Venture Capitalists play a crucial role in funding innovative
startups that end up valued at tens of billions of dollars.
By Michael Megarit.
How Venture Capitalists Create Trillions in Value
Venture Capital is taking over the world.
In the first 6 months of 2021, global Venture Capital investments reached roughly $300 billion, more than twice the amount invested over the same time frame in 2020. This year, more than two Unicorns – startups valued at $1 billion or more – emerged globally every single day.
Worldwide, there are 1,601 Unicorns and exits totaling $1 billion or more, of which 1,071 are still private Unicorns. These numbers can largely be attributed to investments made by Venture Capitalists.
What is a Venture Capitalist?
A Venture Capitalist is an investor who provides capital to startups with high growth potential in exchange for an equity stake. Over the past decade, Venture Capital has contributed to the creation of trillions of dollars of market capitalization.
Founded in 2009, the ridesharing company raised $20 billion from Venture Capitalists, including Morgan Stanley, Softbank and G Squared. In 2018, Uber’s final round of financing raised $500 million. In May 2019, the company went public, raising an additional $8 billion. Today, Uber has a market cap of $87 billion and an enterprise value of $91.7 billion.
Would this success have been possible without Venture Capital?
Maybe. But maybe not.
Startups are Very Risky Investments
Startups are incredibly risky business ventures.
A 2019 study published by Startup Genome concludes that only 1 in 12 entrepreneurs succeed in building a successful business. This represents a success rate of just 8%. Most business owners say that a lack of money is one of the main reasons for their failure.
The truth is that startups are risky investments.
During the seed stage, as well as during the early and even mid-stages, very few banks and investors are willing to invest in startups. The risk of failure and losing the initial investment is simply too high for most investors, who prefer safer options.
Ultimately, Venture Capitalists are usually the only source of financing these startups have access to. Without it, many generational companies would never be able to market their products and services – let alone reach the blockbuster IPO stage.
Shikhar Ghosh, a senior lecturer at Harvard Business School, claims that nonventure-backed companies fail more often than venture-backed companies in the first four years of existence, mainly due to finance problems.
How do Venture Capitalists identify unknown startups and build them into billion-dollar corporations?
In this article, we will present the methods and strategies Venture Capital firms implement to scale startups and turn them into multi-billion dollar ventures.
How Venture Capitalists Identify Promising Startups
Venture Capitalists specialize in identifying innovative startups with high growth potential.
Every year, these firms may look at hundreds – if not thousands – of startups that spark their interest. However, they usually end up investing in a handful. Sometimes, they only invest in one or two companies.
While they are spoilt for choice, big VC firms have two great fears: making the wrong decision or overlooking the next big thing. Of course, VC firms understand that they will make poor investment choices and lose money. But that is the price they are willing to pay to hit the big time when they do get it right.
Chris Dixon of VC firm Andreessen Horowitz refers to this phenomenon as the “Babe Ruth effect”: just like the legendary 1920s baseball star, VC firms strike out a lot but also hit plenty of homeruns.
The National Venture Capital Association estimates that at least 75% of venture-backed firms in the US fail to return investors’ capital. Of the 25% that do return money, the majority fail to generate the ROI investors had hoped for. Ultimately, only 10% of startups generate meaningful ROI.
This high rate of failure means that Venture Capitalists have to invest in a lot of companies. Thus, they are always on the lookout for opportunities.
These firms usually have well defined research structure:
- Associates are out in the field vetting startups: they cold call companies, connect with founders at conferences and network with accelerators and incubators. Once they have a shortlist, they redact summaries and send them to principals.
- Principals audit the candidates: they check customer references, analyze the competition, speak with other investors about the target, vet the management and gather all necessary intelligence to conduct thorough due diligence. Once they have a complete picture, they draft negotiating terms and refer to the firm’s partners.
- Partners are responsible for investments: these seniors members of the firm compete with other partners for resources. Each partner presents their shortlist and tries to convince the other to invest in their candidates.
Venture Capitalists Minimize Risk
As you can see, Venture Capital firms deal with a very high level of risk.
In order to reduce it, they must be in tune with the macroeconomic climate and the secular growth trends that will define the next decades. These days, VC firms know that technology and healthcare are the driving forces of economic creation. Consequently, they are setting up funds targeting startups operating in these sectors.
But that’s not enough.
There are 63,703 startups in the USA, 8,301 in India and 5,377 in the UK. In the fintech sector, there are more than 12,000 startups in the world and 5,779 in the US alone. Clearly, VC firms cannot invest in every single one. They must sift through the vast number of startups and identify the ones with the highest potential.
