The best single line I’ve heard about how venture capital works is from investor Marc Andreesen: “returns are a power-law distribution” with the majority of returns concentrated in a small percentage of companies. That’s true now more than ever, and one of the great promises of the venture capital industry that motivates and drives investors.
It’s vitally important that founders seeking investment understand the venture capital industry, what motivates VCs and how they make investment decisions. The article on Medium by Eric Feng A stats-based look behind the venture capital curtain is de riguer reading for founders planning to raise capital from VCs. Eric Feng is now at Kleiner Perkins. Previously CTO of Flipboard, Founder of Erly, Founding CTO of Hulu, and Microsoft Research alum.
Mr. Feng’s article focus on how the VC industry has changed in the last fifteen years – which is substantially – more money, more investors, more deals, bigger exits!
In the past 15 years, the amount of money invested by US-based VC firms into startups grew more than 4x to almost $85 billion dollars last year. Before 2011, an average of $28 billion was deployed each year but in the past 7 years, that number has jumped to $62 billion invested annually. Not surprisingly the number of deals has seen a corresponding sharp increase. From 2003 to 2010, the industry averaged almost 3,800 investment deals per year. But since 2011, the average number of deals per year has shot up to more than 8,700.
What is the effect of many more funds deploying more capital into more companies? The industry is making over 5,000 more investments each year compared to 15 years ago (with most of those being seed investments). One would think that it must true that any given startup thus has a better chance of raising capital than 15 years ago. However, there’s an unintended consequence of the changes: On average, there are more than 7x the number of billion dollar exits now than a decade ago. 15 years ago venture capital was considered a hits business where the hit had to be a home run to make up for all the strikeouts in an investors portfolio. But now?
“Venture capital is not even a home-run business. It’s a grand-slam business.” Bill Gurley, Benchmark
As a result there is even more pressure on an investor from their fellow partners, their peers and their limited partners to swing for the fences. Now the rule of thumb is that you need to build a company with a minimum of $100 million in yearly revenues, so it would be valued at 10X sales, or a billion dollars, commonly called a unicorn. If you can’t meet this yard stick don’t waste your time chasing VC dollars or pivot to a multi-billion dollar market where you have a markedly better chance to qualify for the grand slam derby.
If you search Eric Feng’s article for the term “profit” you will get zero hits! That’s right in an article about venture capital the word “profit” doesn’t appear even once. If you need more proof that profitability is not a key success factor for startups just look at all the companies now going public or that have gone public recently. They are all losing money with the exception of Zoom! Uber and Lyft are losing billions of dollars.
So founders, pay attention to what VCs pay attention to: top line revenue, revenue growth, growth of your customer base, and stickiness of your customers. You can start worrying about making money after your IPO, what you need to worry about now is growth and the ability to scale.