A few days ago, someone I met wanted to pick my mind regarding a business idea she had. Not that I'm an expert on what she wanted to do but she simply wanted to know what a venture capitalist thinks about when evaluating a potential investment opportunity.
Let's put the standard stuff around size of market, product differentiation, entrepreneur quality, valuation and all the rest to one side for the nonce. What I'd like to do in this post is set some context around how VC firms are organised and how this affects the kinds of decisions they (we) make.
A few disclaimers: I am not an expert. This is not investment advice. This is not start-up advice. What I am saying is based on my personal experience and observations of the world, and may not be representative of either my employer's views or those of the VC industry as a whole. Heck, my own thinking may change in future when faced with new data. In short: caveat emptor. These disclaimers hold for all posts on this blog.
First of all, VCs are money managers. They invest other people's money on their behalf. This means that they themselves have investors (called LPs) to answer to. (It also means, by the way, that investments I make aren't from some pot of gold I myself possess. I've been surprised how often people assume this! I'm just a salaryman like most other people.)
Second, returns are generally measured in terms of multiples of cash invested not IRRs
- Money is committed to funds by LPs for long periods, generally about eight to ten years. Given that the time period is fixed, it's just easier to think about returns in terms of multiples.
- VC investments are higher risk and dependent on several qualitative factors (including luck), more so than the typical stock punt. Detailed IRR calculations are just not meaningful when evaluating an opportunity. Is something a 4x or an 8x is more important to know than whether it will yield 30% or 35%.
- VCs do not want dividends! Dividend payouts imply that the company is not growing quickly enough to justify reinvesting cash in the business. (Warren Buffett has the same philosophy.) If you don't have dividends, again IRR calculations are unnecessary.
Third, unlike buying and selling publicly listed stocks, an individual VC generally can't manage investments in more than perhaps half a dozen companies at a time. Limited "bandwidth" (as we say in the trade) requires us to pick and choose companies with the biggest bang for the buck. By "buck", I mean, of course, not just the literal dollars invested but also the time and effort that goes into making any investment a successful one.
Why does all this matter? It matters because it affects the kinds of investments a VC will or won't do.
- No income-generating companies. Capital-appreciation is the goal.
- VCs want a team running the company. They don't want majority control or having to run companies themselves.
- Companies that don't just grow capital but have the possibility of growing that capital in j-curve fashion (meaning growing it by large amounts quickly). Because there are LPs looking to make a return on their money, the time horizon for returns is limited.
- Cannot make small investments even if each individual investment looks like returning large multiples.
- Every prospective investment opportunity needs to show the potential for being a superstar going in even though every VC knows that, because of the high risk involved, only a few companies in the portfolio will achieve that dream. The point is that it's (usually) no use trying to get a VC to invest in a "safe", decent-return company.
Of course, investment styles and philosophies will vary from one firm to another and one individual to another so treat the above as rough guideposts.
I'll try to post more such articles in future.