What is Venture Capital?

This is Chapter 1 of The Venture Capital Bible by Kieran Ryan.

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1:1 What is venture capital?

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Venture capital (VC) is a way to raise money for your startup. It's a form of financing in which startups receive cash in exchange for an equity stake in the company. VC aims to provide startups with the capital and resources they need to grow into large companies faster.

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VC is a powerful accelerant for startups. 

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1:2 History of venture capital

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Venture capital dates back to before World War II (1939-1945). Then, wealthy individuals and families, such as the Rockefeller family (oil), Warburg family (banking), Whitney family (railroads), Wallenberg family (conglomerate), and J.P. Morgan (banking), started investing from pools of money into private companies. For example, the Wallenberg family started Investor AB in 1916 in Sweden and made several early investments into long-standing industry leaders ABB, Atlas Copco, and Ericsson.

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In 1946, American Research Development Corporation (ARDC) and J.H. Whitney & Company became the first recognized VC firms as they were the first ones to accept money from sources other than wealthy families. The founders of ARDC started the firm to encourage investments in businesses created by soldiers returning from World War II. ARDC has had an enduring impact on the VC industry as many former employees went on to start notable VC firms, including Greylock Partners, Flagship Ventures, Charles River Ventures, and Volition Capital.

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A rule change in 1958 marked a turning point that led to the creation of many more VC firms. Congress passed the Small Business Investment Act of 1958, which allowed the Small Business Association (SBA) to license private "Small Business Investment Companies" (SBICs) to facilitate the financing of businesses and provided tax breaks to VC firms.

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In 1972, the next major inflection was the emergence of independent VC firms Kleiner Perkins and Sequoia Capital on Sand Hill Road, a street running through Palo Alto, Menlo Park, and Woodside in Northern California. These two firms have seeded many of the brands and companies we, as consumers, love today.

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In 1978, VC firms had their best fundraising year yet, raising $750 million, following the relaxation of the Employee Retirement Income Security Act (ERISA) by the US Labor Department, which allowed corporate pension funds to invest in the asset class. While notable at the time, many VC firms today have been able to raise more than that individually.

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VC is one of the largest asset classes today, reaching $235 billion in 2022 in the US alone. 

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1:3 How does venture capital differ from other types of financing?

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VC is different from other types of financing in several ways, including:

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• Risk tolerance: VCs have a higher risk tolerance than other investors, such as banks. The potential for high returns in successful investments can outweigh the risks, leading some VCs to invest in founders simply off of track record, startups with no revenue, or ones that are just an idea.

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• Investment horizon: VCs invest on much longer horizons than other investors. The typical timeline for a VC investment is 8-12 years.

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• Amount of funding: VCs invest more capital than other investors, such as angel investors. Early-stage VCs may invest millions in each startup they decide to fund, and late-stage VCs may invest billions.

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1:4 What types of businesses do venture capitalists fund?

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At a high level, VCs fund startups that can be worth one billion+ in less than ten years. Another way to look at it is they want to invest in startups that can reach $100 million in annual recurring revenue with greater than 60% gross margins in less than ten years.

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VC is for high-growth startups, not small businesses.

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While VCs invest in startups in every industry, from biotech to media, they direct most of the dollars toward software startups. In 2022, VCs invested $90.2 billion into software startups, with the following industry being less than half that at $37.2 billion for commercial product and services startups.

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There is also a geographic skew to be aware of with VC funding in the United States. In 2022, roughly 50% of the total VC dollars went toward startups in California, New York, and Massachusetts.

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However, the real black eye for the VC industry is the breakdown of investments in startups founded by female founders vs. male founders. In 2022, all-female-founded startups only received 1.9% of the VC funding, or ~$4.5 billion of the ~$240 billion allocated by VCs in US startups.

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1:5 The stages of venture capital

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VC firms tend to invest in specific stages of the startup journey – some invest at the very beginning, and others wait until the startup matures.

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The most common stages of venture capital are:

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• Pre-Seed: The first money for startups at the very beginning. Some VCs, like Hustle Fund, will invest this early in startups, but more often than not, startups fill this round with investments from angel investors and family and friends.

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• Seed: Some startups skip the Pre-Seed stage and raise a Seed round as the initial investment in the company. While an MVP and traction can make the opportunity for VCs more attractive, the bare minimum needed to raise a seed round is a compelling story. Typically, the Seed round fills up with VCs, angels, friends, and family checks.

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• Series A: Unlike previous rounds, startups must demonstrate a compelling business, not just an idea. To do this, startups should use data (revenue, users, retention, etc.) and significant milestones (started production of the hardware product) to support their story.

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• Series B: The startup demonstrated they have a product or service that customers love and can scale to match the unmet demand with more money.

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• Series C: The startup has product-market-fit and, with additional funding, can grow even faster to scale to new markets, build new products, and create new profitable revenue streams. Most VCs and startups consider a Series C round the first round of growth capital for a business.

