22 January 2012

Venture Capital: Serious Mathematics and What It Means

Now I’m probably asking a question that I’m not supposed to ask at this point as a first time early-stage start-up entrepreneur: “What does venture capital cost?” Indeed, instead of doing market research for my venture and preparing a typical hockey-stick like projection as guided, I find myself googling for terms such as “seed funding” and “venture capital”, “cost of venture capital”, “vulture capital” etc. Curiosity or paranoia of a financial blogger...

Anyway, for me it is among others an interesting philosophical issue: should venture capital and VC-s (first of all, in this article I mean VC-s that focus on early stage companies) be this much praised for what they are doing? What if this all is just a “theatre” where most of the entrepreneurs are “actors” at their own expense? That’s the feeling what one may easily get when surfing in internet. On the other hand, there are inspiring success stories... and there is always so much positive energy and excitement in the start-up world.

To illustrate the eagerness of young “hungry want-entrepreneurs” when it comes to money, let me quote a conversation. A few days ago in a networking event we discussed in a small group of young aspiring people about Silicon Valley as a dream destination for start-up entrepreneurs. I asked what the others are considering as the main attraction of this place.
“Money, money!” one of them replied with sparkling eyes.
“And,” I continued calmly.
“And??!” She seemed surprised at my note, to say the least.
“Isn’t it cool only until you start taking a serious look to the terms and conditions and all the legal stuff?”
(To be clear, I’m not saying anything about Silicon Valley – I haven’t even been there by myself, and I still do believe / hope that money and glamour are not the best bits there.)

The reason for my own rather cool attitude was that I had just read some standardized documents of a venture capital firm, something “to get your startup over the legal legwork quickly”. Here are some of my findings and conclusions (to which I later found confirmation from various other sources):
* Founders are generally being “diluted out” pretty quickly, which means that they become from owners to employees (who are locked to the company with stock options – what an outlook if you happen to have different views than the investor).
* Several implications to a built-to-flip scheme (which, as it turned out, is precisely the dream-exit of venture capital).
* Investors get clearly more preferential treatment than the Founders; a la: you sign the Non Disclosure Agreement, we don’t; you do the work, we request information and control; you need our approval for selecting key staff, we can fire you when we deem necessary. (Maybe I exaggerated a bit, but not much).
* Etc. etc.
Of course, this was just a standardized format and what is agreed at the end, is a subject of negotiations. (At some point, law firms need work too, right?)

Yet “serious math” about the venture capital does not leave much room for playing... We are investing other people’s money, you know; we have certain responsibilities.

Investing into start-up companies is deemed risky, very risky (and yes, the companies have very short if any track record, projections are pure speculations based on some market research at best etc.). So, as a rule of thumb, a venture capital fund may invest in one in four hundred opportunities presented to it only.

A VC assumes that out of these carefully selected companies, five will fail, three will generate low to average returns and two will be successful.

General partners and other investment professionals of the venture capital firm want to get paid for their job too. Thus there are management fees, typically up to 2% of the committed capital. Venture capitalists are also compensated through carried interest, a share of the profits of the fund (typically 20%) as a performance incentive.

VCs are expected to return 30%+ to their investors.

(Sources of the above data: Wikipedia, go4funding.com and onstartups.com).

By definition, vast majority of the losses, costs and the expected returns have to be covered by the two successful companies out of the ten “chosen ones”. In other words, the expected cumulative return on investment (ROI) from a start-up company is 10 and more times within the time frame of the investment, typically 3-7 years. Figure 1 below provides an illustrative calculation.

Among others, these simple data and calculations:
* Explain, why the hockey-stick like projections are this typical (with nothing less your start-up probably doesn’t get funded anyway).
* Imply that only very little companies can actually have access to venture capital (the others are probably not using their resources optimally, because all the bureaucracy and communication with VCs requires a fair amount of time and money).
* Illustrate that non-funded companies could often be pretty ok: maybe to choose a bit slower pace and, let’s say five times growth instead of ten times growth during the first years?
* Imply that the two successful companies are probably under enormous pressure (because they have to keep the venture capital fund afloat), but at least get a lot of expertise and VC attention in return.
* Imply that the five failing companies in the portfolio maybe just failed and the other three underperformed because they had devoted too much energy for the VC presentations and stuff (instead of doing real work) without getting much in return.
* Lead to the question that if you have a really great venture (like Company 1 or Company 2) then maybe the cost of capital is disproportionately high for you.

In other words, venture capital presents an asymmetric and suboptimal solution for providing the necessary funding for most of the start-ups. It still is a bit theatre and unfortunately not a comedy for the many... What about skipping the VC-layer, and all the fund management fees? In any case, think twice before you choose this route (a reminder for myself for the future :)).

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