VCs invest in startups with the aim to make outsized returns on a few investments. Learn how the Venture Capital business model creates high expectations for your startup.
Startups are a special type of new company. They're different because of how they're funded and the growth expectations that come along with that funding.
There are three ways for a new company to fund itself - revenue, debt, and equity. Many will pursue a combination of all three over time.
With revenue and debt funding, founders retain full ownership of the company. They typically choose to grow the company at a slower pace which reduces the likelihood that the company will run out of cash.
By contrast, startups are equity funded - founders sell part ownership to venture capitalists. The new part-owners typically emphasize faster growth. It's a model that increases the probability the startup becomes really big, really quickly but it also comes with an increased likelihood that the startup runs out of cash. Startups typically grow faster than can be funded by revenue or debt alone.
The way to avoid running out of cash is to raise more money from venture capitalists. It's this need for cash that gives rise to the Pre-Seed, Seed, Series A, Series B, and so-on dynamic - it's the repeated raising of new money from venture capitalists.
Venture capitalists are companies themselves. Specifically, they're funds with fund managers and investors.
There are many ways to structure a venture capital fund. The simplest is a single closed-end fund.
A sponsor is someone who helps the venture capital fund get off the ground. Just like how a startup sells a portion of itself to a venture capitalist, a venture capitalist can sell a portion of itself to a sponsor.
The fund managers themselves are known as general partners (GPs). They're typically the same people that run the management company. The differences between the two typically aren't relevant to the startups they invest in.
Each one of the boxes on the page is technically a separate company. When we say "venture capitalist," we typically mean the combination of the management company, general partner, and fund. Most venture capitalists have only one management company and one general partner but will launch many funds over time.
Investors - also known as limited partners - invest in the fund. The fund, at the general partner's direction, then invests in startups. Most venture capital funds are closed-end - they raise money from investors once at the launch of the fund and then return money to investors as the startups get acquired or go public.
You can learn more about acquisitions and other liquidity events here.
The goal of any venture capital fund is to return more money to the investors than they originally put in. Most funds target about a 10-year life - they anticipate returning money to investors over 10 years. The math on how venture capital generates returns helps illuminate why they emphasize rapid growth for startups.
Let's assume that an investor invests into the fund on Day 1 and whatever proceeds the fund generates from successful investments are returned to the investor after 10 years. This is a bit simpler than reality but it makes the math easier to understand.
The public stock market returns ~7% a year on average and investors can get their money back anytime they request it. Because venture capitalists lock up investor money, they have to generate an even bigger return to compensate investors. Let's assume that the venture capitalists have to provide an additional 3% annual return as compensation for a total of 10%..
A startup that grows at 7% a year for 10 years will double (2x) in value. A startup that grows at 10% a year will be 2.5x more valuable after 10 years. So at a minimum, venture capitalists need their startups to increase by 2.5x in value over 10 years.
But that doesn't account for the venture capitalist fees or the startups that fail. To get back to a minimum 2.5x return for investors, we have to add those onto the growth rates for the startups that survive.
The most common fee structure for venture capitalists is 2-and-20: an annual management fee of 2% of investor money under management and 20% of all fund proceeds from when the startups get acquired or go public.
Adding on the 2% annual fee to the required rate of return (now 12% a year) means that the startup needs to triple in value. Adding in the 20% performance fee means that the startups need to quadruple in value, a growth rate of 15% a year.
But not all the startups the fund backs will be successful, some will fail. Let's assume half of the startups fail. To compensate for the failed startups, the remaining startups need to grow by 24% a year, almost a 9x increase in value over the 10 years.
It's this math that drives why venture capitalists crave growth. To generate a rate of return for investors in excess of what's available in the stock market and compensate them for locking up their money, an average venture capitalist needs their portfolio companies to aim for at least 900% growth in just 10 years.
If the fund has a longer time horizon than 10 years - for instance, if they're funding just someone with an idea - the companies will need to grow even more. If more of the startups will likely go bankrupt, the same thing. Later stage venture capitalists do the reverse - shorter time horizons and fewer startups failing. They typically don't need startups to grow as much to generate the same returns for investors.
Different investors like different types of fund dynamics. Some are more comfortable with funds that focus on super early-stage startups knowing that a couple will need to make it big to generate an attractive return. Other investors are more comfortable focusing on later-stage startups - lower growth rates and lower risk.
This dynamic is why different venture capital funds focus on different stage companies.
The nature of funding rounds changes over time. As venture capital has become a bigger industry, the amount of money raised at each stage has generally increased. That said, it waxes and wanes over time with macroeconomic conditions.
Pre-seed is the earliest stage of funding. It's appropriate for when a startup may not be more than a couple of founders and an idea. Typical round sizes are around $500,000 and often come from family and friends. Startups that don't need as much capital to get going and founders that may already have significant capital often skip the pre-seed stage and fund the startup expenses themselves.