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• Series D: The startup is mainly de-risked but may not be profitable or have good enough unit economics to go public. A Series D round can extend the startup's runway, giving them more time to improve its unit economics as they continue scaling and increasing its top-line metrics.

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When you raise a round of VC, you progress to the subsequent stage as long as you hit the milestones you outlined when pitching to VCs. If you cannot reach your milestones and need more money from VCs to stay alive and get there, then you would raise an extension or bridge round. For example, if a company raises a Series A round and 12 months later has yet to make considerable progress, it will need to raise a Series A Extension. Unfortunately, when startups raise an extension, investors require them to raise on the same or similar terms to their last VC round, which can dilute your startup's equity pool more than you want. At the end of the day, prioritize the survival of your business, even if it requires you to raise an extension, bridge, or down round, which we will discuss later.

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1:6 The benchmarks to raise venture capital

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The benchmarks and metrics needed to raise for each VC funding stage are different based on various factors, including industry, location, and the market. For example, a startup in San Francisco may be able to raise more money on better terms than an identical startup in Texas. There is an art to knowing when you may be able to raise VC that we'll talk about later in The Venture Capital Bible.

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David Sacks and Ethan Ruby from Craft Ventures wrote a piece on The SaaS Metrics That Matter that I highly recommend checking out. It is an excellent example of how VCs think about benchmarks and metrics when evaluating whether to fund a startup. In the post, they outline a SAAS startup needs to hit the following metrics to raise a Series A VC round:

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Growth: Are you growing fast?

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• At least $500K in Annual Recurring Revenue (ARR)

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• A Compound Monthly Growth Rate (CMGR) of at least 15% if you're below $1 million in ARR or 10% if you're above $1 million in ARR

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Retention: Does your business have a leaky bucket?

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• Net Revenue Retention (NRR) of at least 100%, with the best SAAS companies exceeding 120%. NRR can be above 100% if expansion exceeds churn.

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• Logo Retention, which can't be above 100% since the number of logos can't expand, of 90%-95% for enterprises, 85% for mid-market, and 70%-80% for small businesses.

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Unit Economics: Is your growth sustainable, or are you faking it?

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• New Sales ARR equals or exceeds Sales and Marketing (S&M) department spending.

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• Annual Contract Value (ACV) exceeds Customer Acquisition Cost (CAC).

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• Net New ARR in a period divided by (S&M) expenses in the prior period is better than one.

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Margins: How is the financial health of your business?

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• Gross margins greater than 75%.

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• Cross the $0 Lifetime Value (LTV) line within 12 months and grow towards 3x original CAC over time.

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Capital Efficiency: How much are you getting out of a dollar?

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• A burn multiple of less than 2 is reasonable; a burn multiple of less than 1 is excellent.

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Engagement: How often are customers and potential customers (i.e., during free trials) using your product?

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• The typical monthly user visits your site at least two weekdays per week.

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1:7 What are the different types of venture capitalists?

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You can break down the different types of VCs based on their investment focus and stage of investment. Here are some common types of VCs:

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• Early-Stage VCs: These firms, sometimes called Seed funds, primarily focus on investing early in startups during the Pre-Seed, Seed, and Series A rounds. Micro VCs, who invest smaller checks than traditional early-stage VC firms, would also fall into this category.

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• Later-Stage VCs: These firms, sometimes called Growth funds, focus on investing in startups during the Series B, Series C, Series D, and beyond rounds.

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• Industry-Specific VCs: These firms invest in specific industries, such as hardware, fintech, or healthcare.

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• Corporate VCs: These firms invest on behalf of large corporations in startups that align with their company's long-term strategic goals.

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1:8 How are venture capital firms structured?

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Traditional VC firms are structured with the following stakeholders in mind:

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• General Partners (GPs): GPs, or Managing Partners, are the leaders of the VC firm and are responsible for the fund's overall success. They are integral in raising money from LPs, sourcing and leading investments, and hiring investment and platform team members.

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• Limited Partners (LPs): LPs are the VC's investors. These individuals and institutions contribute to the pool of money VCs invest from. Typical LPs in VC funds include high-net-worth individuals, family offices, pension funds, university endowments, trusts, sovereign wealth funds, and more.

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• Partners: Partners source and lead investments on behalf of VC firms into startups. They are also the primary individual responsible for supporting the portfolio company for its existence, which can be a 10+ year commitment. 

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• Associates: Associates, also called Investors or Principals at VC firms, usually have 2-10 years of investing experience. Associates have investing autonomy at some firms, but most still need a Partner's approval to do the deal. Associates are responsible for sourcing deals, helping with due diligence, conducting industry research to find trends and opportunities, and tracking the deal pipeline.

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• Analysts: These are junior investors, with usually 0-2 years of experience, that can not do deals alone and spend most of their time shadowing and assisting more senior investment team members. Analysts have similar responsibilities to Associates but with less autonomy.

