Businesses funded by venture capital represent less than 1% of all businesses in the United States. Yet, if you go to any publication or social media platform, you’ll hear so much about fundraising.  

The truth is, for most, you never have to raise money and you’ll still have a really big impact on the world. However, it's still important to understand how venture capital funding works.

How Venture Capital Works

The ability to understand how venture capital works is important, but it’s complicated in its entirety. I’m going to do my best to simplify how venture capital works and take it mostly from the venture capitalists perspective. The venture capitalists being the investors that select which startups to invest in.

The graphic below does a great job of explaining the basic flow of money between the 4 main stakeholders in the venture capital industry: entrepreneurs, venture capital investors, investment bankers, and private investors. For clarity’s sake, private investors are also known limited partners or LPs who invest into venture capital funds.

In this graphic, you can see the simple flow of money between all of the different stakeholders. The main concepts to take out of this graphic is that VC funds receive their funding from two main sources: private investors or LPs and investment bankers that operate in the public markets.

LPs are similar to angel investors and investment bankers are the people you would think of when you think of Wall St. Both are looking for venture capitalists to make money back from startups through exits of some sort. Typically through acquisitions or an IPO.

This is why VCs are so incentivized to have exits and IPOs - it allows them to return funds to the people that funded them and continue working as investors. If VCs don’t return money to the people that funded them, well, they’re out of a job and there’s a good chance that they're starting a new type of career.

Let’s now talk about how returns are gathered and how much return is needed for VCs to be successful.

What returns are needed for a venture capitalist to be successful?

The very basic number is that for a seed/early stage fund, they need to have tripled or quadrupled the fund size. So, for example, if a VC has a $50 million dollar fund, they have to invest that and return anywhere between $150-$200 million dollars to be successful. Typically, that’s over a 10 year period. Almost all funds have a 10 year lifespan.

To receive that $150-$200 million dollars, typically it’s only a few companies that return the majority of that money. So, if the investor invests in 50 companies, only 3 of them will give them a significant return. Half or more of the ventures won’t return anything and just go bankrupt while a few others will give a little back. Maybe double or triple the original investment.

According to Horsley Bridge, an LP in of a16z’s funds, who are some of the best investors in the world, here’s the breakdown of the return of one of their past funds between 1985-2014:

• 6% of the deals produced 60% of returns
• Half of the investments lost money
• Out of 10 companies, only 2 are returning 7x or greater.
  

To show you more explicitly, let’s continue with the idea of having a $50 million fund.

Let’s say we follow the same ratios as this fund did. Here’s what the breakdown would be if we invested $2.5 million in each of those companies:

This venture math would only return 2.4x a return on the fund which for a seed fund isn’t great. Ideally, we’d like to get to at least 3x of a return. The ratio of exits we used is probably for a little later stage of a fund than the typical seed state fund, so a 2.4x return on the fund isn’t necessarily bad.

You can see in this example what the value of having 10x returns is. In just one investment, it returns the fund and the risk portfolio of this fund is significantly upgraded.

The ability to have one single investment return the fund is a high value proposition which it’s why its a good rule of thumb when it comes to approaching the right investors for your startup if you are considering venture capital - do you think your startup can potentially return the entire fund of your investor based on their small investment in your startup?

With all of these returns in mind - we also need to keep in mind that timing is crucial. If this return all comes 20 years later, it’s not as valuable if it came at year 10 instead.

The sooner the return of capital invested, the better.

As Doug Ludlow, the CEO of MainSteet.com puts it, VC funding is like rocket fuel. It wants you to accelerate your venture and shoot to the moon. If the rocket doesn’t react well with the rocket fuel though, the rocket (your startup) will explode and shut down.

VCs want to move as fast as possible and shoot for the moon. The way the traditional venture math works creates this dynamic which causes some companies that would be wonderful ventures without venture capital to eventually shut down because they are not on the growth trajectory that is acceptable to VCs.

It’s better for a VC to cut losses early rather than continuing to invest in a company that isn’t growing fast enough.

It’s why if you are considering raising money from venture capitalists, you should be very careful.

Why Venture Capital get so much love and why it’s wrong

If you ever read news in the business section of a publication or even just go on the internet to learn more about what is happening in the startup world, you’ll commonly see one particular common thread: fundraise announcements.

You can go on Twitter, Techcrunch, or spend time at any entrepreneurship support organization and you’ll consistently hear about fundraises like they’re a finish line.

The thing is that they’re not a finish line or a marker of success. They’re really a starting line. They’re the beginning of a venture or a new era of that venture. These fundraising announcements are by no means a finish line or a measure of success.  

