The Venture Capital Secret
I recently finished reading a really good book called “Zero to One: Notes on Startups, or How to Build the Future” by Peter Thiel. While reading the book, I learnt a lot of interesting things, but there was one thing that stood out to me the most. It was Thiel admitting that there was such a thing as a venture capital secret. Even though, I knew about this secret, I realized a lot of founders did not know about it or if they did, they never kept it in mind when talking to investors. Hopefully after knowing this secret, you can approach Venture Capitalists with a stronger argument of why they should invest in you.
The Secret: “The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined.” For example, if a fund of $10M invests in 10 startups with a ticket of $1M in each, they expect that one or two companies will get them a return on their investment that will be 10X their initial investment. Those two 10X exits will get the fund $20M return (2X their initial fund).The rest of their investments will either have a small exit or be written off.
It is estimated that 90% of startups will fail; some of the failing startups will become good small businesses, others will completely shut down, but there are a few gems that will succeed at an exponential rate. Those few gems are the startups that venture capitalists are looking for, those are the companies that will allow them to make a return on their investment. As a result, whenever a venture capitalist is sitting across from you, just know that in the back of their head they are thinking, “can this company make up for the rest of our fund? Am I talking to a founder of a unicorn startup?” If you truly believe the answer is yes, then you need to make that extremely clear to the investors across from you and convince them to write you a check.
Venture capital firms try their best to de-risk their investments and find the best startups; but this is not an easy task. Most probably, the firm that invests in startups will make so many wrong judgements and within the first few years of their investments, they will be able to recognize the best preforming companies from the worst performing companies. So what do these venture capitalists do? They try to support the best companies as much as possible. It is no use for a venture capitalist to support a failing or a mediocre company, it is just a waste of their time and resources. The average and below average companies will not be able to make the investor a great return on their investment and prove that they are a successful fund. Hence, that is why the better performing companies usually get more attention in a portfolio. VCs know that they are in a tough business and that most of their investments will fail, so they are not trying to help everyone, they are just trying to help the best companies in order to get a return on their investment. In fact, VCs actually prefer seeing their failing companies die quickly.
Founders are usually agitated about this, and they start believing that their investors are bad investors. However, that is not the case, it is just how the game is played. Investors will spend most of their time and focus on the companies that will most probably exit, since those startups are their best chance of succeeding as a fund. They are not bad investors, they are just being smart investors.
Then again, this is a common thought in the startup world. Many of the entrepreneurs that I sit with often complain to me how they had a bad investor come onboard and that all they provided was capital. They eventually go on to tell me that they want a strategic investor moving forward and not just capital. I often agree, but in my mind I know that they are just telling me what I want to hear and that they most likely had a “bad” investors in the past because they are not the high growth company they thought they were. Regardless, I just nod my head.
Now, having a strategic investor that is connected or has experience in your space is super useful, but most investors have that. Some might be more experienced or are more connected than others, but I can promise you that if you are worth the investment, all investors will be supporting you as much as possible. However, keep it in your mind that an investor will try to support you as much as possible when you are doing good, but once you start to show that you won’t be a top 5% company, then you should know that you are on your own moving forward. That is funny because, when a company is doing good, they probably do not need that much support. They actually need the support when they are struggling.
To be fair, there are many VCs that will support all their companies and try their best to see them succeed (it is for the best interest), but what I am trying to say is that they always have favorite companies, and coincidently they are their best performing companies.
I hope what I mentioned in this blog was not very boring and was actually eye opening. But, to summarize, if you were to learn one thing from this blog, I hope it is this: before approaching a VC, ask yourself this, ‘are you building a company that will experience mediocre growth or do you have a company that will experience massive growth. If it is the latter, go talk to VCs, they will be ready to give you a check.
Before you leave I want to leave you with this fun fact: “After all, less than 1% of new businesses started each year in the U.S. receive venture funding, and total VC investment accounts for less than 0.2% of GDP. But the results of those investments disproportionately propel the entire economy. Venture-backed companies create 11% of all private sector jobs. They generate annual revenues equivalent to an astounding 21% of GDP. Indeed, the dozen largest tech companies were all venture-backed. Together those 12 companies are worth more than $2 trillion, more than all other tech companies combined.” Excerpt From: Peter Thiel. “Zero to One: Notes on Startups, or How to Build the Future.”
