The popular mythology surrounding the U.S. venture-capital industry is that venture capitalists are legendary risk-takers who provide sage guidance and capital to entrepreneurs. However, the reality is that today’s venture capitalists are more like conservative bankers, carving out a specialized niche in the capital markets. They invest in good industries that are more competitively forgiving than the market as a whole and structure their deals to minimize risk and maximize returns. Venture capitalists must earn a consistently superior return on investments in inherently risky businesses, but they do not necessarily invest in good ideas and good plans. Instead, they focus on identifying and funding promising industries and startups.
Key Takeaways
- Venture capitalists are more like conservative bankers than legendary risk-takers.
- They invest in good industries and structure deals to minimize risk and maximize returns.
- Venture capitalists focus on identifying and funding promising industries and startups.
- The popular mythology of venture capitalists is different from the current reality.
- Understanding the realities of the venture capital industry is crucial for entrepreneurs and investors.
Venture Capital Mythbusting
The popular mythology surrounding the U.S. venture capital industry derives from a previous era when venture capitalists who nurtured the computer industry in its infancy were legendary for their risk-taking and hands-on operating experience. However, today’s venture capitalists are more akin to conservative bankers than the risk-takers of the past. They have carved out a specialized niche in the capital markets, filling a void that other institutions cannot serve. The venture capital industry has evolved, and separating the myths from the realities is crucial to understanding this important piece of the U.S. economy.
Separating Fact from Fiction
The popular perception of venture capitalists as legendary risk-takers is often at odds with the reality of the modern venture capital industry. Today, venture capitalists are more focused on minimizing risk and maximizing returns, rather than embracing the high-risk, high-reward approach of the past. They invest in industries and startups that are more competitively forgiving and have a higher likelihood of success, rather than funding good ideas and good plans.
The Evolution of Venture Capitalists
As the venture capital industry has evolved, the role of venture capitalists has shifted from that of hands-on operating experience to a more specialized, conservative approach. They have carved out a unique niche in the capital markets, providing funding and guidance to startups that other institutions cannot serve. This evolution has led to a more calculated, risk-averse approach to investing, which differs from the popular perception of venture capitalists as daring risk-takers.
Typical Venture Capitalist Equity Stake
Before asking what percentage of your company you should give to investors, it’s helpful to know what percentage venture capitalists typically take on average. A study of 105 tech companies at the time they went public found that the median and average level of VC ownership at exit was 53% and 50% respectively. In other words, by the time of exit, venture capitalists are likely to own half of the business.
| Metric | Percentage |
|---|---|
| Median VC Ownership at Exit | 53% |
| Average VC Ownership at Exit | 50% |
The remaining equity is distributed among other stakeholders, such as employees via stock options, companies acquired along the way where part of the price was paid in stock, board members, and consultants for their services. As a founder, it’s important to be mindful of every equity grant, no matter how small, as it can add up over the long run.
Factors Influencing VC Ownership Percentage
The percentage of equity that venture capitalists (VCs) own in a startup can be influenced by several key factors. Understanding these factors can help founders better navigate the fundraising process and optimize their equity allocation.
Company Profitability
Businesses that tend to be more profitable, such as e-commerce and hardware, tend to have lower levels of venture capitalist ownership, with median VC ownership levels of 44% and 42% respectively. This suggests that more profitable companies can often retain a larger portion of their equity when raising venture capital.
Industry Hotness
Being in a “hot” industry, such as social media, can also help preserve equity, as evidenced by Facebook and Snapchat having VC ownership of only 17% and 18% respectively at IPO. When VCs perceive an industry as particularly promising, they may be willing to accept a smaller ownership stake in exchange for the opportunity to invest.
Tier 1 Venture Capitalists
Additionally, raising funding from top-tier venture capitalists, such as Benchmark, Sequoia, Greylock, Bessemer Venture Partners, and Khosla Ventures, can increase the odds of success and potentially lead to lower VC ownership percentages. These prominent investors often have a reputation for adding significant value to their portfolio companies, which can justify a smaller equity stake.
What percentage do venture capitalists take?
Median and Average VC Ownership at Exit
Based on a study of 105 tech companies at the time they went public, the median and average level of VC ownership at exit was 53% and 50% respectively. This means that venture capitalists are likely to own around half of the business by the time of exit.
Equity Distribution Among Stakeholders
The remaining equity is distributed among other stakeholders, such as employees via stock options, companies acquired along the way where part of the price was paid in stock, board members, and consultants for their services. As a founder, it’s important to be mindful of every equity grant, no matter how small, as it can add up over the long run and impact the startup equity distribution.
