UNDERSTANDING VENTURE CAPITAL 3
© Tien Nguyen
Why do venture capital funds often choose emerging technology businesses to invest? Why don’t they invest in classic businesses, wear durable clothes and rest assured that their capital flow will not be lost? There are many questions about who the venture capital funds will be interested in. What these businesses are like and the investment logic of venture capital funds for these businesses is what we will discuss in today’s article.
Part 3: Fast-growing startups.
Classic businesses will typically decide on a market to enter, produce products and services, and then find a way to get their first customers. Gradually increase the number of customers paying for the product. After 3-4 years of steady growth, cost control and gradually increasing profit margins, these businesses continue to compete until the market pie is divided and business owners benefit from their investments. slowly, of course, after about 15-20 years. This type of business will prefer debt financing because their profits are planned to cover reinvestments and borrowed capital is a cheap flow of capital as we know it.
The picture completely changes when we talk about venture capital funds. The goal of success for funds and fund managers is to increase the share of assets they are managing. This goal can only be achieved when the valuation of the business in which they invest increases, and must increase rapidly. From there, the fund can divest by selling shares or IPO. With a life cycle of typically 10 years, funds expect to divest some or all of them in about 3-7 years. This, for the business receiving the investment, means that their growth rate must be outstanding during this time period.
The Venture Capital industry is driven by the hope of finding a handful of successful businesses and that success must be large, resonant and high value. In a portfolio of funds, 10 failed deals can be salvaged by just 1 successful one. A hugely successful megahit deal can accelerate the growth of the entire industry.
These megahits will be called by the beautiful name: “Unicorn”, which are startups with a valuation of over 1 billion USD.
Typically, businesses that are able to meet the criteria (1) high growth rate and (2) ability to expand quickly are enterprises with disruptive innovation capabilities. Like the UBER case has done for the taxi industry.
Today’s technology allows the number of users to grow almost unlimitedly. Social networks are operating with as many users as the population of the most populous countries in the world, something that before, private businesses could not dream of.
The cost to serve a new customer is now almost negligible for the technology industry thanks to the extensive network infrastructure and very high automation capabilities.
Thus, we clearly see that: VCs are unicorn hunters.
However, in reality it is not easy to distinguish a real unicorn from a colorful old horse.
A startup at the same time as the Amazon monument whose name few people remember now. It’s Webvan. Founded in 1996 with an online grocery model, Webvan is one of the pioneers with a post-IPO valuation of only 3 years after its founding of $ 4.8 billion. Webvan went bankrupt just 2 years after its IPO. Many reasons were given, and most of them became lessons for a truly unicorn of the time, Amazon.
Investors for Webvan through the stages include many famous names such as Benchmark, Goldman Sachs, Softbank, Sequoia, Yahoo, etc. Even the super and experienced eyes of the Venture Capital industry are sometimes That’s how old horse and unicorn are confused. However, always remember: failure is part of the venture capital process. Sequoia has also had many admirable tractions such as investing in Google with Kleiner Perkins so that not too many people remember their Webvan failure. To this day, Sequoia remains one of the most trusted VC fund managers.
The venture capital industry exists and develops based on the “Hits Driven” principle, which is very similar to the industries of gold mining, oil and gas exploration, space exploration, music, literature or cinema. Investors in these industries often have to foresee a prospect of success, willing to take the risk to invest money, time, and effort in pursuit of their beliefs. With a little luck, if successful, it will be a great success.
In the literary world, one can take J.K. Rowling as an example for an entrepreneur. The book “Harry Potter and the Prophet’s Stone” was submitted in manuscript to 12 publishers and was rejected. Surely there are founders or pitchers who will understand this pain. When Bloomsbury decided to publish the book, they were like venture capitalists themselves. So far, Harry Potter has remained a bright spot in the company’s portfolio with 13% contributing to 2018’s profits.
Venture capitalists are not interested in a startup with steady profits and slow growth. For us, those are the “walking dead” that, when there are too many in our portfolio, we will never be able to return the investment to our investors, not to mention the increased assets. We are looking for startups with “Hockey Stick” growth potential (as shown). To achieve this form of growth, we will commit to multiple rounds of funding, enough for the startup to hit certain milestones (milestones).
A VC when investing is like launching multiple rockets to the moon (which is when we exit). Fuel will be burned in stages to overcome the atmosphere and the resistance of gravity. Here is each round of funding that we will be participating in. Any rocket that does not reach the moon is considered abandoned. The moon is the ultimate destination with a VC and pretty milestones along the way don’t mean much.
In short, to understand these principles, startups should carefully consider their vision and model to understand what VCs want when they refer to “a startup with high growth”.