VENTURE CAPITAL

5 Best-Kept Secrets About Venture Capital

The most important things you need to know about how venture capital works--demystified.
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After 10 years as a successful entrepreneur, I've recently become a venture capitalist. There's a lot of mystique and confusion around VCs. It turns out, now having been on both sides of the table, most entrepreneurs don't understand how VCs actually work and think.

Once you do, the odds can tilt more to your side. Or at least, you'll find it easier and experience less confusion and friction if you try to raise funding, or work in a venture capital-backed company.

Here are my top 5 secrets I've learned about venture capital:

1. VCs, as individuals, aren't that diversified and don't do very many deals.

It may seem to you like VCs should be taking lots of risk. They do take risk--but it's pretty measured risk. The reason is that while VC firms, as entities, are somewhat diversified, the average VC partner isn't. The average VC partner only invests in one to two new deals a year. So their deals really need to work. It's one reason why it's harder to get VCs to take a risk on you than you might think, and why you need to have 100 percent of your ducks in a row when you pitch.

2. VCs, even as individuals, may end up owning more than you in the aggregate.

VCs often try to own 20 percent of each company they invest in. What can be confusing is what that means to them as individuals. If the firm purchases 20 percent of each company, the VC firm itself doesn't get to keep all of that. They have their own investors. Instead, the VC firm keeps 20 percent of the gains. Twenty percent of twenty percent equals 4 percent effective ownership in your company. That's not a huge amount, but VCs each get to make, say, eight investments per VC fund. That's 32 percent effective ownership of one composite company. That's probably more than you'll end up with.

3. VCs have their own investors and have to make them happy, too.

VCs have investors, too--their Limited Partners, or LPs. The very top VCs don't have to wine-and-dine their LPs. They just pick up checks. But most VCs have to sell up just like you do. In fact, they have to do more of it in some ways, because they probably have to keep 15 to 20 core LPs happy, vs. a founder who just has one to four VCs in his or her company. VCs are very driven to make their own LPs happy, so they can themselves get funded the next time, too.

4. Valuation increases really matter to most VCs, so they want you to go raise a big round.

VCs only make profits on an exit--an IPO or a sale of a portfolio company. But they make money on management fees too, and to get them, they need to raise multiple venture funds. They need to raise another fund. When they go to raise another fund, some and probably even most of their track record is still going to be illiquid, in companies that haven't yet gone public or been acquired.

Those illiquid companies will be valued based on their most recent valuations. If you as a founder raise another round at 2x-3x the price of last one, VCs can tell their own investors, the LPs, how strong the return on this investment has been--even if it's just paper gains. They can sell this when they raise their next venture fund. If there isn't another fund, the venture firm just becomes a zombie.

5. Small VCs align with you, but can lowball you. Big VCs don't align as well, but can pay more.

A smaller VC versus a larger VC is one of the most important decisions you'll make as a founder. The smaller the fund, the more aligned with you they are. But because they can't write the large checks, they need someone else to. And small VCs also need to buy a lot for a small amount. If they can only invest $2 million to $3 million and want to own 15 to 20 percent, that pretty much puts a cap on small VC valuation potential. By contrast, big VCs can write a big check. In fact, they need to. But the return has to be huge to impact the fund. Fire the CEO, fire the founders, dilute you--they don't care. But they'll give you more money to go big. Both have pros and cons. Pick the one that best matches how you want to grow.

IMAGE: Getty Images
Last updated: May 2, 2014

JASON LEMKIN | Columnist | Managing Partner, Storm Ventures

Jason is a managing partner at Storm Ventures. Previously, he served as VP of Web Business Services at Adobe and CEO and co-founder of EchoSign (acquired by Adobe).

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.



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