Finding Genius

by Kunal Mehta

  “There is a false perception that investors and venture capitalists are like ATM Machines — walk up to them, input data or a slide deck, and cash comes flying out. That’s not how it works but I’m shocked that so many founders think it’s still that easy.”

  As far as incentives are concerned, in every case as it relates to traditional venture capital, the LPs and GPs are financially motivated and are looking to generate returns on their capital. The GPs are the contractual decision makers for the fund and receive carried interest paid by the fund, typically 20% of the profits earned through liquidation events. The management company, or the business unit of this partnership between the LPs and GPs, absorbs about 2% of the total assets under management to finance the overhead costs of the fund, including staff salaries, office space, marketing, etc. This incentive structure is often where venture capitalists can be misaligned with founders at any stage of the company’s growth.

  Venture funds receive equity from a company in exchange for capital, but the venture fund cannot recognize any gains on their investment until there is a liquidation event. Liquidation events generally occur through a strategic acquisition by another market player, an initial public offering of equity, or through a share purchase where an investor’s position, or ownership within a company, is bought out by a new investor. As valuations creep higher, investors are faced with the growing dilemma of what valuation an exit/liquidation event will occur at, in what time horizon, and if it will be enough of a return to justify the investment in the first place. Just as founders know that starting a company can be a risky proposition, investors have an appetite for risk as they try to maximize returns. Venture capitalists filter thousands of deals each year, searching for those specific geniuses amongst the masses of entrepreneurs that approach them. Venture funds run an extensive diligence process prior to making an investment and attempt to minimize the risks that come with their investments. Pocket Sun of SoGal Ventures boils this level of risk down:

  “Over 70% of startups fail or die. 3% of companies exit above $100 million, 0.7 % exit above $500 million, 0.2% exit above $1 billion, 0.06% exit above $2 billion. In the 1,000 companies hand-selected and funded by venture capital, only two of them can get to an exit over $1 billion. Five companies exit between $500 million and $1 billion. A total of 30 lucky ones exit for over $100 million. Another 70 have some sort of an exit. That leaves us 900 companies with no exit.”

  Given that 90% of venture funded companies fail, investors are thereby further inclined to find the outsized returns one or two companies can deliver to them.

  While understanding the structural returns and portfolio theory of investing is important, the timeline of a fund is also critical to an entrepreneur. Most funds last for seven to 10 years but are generally active in the first three to four years. At the end of year four, the majority of the fund will already be invested. The rest of the fund enters a harvest period for follow-on investments in a few good performers. Many VC funds reserve about 50% to support existing portfolio companies. A smaller fund may not even do follow-on investments because they require a larger capital for a small incremental ownership. In other words, ownership gets more expensive and the economics do not always make sense. As an entrepreneur, you need to do your research and know a fund’s vintage, which refers to the year the fund was raised.

  Entrepreneurs should be aware that at the end of this lifecycle, depending on the history of the fund and their LPs, the GPs will need to go out and raise more capital from LPs in order to stay in business. While this has minimal impact on the founders from a day-to-day perspective, it is important as some venture investors may attempt to force a liquidation event in order to generate an actual return to LPs. Also, should the fund not be able to successfully raise additional capital, the founder may lose the interest of that investor as they move on to their next endeavor. The LP makeup, GP backgrounds, past investments, liquidation events, and fund timeline are all important points for an entrepreneur to consider prior to partnering with a venture capitalist. Most entrepreneurs see any capital infusion as cash flow to their business and are unbiased when accepting it, regardless of where this capital is coming from. However, some of the fund differentiators listed above may lead to a strategic misalignment and cost a founder their company.

  Measuring and Reacting to Risk

  As for the statements around venture capitalists taking outsized risks to find these returns, Brad Feld, an investor with the Foundry Group who has invested in Zynga, Fitbit, and MakerBot, disputes this claim. He believes that the successful venture investors are smartly placing their predictions for the future as opposed to a spray-and-pray mentality:

  “ ‘A venture capitalist’s job is to invest in risky projects.’ This statement is scary to me. We should be risk evaluators, not risk takers. We should invest where our background and instincts and due diligence convince us the anticipated return will far exceed our evaluation of the risk. There are five key risks in any deal: market, product, management, business model, and capital. Taking all five at once is crazy. Most losses happen when you combine market and product risk — take one, not both, and take it with a proven entrepreneur.”

