Finance Growth Stages Strategy

Why 100% of venture capital can be explained in one 4-letter word

By Dileep Rao – Guest Contributor

I know the word you are thinking of. But, actually, the word is ‘exit.’

Many have tried to explain venture capital (VC).

For entrepreneurs, VC is hope in a check. They hope that VCs like their idea (hence the fascination with Shark Tank) and hope that VCs will fund them, guide them and make them rich. Unfortunately, these hopes are misplaced most of the time. As I have noted before:

  • VCs invest in 100/100,000 ventures and fail on 80
  • VCs invest after Aha, when potential is evident. Pre-Aha, entrepreneurs are on their own
  • 20 VCs are said to account for about 95% of VC profits. Your odds of getting VC from this small list are next to nil. And the odds of becoming wealthy are even smaller as the average failure rate is 80% for VC-funded ventures and only 1% are home runs.

For areas, VC is hope for high-growth ventures and high-paying jobs. Most areas believe that the only thing standing between them and Silicon Valley riches is the lack of VC. Unfortunately, they are sadly misguided. VC has succeeded mainly in Silicon Valley because:

  • VC needs potential home runs, and Silicon Valley is where the home runs mainly are
  • VC needs entrepreneurs with unicorn-skills to build the venture from idea to Aha, and Silicon Valley is where they mainly are.
  • VC needs angels who are willing to fund ventures before Aha. VCs come after the heavy lifting is done – and hog the rewards. The most successful angels are in Silicon Valley.

VCs describe themselves to the world as the magic elixir to create wealth. The capital they bring along with their brilliant advice is often touted as the difference between failure and the blooming of high-growth ventures that create jobs and wealth.

VCs promise high returns to their investors. They seek to generate high returns by using their skill at picking potential home-run ventures. Returns refers to the net annual rate of return received by the investors after all VC fees and profit-sharing incentives are paid.

To really understand VC is to understand the relationship between VCs and their investors. VCs need capital to invest. To get capital to invest, they need to convince their own investors that they can generate high annual returns and prove that with a great track-record.

To get high returns, VCs need great exits. With a great exit, where the venture is valued very highly, the VCs get a great payday.

If a great exit can be had by a strategic sale to a buyer at a very high price, VCs will do it. Instagram was sold at a very nice price within a few days after the VCs funded the venture – doubling the VC investment. Not sure about the value they added in a few days, but one has to admit that doubling one’s investment in a few days is a great exit.

If great exits can be had by an initial public offering, VCs will do it. The problem with IPOs is that the market is often not frothy enough for IPOs to be attractive. WeWork was supposed to be this great IPO since the market seemed frothy. But WeWork, and its VCs realized that the market was not frothy enough for WeWork. Let’s hope it never is.

What should entrepreneurs do?

  • If your goal is a quick buck with a fast exit that you can prove, think about VC. VCs are “long-term” investors when they do not have a better option.
  • If you can prove a home run in an emerging industry, your odds of VC are better
  • If you can prove that a corporation (provide names) will buy you out in an insane valuation in a strategic sale because it fills a corporate hole, your odds of VC are better
  • If you can convince VCs that you can go public at an insane valuation, your odds of VC are better. But it usually takes 5-7 years for the “average” venture to go from startup to IPO. Can you accurately forecast an IPO 5-7 years in the future? At an insane valuation?

If your goal is to build a venture and control it, there are two models:

  • The VC model, which will benefit 20/100,000 of entrepreneurs after Aha — and you have to get to Aha without VC; and
  • The unicorn-entrepreneur model, which can benefit 100% of entrepreneurs from startup – and used by 94% of billion-dollar entrepreneurs to take-off without VC.

If you cannot convince VCs of a great exit, learn from unicorn-entrepreneurs. Take off without VC.

MY TAKE: The lure of VC is the temptation of the fast buck. For a fast buck, focus on the exit. VCs talk about building a great venture. What they are really seeking is a great exit.

This column was first published in Forbes.

Dileep Rao is the author of Finance Secrets of Billion-Dollar Entrepreneurs  (FIU Business Press, November 2020) and teaches entrepreneurship, unicorn-entrepreneurship, and venture financing at Florida International University. He is a former venture financier.



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