Successful companies require 3 ingredients: the right idea at the right time with the right team. While the first two ingredients are no doubt important, in order to achieve any level of success, it requires a great team with a common goal.
Most tech startups look to raise investment capital to finance their product development, go-to-market, and to scale growth. As you may have read in many technology-focused publications, building a large, enterprise technology company usually requires in the tens to hundreds of millions to billions of dollars in investment capital. And for every round of investment dollars raised, a company adds another team member. A board member. Their new venture investor.
Adding the right venture investor to your company’s board can be immensely valuable. The right investor can make all the difference when it comes to:
- Recruiting the best team
- Getting access to customers
- Honing your go-to-market strategy
- Helping your company achieve a great outcome
It’s important to remember that venture capital firms are also businesses just like the companies they invest in. While venture capitalists do want to help your company be successful, they’re really in the business of raising more venture funds.
Venture firms are driven to build the most oversubscribed venture fund and make a lot of money doing it. However, a venture fund’s business model is quite different from traditional businesses. If you learn how venture investors make money, you'll understand what motivates the decisions they'll make while working with your company.
How VCs make money: a breakdown
Venture capitalists make money in 2 ways: carried interest on their fund’s return and a fee for managing a fund’s capital. If all goes well, your company is going to experience a liquidity event in the form of an M&A transaction or an IPO. At the point of your company’s liquidity, investors are paid their equity portion of the company’s proceeds (cash, stock, etc.).
Investors invest in your company believing (hoping) that the liquidity event will be large enough to return a significant portion: all of or in excess of their original investment fund. Once an investor has returned their investor’s capital, they begin to earn carried interest on the returns in excess of their fund size.
Carried interest is the most lucrative way a venture investor makes money. Traditionally, venture investors earn 20% carried interest on their fund. That means if a fund’s size is $100mm, venture investors earn $0.20 on every dollar earned over $100mm. So if a venture fund can return $300mm on their $100mm fund, they will earn $40mm in carried interest (($300mm return - $100mm original investment) * 20% = $40mm).
The second way venture investors make money is from a management fee. A venture fund is a pool of capital invested by high net worth individuals, fund of funds, endowments, retirement funds, etc. These investors in a venture fund are known as Limited Partners or LPs. When a venture fund raises capital, it charges its LPs a fee for having venture investors invest and manage investments in startups.
Traditionally venture funds will charge their investors 2% per year of the total value of a fund. Using the previous example of a $100mm fund, the venture firm will earn $2mm per year to pay salaries and other operational expenses of the fund ($100mm * 20% = $2mm per year).
Management fees become more lucrative to venture investors when a venture firm manages multiple funds simultaneously. Typically venture firms try to raise a new fund every 2 to 3 years with the lifespan of a fund being 7 - 10 years. Oftentimes, you’ll see in tech publications that “Great VC” has just closed its new $100mm fund called “Great VC II”.
This means that Great VC has raised its second fund and is likely still managing its first fund: Great VC I and now Great VC II. Let’s assume that Great VC has two active funds at $100mm each. Assuming the same 2% fee, Great VC is making $4mm per year in fees for managing two $100mm funds (2 funds * $100mm * 2% = $4mm).
Picking your investor strategically
All venture investors’ actions relate to one prevailing goal: how do you help me raise my next fund? As demonstrated above, an actively managed fund creates a steady income stream for venture investors. If investors can layer multiple active funds on top of one another, the income stream becomes even more lucrative.
In order to accomplish a successful fundraise, venture investors need to show traction. Traction in the business of venture capital comes in the form of liquid capital returns in excess of the size of their fund, or more likely, the perception of liquid returns that have the potential to return their fund many times over.
As an entrepreneur raising capital, you need to be as strategic as possible when adding an investor to your team. Never forget: size matters. The size of the fund your investment is coming from. The size of the investment you’re asking for. The size of the valuation you’d like to get for that investment. All of these data points will indicate an investor’s actions.
For those raising their first round of capital, taking money from a large fund could pose potential optionality problems if a lucrative sale opportunity arises early in the lifecycle of your company. Typically investors will include a blocking right in your investment agreement that gives them the ability to say yes or no to a sale or even a future fundraise for your company.
As an example, let’s stick with our Great VC investors and say that they led your seed round for $1mm at a $5mm post-money valuation. Otherwise put, they purchased 20% of your company for $1mm.
In this example, the founders and team own 80% of the company’s equity (which includes any employee stock options and option pool). Over the course of the first 12 - 18 months building your company, a potential acquirer comes along to buy it for $30mm. That would mean, if sold, the investor would earn $6mm (20% * $30mm = $6mm) and the founders and team would earn $24mm (80% * $30mm = $24mm).
That’s a life changing amount of money for the founders and a good return on stock options for employees. However to Great VC, who has to return a $100mm fund, $6mm return from one of their investments only gets them 6% of the way to returning their fund. If you, the founders, decide to take the money off the table and sell your company, the investor has to make a decision on either going along with the sale of the company or convincing you to forego the sale and continue building your company into an asset of greater value.
To sell your company or to continue raising? That is the question
Rather than selling, Great VC would likely prefer your company raises its next round of financing. They may tell you that this offer is an indicator of having the right tech at the right time and we are on our way to a $1B exit. That logic could totally be true. There is no way of knowing unless you try. But my point is to make sure you’re aware of why the venture investor may be telling you to go long with your company.
A $6mm return on a $30mm exit only gets their fund 6% of the way to being returned ($6mm / $100mm = 6%). If you instead raised a $6mm Series A at a $30mm post-money valuation, the investor gets to go back to their LPs and show how their investment has created a 5x uptick in value over 12 -18 months (($30mm - $5mm) / $5mm = 5x). That kind of uptick becomes investor deck material for their LPs.
Your company has become an indicator of a positive investment they’ve made tracking to potentially offer a massive return for the fund. Great VC might then suggest to their LPs “How about writing us another check for Great VC Fund III so you can continue getting access to these types of deals?” The suggestion to contribute to another fund is also known as the ABC’s of venture capital: Always Be Closing your next fund.
Understanding how the money is made
The point of this piece isn’t to say venture investors are bad. Rather, a good investor with the right motives and alignment with your company can be extremely helpful. Just make sure you’re cognizant that venture investors are running a business like you.
If you’re raising venture investment, it’s important that you, the entrepreneur, are educated on the business of venture capital. The more you understand about the motives driving your investor, the better prepared you’ll be to handle the inevitable conversations that will arise on your journey of building a successful company.