Tip For Innovators: Don’t Chase VC Money

Tip For Innovators: Don’t Chase VC Money

This is where I am coming from: I see so many innovators that lose all their time and money by chasing Venture Capital (VC) firms, without knowing what they are doing. And without knowing what follows if they are really successful in getting that VC investment.

I am not only talking about the lost time and money when attracting the interest of VC firms. It is also about the pain that is caused when the founders discover that they are just another start-up that has been burned through as part of the process of searching for the next “Unicorn”, a term that is used for a start-up that is valued at more than $1 billion after being fostered with VC money.

There are warning signs all over the place. Companies that go bankrupt after all the investors’ monies have been burnt. As far as Singapore is concerned, there is the recent Zilingo case, a start-up company that has scorched more than $200 million in a little more than 2 years’ time. A comprehensive report of what has happened has been published in the local newspaper Straits Times (click here). Now step into the founders’ shoes: and answer my rhetorical question: do you want that for yourself?

Surely not. Insolvency is a painful process and you will age much faster than normal if you have to go through it. There is no easy walk away from facing the consequences of bankruptcy of your company, whether you as a founder have an extended liability into your personal assets or not.

Still, Venture Capital has its own dynamics and people like to ride that storm, just because of the huge upside of such an endeavor. We all know the stories of entrepreneurs with a hot technology and venture-capital funding becoming billionaires in their 20s.

The True Failure Rate of VC-backed Start-Ups

While it was very normal ten years back, that 3 out of 4 Venture Capital backed companies were not able to even pay back the capital that they have been given (click here), it is my impression that it is today rather 9 out of 10 Venture Capital backed companies that do not perform as they should.

Now let that sink in: of ten start-ups that go into the endeavor of taking Venture Capital money, nine start-ups fail. That is much worse than the 50% that you achieve when you are playing a round of Russian Roulette. And the miserable life that start-up founders have lasts in average 4 years until that happens.

I have seen that often in my own practice. Why do I know? Well, that is because the last thing that is liquidated after a start-up failure are its patents and trademarks. And I as a patent attorney would know because I am helping the liquidator to sell them to a new owner.

 

How Venture Capital Firms Work

There is quite some literature out there about how start-ups work and I have found one recent article that nicely brings the secrets of running a Venture Capital firm to the light of the day. It has been written by Haje Jan Kamps (click here)

Kamps says that he worked for a large VC firm for several years, as a portfolio director. He says of himself: “… that means I talk to a lot of early-stage companies, and I’ve seen more pitch decks than any human should.” Now that is an impressive statement!

And this is what Kamps says about what he has seen in that function:

A lot of the pitch decks I see, however, make me wonder if the founders have really thought through what they are doing. Yes, it’s sexy to have a boatload of cash, but the money comes with a catch, and once you’re on the VC-fueled treadmill, you can’t easily step back off. The corollary of that is that I suspect a lot of founders don’t really know how venture capital works. That’s a problem for a number of reasons. As a startup founder, you’d never dream of selling a product to a customer you don’t truly understand. Not understanding why your VC partner might be interested to invest in you is dangerous.

That is a clear warning to me. Start-up founders need to know more about Venture Capital firms.

Again, what I have seen in my own practice is that, contrary to popular perception, Venture Capital plays only a minor role in funding basic innovation. Venture capitalists invest only a small part into Research & Development (R&D). It is my impression that the majority of Venture Capital goes into follow-on funding for projects that stem from the far greater expenditures of universities, in other words “tax payers money”.

So, according to what I have seen, VC money plays a more important role in the stage of the innovation life cycle when the first product is ready to be sold: when the company begins to commercialize its innovation. And that is when VC money is most useful for expansion, starting with so-called “Series A” investments. That money goes into building the business infrastructure that is required to grow the business and into working capital for bringing these products to the market.
And still do I see start-up founders chasing VC firms when they should focus on doing sales and finding useful team members!
What a waste of time!

Going To The Source: Where VCs Get Their Money

If you do not believe me, then step now into the shoes of a VC firm. What is their reason to exist and why do they hand out money to start-up founders?

