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How VC Works – A Beginner's Guide

166 points by simonpure 6y ago

boffinism 6y ago
This is great. I'd love to see more on how the basic VC model, described admirably here, contributes to the weird dynamics of the startup ecosystem. E.g. if the fund size is large enough, VC partners can do very well ($ millions a year) purely from the fee. So they are incentivised to close large funds, and for that they need to demonstrate potential, which is easiest to achieve through huge valuations on paper for their portfolio rather than actual exits. Like, I'd love to see some relatively impartial analysis of stuff like that, because mostly the only people who talk about it are ranting.
- vivekraju93 6y ago
  Hey, thanks! I am the author of this. I am certainly thinking of writing about such dynamics. Also want to cover how lead investor dynamic plays out which leads to due diligence being passed on/skipped and other signalling stuff. Still struggling with the structuring of the piece though
l8rpeace 6y ago
Naive question: does this same paradigm apply to angel investing?
- vivekraju93 6y ago
  Not really. A major difference is an Angel invests his own money, not someone else's like a VC does. So the incentives are different. The angel also sources deals differently and invests only in very early-stage companies (mostly at idea stage), so the risk-return picture is even more skewed.
MarcellusDrum 6y ago
I hate it when blogs do this. Does it hurt to put the full word in the title (or at least first paragraph) instead of the initials? It took me a relatively long time to understand what the article is about when I was reading it. I don't know about you, but Venture Capital is not the first term I think of when I hear VC.
- travisjungroth 6y ago
  What is the first thing you think of? The only other thing I can think of is Viet Cong, and it seems pretty obvious from the title it’s not about them.
  - tester34 6y ago
    GTA Vice City
  - M2Ys4U 6y ago
    Video conference is commonly called VC
  - MarcellusDrum 6y ago
    Due to the quarantine and the current crisis, VC is wired to Video Conference or Voice Chat in my brain. The title gives no clue whatsoever. How does X works can have any word in place of X and it would still make sense.
- vivekraju93 6y ago
  Hey, I am the author of this. Fair point - I should've been more thoughtful. Will keep in mind :) Do let me know if you found it useful otherwise.
- user341231434 6y ago
  Your comment is like walking into a computer shop and getting angry when the store asks you what PC you want. The article even mentions venture capital at the top of the article BEFORE the first paragraph - no reason to get angry from your lack of knowledge.
Havoc 6y ago
Nice explanation. The LP and GP parts feel a little wonky though >they don't run the VC firm (hence the term 'limited'). It’s from the concept of limited legal liability more than who runs it. Same for GP - generally just a legal shell. practically it doesn’t really do the stuff the article implies. The actual running of it is usually in a third entity (again to separate legal liability). And the carry sometimes goes to a fourth.
- rmrfstar 6y ago
  [1] is a good resource. [1] https://www.amazon.com/Mastering-Private-Equity-Transformation-Investments/dp/1119327970/ref=sr_1_1?dchild=1&keywords=mastering+private+equity&qid=1590501034&sr=8-1 https://www.amazon.com/Mastering-Private-Equity-Transformati...
- mbesto 6y ago
  > The LP and GP parts feel a little wonky though I think the distinctions the author tries to use are generally wonky, but otherwise, I think you are trying to take the pedantic legal view of the entities. Semantics here are important. > Same for GP - generally just a legal shell. Legally sure. In fact you might find all sorts of legal structures about how GPs and LPs operate ("Fund I LLC", etc). Colloquially, however, GP means "the party who actually run the fund day to day" and LP means "party who puts money into a specific fund".
mindfulplay 6y ago
Quote: "Being a VC is fing hard". But what he won't tell you is much much harder to be a founder/engineer who actually does stuff. It's not clear how different this is from say hedge fund? I would imagine it's the same set of people who just found a nice, easy alternative?
- nmfisher 6y ago
  > But what he won't tell you is much much harder to be a founder/engineer who actually does stuff. No idea how hard VCs work, but I suspect this isn't a fair comment. Sounds strikingly similar to engineers' opinions of salespeople - "their job isn't so hard, my job is much harder because I actually have to build something". To me, dealing with people is a lot more difficult than dealing with machines. I think I would bomb spectacularly if my job was mostly wining, dining and cajoling investors.
- clairity 6y ago
