The Startup Maths
The Venture Capital maths means that VCs need to invest in outliers. However- how do you become an outlier, or find one?
Venture capitalism is not for the faint of heart. It's a game of extreme outliers, a journey to find a unicorn among a herd of horses.
To understand how start-up funding works, let's first understand how money works. When an investor is looking to invest their money, the first thing they are thinking about is not start-ups. They are likely thinking about something much more safer, such as gold, which has thousands of years of history behind it, real-estate, which is limited in supply, or, public market stocks, which are income-producing assets and companies which have been around for a very long time. Start-up investment is actually a very new concept and does not usually make for more than 5 to 10 percent of a portfolio.
Venture Capitalists, or VCs, are entrepreneurs, just like any startup founders.
The founders of the VC firm are called General Partners (GP). And the investors in their fund are called Limited Partners (LPs). LPs are usually institutions, corporates or even wealthy individuals, who don’t have the time or the inclination to find companies to invest in. Instead they would give the money to GPs to grow that money. In return - the GPs take a management fee (usually 2%), and a percentage of positive winnings from investments (usually 20%).
When VCs are raising their funds, LPs want to know what sort of returns the VCs are targeting. Most VCs are targeting 3x - 5x (few hit that ambitious target). How do VCs get to 3x or 5x? It's not by investing in a lot of businesses that return 5X. VC is a power law business, which means it's a business of outliers.
Rule of thumb might be 1/3 of a firm's portfolio will go to zero, 1/3 will break even, and 1/3 will generate the returns. The distribution is actually much starker than that. 6% of venture investments generate 60% of all venture returns. This has a number of implications for VC firm strategy.
Take a $100M fund that is targeting a 5x return to LPs, i.e. $500M.
First, the firm probably won't invest $100M. They have fees & expenses for 10-15 years that come off the top. The firm might invest closer to $80M. Thus, hitting 5x requires 6.25x of capital invested.
Now, consider the power law distribution. If 1/3 of investments need to carry the whole portfolio, we're actually talking about $26.4M ($80m multiplied by 1/3rd) of invested capital needing to generate $500M in returns, or an 18.9X ROI.
It gets worse though. If you break that top 1/3rd down further, you’ll notice that it’s really the top 6% of the portfolio that needs to carry the fund's returns. So we're relying on $5m of the original $100m to generate $500m in total returns to LPs, or a 100x ROI!
What does this all mean? It means that no matter what kind of criteria a VC is looking for - it will have to rely on extreme outliers to carry the entire fund.
And if you are a startup? You will have to be the company that can get to a 100x return.
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How to be an Outlier
Let’s not sugarcoat it - you will either have to be an extreme outlier, if you are a startup founder, or find extreme outliers if you are a VC. And both of that is very, very rare.
You might think most investments are done through ticking some boxes: a well-rounded team, check; a good product, check; good customer demand; check. But all of these things does not really make them remarkable or special, right?
Your restaurant or laundry business might make money, be healthy and growing - and 20% profit per year all sounds excellent from everything you have learned in your university - but your business has to have a path to 100x the money. This is what people mean when they say something is not venture back-able.
Inversely - most of the large venture successes have had serious flaws. A business like Pathao was very unregulated when we got started - whoever wrote the Motor Vehicle Ordinance Act of 1987 did not think that a motorbike can be used for commercial purposes - and police would very regularly stop and harass our drivers.
We can go through examples after examples - AirBnB, Uber, Coinbase, all had deep regulatory weaknesses, but emerged to produce the strongest returns because they were able to create their own market. The strength of Pathao was that we created our own market even in the face of regulatory challenges.
The number back it up - VCs must invest in extreme strength - and if you are a startup, then you must have an extreme strength.