A Crash Course on Venture Capital From an Ex-investor at a $100 Billion Fund | by Daniel Kang | Apr, 2023

The one business that pays you thousands and thousands even when you lose cash

Enterprise Capital might be one of many few industries on this planet — if not the one one — that, on common, loses cash.

A TechCrunch article from 2017 reported that fifty% of enterprise capital funds make lower than a penny on what they invested.

From the outside-in perspective, it’s perplexing to see how such an business works and the way it operates. I imply, why does it even exist? How do they make a lot cash? Why are they within the headlines within the tech world? These are the questions I’ll be trying to reply on this piece.

Right here’s my try at a Enterprise Capital 101 crash course.

Enterprise capital is cash devoted to investing in firms. In finance, that’s what funds are. It’s cash pooled devoted to investing in sure, pre-defined issues. Enterprise capital particularly invests in firms which might be designed to develop shortly — we name these startups. There’s a motive most startups are technology-based. Expertise is simple to scale. For instance, some startups like Deel and Brex grew to become billion-dollar firms or “unicorns” in three years. When you construct the software program product, the incremental value of including one, hundred, million customers doesn’t value a lot.

Due to the mechanism, it takes cash upfront to construct the product earlier than the product may be bought and scaled to generate income. This usually means startups will lose cash to start with when constructing the product, and scale massively when it’s profitable.

Let’s take an instance. Figma was acquired by Adobe for $20bn in 2022.

Figma helps folks do collaborative work on UI/UX — it’s what colour the buttons are and what the buttons do on each app or web site you’ve used. Figma began in 2012, opened its product in 2015 to a small group of individuals, after which publicly in 2016. It wasn’t till 2021 that they began charging cash for his or her companies. However of their first yr of charging, they made $200m in income and doubled that to $400m in 2022.

So for a few decade, this factor wasn’t producing cash, however then exploded, reaching a $20bn valuation. For this reason Figma raised cash from VCs to pay themselves, rent folks, run servers, and so and so forth.

Sadly, when you go to banks or conventional buyers for cash earlier than you begin producing cash, it’s actually laborious. Typically, founders of those firms need to personally assure loans. So solely folks with a community of rich folks might actually get began.

Now some folks got here alongside and stated, “Nicely, if I spend money on shares, perhaps I’ll make 10–15% a yr. But when one among my startups do properly, I see that I could make 10,000% in a yr. Possibilities of that’s higher than shopping for lottery tickets”. I describe these return profiles as uneven odds, which I’ve defined intimately. To briefly discuss concerning the math, when you make investments $1,000 into 100 firms, you solely want two of your investments to do properly to cowl your loss and double your cash. So when you had been proper 2%-5% of the time, you’d do properly.

That’s enterprise capital.

Family know-how firms like Google, Fb, Uber, and Airbnb began as startups and acquired enterprise funding. Which means lots of people bought wealthy: The founders, workers (who bought to personal items of the corporate), and buyers. Enterprise capital shortly grew to become well-liked, formalized, and high-profile on this world.

Enterprise Capital can are available many types. It may be a certified particular person (the US has guidelines about who can make investments), which we name “angels,” a bunch of people who pool their funds, which we name “syndicates,” or a formalized establishment, which we name Enterprise Capital funds.

Softbank, Sequoia, and Tiger are all enterprise capital funds. A VC fund isn’t some individual however an entity made up of a number of roles.

Listed here are essentially the most notable ones:

• Basic Companions (GPs). GPs “begin” the fund. They’re the primary buyers and put some cash right into a fund, which is pooled cash devoted to investing in startups. GPs put in about 1–2% of the full fund. So a $100m fund means you set in a minimum of $1m. GPs then elevate the remaining $99m from different buyers known as LPs.
• Restricted Companions (LPs). As soon as the GP begins the fund, they are saying, “Hey I’m beginning a fund, it is best to be part of. I’ll make you cash”. LPs put within the different 99%. LPs may be giant asset managers, funds of funds, or prosperous people.
• Administration. Often, these are the folks depicted within the media as enterprise capitalists. They’re employed by the GPs to go discover cool firms to spend money on. GPs are often the top objective for these guys.
• Portfolio firms (Portcos). They’re the startups.

