Understanding the Economics of Venture Capital

Every startup needs to raise money to build and scale. As a founder, you can decide to bootstrap your company, raise money from family and friends, or leverage grants to build your startup. However, as your startup grows, you might need a larger war chest (cash) to expand and scale your company; this is where VC firms come in.

Photo by omid armin on Unsplash

To raise money from VC firms, I believe it is important to understand how VC works. I see so many first-time founders try to raise VC investment without fully understanding what drives VC firms.

The history of VC can be traced to the traitorous eight and Fairchild Semiconductor; however, that is a story for another day. A VC firm raises money from HNIs (High Networth Individuals), corporations and development institutions, to invest the same in promising startups, with a mandate to return not only the money raised but a considerable profit to its investors.

A fund typically lasts 10 years, where in the firm is expected to return the fund and the profits to the investors. Usually, the firm backs new startups in the first 5 years of the fund, and prioritises follow-on funding for companies it has earlier backed in the second half of the fund’s lifespan. If you are actively fundraising, you need to find out if the VC firm you are planning to approach is actively deploying capital to new startups or is prioritising follow-on funding for its portfolio companies.

VC firms have to be very careful about the type of companies they back, as they need to return money to their investors (VC money is not free money). Venture capital is very risky as a lot of startups fail; I am sure you have heard of several startups that raised millions of $ but ended up closing shop. This is a regular occurrence in Venture capital; 8/9 out of 10 investments are expected to fail. I am sure you are wondering how VC firms are expected to return money if only a few companies are going to succeed.

This leads us to what we refer to as the power law in Venture Capital (yunno, the power law that states that 20% of the world’s population controls 80% of its resources). This power law forecasts that 1 or 2 investments are going to return the fund. While other investments might fail, there should be a company that is capable of returning the firm’s funds; such a company is referred to as a homerun. Now, when VC firms are trying to invest in companies, they tend to seek out companies that can be a homerun (that can return the fund). Why is this important to you? Well, when approaching a firm, you should take an objective look at your startup. “Can this startup generate sizeable returns for the firm?'“, “Can we be a homerun?” It is usually harder to tell at the early stage of the company, which makes it important for you as a founder to genuinely know the market size of the product you are building.

Now, how do VC firms make money? Well, when VC firms invest in your company, they get shares in return (preferred shares), and if your company gets acquired in the future or lists on the stock exchange (IPO), such shares convert to cash. Let’s say I have a 20% stake in a fictional company named Ambirion, and Ambirion gets acquired by META for $3 billion, I’ll get 20% of the money (and probably retire while living the rest of my life on a farm in Southeast Asia). However, note that this is subject to the liquidation preference clause agreed to by the investor (VC firm) and the investee (Startup), and whether such clause is a participating and non-participating one (do not worry, I’ll touch on term sheet and its clauses in my next blog post).

That is basically how Venture Capital works. A VC firm raises money (a fund) from other entities with a mandate to return the fund + profit, invests in companies it believes to be viable investments (homeruns), and makes money when it exits its position (through an acquisition, IPO, or selling its stake to another entity).

In my next blog post, I will be diving into term sheets and the clauses you should pay attention to as a first-time founder. Ciao!