I read this tweet a year and a half ago and have remembered it because I found it to be a terrifically concise summary of the venture capital model:
I sold my first startup for $50 million after 13 months and made my investors 5x in a year— Jason ✨SaaStrScale✨ Lemkin ? (@jasonlk) January 4, 2018
None of them showed up to the closing dinner
It took me a long time to understand why that was
VCs are financially incentivized to focus on the one or two portfolio companies that can “return the fund.”
I think of venture-backed technology companies as having three basic outcomes:
- A massive success that results in an IPO or a very large acquisition
- A more modest success that results in a smaller acquisition (this is the sort of outcome that Jason referred to in his tweet)
- A failure in which the company either shuts down or is perhaps acqui-hired or acquired for pennies on the dollar
In terms of fund economics, it might be closer to binary: is the company a home run that returns the fund, or not? This is why something that seems like an excellent outcome (5x in a year) may not be enough to get the partners on an airplane to a closing dinner. Because so many of a VC fund’s investments go to zero, the fund must find companies that grow into truly outsized exits.
Fred Wilson summarizes this well:
If you look at the distribution of outcomes in a venture fund, you will see that it is a classic power law curve, with the best investment in each fund towering over the rest, followed by a few other strong investments, followed by a few other decent ones, and then a long tail of investments that don’t move the needle for the VC fund.AVC
It is an interesting disconnect that a founder like Jason could do something that is incredibly difficult and takes a massive amount of personal energy in starting a company, growing it and selling it for a considerable amount of money, and it doesn’t register as a huge win to the investors.
I wanted to visualize what it takes for an exit to be “meaningful.” Mostly I wanted to do this because even after reading about it it surprises me how big exits need to be and I wanted to internalize what it takes for a company to have a material impact on its investors’ fund.
This is important because it will impact the choices the company makes, the urgency with which it must grow and will hugely affect the experience of the founders and employees.
The top chart shows how big an exit needs to be to be “meaningful” and the bottom chart shows how big an exit needs to be a “home run”, or return the fund. You can toggle the assumption of whether the VC owns 20% or 10% of the portfolio company, which affects the slope of the line.
I based the numbers off of an excellent analysis by Samuel Gil at JME Venture Capital which you can read here.
I think many people would rather build a business or work for a business that doesn’t need to go through hypergrowth in order to be a success. While it is not a new idea that VC isn’t for everyone, it bears repeating that raising from a micro VC (who doesn’t need as huge an exit to return the fund), or bootstrapping or crowdsourcing funding are alternatives that could better align the economics of a business with the goals of founders and employees in these cases.
Raising traditional venture capital probably shouldn’t be the default option for someone starting a tech company.
In keeping with the parlance of the “home run”, there is a trend in professional baseball that is a good analogy to the all-or-nothing nature of venture outcomes. Baseball players are increasingly swinging for the fences, following the analytics that show that the benefit of home runs more than make up for the increased probability of striking out.
This makes sense if you are optimizing for wins; just as it may make sense to attempt to build multibillion dollar companies if you’re optimizing for fund performance.
But psychologically, it may be more fun to hit singles and doubles, with fewer strikeouts and the occasional home run. This is something founders should be cognizant of when choosing whether to raise VC or not, and when choosing the size and type of fund they raise from. It is also something that employees should think about as they decide which companies to work for.
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