This is the second part of a two-part series post on startup funding. Read the first part here.
Part 5. How investors get paid when things work & don't work
VCs raise funds from Limited Partners, in a similar way as founders except for a future portfolio of startups that they will curate via the LPs' investment dollars.
The General Partner is the VC, and the Limited Partner is the investor who commits their money into the fund.
So a VC walks into a bar and would say the following...
I've got a dream. It starts with a trend in the market. The trend is emerging, and will change the way we do things. Our investments are going to own the market by riding the trend, and we'll make a lot of money doing it by effectively creating a new categories in these markets. We've invested money before or at least something noteworthy before, and have a strong team that's great at picking winners. We're going to fund and own large parts of a few billion dollar companies and we only need $100m on a 2 & 20 model.
Whats 2 & 20?
2% annually of the total funds raised. That's the salaries for the partners, the office, staff & any expenses in "picking winners". In addition, when the fund returns $200m in profit (you don't take carry on the principal), they will take 20% of the $200m as "carried interest."
People raising their first fund could lower to 1 & 10, but 2 & 20 is typical.
VC returns are power law distributed. 1 in 20 investments will make more money than all the other investments combined.
Pro tip: Don't ask VCs about their returns unless they tell you.
So while you may have an idea for a business that will be worth $50m if things go very well, it's not going to make your VC deliver on their promise to their LPs.
Part 6. Peeling the Onion-Incentives at Investment Stage
Now to break this down a little further. A typical seed-stage VC doesn't care so much about the eventual exit valuation, but more about the next round of the company.
Let me explain...
If I invest $5m in your company, I expect you to raise $15m in < 18 months. How does that work?
You show me a market trend and a plan. I believe in the market, and then want to see if your plan is any good.
This is very difficult to do since the founder has vague plans for the future. But we must figure out how a founder is going to win. One way is to look at the founder's track record. Another way could be to ask specific questions and look for obvious blindspots in the founder's thinking. For example, raising $5m to build a factory that would typically require $50m to make.
Two philosophies at the venture investing stage:
The economics aren't as crazy as you think they are (but yes, for small funds they really really suck)... and there are two philosophies - everyone is focused on unicorns so they swing for the fences, but others (like me) are going for batting averages and camels.
So naturally, I wanted to learn what batting averages and camels strategy looks like, and we got:
I'm going for 100%, I would be super disappointed in myself if it's lower than 67% and I'm psychologically prepared for 50% - not confidential at all :)
Some of the best investors will often look at hiring plans for a company since they are indicative of the founder's ability to attract talent. If a founder cannot attract top-quality talent at the rate of at least once per week to their company, the company will be overtaken by a fast follower.
Pro tip: Having a detailed hiring plan and bench with 20-30 people to be hired immediately after funding can greatly boost the confidence of an investor anxious about execution risk.
Part 7: Alternative - Raising from a large number of operator/angel investors
New trends: Solo investors with a large following e.g. Lenny Ratchitsky
An automatic-yes on the cap table investor like @naval is more desirable early-on than a firm with a legacy like @kleinerperkins. The best founders will add both as they de-risk their business. One for attracting talent, and the other for building a go-to market.
In my experience, the best investors were/are founders. There are exceptions, but the growing trend of founders running rolling funds is nascent but will grow as founder investors have a fresh experience, proprietary deal flow & talent networks compounded by their day job.