Join Rudolph Rosenberg for an in-depth discussion in this video The VC mindset, part of Entrepreneurship: Raising Startup Capital.
- One thing we all need to realize is that the job of the VC is very different from most of our jobs, in one sense at least. Their job is very visible and super risky, and if things don't go as planned, and if the firm does not generate the expected return for its limited partners, a general partner and some of his team might not be able to raise another fund. Most of us can live with blunders in our careers. Those are not communicated publicly, and chances are they'll just be a small bump in our history, but for VC's it's quite different.
VC's play their career with each fund they run, and few people will remember past successes when a big failure comes. So, why is it so important to understand that when raising capital through venture capitalists? Well, simply because there is not much room for error on the VC side, while at the same time, they play a very risky game. VC's invest in companies that are expected to be game changers in their field through technology, drug development, and so on.
Game-changing companies are, therefore, alone in their field, since not every company can be groundbreaking. Most companies follow the herd, and one of a kind, every few years, will come with a great new concept or technology and change the game for everyone else. That means that VC's usually review and invest in companies that propose new products and services and that those same VC's need to be able to make the difference between the idea that will not succeed, the one that will barely succeed, and the one that will be really game changing for its industry.
To do so, VC's will look into every aspect of their work to reduce their risks as much as possible in the hope of maximizing their chances of delivering the promised returns to the limited partners. To do so, they will focus on industries where they have extensive experience and understand what it takes to be successful, what problems are latent and require new technology, and they understand where the market is going.
Then, most of them will invest in companies that have attained a certain level of maturity and will have proven their ability to generate revenue and sometimes lots of it. Sometimes, the maturity factor will not be the revenue generated, but when there's a big problem in an industry and the company is planning on bringing a solution. The big uncertainty will be in their ability to develop the product. Then the factor that will determine the maturity level will be the level of development of the product, and if, for example, the biggest hurdles have been passed successfully.
They will look as well for massive markets, where the company has a lot of room to grow. They will look at business models that scale, which means that once those businesses have passed the time of initial investment, their revenue will grow much faster than their cost of operations. And outside of reducing their risks, VC's are also pragmatic people. They are not dreamers, and they not only take into consideration the odds of success of companies, they actually factor it in their model.
They understand that 80 percent of all startups fail, and so that despite all of their efforts, knowledge, experience, and methodology, they will most likely be wrong 80 percent of the time or maybe just 70 percent of the time, thanks to all the things they do to beat the odds. So, they know that out of 10 companies they will invest in, only a small portion will be successful. They go even further and assume that out of 10 companies, four will be an utter disaster and just go bankrupt and on which they will lose all their capital and their expected return on investment.
Another three will barely survive and generate enough money to pay for its expenses or, at best, be profitable but in a much smaller market than expected and, therefore, with no potential to be a big success. And here again, they might get back their capital but definitely not generate any return. Then, about two companies should be successful, be well positioned in a big market, and make up for the losses of the other seven companies.
And last, they hope they will have one super successful company, the likes of Google or Facebook, in their portfolio, which could have them be way more successful than they originally planned. That also means that, as we've just seen, out of 10 investments VC's make, they really expect only three of them to be successful and make up for all the losses of the other seven companies they invested in. The issue is that at the time of the investment they have no idea which one is which.
The rule is then, therefore, simple. Each company they invest in should yield a potential success and, therefore, be expected to generate a return that will make up for all the failures of the other companies. And so, when people would usually expect 20 percent or 30 percent or even 50 percent return on investment, VC's will expect a 10x to 30x factor. That means that they invest in companies that they believe can be worth, after five to seven years, from 10 times to 30 times their original value.
That's 10 times to 30 times. That means they're not looking for good companies, not for potential successful companies. They are looking for potential Googles or Facebooks in every project they review, because it's only by doing that and being wrong seven times out of 10, that they will be able to deliver on their commitments to the limited partners.
- List three variables that will affect the source of capital you choose to fund your company.
- Identify the best strategy most entrepreneurs can use for finding capital and investors for their company.
- Name two elements an entrepreneur must consider when determining the amount of capital their business will need.
- Cite two details that should be included in a business plan to help investors become familiar with what they will be funding and the term of their investment.
- Explain what the JOBS Act did to facilitate crowdfunding for entrepreneurs.
- Summarize the typical characteristics of an angel investor.