Venture capital

- When it comes to venture capital, the first thing you should know is that it's more the exception than the rule. In 2018, PitchBook reported at an all-time high in venture capital dollars invested with almost $131 billion being invested across 9,000 companies in the United States. That may sound like a lot of companies, but there are typically 400,000 to 600,000 companies started in the U.S. every year. So what is it about those 9,000 companies that warranted over $100 billion of investment? Remember that investors are running their own businesses. They're in the business of generating high returns on the money they invest. And the money a venture capital firm invests is actually the money of their own investors called limited partners or LPs. An LP expects a 30% return on the capital they give to a venture capitalist. That capital goes into a venture fund and the venture fund is intended to return money to investors on a 10-year timeframe. That means that after 10 years, a venture fund needs to generate three times the amount of capital they accepted from their LPs. Because startup companies are high-risk, high-reward, the majority of companies fail or do not return three times the money they received. So to successfully return the LPs' money, a venture firm typically expects a small number of their investments, as few as one or two out of every 10, to generate enough of a return to pay off the whole fund. So let's do the math. If a venture capital firm has a $300 million fund and needs to return three times that fund, they need to generate $900 million from their investments. If a firm makes 10 investments and expects one or two to pay back the majority of $900 million, a startup company would have to return more than a billion dollars to be a good investment. Silicon Valley refers to a billion dollar company as the rare unicorn investment. And since a venture firm will only own a fraction of the startup company, the startup would need to be worth $2 billion or more for a 50% ownership stake, which is high, to successfully return the fund. Now, these are round numbers based on a $300 million fund size. There are many firms that are much smaller and don't need you to build a billion dollar company to be a good investment. But you need to understand the math so that you can select investors that match your vision for the company's growth. One more thing. Investing typically receive their return when there is a liquidation event. Ownership in a private company is an illiquid asset, meaning the investor can't quickly or easily turn that ownership into cash to reinvest elsewhere. A liquidation event is a milestone that takes that non-liquid asset ownership in a private company and makes that ownership liquid, paying out cash for that ownership or converting private ownership into stock in a public company. The most common liquidation event is an acquisition by another company, which is also called an exit. Another liquidation event is the IPO, or initial public offering. When a company goes through an IPO, it gives the public the ability to buy and sell ownership so private investors can sell their ownership stake in a company to the public and cash out. All this to say that venture capital firms are incentivized to invest in high-growth, highly scalable technology companies that they can buy a significant ownership stake in. So if your company doesn't have a clear path to that type of growth, venture capital probably isn't for you. And that's okay, when you take on venture capital, you're taking on rocket fuel, the investors want you to burn through that cash to project your startup rocket into orbit. That's not the type of company or growth that a lot of entrepreneurs want. We've already covered several other means for raising capital for your company, so don't worry if venture capital isn't the right path for you. But if you are creating a high-growth, scalable tech company, venture capital can be just the rocket fuel that you need.