According to Harvard Business School lecturer, Shikhar Ghosh, over 75% of venture capital backed startups never return cash to investors. This is based on over 2,000 ventures from 2004 to 2010 that raised over $1 million in capital.

Yes, there are probably a million different reasons why this data is the way it is. A few common ones that you’ll hear lately is that investors just invest in people they know and it’s not inclusive or that VCs are just taking big bets and it’s okay for all of those ventures to fail. We want to swing for the fences.

Both of these reasons can be true and probably are true. However, why are investors the gatekeepers to innovation and why do we only need to hit home runs every single time? A home run in the investor world is just selling a company for large multiples or having an initial public offering.

The last time I checked, the ability to hit a triple, a double, or even a single isn’t a bad thing. Getting on base is what matters.

Okay - the modern day metrics in baseball want the home run ball, but you get my point.

Having a business that scales and maybe doesn’t IPO, but is worth $50 million dollars still is a really big deal.

However, it’s not one that grabs headlines and not the type of business that has been glorified by so many.

We’ve put SO MUCH attention on fundraising and these big, sexy exits that we’ve turned  people like Elon Musk and even people like Elizabeth Holmes and Adam Neuman to look like the future of innovation. We’ve made the role models of innovation look like people that aren’t healthy.

What we should be talking more about is role models of innovators that are healthy and are leading truly impactful ventures.

Sure, SpaceX, Tesla, and other VC backed ventures are cool, but there are a lot of other innovators that are having a dramatic impact on the world that we just don’t talk about because they’re not venture backed. As a result, they don’t grab the headlines.

Let me show you an example.

On August 16th, TechCrunch posted this article: Shopify launches Collabs, a new way for creators to earn revenue on the platform. Obviously, if TechCrunch is talking about it, it’s probably something worth paying attention to and is meaningful.

This article is interesting because it’s another sign that more and more companies are shying away from using ads on Facebook and other social media platforms with the new privacy laws going into effect. It’s a sign that more creators are going to be paid well with sponsored content.

As some would think about it, it’s a win for the little guys!

We’re not going to dive into this subject in this post, but it’s definitely important to keep an eye out for how this impacts the future of advertising.

If you don’t know Shopify and its history, Shopify is an e-commerce company that allows merchants to sell their goods and products online. Truthfully, Shopify is a really wonderful service and product. I used it at my last startup and it does make life easier. It’s a venture backed company that raised over $122 million and is now a publicly traded company.

That’s all fine and dandy. TechCrunch missed an important opportunity earlier though.

Back in June, ConvertKit, a non-VC backed venture that is currently making over $30 million per year in revenue launched a very similar feature for creators: The ConvertKit Sponsor Network.

The ConvertKit Sponsor Network currently pairs creators with over 10,000 email subscribers to brands for sponsorship deals. That’s a really big deal because ConvertKit has over 40,000 customers. That’s 40,000 creators!!

The amount of press ConvertKit received for this? You probably guessed it. ZERO. Not even a college blog wrote about it.

And let me tell you a little bit about how ConvertKit is operating right now.

When a lot of companies are laying off staff because they didn’t take care of their burn rate well enough or just didn’t make enough money to support the venture, ConvertKit is doing the opposite. They’re continuing to grow and hire.

ConvertKit is a profitable company, one that gives a profit sharing commission to every employee twice a year, and is a remote first company.

ConvertKit sure seems like the future of what innovation and entrepreneurship really is.

It’s sustainable, profitable, and impactful growth. It’s a venture that is owned by its community and staff. It’s a company with a mission and is led by healthy leaders.

They’re not the only ventures like this either. Transistor.fm, MailChimp,  and 99% of the rest of businesses in the United States never raised venture capital.

Yet, it always feels like we’re optimizing and hearing about the 1% of ventures and holding the founders of these ventures so high that the younger generations and people that would be wonderful founders don’t create ventures because they don’t fit the mold per se.

That’s a big deal.

For 3 decades now, the United States has been declining in entrepreneurship. There are less and less new businesses being created in the United States.

I’m by no means a policy maker or an economist. The little that I do know about economic equality though is that people have to own things. It’s owning a home, it’s owning stock, it’s owning things that appreciate, not depreciate.

We have to stop idolizing fundraising. It’s meant for exactly what it funds: less than 1% of ventures. We need ventures that are scalable, non-VC backed and provide meaningful ownership to its community and employees.

It’s okay to not create the largest company in the history of the world. Heck, it might even be better that you don’t create the largest company in the world.

All you have to do is create a healthy, impactful venture.

Don’t buy into the hype.