Venture Capital: The Black Sheep of Finance

The venture capital space is an interesting one. It’s in an industry that’s worlds apart from its nearest cousin — the leveraged buyout industry, more commonly called the private equity industry (despite this being the umbrella term for VC, LBO, and growth capital).

An Intro to Private Equity

Private equity is, simply speaking, investing in private assets. And private assets are simply that — assets that are not listed on the public exchange. Real estate would fall under this as well (commercial real estate, anyways), but the main instruments of private equity are, in no significant order, venture capital, leveraged buyouts, and growth capital. These instruments are, by their very nature, high risk – high return. On average, they offer returns on an order of magnitude greater than the market, but fail on that same scale as well.

LBO, Growth Capital, VC

Leveraged buyouts (LBO) are what we typically associate with the term private equity. It’s when a PE firm takes on debt to buyout a company, restructure it, and then sell it at a higher price than it was attained. Or, in more derogatory terms, it’s flipping companies. It’s a lot like flipping houses — you take on debt at a set interest rate, to invest in a project with a higher interest rate, so that you augment the return on your capital contribution. Now the ethics of this practice is a story for another time. For now, all we need to know are that because of the risks associated with debt instruments, LBO funds usually exit projects very quickly.

Growth capital is investments made to established enterprises looking to expand. Usually, these are firms that are well established in a given market, looking to expand. This could be anything from an established domestic automaker looking to expand into foreign markets, or even the same firm looking to expand into motorcycle manufacturing. The possibilities are endless. The risks typically associated with these projects are that, like any new venture, it may not go as planned. On the other hand, they have the brand to work with to make the project succeed.

That’s in stark contrast to the final instrument on our list — venture capital. Venture capital funds purely invest in startups and early stage companies. Uber, Airbnb, even Google — all of these companies surfaced out of the blue thanks to venture capital investments. But, as numerous as the successes are in this industry, there are far more failed investments that line their feet. Anecdotally, for every 1 successful startup. there are anywhere between 8 – 9 startups that have failed. VC funds have, compared to the other 2, the longest exit timelines, and the highest risks. But they command some of the highest returns.

Venture Capital: Glamorous, yet Daunting

The thing that gets most people interested in venture capital are their returns. The industry standard expectation return on capital is usually 10x their capital investment. That’s for a typical startup investment project. Most expect 20x, even 30x on their investments.

Before I move on, I should explain a typical startup investment project for a VC fund. The typical startup investment for a VC fund would be:

  • invest in series A round of funding, at a valuation of $25M post money
  • invest in year 2 of operations
  • well on track to meet key milestones of operations
  • a primed acquisition target by a big firm in the space by year 5 of operations

Of course, this varies from fund to fund, but this was what I’ve found, talking with investors in Silicon Valley and abroad. I wrote this for series A venture capital funds, primarily because those are the most famous, elusive firms new graduates want to work for, and the funds where most people involved in VC funding will invest in.

From all this, we can infer that VC funds require, at bare minimum, 10x return within 4 years of investment. That’s an IRR of 78%. That means, every year, your company needs to increase in value by 78% year over year. That’s ridiculous. Unless you’re a VC investor. Then, it makes sense. This is where the daunting part of the subtitle comes into play.

Like I said before, for every 10 investments you make, 8-9 of them will fail. Unless, you’re clairvoyant. In that case, congrats to you and your incredible success. Unfortunately, for the most of us, this won’t be the case. Normalize for all these failures in your calculations, and suddenly, the 10x return minimum suddenly makes a whole lot of sense. You mitigate risk by making sure your successes are ridiculous successes, so that, at the very minimum, you make 10-20% return on your investments as a whole.

Risk Mitigation in Venture Capital

In the world of finance, this is the biggest point of discussion — how do you hedge against risk? Hedge funds, as per their name, specialize in this, mitigating against every risk imaginable, save for a few, extremely rare, overarching ones. Index funds hedge against risk by investing in the same ratio to a given market index, hoping the index itself is diversified enough to power through turmoil. LBO funds mitigate risk by reducing time to exit, so as to minimize market risk exposure.

But what about VC? With minimum time to exit at 5 years (on average), it’s impossible to minimize market risk exposure. And, with no historical data to go off of (let’s be honest, these companies are looking to create new industries), there’s no diversification like in hedge funds.

The truth is, it’s a numbers game. You make educated guesses, based on the best market data you can get, to predict what the world will look like in the future. Based on these educated guesses on the future, you make investments that align with that view. And you hope for the best. You justify your investments based on the market data.

Unfortunately, that’s the truth to this Venture Capital. It’s much more an art than it is science. There’s no formula that can accurately model potential returns and risks associated with a project. They have the IRR formula, sure, but that formula works better in an LBO situation.

That’s because IRR requires you work backwards from a net present value (NPV). This means you need to work out future cash flows. In an LBO project, this is relatively easy, because you’re working with established businesses, with market data, and real world examples to work with. In VC, that’s not the case. It’s really difficult to forecast future performance of a project, except by gut feeling.

Venture Capital Perceptions

Venture capital is considered by many, especially in today’s world, as a very glamorous industry, filled with some of the greatest minds in finance. It’s seen as the new frontier of finance, as a new science, that’s guaranteed to make a sweet return.

Let me say this right off: none of that is true. VC, and all other forms of finance, is not glamorous. It’s very much a winner takes all game. Every bet placed on a company must be taken as if it were the one to make or break the fund. There is no such thing as a whimsical investment.

At the same time, it is highly rewarding. You get to work with people who are looking to change the world — to bring humankind to new frontiers. These are the people who envision Mars colonies by the end of the next decade; the people who are looking to forever make obsolete fossil fuels; the people who are looking to make death a thing of the past. Regardless of how ridiculous their ideas sound, they’re driven. And you feel their passion.

This is why you should be doing venture capital. Because you want to find the next big thing, to help allocate the resources to the people who are going to change the world for the better. Not because you’re in it for the money; not because you dream of owning a Mediterranean beach front property; but because you feed off the energy that drives these people.

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