Let’s see how the business makes cash.

Right here, I’ll breakdown the part into the next:

1. The pie — How do they generate profits?
2. Splitting the pie — who will get what?

For the sake of brevity, I’ll simplify and ignore some real-life particulars for now to get an 80% correct image of issues.

The pie

For any authorized contract to be legitimate, there must be one thing for each side. That’s known as consideration. Startups obtain cash from VCs. VCs obtain partial possession of the startup. Usually, the goal possession is 10–20%.

VCs generate profits when startups improve in valuation, usually pushed by the corporate’s progress charge.

Let’s take the Figma instance once more. The desk beneath is the historical past of all “rounds” of funding Figma has acquired because it was based in 2012. The primary “spherical” of cash startups elevate known as a pre-seed or seed spherical. Each different spherical after that’s known as “Sequence + The letter of the alphabet beginning with A.”

On the threat of oversimplification, the valuation of a startup is a few operate threat and potential (to generate money) of startups. Early-stage buyers threat extra and get extra, whereas late-stage buyers tackle much less threat.

Say you labored at a VC fund and invested in Sequence B. You’d put in $25m at a $90m valuation. So that you personal 27.8% ($25m/$90m). We talked about that Figma was acquired for $20bn. 27.8% of $20bn is roughly $5.6bn.

Your $25m would’ve been price $5.6bn — a 222x return.

That’s how VC funds make large quantities of cash investing a small quantity. When you had put in $1,000, that will’ve bought you nearly 1 / 4 million {dollars}.

Now, this isn’t fairly correct. Listed here are some important particulars:

1. Corporations, not firm. VCs spend money on a number of firms, and plenty of don’t end up properly. So the nice investments subsidize the unhealthy ones earlier than anybody splits the pie. This implies your positive aspects and wins develop into extra reasonable as an entire.
2. Dilution. On this instance, we assumed you continue to owned 27.8%. In actuality, your possession decreases as different buyers come into the spherical. For instance, in Sequence C, Figma raises $40m on a $400m valuation. Which means Figma gave up one other 10% of possession, and your possession will even be decreased, or “be diluted”, by 10%. The identical factor would occur for Sequence D and E until you set in additional capital to maintain your 27.8%.
3. Liquidity occasion. You don’t generate profits till somebody pays money for the corporate. Regardless that Figma was valued at $10bn in Sequence E, you wouldn’t generate profits as a result of no liquidity occasion has occurred. These are mergers and acquisitions or IPOs. In much less widespread circumstances, there’s a secondary buy, which implies somebody gives to purchase your shares at a reduction to the most recent valuation.

Splitting the pie

After the annoying particulars of actuality, let’s say the fund finally ends up with about $3bn in returns after all of the positive aspects and losses. This pie is unique of the returns founders and workers would’ve made.

How do they cut up the pie? The primary cut up is between LPs and everybody else. Whereas splits can range by LPA (Restricted Accomplice Settlement), a typical cut up is 80/20 for the LPs and everybody else.

• LPs take 80% of the pie ($2.4bn). LPs make investments their cash and take dangers.
• GPs take nearly the entire 20% ($600m). Do not forget that GPs put in 1–2% of their very own cash and get their share of the LP returns. GPs coordinate all this.
• Administration takes a flat wage and bonus set by the GP like another worker. Few senior administration, usually known as companions, share a small portion of the 20% above. That is known as“carry” compensation. To be clear, these crumbs are nonetheless sizeable. Think about that the GPs share 4% of the 20%. That’s nonetheless $120m. If there are six companions with an equal cut up, that’s nonetheless $20m per individual.

In fact, this isn’t precisely the way it works both. There are a couple of annoying particulars right here as properly.

