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How VC works

“[A] growing number of venture capital teams have recognised investment opportunities, driven by large underserved African markets, the ability of entrepreneurs to design innovative business models that leverage the high penetration of mobile technology, a lack of legacy infrastructure and increasing spending power.” – Maurizio Caio, Founder and Managing Partner of TLcom Capital

While the above places the African continent in a VC context, for the startup founder seeking funding, we should go deeper on the inner workings of venture capital. While it’s important to have a great pitch, and a solid data room, it’s just as critical to understand what drives VCs and why they’re focussed on this high-risk asset class: early-stage startups like yours. 

At the top of the pyramid, venture capital firms have fund managers, known as Limited Partners (LPs), with an option to invest. The pools of capital defined as LPs include pension funds, corporations, wealthy individuals, etc. Their role is to ensure at the very least that these pools of capital grow in line with inflation, to avoid purchasing power from shrinking. 

If the VC firm or its managers, the General Partners (GPs), invests in a startup at the earliest stage there’s a decent chance that the individual company fails and the VC loses its investment. At the same time, if that company succeeds, the venture firm could stand to see a huge exit with an outsized return. 

Investing at a much later stage could mean that there’s less risk. The company already has a product, product-market fit, and many of the hard problems have been solved. There’s less risk, but there’s also less chance of making a 10x or 100x return.

The reason fund managers invest in venture capital firms is simple: it gives them a diverse portfolio for relatively little effort. The high risk is spread out across a number of startups. Instead of putting $100M into one company that may fail, venture capital is, in effect, spreading its bets across a number of startups, putting $5M into 20 startups, for example. Even if 90% of the startups fail, the two that are left standing should more than cover the cost of investing in the ventures that went nowhere. The outsized returns only early-stage companies offer are what generate huge profits for VC firms and their LPs alike.

For this reason, VCs are looking to “return the fund”: if it’s a $30M investment, they’re looking for an exit that is worth $30M or more. Realistically venture capital firms have costs as well (typically 2% of revenue), and the VCs only really start making money (called the “carry” of the fund) when they have taken their 2% cut and returned the rest to their LPs. 

In other words, a $30M fund doesn’t really start making money for the VCs unless it is able to return the $30M for the LPs plus 2% per year that the fund is running. For a 10-year journey to scale and exit, that means $6M of management fees over 10 years. In addition, the firm will need to beat inflation to turn a profit for its LPs.

The way that VC makes its money is not actually the 2% per year management fees charged to the LP, but the roughly 20% “carry” or carried interest that most funds get. The carry works as follows: once the LPs have their money back, the venture fund takes a 20% cut of any profit beyond that threshold. 

In a cycle of over 10 years, with 5% average inflation and 2% of management fees. The opportunity cost to the LPs is almost $60M on the imagined $30M fund. So, for a 10-year investment period — the standard fund lifecycle — to make any sense at all, a VC firm needs to turn $30M into at least $60M. 

The benchmark against which your company will be graded by a VC is very high. For a venture investment in your company to make sense, ask yourself the following: “could the investment the VC firm is about to make in my company potentially return its entire fund?” 

Or, put differently: if you are about to take a $1M investment at a $10M valuation, giving the investor 10% of your company, you would need to have a good chance at exiting your company at a $600M valuation or more, since you need to return a $30M fund. And that is before the investor has exercised any of their pro-rata rights, which allow an investor to maintain their initial level of ownership percentage during later financing rounds. 

What all of this means is that a 3x or 4x return might be rewarding for the founder, and perhaps for your early angel investors. The VC industry, however, is looking for much higher potential. 

If everything goes perfectly to plan – your company gets everything right and sees a huge tailwind, where everything goes better than imagined – and you’re still not able to get the VCs to the returns they need, you may be knocking on the wrong door.

You may be selling something that doesn’t work within the VC model, or you may not be selling it correctly, all of which point to your company not being a good VC investment case. 

Far from discouraging founders, we encourage you to think big, and the numbers in your financial projections must back up the potential for a significant financial reward for everyone around the table.