The Role of Strategic Investors
When it comes to startup funding, the presence of strategic investors can be a significant factor. Strategic investors are corporations that make venture investments to gain a strategic advantage, such as access to new technologies, markets, or distribution channels. However, the data suggests that strategic investors are not a necessity for startup success.
According to the study of 105 tech companies at the time of their initial public offerings (IPOs), strategic investors were only present in 17 out of the 105 IPOs examined. This leads to the conclusion that while a strategic investor can be valuable, they are not essential for a startup’s success. Some examples of strategic investments include Delta Airlines investing in Priceline, USAA investing in TrueCar, and Fox investing in Roku.
The role of corporate venture capital and strategic investors in the startup ecosystem is an interesting one. While they can provide valuable resources and connections, the data suggests that their presence is not a make-or-break factor for a startup’s ultimate success. Entrepreneurs should carefully consider the potential benefits and drawbacks of involving strategic investors as they navigate the fundraising process.
Maximizing Founder’s Equity
To maximize the founder’s equity, it’s crucial to run the business as lean as possible and make cash efficiency and frugality a core part of the culture. Scrutinize every equity grant, no matter how small, as it can add up significantly over time. Be cautious about granting equity for M&A or services, as those shares given away can end up being the most expensive services the company has ever bought if the startup is successful.
Lean Operations and Cash Efficiency
Maintaining a lean and cash-efficient operation is paramount to preserving as much founder equity as possible. Prioritize maximizing founder equity by being disciplined about every expense, minimizing unnecessary spending, and focusing relentlessly on cash efficiency. This mindset will not only help you avoid dilution but also extend the runway for your startup, giving you more time to achieve key milestones and potentially secure better terms from investors.
Equity Dilution Considerations
As your startup grows, it’s crucial to be acutely aware of equity dilution and its impact on the founder’s stake. Carefully consider each equity grant, whether it’s to employees, advisors, or acquisition targets. Every share given away can significantly reduce the founder’s ownership percentage over time. By maintaining a vigilant approach to equity dilution, you can maximize the founder’s equity and ensure that you retain a meaningful stake in the company you’ve built.
Venture Capital vs. Angel Investing
When it comes to startup funding, venture capital and angel investing represent distinct approaches with unique funding structures and compensation models. Understanding these differences is crucial for entrepreneurs and investors alike.
Differences in Funding Structure
Venture capitalists typically manage funds raised from limited partners (LPs) and make investment decisions on their behalf. They write larger checks than individual angel investors, with the average venture capital investment reaching $9.9 million. In contrast, angel investors invest their own capital, often as part of angel networks that charge member dues, usually around $3,000 to $5,000 per year in major cities.
Compensation Models
The compensation structures for venture capitalists and angel investors also differ significantly. Venture capital firms follow a “2 and 20” model, where they earn a 2% annual management fee and 20% of the fund’s profits. This incentivizes them to seek higher returns, as their earnings are directly tied to the performance of their investments. Angel investors, on the other hand, are compensated through the appreciation of their individual investments, typically seeing annual returns between 20-40%.
The Startup Investment Spectrum
When it comes to startup investing, there is a diverse spectrum of options that offer varying levels of control and diversification. At one end of the spectrum, investors can choose to participate in an LP fund managed by a venture capital firm, where the general partners (GPs) have full decision-making authority over the investment portfolio. This approach provides the least amount of control for individual investors, but it also allows for broader diversification across multiple startups.
At the opposite end of the spectrum, a solo angel investor has the most control over their investments, but they also face the highest risk of lack of diversification. In between these extremes, there are angel funds, where a group of angels pool their resources and make collective investment decisions, as well as angel networks, where the network curates deals but the individual angels invest independently.
Control vs. Diversification Tradeoff
Investors navigating the startup investment spectrum must carefully weigh the tradeoff between control and diversification. Those who prioritize control over their investments may opt for a more hands-on approach, such as becoming a solo angel or participating in an angel fund. Conversely, investors seeking broader diversification may find more value in an LP fund, where they can leverage the expertise and deal-sourcing capabilities of experienced venture capitalists.
Ultimately, the choice of investment approach depends on the investor’s risk tolerance, investment objectives, and the level of involvement they are willing to commit. By understanding the nuances of the startup investment spectrum, aspiring investors can make more informed decisions and align their investment strategy with their personal preferences and investment goals.