This is what Kamp writes about that:

To really understand what’s going on when you raise venture capital, you’re going to need to understand what drives the VCs themselves. In a nutshell, venture capital is a high-risk asset class that capital managers can choose to invest in.

These fund managers, when they invest in venture capital funds, are known as limited partners, or LPs. They sit atop giant piles of cash from — for example — pension funds, university endowments or the deep coffers of a corporation. Their job is to ensure that the giant pile of cash grows. At the lowest end, it needs to grow in line with inflation — if it doesn’t, inflation means that the buying power of that capital pool is shrinking. That means a few things: The organization that owns the cash is losing money, and the fund manager is probably going to get sacked.

Let that sink in again. VC money is not thought to be a lost subsidy, as handed out by governments that believe that they can foster the well-being of their domestic economy by doing so.

VC money is meant to grow, and given the high failure rate of VC investments, that growth has to be tremendous for those very few investments in the VC fund that turn out to be successful.

What Is A Decent VC Fund Growth Rate

Seen as a whole, a VC fund needs meet certain performance criteria in order to be able to compete with other investment alternatives. And the most important performance criteria is the return on investment (ROI).

This is how Kamps puts it:

So, the lowest end of the range is “increase the size of the pile by 9% per year” to keep up with the current inflation rate in the U.S. Typically, fund managers beat inflation by investing in relatively lower-risk asset classes, a strategy that works better in lower-inflation environments. Some of this low-risk investing may go to banks, some of it will go to bonds, while a portion will go into index and tracker funds that keep pace with the stock market. A relatively small slice of the pie will be earmarked for “high-risk investments.” These are investments that the fund can “afford” to lose, but the hope is that the high-risk/high-reward approach means that this slice doubles, triples or beyond.

No, if you now think that the “fund managers” that Kamps is mentioning here are “VC fund managers” then you are wrong. Those “fund managers” are located one level above the VC firms. Those fund managers – also called “asset managers” – are typically only customers of VC funds. They will never directly invest into a start-up, although they could. In other words, VC firms are in the same position as the start-ups that they are investing in: they need money from other people, typically from investment funds.

How Asset Fund Managers and VC Firms Work Together

Kamps describes how these asset managers are ticking.

Asset managers for these huge funds can choose to invest in any number of asset classes. Some might speculate on art, high-risk stock market investments, cryptocurrencies, high-risk real estate or even speculative research.

One of the asset classes they may choose to invest in is venture capital. The way that works is that an asset manager finds a venture capital firm they believe in and invests capital into a particular fund that the firm is compiling. VC firms tend to have an investment thesis for this reason: A particular fund might want exposure to biotech, or companies in the U.S. Southwest, or startups in developing markets, or only very late-stage companies. The investment thesis has an expected return range and a calculated risk ratio. If the VC firm invests at the earliest stages, for example, there’s a pretty decent chance that the company fails and it loses its investment — at the same time, if that deal succeeds, the venture firm could stand to see a huge exit with a terrific return. Investing at a much later stage could mean that there’s less risk (the company probably already has a product, a product-market fit and a pretty fair shot at success), but there’s also less of a chance that you will 10x your money.

The reason fund managers invest in venture capital funds is that this gives them a portfolio. That means that their risk is spread out across a number of startups — instead of putting $100 million into one company that may succeed, venture capital is, in effect, spread-betting across a large number of startups, putting $5 million into 20 startups, for example. That means that even if 90% of the startups fail, the two that are left standing could well prove to be the next Facebook or Tesla. This can generate huge returns for VCs and their LPs alike.

You now realize that my “90% failure rate” mentioned above is not far-fetched.

And please note the language: a traditional investment fund is called “Limited Partner”, not because its liability towards its investment is legally limited to the extent of its investment, but because its gain is limited to what has been agreed upon in the investment agreement. At least this is what I understand from speaking with successful VC managers.

Kamps has more insight into the relationship between LPs and VCs:

Some venture firms only have one LP. In that case, the firm is usually either investing money from a corporate source (known as a corporate venture capital firm, or a CVC) or from a high-net-worth individual (usually known as a “family office”). You’ll come across both from time to time, but the vast majority of VC firms have multiple LPs. That means multiple investors and sources of money, and multiple sets of desires and expectations of how the VC firm performs.