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• Platform: A platform team is a team at the VC firm dedicated to providing leverage to portfolio companies by helping them recruit talent, find new customers, and more. A platform team can be a competitive advantage for VC firms to help them win and get into hot deals. a16z has one of the more extensive platform teams in the VC industry – supporting their startups' marketing, go-to-market, operations, people, talent, and capital functions. If a VC firm does not have enough resources to create a platform team, then the responsibilities of a platform team typically fall underneath Partners, Associates, and Analysts.

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• Advisors: VC firms surround themselves with advisors for several tactical reasons, including deal flow, investment evaluation, and expertise in supporting portfolio companies. Additionally, VCs add advisors to improve their brand reputation. VCs with many resources may establish their advisors through Scout, Venture Partner, or Entreprenuer-in-Residence programs. Advisors in these programs may get capital to invest directly alongside the fund or a promise of carried interest (i.e., a share of the profits) in investments they contribute to.

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1:9 How do venture capitalists make money?

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VCs make money from management fees and the profits of the fund. The standard fee structure that most VC firms use is called the two and twenty rule.

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VCs charge a 2% management fee annually on the total amount in the fund during the active investing period. Typically, the active investing period for a VC fund is 4-5 years. For example, if the active investing period is five years on a $100 million fund, then the VC fund will earn a total of 10% or $10 million in management fees for the fund. Some LP agreements require VC firms to draw only up to 2% annually, but some allow the VC firm to pull the entire amount upfront. 

VCs charge 20% on the profits from the fund. The VC first needs to return all the capital invested back to investors. Then, every dollar after is split 80% to LPs and 20% to the VC firm. For example, if a $100 million fund delivers a $200 million return, there is a $100 million profit split under the profit-sharing agreement. So, in this case, the LPs receive 80% or $80 million, and the VC firm receives 20% or $20 million.

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1:10 What is the typical timeline for a venture capital investment?

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The standard time horizon for a VC fund is ten years to deploy the entire fund into startups and return the profits to LPs. In 2021, the median time for a US startup to go from its initial VC financing to IPO took six years.

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With the public markets falling flat, startups are waiting longer and longer before going public, so expect this number to increase in the coming years. An upstream effect of this will be VCs negotiating with LPs to shift the time horizon for VC funds out more.

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1:11 How are venture capitalists measured?

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VCs are measured based on the financial performance of the fund. However, since the true financial performance of the fund takes ten years, as we just mentioned in the previous section, VC funds use a combination of metrics to act as leading indicators for its performance. This allows them to report to its LPs annually on how the fund is tracking, and VC firms use early results to raise their subsequent funds.

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In the very early innings, VC funds may be benchmarked based on subjective measurements such as:

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• Notable Logos: Are they getting access to hot startups where they need to win the deal?

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• Investment Markups: Startups raising subsequent rounds of funding from VCs.

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• Co-Investors: Are they investing alongside top-tier VC firms like Sequoia Capital and a16z?

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• Founder NPS: What do the founders they work with say about them?

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When the fund starts to mature, the most critical metrics VCs share with LPs are:

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1. Multiple on Invested Capital (MOIC): The value of the fund relative to the cost of its investments. Anything above 1.0x is profitable, but the metric uses unrealized value or factors in startup paper valuations, making it a good metric but not perfect for measuring the fund's value.

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How to calculate MOIC: (Unrealized Value + Realized Value) / Total Invested into the Fund

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2. Gross Total Value to Paid-in-Capital (TVPI): The fund's overall performance relative to the total amount of capital paid into the fund. It demonstrates how much each individual LP has received back from the fund and how much they can expect to receive when the fund liquidates all of its remaining startup assets.

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How to calculate TVPI: (Total Distributions + Residual Value) / Paid-in-capital = TVPI

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3. Residual Value per Paid-in-Capital (RVPI): The value of the remaining companies in the portfolio that have not returned capital compared to the total contributions of LPs to date. By comparing this number to funds on a similar timeline, they can see the upside left in this fund versus other funds.

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How to calculate RVPI: Residual Value / Paid in Capital = RVPI

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4. Distributions per Paid-in-Capital (DPI): The ratio of money returned to LPs relative to the amount of capital LPs provided to the fund.

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How to calculate DPI: Distributions / Paid-in-capital = DPI

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5. Internal Rate of Return (IRR): The annualized percent return that is realized or will be realized in the future over the life of a fund. A high-performing VC firm has an IRR of 30% or better.

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How to calculate IRR: 

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1:12 The venture capital power law

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The performance of startups and VC funds tends to follow a power law curve. The idea is a few startups will generate most of the returns in a portfolio. As a result, a few VC firms that invested in these startups capture most of the returns for the entire VC asset class. 

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It's easy to be an average VC firm but extremely hard to be exceptional.

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