Understanding the Economics of Venture Capital

If you are reading this blog, you know that venture capital is a power law game. Venture investors invest in ten companies hoping one returns the losses of the other nine many times over. 

And they have to because so many startups and small businesses fail.

But to really understand the implications and motivations of venture capital, you need to first get your head around the concept of carry – the upside that VCs have when investing in startups.

As a quick refresher: most VC firms operate on a 2/20 principle: 2% management fees, 20% carry. This dates back to the days of ocean voyages and trade caravans where the head trader/ship captain etc… would earn 20% of whatever they could “carry” back from Asia, Africa, North America etc… 

Merchant Trader Caravans
Source: Sahapedia

There was so much risk from bandits and piracy, crossing the seas and deserts and the years of hardship transporting the goods, that as a motivational “insurance” policy/upside, they literally earned one-fifth – despite not being the ones who financed the trip or paid for all the goods.

Somehow, venture capitalists (and many financial managers) have managed to preserve these lucrative terms through to today despite significantly less risk and significantly greater upside.

But before we go further with carry and how it affects venture motivations, let’s talk about management fees. Management fees are the percentage of the fund/assets that fund managers are paid by their LPs (limited partners) to handle the day-to-day aspects of running the fund and doing business – i.e. setting up legal entities, bookkeeping and back office, finding and analyzing startups to invest in…

These are the operating expenses that keep your modern venture capital firm in business. And because they are based on the size of the fund/AUM (assets under management), as you can guess, they incentivize VCs to raise larger and larger funds.

Because 2% of $100B is a lot sexier than 2% of $100M.

Hence why most venture firms keep raising larger and larger funds. Imagine SoftBank’s $100B Vision Fund – that’s ±$2B/yr just in management fees…

Talk about lazy, easy money. Which forces VCs to deploy more and more capital into larger and later stage opportunities… all to fuel the AUM and pad the bottom line.

Which leads to more and more VCs raising $1B+ funds and building out full-stack venture firms: covering as many stages of the investment funnel as possible.

Because easy money is easy money.

But that is just $2B/yr – which, if you can imagine it, is actually the boring part. 

Carry is where things get interesting.

If you want to understand how investors think, you need only understand carry. Carry is what drives the power law of venture capital – the “go big or go home” mindset. It (in addition to the incentives to raise larger and larger funds) is the primary driver that motivates venture capitalists to push startups for growth at all costs (aka the SoftBank effect, which often ends up killing or crippling the company – for more what SoftBank did to WeWork).

This is CRITICALLY important to understand!

Think about it. As a startup founder, because you only have one company and don’t have a backup plan, you do EVERYTHING in your power to make it succeed. IYou obsess about every little metric, mistake and expense because if you grow too fast or try to bite off too much, it can spell the end of your company.

And when that happens, you’re left with nothing.

That’s not how your investors think. Remember, venture firms invest in dozens if not hundreds of companies. They build a diversified portfolio of possible game changing companies like yours and inject them with steroids (i.e. cash) to ensure at least one or two become grand slams.

And even if the jet fuel causes most to burn out and crash, it almost doesn’t matter. 

As long VCs hit the one Uber, Airbnb, Facebook etc… that goes 1000x and returns their fund five times over, they don’t really care. 

That’s what carry means – caring only about companies able to turn $100k into $100M or $1B.

Because remember what we said earlier: as a VC, you get to keep 20% of the upside…

Imagine Benchmark’s 1st investment in Uber when the company was valued at just $30M-40M. Fast forward eight years to Uber’s IPO and that $11M investment had 2000x’ed, making it worth in the neighborhood of $10-20B. 

Think about it… if Benchmark’s GPs (general partners) got to keep 20% of that return, or $2B-4B (depending on dilution) – compared to the roughly $8M/yr in management fees they made off running the fund that invested in Uber – it’s no wonder they sued Uber/Travis Kalanick to make sure the company would finally see an exit (and make Benchmark and Benchmark LPs filthy rich – more on this here).

Benchmark Capital Suing Uber

The sad thing is, it wouldn’t have mattered if EVERY other startup in Benchmark’s Uber fund failed miserably. Either way, Bill Gurley and team would be dancing all the way to the bank as they cashed their life-changing checks.

That is the concept of carry. That is the brutal truth about venture capital. 

Outliers are everything.

And everything else is nothing.

Remember that when you consider taking money from investors. Are their incentives aligned with yours? Is their need for growth-at-all-costs aligned (or even feasible) with your business? (Not sure – check out our Ultimate Guide to Startup Fundraising to learn more about the various types of startup investors and the pros & cons of each).

So, are you willing to shoot for the stars, come up short and die of oxygen deprivation as you burn your last dollars on building a bigger rocket instead of a more sustainable business?

These are questions you NEED to ask yourself before taking venture capital.

You need to know what you are getting yourself into.

That’s not to say you shouldn’t take outside funding. Heck, I work with amazing funded startups everyday and help plenty of founders polish their pitch decks, raise capital and scale faster…

But it all comes down to you, your business and your goals.

And only you know the answer.

So, is venture capital right for your business? Who is your ideal investor?

If you’re not sure, don’t go into your raise blind. Schedule a strategy session today and let’s chat. Because when it comes to results, a little well-thought out strategy upfront beats months of mindless execution any day.

 

 

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