Being a VC firm does not sound like an easy job. VCs get pressure from both sides, from their investors in the form of LPs and from their investments which are start-ups that most of the time, in 9 of 10 cases, do not behave as they should.

 

The Mechanics Of VCs And What They Do With The Borrowed Money

It sounds so easy, right? VCs money from an investment fund, they find aa a set of startups that matches their expectations, they give away that money, and they hope not to lose it. The start-ups grow, some investments do not work out while others do.

It sounds so simple, but Kamps makes it clear that this is far from the harsh truth:

But remember that “at least you got your money back” is a terrible outcome here; the LPs invested in a high-risk asset class. I’ve spoken to VCs who have the opinion of “I’d rather they run the startup into the ground and return nothing than get a 1.5x return on investment.” It’s hard to say how prevalent that opinion is, but it makes sense from the portfolio math point of view.

Again, if you are a start-up founder, would you want to be in that category “run into the ground”? Of course not!

To explain how that works, Kamps provides a spreadsheet that captures the portfolio of a made-up $30 million fund that invested $1 million into 15 companies (click here). Please refer to Kamps’ original article for a comprehensive explanation of that investment table.

What is important is the outcome, after the VC fund is closed. The mock portfolio of 15 investments results in one IPO, three decent acquisitions and four small acquisitions. The term “acquisition” is not fully clear. What is meant is that the shares in these start-ups are sold to new shareholders.

Kamps highlights what he is calling “acqui-hires” where the new shareholder of a start-up acquires the start-up company for their team (acquisition-to-hire). Please note that from this follows immediately that one of the main duties of a start-up founder is be in touch with the best talent in their industry and constantly trying to lure them to the start-up: nothing is more effective in getting talent to a company as when the CEO reaches out directly and makes people feel wanted.

Kamps also mentions companies that get sold in a fire sale for their intellectual property, for their customer lists, to kill off a competitor or any number of other reasons. According to Kamps, typically, these are relatively poor exits for the VC that has invested into those start-ups.

In Kamps’ example table, even the “pretty decent” acquisitions were relatively small, and the only reason the fund made a substantive return, in this case, was one single start-up company: the venture firm invested $1 million initially for 11% ownership. It then poured an additional $3 million into the company because it participated in some follow-on rounds, and ended up with 7% ownership at an IPO valuing the company at $1.2 billion. In VC terminology, that is called an “outsize return” in the business, which is a Unicorn.

It takes a few years from setting up a VC firm until the first returns can be seen. Imagine the dynamics when one of the companies shows signs of becoming such a Unicorn.

When VCs Let Start-Ups Die

Part of the strategy of running a venture fund is deciding which companies to keep putting money into and which to give up on.

But how does that work in practice?

Kamps explains the dynamics as follows:

The important thing you need to understand from the above is that VC investing is a hits-driven business. A 2x or 3x return on investment isn’t really going to move the needle because the portfolio model of VC means that there are going to be a lot of misses, too. A 3x return sounds good, but in effect, it only makes up for two or three other investments that failed, leaving the VC firm at a net zero.

What the VCs are looking for is a “fund-returner” — if it’s a $30 million fund, an exit that is worth $30 million or more. Realistically, venture capital firms have costs as well (typically 2% of the fund), and the VCs only really start making money (the “carry” of the fund) when they have returned the invested funds to their investors — after costs are taken off. In other words, a $30 million fund doesn’t really start making money for the VCs unless it is able to return the $30 million plus 2% per year that the fund is running. For a 10-year fund, that means $6 million of management fees over 10 years. In addition, the firm will need to beat inflation to make any sense to its LPs.

The way the VC makes most of its money isn’t its 2% per year management fees (a common percentage), but the 20% “carry” that most funds get (the number can vary, but 20% is the benchmark figure). The way carry works is that once the LPs have their money back, the venture fund gets a 20% cut of any profits beyond that threshold.

So, in the hypothetical example above, the VC stands to make $6 million over 10 years from management fees and an additional $12.7 million of carry.

Again, what I understand from successful VC managers is that there are more ways to make money than just a percentage of carry. One way is to pack one’s own savings into the VC fund and to also benefit from the upside of the carry.

Is Running a VC a Good Business?