  being a VC is hard, but the surprising part is how and where. it's not in picking investments, as we might imagine at first blush, but in constantly securing funding, accessing good deal flow, building relationships, making connections/deals (partners, companies, customers, employees, etc.), gathering (private) information, etc. once you do all that hard stuff, picking the investments is relatively easy, and mostly a numbers game, because any (large enough, ~60+) portfolio of not-unviable investments will perform reasonably, assuming you do, and keep doing, all the hard things noted above. it's mostly tending to people and being proximate to both talent and wealth. only a small slice of the job is picking investments.
- jasode 6y ago
  >It's not clear how different this is from say hedge fund? I would imagine it's the same set of people Although a hedge fund and a venture capital fund look superficially the same, they attract very different types of people because they specialize in different aspects of finance. I wrote a previous comment on this.[0] Many folks who start hedge funds or join hedge funds come from traditional banking sectors like ex-Goldman Sachs, ex-Citi, ex-MorganStanley, etc. Their mental model is arbitrage and finding inefficiencies in financial markets. In contrast, the type of people who start VC funds often come from the tech industry. E.g. ex-Intel, ex-Google, ex-Netscape etc. Their dominant perspective is growing new startups that beat the competition. E.g. The VC Marc Andreessen was not an ex-banker. He was the Netscape wunderkind programmer. Yes, sometimes some lower-level VC partners come from Wall Street (e.g. KPCB partner Mary Meeker was analyst at Morgan Stanley) but the prominent names in VC came from the technology sector. Likewise, the next generation of VCs will come from employees of today's tech unicorns. The disposition and personality of a venture capitalist is closer to an angel investor rather than a hedge fund partner. The angel is just investing his own money to grow a hot new company whereas the VC is investing others' money. [0] https://news.ycombinator.com/item?id=21365966 https://news.ycombinator.com/item?id=21365966
tasuki 6y ago
> VCs are expected to generate a 25-35% annualized return compared to the 12-15% that public equity markets generate and much higher than the 8-10% return that debt markets give. What does "expected to generate a 25-35% annualized return" mean here? Is that the mean/average annualized return of a VC fund? Or the "wished for" annualized return?
- xmot7 6y ago
  It's a very aspirational target. 25% annualized return (after fees) is a top decile fund. I've heard that number as a target before, but rarely and from investors that weren't used to the market. 12-15% from public markets is a top quartile hedge fund, still a great return but a little less aggressive than the VC number.
  - pbk1 6y ago
    Under this definition, it would seem as if Andreesen Horowitz is not anywhere close to a top decile fund[1]. Does anyone know which ones are? Data on VC returns seems hard to come by. [1] https://www.theinformation.com/articles/andreessen-horowitz-returns-slip-according-to-internal-data https://www.theinformation.com/articles/andreessen-horowitz-...
    - xmot7 6y ago
      For industry wide statistics, something like https://www.cambridgeassociates.com/wp-content/uploads/2018/05/WEB-2017-Q4-USVC-Benchmark-Book.pdf https://www.cambridgeassociates.com/wp-content/uploads/2018/... is pretty good. All returns there are gross, not net, but they show top quartile funds returning 15-20% gross over the last decade, varying a bit year to year. For specific fund performance, I don't know of anything public. Most of the big names have had some funds with >20% returns, usually as they get bigger those get harder to maintain.
jashmenn 6y ago
Even though a lot of engineers want to raise VC (or work for companies that have) the incentives are weird and it can influence your work/job in ways you might not expect. When you take VC, you're given millions of dollars to build something huge, but it's also a Faustian bargain because you're limiting your range of outcomes. You might grow a nice, profitable business, but if you can't 100x (or 1000x) their investment, your investors will be unhappy. shameless self-plug: I just interviewed Sumukh Sridhara (AngelList Engineer, @vcstarterkit on Twitter) about VC from a programmers perspective on our podcast [1] and he's really, really good. If you're a dev looking to learn more about this, give it a listen. [1]: https://podcast.newline.co/episodes/a-software-engineers-guide-to-venture-capital-with-angellist-engineer-sumukh-sridhara https://podcast.newline.co/episodes/a-software-engineers-gui...
- xmot7 6y ago
  The return profile depends a lot on the stage of VC you're at - while a 100x return might be plausible for an early angel investor (who also expects 90% of their investments to go to zero), lots of later stage VC's will be quite happy with the more consistent 5x outcome.