  As we will see throughout this book with the ‘calculated risks’ that entrepreneurs take, venture capitalists also need to learn to manage this risk as they swing for the fences with their investments. In discussing his career over a 20 year period, Fred Wilson, the founder of Union Square Ventures (USV) offers insight into how venture capitalists approach an entire portfolio of companies:

  “I remember back in the mid 90s, I used to say with some pride that I had not lost money on any of my VC investments. Then one day, someone told me ‘then you are not taking enough risk.’ I ended that streak of not losing money on VC investments in the late 90s in a series of epic flameouts. I lost somewhere between $25 million and $30 million on one single investment. I am not proud of those mistakes. They were stupid. I am ashamed of them to be honest. But I learned a lot from them. Not only was my “winning streak” a case of not taking enough risk, it was also a case of not enough learning. The go-go Internet era of the late 90s fixed both of those things for me. I took more risk and learned a ton.”

  Wilson’s first fund with USV, launched in 2004, turned out to be the best fund that the firm has ever invested out of. Wilson recounts in his blog that of the 21 investments made from that fund, 12 of those made money for the fund and the fund lost their entire investments in the other nine companies. The fund’s performance, however, was based on five investments in which they made returns of 115x, 82x, 68x, 30x, and 21x. Similarly, in the 2008 fund launched out of USV, a fund that is projected to be another high-performer based on companies within that portfolio, USV has ‘completely written off’ six companies as losses. In sharing these performance metrics, Wilson reveals that portfolio theory of venture capital is to explain that ‘losing money is part of being an investor’. In his decades of experience as a venture capitalist, Fred Wilson shares a unique perspective on managing risk and swinging for the fences:

  “There are some things you can do with your winners and losers to drive up your performance. The first and most important thing you can do is minimize the amount of money you invest in your losers. In our 2004 fund, we invested a total of $50 million out of $120 million of total investment in our nine losers. That wasn’t so good. We could have, and should have, recognized our bad investments earlier and cut them off. In our 2008 fund, I think we will invest roughly $35 million out of roughly $140 million of total investments in failed investments. So even though our loss ratio on “names” is around 40%, our loss ratio on dollars will be around 20%. We did a good job of not allocating too much of the fund’s capital to losers in our 2008 fund.”

  In speaking with other venture capitalists, I came to understand how investors approach companies that are perceived to be ‘failures’ within a portfolio. The investors generally agreed that a venture capitalist should minimize their exposure and gai
n clarity quickly on whether or not a company is hitting its metrics and still has the same potential as when the investment was made. Wilson says he is a big believer in ‘loving your losers’ in that companies should not be orphaned, and an investor or board member should work hard to get those companies to the right outcome — whether it is sold or shut down quickly. Likewise, the venture capitalists are also obsessive with how they spend their time and believe a high proportion of time and effort should be spent preserving their capital in promising companies and helping them to succeed. These are all interesting points for an entrepreneur who is considering whether or not they should raise venture capital. On finding the right venture capitalists to work with, Wilson believes humility and failure, as it is for founders, is often the best teacher for investors. He says:

  “Making bad investments is humbling, frustrating, annoying, time sucking, and most of all, a big part of the VC business. I look for VCs who have done it a lot, have done it with grace and respect, and continue to learn from it. They are the best VCs to work with.”

  Through Wilson’s experience, investors and entrepreneurs can begin to better understand how investors are motivated and what outcome they are searching for.

  CHAPTER 2

  RAISING A VENTURE CAPITAL FUND: VCS AS ENTREPRENEURS

  “The thing that drives me is that people are invested in us and I cannot let those people down. There is a world where I am hugely successful. Or, there is a world where this fails and I lose money, but one thing is for damn sure: in that scenario, it will not happen from a lack of effort.”

  Jacob Yormak, Story Ventures

  Jacob Yormak, a former lawyer with a lucrative career ahead of him, set out to be an entrepreneur in 2016. During the two years that I followed Yormak’s entrepreneurial journey for this book, he was transparent about his struggles, long nights, self-doubt, even while he established a respected reputation within the New York startup ecosystem. In an industry where public perception and personal branding is often overvalued, such transparency and honesty is hard to find. It is difficult to distinguish from Yormak’s sentiments above that he was not embarking on the typical startup journey one would expect. Instead, Yormak was opting to launch his own venture fund with his brother, Brian Yormak, who also left a role at a top venture capital fund to build what would become Story Ventures. While much of venture capital is often portrayed as an elitist industry of affluent individuals who are disconnected from their entrepreneurial counterparts, the Yormaks’ story, and other ones like theirs, reflect the reality of the industry.