Risks of Venture Capital Investments
Venture capital is a highly risky asset class, with the goal of early-stage investors being to triple their money in 10 years. However, the reality paints a different picture – half of all venture capitalists do not even return their limited partners’ (LPs) original investment. This dismal low success rate highlights the inherent risks associated with venture capital investments.
Illiquidity and Limited Control
Startup investments also tend to be illiquid, with the time from seed to exit currently taking around eight years on average. Additionally, as an investor, you have little legal control over what the portfolio company does, and the emotional aspect of investing in startups is much different than investing in the public markets.
Low Success Rates
The venture capital industry is notorious for its low success rates, with only a small percentage of investments yielding outsized returns. Despite the allure of potential high-growth startups, the reality is that the vast majority of venture capital investments fail to deliver the promised returns. This high-risk, high-reward nature of the industry is something that all aspiring investors must carefully consider.
Understanding the risks of VC investments, including the illiquidity of startup investments and the limited control investors have over portfolio companies, is crucial for anyone considering venture capital as an asset class. By being aware of these potential pitfalls, investors can make more informed decisions and manage their expectations accordingly.
Choosing an Investment Focus
When deciding where to focus your venture capital or angel investing efforts, it’s important to consider both your
expertise and personal interests
, as well as your
network and ability to add value
to portfolio companies. Picking an area that you’re genuinely interested in and knowledgeable about will make it easier to consume relevant content, meet founders, and attend industry events. Additionally, being able to leverage your network to introduce startup founders to valuable connections, such as potential hires, partners, or other investors, can significantly
enhance the value you provide as an investor
.
Expertise and Interest
Having a deep understanding of and genuine interest in your chosen investment focus is crucial for success as a venture capitalist or angel investor. This allows you to quickly identify promising opportunities, provide meaningful guidance to founders, and stay up-to-date with the latest trends and developments in the industry. By aligning your investment focus with your areas of expertise and personal passions, you can make more informed decisions and add greater value to your portfolio companies.
Network and Value-Addition
In addition to subject matter expertise, the strength of your network and ability to provide tangible value-addition can set you apart as an investor. Leveraging your connections to introduce startup founders to potential hires, partners, or other investors can significantly enhance the chances of your portfolio companies’ success. Furthermore, offering strategic advice, industry insights, or access to valuable resources can make you a more attractive investment option for entrepreneurs seeking not just capital, but also guidance and support.
Tips for Aspiring Investors
Becoming a successful venture capitalist or angel investor requires a strategic approach. To thrive in this high-risk, high-reward asset class, aspiring investors should focus on three key areas: developing an investment point of view, identifying quality deal flow, and avoiding common mistakes.
Develop an Investment Point of View
The first step is to develop a clear investment thesis that aligns with your expertise and interests. Identify the specific industries, business models, or technology trends that you’re passionate about and have deep knowledge in. This will not only help you make more informed investment decisions but also enable you to provide meaningful value-add to your portfolio companies.
Identify Quality Deal Flow
Building a robust pipeline of quality deals is crucial for any aspiring investor. Leverage your network, attend industry events, and actively engage with accelerators and incubators to gain access to the most promising startups. Additionally, consider joining angel networks or angel funds, which can provide a curated selection of investment opportunities.
Avoid Common Mistakes
The venture capital and angel investing landscape is fraught with common pitfalls that can derail even the most seasoned investors. Be wary of overvalued deals, investing in areas outside your expertise, and succumbing to the fear of missing out (FOMO). Maintain a disciplined and well-diversified portfolio to mitigate the inherent risks of early-stage investing.
Conclusion
In conclusion, the reality of the venture capital industry today is quite different from the popular mythology. Venture capitalists are more akin to conservative bankers than legendary risk-takers, and they structure their deals to minimize risk and maximize returns. While the percentage of equity they take can vary, venture capitalists typically own around 50% of a startup by the time of exit.
To maximize founder equity, it’s crucial to run a lean, cash-efficient operation and be cautious about equity dilution. Aspiring investors must develop a clear investment thesis, build a strong deal pipeline, and avoid common mistakes to find success in this high-risk, high-reward asset class. As the venture capital industry continues to evolve, understanding the key takeaways and adapting to the changing landscape is essential for both entrepreneurs and investors alike.
The U.S. venture capital industry plays a crucial role in meeting the needs of institutional investors, entrepreneurs, and investment bankers, underscoring its importance in the capital markets. By staying informed and adapting to the industry’s nuances, entrepreneurs and investors can navigate the venture capital landscape more effectively and capitalize on the opportunities it presents.