1. The well-known “2/20 construction”. When you’ve been following, you could be inquisitive about how VCs function in the event that they make returns after they invested the cash? The reply to that’s administration charges. LPs pay 2% of their managed cash to GPs yearly. So if the fund is $500m, the LPs would pay $10m a yr in administration charges no matter efficiency. Administration charges are the “2” of the well-known “2/20 construction”. The opposite 20 is what we’ve already mentioned, which is the cut up of the fund returns.
2. Hurdle charge. Some would possibly take a look at assume this isn’t a good deal for LPs. Nicely, LPs even have a method to defend themselves. The hurdle charge is a minimal return on funding that have to be met earlier than GPs can take their 20% curiosity. The hurdle charge is often set between 5–15%, with 7–8% being the norm. It serves as a safeguard for LPs to make sure that GPs solely obtain carried curiosity when the investments have been profitable. There are a number of different clauses, like clawbacks, however we are able to maintain off on this for now.
3. Seniority. Associated to the above, there’s a formalized order of who will get what when issues aren’t going so properly. The stack is who will get paid first. The primary in line are debt suppliers (convertibles or loans), which we haven’t mentioned in our construction. Think about a financial institution. Second in line are LPs who demand their hurdle charge. Then it’s the GPs & administration by clauses like liquidation preferences. Then it’s the founders and workers. We name stack seniority.

HBR as soon as made commentary about this construction.

VCs have an awesome gig. They elevate a fund, and lock in a minimal of 10 years of mounted, fee-based compensation. Three or 4 years later they elevate a second fund, primarily based largely on unrealized returns of the present fund.

Often the next fund is bigger, so the VC locks in one other 10 years of bigger, mounted, fee-based compensation along with the remaining charges from the present fund. And so forth…companions make excessive six, and extra typically seven, figures in mounted money compensation.

Whereas I agree some structural issues might exist, enterprise capital stays an necessary a part of the startup ecosystem and innovation. A number of the largest firms that we use like Airbnb, Uber, Robinhood, and Coinbase had been all funded by VCs. And these are simply firms that concentrate on people as customers. There are firms like Stripe that processes funds globally for 1000’s of companies.

For individuals who wish to go deeper, listed below are some phrases to grasp.

• Lifetime of the fund is how lengthy the GPs need to return the cash to LPs, and finally shut out the fund. Often, that is 7–12 years, the place about 40–60% of the cash is deployed within the first 2–3 years, and the remaining is often used to double down on winners.
• Dry powder is how a lot the fund has left to spend money on firms. If the fund is $500m, and so they invested $100m, then dry powder can be $400m — once more, a bit simplified.
• Capital calls is when the GP asks for cash from LPs. GPs don’t maintain the entire cash and depart it. That might be a waste. For instance, Softbank Imaginative and prescient Fund, the place I labored, was a $100bn fund. We didn’t have $100bn mendacity round in some checking account. LPs had the fund, and we’d do a “capital name” when making particular investments. Why? Even vanilla financial institution deposits yield 3–4% curiosity today. 3% of $100bn is $3bn. They’re not going to go away it uninvested.
• Returns are how a lot a fund generates relative to the dimensions of the fund. Often, it’s described as a a number of of a fund or “cash on cash” (MoM) or an annualized return known as IRR (Inner Fee of Returns). For instance, when you doubled your cash over two years, you 2x MoM with a roughly 40% IRR. Why isn’t it 50% (100%/2 years?), since you take note of the time worth of cash. It’s as when you put your cash in an account that yields 40% a yr. In two years, you’d double your cash.
• Funding committee is the assembly made up of some senior decision-makers who make the ultimate name on investing. Often, it will probably embody LPs, GPs, and senior administration. Relying on the fund, an funding might take a couple of days to a number of weeks to get to this stage.

This was my try at Enterprise Capital 101, designed for folks unfamiliar with the business. Like many industries, there are lots of different matters that might be coated. For instance, what do all these titles of IR, EIR, Enterprise Accomplice and the like imply? How do VCs discover firms and make selections? What’s an information room and due diligence? What are devices like SAFEs, notes, most popular and customary shares? Why are some funds billions of {dollars} whereas others tens of thousands and thousands?

You probably have questions like this, then I succeeded in what I attempted to do — that can assist you change your unknown unknowns into identified unknowns. It means you already know what to search for. Subscribe to see extra content material on enterprise capital and startups.