A Seed round is the first "official" funding round that will likely involve outside investors other than family and friends. At this point, most startups have built some sort of minimum viable product and have proof that users will use the product. More mature seed-stage startups will have paying customers. Typical seed rounds are $1 to $4 million.
Angel investors are professional startup investors that typically invest at the seed stage. Professional is a loose term here as it includes both successful former founders looking to fund the next big startup and formal venture capital firms that focus on seed stage startups.
A Series A is a milestone for a startup. Venture capitalists generally expect that the startup has achieved initial product-market fit and that there are happy, paying customers. The focus begins to shift from proving that an idea might work to growing a company that has a proven idea.
Series A rounds vary significantly in size. A venture capitalist's goal is to provide the appropriate amount of capital - enough that the company can fuel the next stage of growth, but not so much that the startup has to grow so fast that it's likely to fail. It's as much art as it is a science to get the right amount right and is part of the skillset successful venture capitalists bring to the table.
Series B and later rounds (each one gets the subsequent letter in the alphabet) keep providing more fuel to the fire. The goal continues to be to help the startup grow - enough but not too much capital. That'll typically mean 18-24 months of "runway" - enough money to grow the company for the next 1.5 - 2.0 years. After that, the startup will likely need to raise more capital.
The hope for everyone involved - founders, employees, and investors - is that the startup grows steadily over time and increases in value. That usually, but not always, works out.
Like providing the appropriate amount of capital, valuation is a combination of art and science. There's more art valuing early stage startups and more science with later stages.
Later-stage startups are valued based on a combination of how quickly they're growing revenue, how rapidly they burn through cash reserves, and how big the addressable market is. When macroeconomic conditions are favorable, startups tend to be valued more highly relative to their maturity. In harder times, the same startups raise at lower valuations.
With each round, existing owners - founders, employees, and investors - are diluted. Diluted means they may own the same number of shares, but each share represents a smaller piece of the total company. The company quite literally creates new shares to sell to new investors. It's like owning the same-sized pie slice, but the pie keeps getting bigger.
When startups are successful, the value of the startup increases with each funding round. It means that the per-share price increases with each raise. The goal is to increase the valuation more than enough to offset the dilution. 20% dilution per round is typical, although the amount usually decreases for companies valued in the many billions of dollars.
If a startup isn't as successful as expected and is still able to raise money, it'll usually take a down round. A down round is when the per share price decreases in between funding rounds. To raise the same amount of money it originally intended, the startup has to sell more shares. That can create significant dilution for existing shareholders - the pie gets a lot bigger a lot faster, but your pie slice keeps staying the same size.
Working through an example can help illustrate the difference. Let's assume you own 5% of a startup worth $10 million. The per-share value is $100 so you own 5,000 shares of the total 100,000 shares. Your 5% stakeis worth $500,000.
Employees generally receive common equity that doesn't have protections from events like down rounds. Investors typically negotiate for preferred equity that includes protections for various negative outcomes.
The possible list of protections is practically infinite - if an investor can think it up and a lawyer can get it into a contract, it can exist. That said, most startups and venture capitalists limit protections to just the most common, including liquidation preferences and anti-dilution.
A liquidation preference guarantees an investor a minimum return before anyone else gets paid when a liquidity event happens, like an acquisition or a public company. Most preferred equity includes a 1x liquidation preference - at a minimum, investors get their money back before anyone else shares in the proceeds.
When funding environments are more difficult - like during a down round - liquidation preferences can increase to 2x or more.
Anti-dilution focuses instead on downside protection - ensuring an investor retains their percent ownership in the event of a down round. Many preferreds include broad-based anti-dilution protections, a way to calculate dilution that does not compensate investors when the startup issues employees additional common equity.
Like with liquidation preferences, there are more investor-friendly versions of anti-dilution. Narrow-based does compensate investors if new common equity is granted. At the extreme is a full ratchet, a guarantee that an investor will be granted - for free - additional shares to offset all dilution.
Protections are ultimately a zero-sum game among new investors, existing investors, and employees. Startups try to avoid the most onerous protections - like full ratchets - because of the outsized negative impact it can have on all other shareholders. Because protections typically stack, meaning the protections granted to more recent investors take priority over the early investors, employees holding common equity without any rights bear the brunt of the zero-sum outcomes.
In a successful event - when the company sells for a much higher valuation than it raised or goes public - all investors typically receive the full value of their shares.
If the startup is less successful - and especially if there are many rounds of funding and each set of investors is granted liquidation preferences - there can be a long line of investors that have to get paid before any of the founders or employees see any proceeds. Sometimes this means that employees, founders, and early investors receive nothing even if the startup is acquired.
Without insider knowledge, it's difficult to know what threshold exit valuation is necessary to make the liquidity event a success for everyone.