem. It's probably easier to cook up a bunch of buzz and interest over an orchestrated 3 month campaign (esp. with a Kickstarter) than to actually do a startup. And since you're faking it you can promise the world and raise huge money from unsuspecting dupes with no intention of (much less a plausible method for) making good on your promises.
Great idea, in theory. But even if you simply shared equity across, say, a 20 or 30 person company. The agendas, the politics, the perceived golden handcuffs because of equity ownership. Hard to start a business with 20-30 people. Even if those are your 20 best friends.
Now multiply this across dozens of companies. Plus, most startups give options, not equity unless you are a very early employee.
I think you get most of the benefit of diversification with as few as 8 stocks [0], so if you kept each of the pools small you could avoid a lot of the scaling issues.
I feel it's a good lesson that people new to the industry often learn. And working for a startup is a lot of fun; you get to wear a lot of hats and a 23 year old software developer gets way more responsibility at a startup than they would working at Microsoft or Google.
If you're fresh out of college, what do you have to lose? You either get underpaid for a few years and learn some valuable lessons (one of which being equity in a startup has a value close to zero) or you get lucky and can retire before you're 30.
Not an office manager, but I know an executive assistant who was making $4-500K before she retired, working for a Fortune 100 CEO. She was incredibly effective but hated the stress of the job, so she kept quitting and the CEO kept raising her pay until she eventually couldn't take it anymore.
There is the issue of control. Not having external investors means you can do what you want with the business. The value of this freedom is worth a lot to the business owner.
This is the big reason for me. I've built my business on my values, and it is incredibly satisfying to see it succeed against competitors with different values.
Another problem with raising money: if you raise early, you probably don't yet know if you have a VC-appropriate business or a lifestyle business. If you turn out to have a lifestyle business and you've raised VC, it is amazingly depressing - as in, "I'd love this business if I owned all of it and I'd be happy with a small exit".
I don't know much about VC, but these sorts of claims are always surprising to me. Is it really moonshots or bust when you raise a VC round?
Even with a 2x liquidity preference, don't you just need to double the invested amount in order to have personally broken even on the VC deal?
Say you have a $10M business (pre-money), and you raise $5m at a 2x liquidity preference, giving up 50% of the company in the process. That would leave you with a $15M post-money valuation. So long as you can use that $5M to turn you from a $15M business into a $20M business, didn't you just break even on the deal?
I'm know it's not an outcome that the VC is looking for, but it would seem to be a fine outcome from the founder's perspective.
My point isn't that it is moonshot or bust - but that you may (like a friend of mine) find yourself having raised $5m to create a business that is very nice, but won't scale to the level the VCs expect or want. And the exit might be good or might be bad depending on market timing. But the contrast here is that he'll often talk about how much happier he'd be if he'd just bootstrapped the company. Now you can make the argument that he may not have been able to - but the point remains - he's got a good, non-scalable business where his investors are expecting him to magically solve for scalability. Not a great place to be.
Your numbers are a bit off compared with what I'm thinking as well - "say you have a $10m business" - that misses the point - he starts the business and there is little to no revenue. He raises a bunch of money but doesn't know if he can create a business that can get bought for $20m. He takes the money and then discovers he has a nice $2m business - but he can't scale it anymore. Because he doesn't have a great growth plan, no one is buying him out for 10x revenue. Thus he's a bit stuck.
I think this happens a lot more than people realize. At that point, it's like being stuck in a bad marriage with lots of kids. No easy options.
The worst part about it - if the company exits at a low value, it's likely to be classed as a 'failure' - even if it is profitable and has happy customers.
It's impossible to know in advance which companies will only scale to a certain size - hence the problem.
I guess the solution is to only take on money when you can show that you have a scalable business that just needs more investment to fly higher.
If you have sold 50% of your business to the VC, then you no longer have control of the business. (Seed-round investors may have stock; employees and/or cofounders certainly will.) You won't be able to close a deal that the investors don't like.
My understanding is that even if you take less, so that investors don't have outright controll, VCs will have incentive and substantial power to push small wins toward becoming either big wins or big failures. And they begin that push early, so that it's easy for VC-funded startups to end up in a grow-or-die situation, even if they theoretically might have taken a different path.
Note that there's some selection bias involved. If a VC thinks that the business is only going to be a $20m business, they won't invest. They also won't invest if the founders seem like the kind of people who will stop early. They're in the business of finding 10:1 odds on 100:1 money.
As an aside, it's a little dangerous to do valuation math like that. The valuations at A-round levels are highly speculative. If you take your $10m company and add $5m in cash, in theory it's a $15m company. But it's mainly fantasy. It's very different than a $15m operating business whose valuation is based on revenues and profits.
The most interesting section of this article is the very appropriately named section "venture math is a harsh mistress". Out of the 1000 companies 188 were acquired, 28 went bust big time, 8 went public, leaving 80% unaccounted for. What are all these companies doing?
Yes for normal companies this is fine, but for VC companies? How long do VCs let companies slog along before the pull the pin? It would seem not that often.
VCs never pull the pin, they just refuse to continue funding. If the company is break-even or a little better, it can go sideways for years and years. VCs sometimes used to get a 'redemption right' that allowed them to sell their stock back to the company at price after a certain number of years. I haven't seen that in a while now though.
The General Partner of the fund usually has the right to extend the life of their fund for some period of time. Management fees for the time during the extension are negotiated with the Limited Partners. A cliche in the industry is that the average life of a ten year fund is thirteen years.
