New VC game
Venture capital isn’t easy and has many challenges. As a very brief primer, venture capital ( VC) f unds raise money from investors (typically called ‘limited partners’ or LPs) and invest this money into businesses that they believe have very high growth potential. The VC management team takes about 2% of the funds it’s raised and spends it on expenses. The team makes real money when the fund does well, typically making 20% of the returns above a hurdle rate (which varies but is generally above 15%). So when a fund makes an annualised return of 40% and the hurdle rate is 20%, then the VCs would make 20% of the ‘excess’ 20% – i.e. they’d make 4%. This can be substantial when compounded and becomes a large number when the fund performs well. It’s very hard to spot winning companies, especially early in their lives when they’re at their most risky. So typically VCs expect that for every 10 investments they make, one or two successful investments will return their entire fund value, another three or so investments will produce moderate returns and the rest will fail. In this you have a bit of a conundrum – if you want to invest in the kind of high-growth opportunities where one or two investments will make a substantial amount of money, then you have to appreciate the risk (i.e. that you will also have three or four complete failures where all capital invested to date is lost). The trick then is to identify exciting companies very early on, take a sizeable stake and be able to follow your rights by investing in the firm as it grows and raises more money. LPs like to see focus. So funds have split between being seed and Series A (the earliest two funding rounds for a business), while others do the later but much larger rounds. The investors who get in later do so because they are seeing businesses with a far better track record, but if the business is doing well then for them to get a meaningful stake of the action (important to generating returns on their invested capital) then they will only be able to do so a much higher valuation. If you want control and board seat then you need to have a lot of money to buy a meaningful stake. So there is more capital at risk in each later stage deal.
Typically, the early-stage funds have a very fine line to walk between being able to invest in more attractive new companies versus supporting their existing