When venture capital rains down, the smallest seed of an idea can become a beanstalk to the sky.
They talk about burn rate and clawback and deal flow and exit velocity. They work in nondescript buildings, undersized companies of 10 to 20, yet capable of generating oversized swaths of capital. They have vast monied networks, yet their clients are often unsung entrepreneurs who’ve yet to see 30.
They are venture capitalists, and we’d like to think they’re not as cool as all that — it’s just investing, after all — but we’d likely be wrong. If the financial industry was set in the Old West, the venture capitalists would not be the ones mining for gold, they’d be alchemists making what’s transformable into gold before anyone else gets wind of it.
A ride-sharing service called Uber? Uber? Who shares rides? In strangers’ cars? Ten billion in VC dollars bet that we all would, and did and do. (And the other guy, Lyft, got $500 million.) Let’s ride!
A company that prompts us to vacation in each other’s houses, apartments and condos? An air bed and breakfast? What does that even mean? To VC it means $280 million cash money, and who needs a hotel?
Oh, and Facebook. And Google. And Twitter. And Zoom. And you start to get the picture that venture capital, small though it is, might just as well be Atom Ant. In fact, according to a survey of the VC industry, even as far back as 2015, U.S. public companies that had received venture capital backing accounted for 20% of public market capitalization and 44% of public R&D spending. And almost every drop of that fast-flowing river of investment was poured into these beautiful little puddles of innovation called startups.
Hand, meet glove.
A “startup” has many definitions, but in the VC world it’s thought of as an entrepreneurial venture, typically a newly emerged, fast growing (or potentially so) business with the goal of meeting a marketplace need by developing an innovative product, process or service. Think Bill Gates tinkering away on his little Microsoft project in his garage, or young Steve Jobs biting into a fresh Apple.
Usually associated with Silicon Valley and the dot-com bubble which burst expensively in the late 1990s, modern startups have recently slipped the surly bonds of Palo Alto, Cupertino and Mountain View and spread to “tech hubs” literally all over the world from Austin to Berlin to Helsinki. But you can bet a bitcoin that no matter where they are, venture capitalists are peering over their shoulders. Truly, there are many symbiotic relationships in nature — elephant and tick bird, for instance — but none more joined at the hip than the startup and venture capital.
What makes it work? Pretty simple, really. VCs have money and know a good idea when they see one; startups have good ideas but need someone with money to help bring them to life. How’s that for symbiotic?
Obviously, not every startup is going to be an Apple. In fact, for every deal sheet that a VC firm may write to help a startup grow from puddle to ocean, there have been a hundred who didn’t make the cut. Of that hundred, only 30 or so even managed to get a meeting with firm management, 10 got to sit down with a partner-decision maker and half of those were put through a due-diligence search. In the end, statistically, only one caught a glimpse of the glory.
So, with such a smorgasbord of potential gold mines out there for our alchemists to turn into the next Google, how do VCs choose? With more cool jargon for starters. “The jockey or the horse,” according to Harbert finance professor Mo Shen. “The entrepreneurial leadership team of the startup is called the jockey, the business model itself is called the horse. And both are important.”
One of the superstars of the VC world, Peter Thiel, was quoted as saying “We live and die by our founders.”
But long before deal sheets get proffered, members of a VC firm spend untold hours sourcing, working their contacts, looking for deal flow. They cast a wide net, haul in potential keepers, winnow down the startups they deem worthy to put through due diligence — the financial version of a full body search — and come out the other side with one next big fish.
Which all sounds groovy, but what about the rigorous financial evaluations that banks are required to establish before investing? What about DCF, IRR or NPV? (OK, if we must: Discounted Cash Flow, Internal Rate of Return or Net Present Value.) Well, it seems that VCs are much less interested in those gold standards of MBA textbooks than we might assume. Some don’t even forecast company financials at all.
Here’s why: What truly drives return on investment for VC firms is the exit. Whether an M&A or an IPO, in the VC world it’s cashing out that matters. And firms often have to wait five to seven years, or even longer, before their judicious choices begin to pay off. Most yield hardly anything at all. But when they get it right, when all’s worked as it should, those singular deals can yield huge multiples of what was originally invested. And that’s when the champagne flows.
Of course, getting it right’s the tough part, and after the handshake and the ink’s dried, the VC firm begins wearing a lot of different hats to keep their newest portfolio star firing on all cylinders. They become actively involved in advising the company as it grows — often the most time-consuming and important value-add for a VC. They can help the company pull in other investors, find and hire board members, even introduce the company to major new customers.
Then, of course, there’s the money in the form of series investment. Most VCs don’t get involved in seed round investments, those that help startups take initial wing, get off the ground and see whether they can fly. It’s only when a startup shows traction, has a limited but growing customer base, and shows marketability and good choices from leadership that VCs pick up the ball.
“Series A” funding from the VC can help a startup solidify its development stage, build marketing capabilities, refine product offerings, fill leadership gaps or whatever the company may require to maintain growth. Series A funding for 2020 averaged north of $15 million, and can lead to other investors, even other VC firms, putting money into the venture.
“Series B” funding usually happens after a company has proven that it’s ready to scale up and can include business development, tech support, recruiting more and more experienced employees, sales and advertising. All of which is costlier. The average Series B round for 2020 was north of $30 million.
“Series C” (and beyond) funding rounds are usually reserved for companies that are successful and looking to expand into new markets with new products or even to acquire other companies.
And the more successful the VC firm is at shepherding the company leadership team along and injecting cash at the right moments for the right reasons, the more likely a company will grow, succeed and eventually pay off well for the VC’s original investment.
For all the positives around venture capital and its very successful track record over the past 30 years, the negative comes in the tried-and-true form of exclusivity and lack of diversity. It’s the men in nondescript buildings because roughly 95% of venture capitalists are white and male, as are their networks from which a full third of VC deals are born. This can make it difficult to break in, although strides are being made, especially among women, and to a lesser degree diverse populations. There are glimpses on the horizon of pioneers pushing against that old status quo in hopes substantial progress will be made.
Finally, as of this writing, we can at least hope the COVID-19 pandemic is in its waning moments, and perhaps it’s informative to take stock of VC during and after the pandemic. In short, venture capital shrugged it off. In the year of the pandemic, VC had its second biggest year in history, according to EY’s analysis of Crunchbase data, deploying over $141 billion in investments. VC firms have also come out of the dark times with clues about several sectors, making for easier deal sourcing post-COVID:
Healthcare, where many startups got an unexpected push, especially those focused on remote care and patient management. Fintech is another area where VCs will reap profits as more businesses turn to digitalization and mobile banking. Hybrid work is a field where great innovation and lessons learned walked hand in hand, and startups building remote collaboration and productivity software will certainly garner lots of attention.
So, if COVID didn’t put a dent in venture capital’s bull run, what will? Nothing for the foreseeable future. There is so much money available for investing at this point in history that financial entrepreneurs are inventing new vehicles like NFTs in order to have some place to put it all.
But one thing’s pretty certain. The one-two punch of VC and entrepreneurial startups will continue to provide more men (and hopefully women) in nondescript buildings with opportunities to create venture capital alchemy out of which will spring companies charged with no less than changing the very future.