The Limited Partners could force the dissolution of the fund after ten years--the remaining assets, including any private company stock, would be distributed to the LPs--but they generally don't want to deal with direct ownership of the equity of a company going sideways. VCs are usually better at finding creative ways to sell their piece of a business for some small amount of money, so they would rather the VC take the responsibility for it.
In my opinion its a no brainer to accept the money, some group is giving you $$$ for you to do what you want to do, and if you fail ther's no real downfall, you just go back to doing what you did before.
Until you get into the board meeting and realize you don't get to just do whatever you want to do while telling everyone what is best. If you go cowboy, you better make sure it 100% pays off, otherwise your time to failure is going to be quite short. At best you don't get more funding, at worst you get yourself blacklisted.
I found the comments about the derision of lifestyle businesses interesting, particularly in light of some of the consternation around the Tarsnap price cut [0]:
There's a world of difference between, at one end, taking VC that puts you on a rocket ride of "get rich or die"; or, at the other end, not taking any money at all so that you cannot hire even 1 engineer to help you making the essential backup service into something that's one bus away from losing all my data.
The other issue that didn't come out here, is that venture funds are time limited by definition. So it's not just that the VC fund wants their portfolio company to have a big exit, but they want them to have a big exit in a specific timeframe.
This is one thing I like about bootstrapping... the timeframe goals are down to a combination of what me and my co-founders want, influenced by competitive issues. But, as it stands, our burn rate is low enough that our "runway" is, essentially, infinite. Except that's not completely true since we don't live in a static ecosystem. Other companies are out there advancing tech and making moves of their own.
But still, I generally like not being bound to a VC and having to deal with the whole misalignment of objectives issues. We may still raise VC money at some point, but it'll be if/when conditions clearly mandate it - it's not something we'd do "just because that's what startups do".
I've seen this time issue with a couple of companies. There hits a point when the VC wants to exit so they start pushing to shut down areas of a business that have future potential to maximise the expense/revenue/profit ratios within their short planned exit window.
This is what I have learnt from my experience and what I have seen in Indian startup ecosystem
1. VC making money, Company making money and Founders making money are three different things. Don't get confused between them. Most often, the founder get the leftover, with big exit, it can be huge amount but not for everyone.
2. VCs are there to make money. That's it. That is there ONLY goal. Anyone VC firm who is saying that they are behind entrepreneurs, they are NOT. They are only after money and the entrepreneur is between them and money. So if your goal is same as their's, start chasing money.
3. You will lose your freedom for ever once you raise VC money and along with it, your choices.
But there is one important reason why to get VC money: if you have business model working, VC money will help you (or it is necessary) to hire more people and generate more revenue.
Now, of course VCs want great returns but they are also ok with ok returns.
But did you see the bit about preferred investment shares? An "ok" return may be ok for the VC, but it could leave the founders and options-holding employees with very little (or nothing).
Contrast this to a bootstrapped company. In that case, an "ok" return can be pretty good. If you're bootstrapped and you own 40% of the company, a $5 million sale is pretty great.
It's interesting how things work out. Since we didn't have the connections at first, we wound up getting our company to the point where we don't NEED venture capital to get to where we want to go. We can get there organically. If we take VC, it will be for a land grab and massive acceleration. So in some ways, things work out just the way they should if you don't go out of your way to chase people.
Kind of like how you get married to the right person if you just keep being yourself.
It baffles me that more startups don't have this approach. If you're going to take VC, you'd damn well be targeted and have a specific idea of how your going to use it to grow your business.
The main problem with the OP is that it was looking at
broad averages while necessarily venture capital and
ambitious start ups need to be quite exceptional. The
broad averages say next to nothing about the exceptional
cases. In particular, the probability of being exceptional
is just irrelevant. Instead, what is just crucial is the
conditional probability of being exceptional given
the details of the specific project. So, it's just
crucial to consider the details of a particular project.
A sad part about venture capital is that it is looking
for exceptional projects, necessarily ones that will
in effect push forward the boundary of computing in
our civilization, and doing so with in nearly all cases
very poor qualifications in doing or evaluating
such projects.
And venture capital has another problem: Too few
projects on the other side of the table have much
potential of such pushing the boundary.
For all concerned, only a tiny fraction of the
venture general partners have any hope at all of
evaluating projects that push the boundary.
Oh, the article's definitely appropriate, because right now there are a lot of people for whom raising money is basically the point.
I mentor sometimes at startup events, and there's a big difference between the people there to build a business and the people who have been freebasing startup propaganda. I never thought I'd be nostalgic for the post-bubble period when startups were unfashionable.
Wonder if any VC would refuse to invest money in a very promising startup after realizing the funders are not "aligned" with the VC goals ( providing the money would give a certain amount of control of course ).
We put the blame on funders for accepting, but maybe offering is to be considered as well.
I heard an interesting explanation a while back ago about not seeking venture capital, and instead seeking an investor.
Investors are more committed and interested (by the explainer) to the entrepreneur instead of looking for deal flow and exits above all else (which I guess most VCs are more interested in)
"2. Raising venture capital doesn’t make you a good person." Is there anyone out there trying to raise money because they think it'll make them a good person?
"VCs aren’t unintelligent. Nor are VCs evil (not all of them anyway). They’re not even necessarily misaligned with you. What they are doing is optimizing for a very specific outcome. Share that alignment, or don’t take their money."
If you understand what the VC wants and you want that too, then you are aligned. If you don't then you are making a mistake.