The above figures also show that the job of being a VC partner is not a money-printing machine.

Imagine that this venture fund has five equal general partners and that nobody else has any carry in the fund. That means that each partner will get a $2.5 million payday after 10 years of work — or an average of $250,000 per year. That’s not pocket change, but there are less stressful ways of making $250,000 per year. (The management fees are also paid as wages and cover things like office rent, marketing spending, etc., but typically the general partners don’t pay themselves much out of the management fees.)

If you are interested in setting up a VC firm, then there is good news: The Founder Institute is offering a course that comes with the business network to run that VC firm (click here): “The Founder Institute is working to launch 1,000 new venture capital firms over the next five years to support innovative companies worldwide that are working to make an impact.”

Is Your Start-Up A Fund-Returner?

This is the crucial question, and Kamps answers it as follows:

Over 10 years, 5% average inflation and 2% of management fees mean that the opportunity cost to the LPs is almost $60 million on our invented $30 million fund. (Compound interest is the eighth wonder of the world, as someone far smarter than me once said). So for a 10-year investment period — the standard fund lifecycle — to make any sense at all, a VC firm needs to turn $30 million into at least $60 million.

By now, you’ve probably realized a couple of things — for one thing, VC investing is pretty damn stressful. The other: The benchmark against which your company is graded is very high. For a venture investment into your company to make sense, ask yourself this question: Could the investment the VC firm is about to make in your company potentially return its entire fund?

Or, put differently, if you are about to take a $1 million investment at a $10 million valuation, giving the investor 10% of your company, you would need to have a fighting chance at exiting your company at $600 million or more. And that is before the investor has exercised any of its pro-rata rights.

You sometimes hear, “Can this founder team take this company and turn it into a billion-dollar exit?” The phrase isn’t hyperbole. In a lot of situations, VC firms need a billion-dollar exit to return their fund. That doesn’t mean that anything less than a billion-dollar outcome is a failure, but this is where a lot of startup founders misunderstand how VC works. If there isn’t at least a tiny sliver of a chance that your company turns into a billion-dollar company, why should the VC place a bet on you?

A 3x or 4x return might be great for you, the founder, and perhaps for your early angel investors. For the VC industry, though, they’re looking for much higher potential than that. If everything goes perfectly to plan — your company gets everything right and sees a huge tailwind, where everything goes better than your wildest dreams — and you’re still not able to get the VCs to fund-returning-sized returns, you’re not in the right room. You’re selling something that doesn’t work within the VC model, which means you’re simply not a good investment.

I speak to a surprising number of founders who don’t understand the above, and who set themselves up for failure when they are on the fundraising path. You’ve got to think big, and the numbers in your financial projections have to back up that you have the weensiest mote of a chance at making everyone around the table a godawful amount of money. If you can’t do that, it’s back to the drawing board.

 

The core message is this: “If there isn’t at least a tiny sliver of a chance that your company turns into a billion-dollar company, why should the VC place a bet on you?”

Is your new product idea something that can obviously be turned into a company with a valuation of $1 billion? If not then do not go for VC funding in the first place. Chances are high that you end up in a spectacular bankruptcy case, maybe even in the local newspaper. Look at Kamps’ examples above! You don’t want that.

The good news is that there are other, better ways to finance your new product idea. Check out my public talk of 29 April 2021 for more information: https://ip-lawyer-tools.com/public-talk-blockchain-technology-meets-4×4-innovation-financing/

Conclusion

Don’t chase VC money. Let VCs chase your company

Reason #1: You do not need to spend time speaking with VC unless you are actually ready to fundraise for Series A. If your business is attractive, VCs will be all over you when the fundraise is on. VCs don’t need a relationship with you for that.

Reason #2: When you take up investments, there should be competition between the investors. Who is allowed to invest in your company and who is not? That will make sure that you get a decent price for giving up your company shares.

Reason #3: You are probably too early in your company history. Most VC money is invested after you have successfully developed a product and it is time to scale the company for doing big sales.

And if there isn’t at least a tiny sliver of a chance that your company turns into a billion-dollar company then do not even think about the term “VC”.

Better look for other ways to fund your next great idea.

 

Martin “VC Insight” Schweiger

 

 







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