Once they identify quality startups, they must assess whether they have a meaningful future: are they revolutionizing their industry? What are the risks and rewards of the products, services and processes they offer? Do they have real and potentially long-lasting competitive advantages over their competitors? Can they disrupt an industry and threaten established corporations? Is the management team experienced?
The VC has to convince himself and his entire organization that the startups he identifies present reasonable risk-reward proposition. Every investment decision sacrifices capital that could be allocated elsewhere. Thus, plausibility is crucial to ensuring a compelling investment thesis.
Once the Venture Capital firm has identified startups worthy of investment, it moves on to the next stage of the process.
Venture Capitalists Want a Big Pie
In the world of investing, higher risks command higher returns.
This holds especially true for Venture Capital firms. Their dream is to transform millions into billions.
Once they’ve identified quality companies, the first thing they look for is whether the startup needs investment. Indeed, the startup should require plenty of investment now and much more down the road. In fact, Venture Capital firms look out for startups that require lots of money. The more money the startup requires, the greater the opportunity.
While this appears, counterintuitive, it will soon make sense.
Venture Capital firms are not interested in small startups. They have no interest in investing in startups that raise a very small amount of money and then exit with massive upside. For VC firms, this results in low dollar returns.
They want to invest large sums over several rounds of financing in startups that have a massive upside. Indeed, this means that they will get a big piece of a potentially big pie. As subsequent fundraising rounds increase the size of the pie, the Venture Capital firm’s dollar amount exit drastically increases.
Venture Capital Attracts More Venture Capital
The logical consequence of a Venture Capital’s desire to invest in “big pie” startups is the fact that successful fundraising attracts other Venture Capital investors.
Typically, when early-stage investors fund startups, they invite other like-minded investors to join them. This serves two purposes: to bring in additional funding, which will help the startup gain visibility and grow faster, and validate their own investment thesis.
In some cases, startups end up selling equity to half a dozen or more Venture Capitalists. This situation is so common that these fundraising rounds are usually referred to as “party rounds”. The consequence for the startup founders is reduced ownership and a higher chance of success.
For example, by the time social media platform Twitter had raised just $60 million, it had more than a dozen outside investors in its capital structure. When the company IPOed, Union Square Ventures, the lead Series A investor, owned less than 6% of the company’s shares. With a current market cap of $50 billion, this seemingly modest 6% share represents a whopping $3 billion.
Venture Capital Eye Big Exits
As mentioned, Venture Capitalists want substantial returns. They invest in early and mid-stage startups when nobody else is willing to. Since they are buying equity – and not loaning funds – they have no guarantee of generating a return on investment or being paid back in case of failure. As a result, they regularly lose money.
To offset these losses, they must occasionally win big.
Thus, Venture Capitalists look for startups that offer potentially massive exits.
Here are just a few examples of the kind of exits Venture Capitalists dream about:
- In 1999, Cisco acquired Cerent for $6.9 billion. Kleiner Perkins Caufield & Byers’ $8 million investment turned into $2.1 billion after the stock switch.
- Facebook IPOed in 2012 and soon reached a valuation of over $100 billion. Accel Partners led a $12.7 million Series A fundraising in 2005 and acquired roughly 7% of the company. When Facebook IPOed, Accel’s share was valued at nearly $9 billion.
- In 2014, Facebook acquired WhatsApp for $22 billion dollar. At the time, this was the largest ever private acquisition of a VC-backed company. This deal saw Sequoia Capital turn a $60 million investment into a $3 billion payday.
- Activision’s 2015 acquisition of King Digital Entertainment for $5.9 billion saw Apax’s initial $36 million investment turn into $3.6 billion.
- Snap Inc IPOed in 2017 at a $25 billion valuation. One of the big winners was Lightspeed Venture Partners, whose initial investment of $8 million turned into $2 billion.
- Snowflake’s blockbuster 2020 IPO saw the company valued at $33.3 billion. Sutter Hill Ventures, which owned 20.3% of Snowflake, saw its stake worth $12.6 billion, up from a total investment of less than $200 million.
These are just 6 of several dozen example of the most lucrative VC bets of all time.
Venture Capitalists Reinvest Their Profits
Often, Venture Capitalists take advantage of billion-dollar acquisitions and IPOs to sell off part or their entire stake. They recoup funds that are then reinvested in other promising startups they hope to bring public.
They repeat this cycle over and over again, creating behemoth corporations that slowly become part of our everyday lives.
ABOUT THE AUTHOR
Michael Megarit is a partner with Cebron Group.
With over 25 years of domestic and international corporate finance experience,
he provides M&A and capital advisory to high-growth technology companies.