  As founders pitch to venture capitalists, many overlook the simple fact that venture capitalists, like Jacob and Brian, are invigorated by the radical and genius entrepreneurs they surround themselves with. Instead, they often view these men and women solely as gatekeepers of elusive capital who do not have skin in the game. In many cases, venture capitalists are entrepreneurs in their own right. During my conversations with veterans in the industry, many shared their entrepreneurial stories, often unprompted, of when they decided to leave the security of a well-paying job to launch venture funds to test their own theses. They candidly shared their failures and how those experiences helped them evolve as investors. It is clear that an investor’s unique experience — even if it stems from a failed investment or startup experiment — makes them assets to the founders they would eventually invest in. Through my conversations, I learned that the majority of these investors ride the waves of the entrepreneurial cycle alongside founders themselves, yearning to share their own perspective and lessons learned with the next generation of entrepreneurs and venture capitalists. Ambitious venture capitalists launching their own funds are choosing a career path with an uncertain outcome. And because of that, the line that once divided venture capitalists and entrepreneurs has become blurred through the similarities they share. In one such anecdote, Jacob Yormak shared his perspective on establishing a presence as a first-time fund in a competitive venture market:

  “Brand building is an important factor with the abundance of capital out there. It would be nice to be a top-tier fund and have quality inbound deals but we [Story Ventures] are years away from that and we need to hustle to find that deal flow. After we have done that, how do we win a deal and convince an entrepreneur to let us into a deal? If we do a great job with our existing founders, they will tell other good founders to work with us. Our brand as a fund is not exclusively to attract founders because it also determines how other investors, future LPs or service providers react to you. All of those parties are key to winning a deal. These pieces are all important to consider as we look to build a sustainable fund. It’s not as easy as it appears from the outside.”

  A common perception of VCs is that they receive an abundance of “quality inbound deals”. This is not the case. VCs themselves are responsible for generating deal flow and finding the entrepreneurs to invest in, just like founders have to find customers. This is yet another example of how the VC and founder share the experience of the entrepreneurial cycle.

  Raising a Fund

  The process of establishing a venture fund is similar to starting a seed-stage company. It requires a hopeful venture capitalist to craft a vision that will sell to investors in exchange for financing. Similar to starting a company, launching a venture fund is often irrational and holds a low probability of success. In order to provide perspective into how venture capital funds are formed and the drivers that motivate LPs to invest in this asset class, I spoke with both new and seasoned venture capitalists. The insights drawn from these conversations might serve to create a higher level of empathy between founders and investors. How did they raise their first funds? How do they sell their vision to investors and manage their expectations? For a change, the onus was off of the entrepreneur to answer questions around financing and now on the venture capitalists themselves.

  Raising a fund is a process that is still largely opaque because LPs do not advertise their theses the way venture capitalists do, and they are not as readily available to deploy their capital. In raising a venture fund, there is no concept of a ‘lead investor’ as there is in a startup financing round which other smaller investors can rally around. Instead, it is a frantic process without a structure where GPs try to find the appropriate introductions to disparate family offices, pension funds or random, high net-worth individuals who will buy into that investor’s belief despite the high degree of uncertainty in the investments they will make. As in entrepreneurship, success in venture capital is not manifested overnight but determined over a long-term horizon. Nicholas Chirls, a co-founder of Notation, humbly and cautiously describes this experience even after successfully raising his second fund and backing lucrative ventures out of his first fund:

  “The venture capital business takes a very long time to get good at. You need decades to prove that you can consistently provide great returns as a VC. Until you’ve proven that over multiple funds, you can attribute much of one’s success to luck. If we find the next Uber-like investment in this fund, it will be luck. If we can find similar returns in fund 1, fund 2, fund 3, fund 4, then we can say we know what we are doing. In this business, whether you’re a VC or a founder, you’re consistently humbled, and when you feel like you’re killing it, something happens, and you’re knocked on your ass again.”

  Indeed, it’s that roller coaster story that so many founders often tell of their own experience. Many of the ‘startup’ venture capitalists of the early 2000s have now established themselves as mainstay players, but they’re not unfamiliar with this struggle. Rick Heitzmann, a venerable venture investor and a co-founder of FirstMark Capital, likens the early days of launching his fund and the competition to get into deals to his time as an entrepreneur:

  “As a startup VC shop, we were competing for mindshare, for deals, and for companies. When we were starting off, the most established venture capitalists would look down at us. They most definitely would not return our calls asking for their advice and oft
entimes, when we would run into them at a conference, they would look at my partner and I like we were asking for a job. We had no initial credibility and it was very much, for several years, like running a startup. Some of the LPs, who we were able to eventually secure, we had solicited and pitched for eight years before they trusted us with their capital. It was like one of those old Wall Street movies where we would show up for a meeting and the manager of investments would then tell us they didn’t have time to meet with us and would send his or her analyst to the lobby. The analyst would then say, ‘I only have 5-6 minutes, do you want to buy me a coffee?’ So, I, with no money, would now be buying this analyst a coffee and hoping he would put in a good word with his boss to invest in our fund. But this is normal if you’re scaling a business. From the operating side or the investment manager side, it’s very much the same hustle.”