166 points by simonpure 6y ago

This is great. I'd love to see more on how the basic VC model, described admirably here, contributes to the weird dynamics of the startup ecosystem. E.g. if the fund size is large enough, VC partners can do very well ($ millions a year) purely from the fee. So they are incentivised to close large funds, and for that they need to demonstrate potential, which is easiest to achieve through huge valuations on paper for their portfolio rather than actual exits. Like, I'd love to see some relatively impartial analysis of stuff like that, because mostly the only people who talk about it are ranting.

vivekraju93 6y ago
Hey, thanks! I am the author of this. I am certainly thinking of writing about such dynamics. Also want to cover how lead investor dynamic plays out which leads to due diligence being passed on/skipped and other signalling stuff. Still struggling with the structuring of the piece though

l8rpeace 6y ago

Naive question: does this same paradigm apply to angel investing?

vivekraju93 6y ago
Not really. A major difference is an Angel invests his own money, not someone else's like a VC does. So the incentives are different. The angel also sources deals differently and invests only in very early-stage companies (mostly at idea stage), so the risk-return picture is even more skewed.

MarcellusDrum 6y ago

I hate it when blogs do this. Does it hurt to put the full word in the title (or at least first paragraph) instead of the initials? It took me a relatively long time to understand what the article is about when I was reading it. I don't know about you, but Venture Capital is not the first term I think of when I hear VC.

travisjungroth 6y ago
What is the first thing you think of? The only other thing I can think of is Viet Cong, and it seems pretty obvious from the title it’s not about them.
- tester34 6y ago
  GTA Vice City
- M2Ys4U 6y ago
  Video conference is commonly called VC
- MarcellusDrum 6y ago
  Due to the quarantine and the current crisis, VC is wired to Video Conference or Voice Chat in my brain. The title gives no clue whatsoever. How does X works can have any word in place of X and it would still make sense.
vivekraju93 6y ago
Hey, I am the author of this. Fair point - I should've been more thoughtful. Will keep in mind :) Do let me know if you found it useful otherwise.
user341231434 6y ago
Your comment is like walking into a computer shop and getting angry when the store asks you what PC you want. The article even mentions venture capital at the top of the article BEFORE the first paragraph - no reason to get angry from your lack of knowledge.

Havoc 6y ago

Nice explanation. The LP and GP parts feel a little wonky though >they don't run the VC firm (hence the term 'limited'). It’s from the concept of limited legal liability more than who runs it. Same for GP - generally just a legal shell. practically it doesn’t really do the stuff the article implies. The actual running of it is usually in a third entity (again to separate legal liability). And the carry sometimes goes to a fourth.

rmrfstar 6y ago
[1] is a good resource. [1] https://www.amazon.com/Mastering-Private-Equity-Transformation-Investments/dp/1119327970/ref=sr_1_1?dchild=1&keywords=mastering+private+equity&qid=1590501034&sr=8-1 https://www.amazon.com/Mastering-Private-Equity-Transformati...
mbesto 6y ago
> The LP and GP parts feel a little wonky though I think the distinctions the author tries to use are generally wonky, but otherwise, I think you are trying to take the pedantic legal view of the entities. Semantics here are important. > Same for GP - generally just a legal shell. Legally sure. In fact you might find all sorts of legal structures about how GPs and LPs operate ("Fund I LLC", etc). Colloquially, however, GP means "the party who actually run the fund day to day" and LP means "party who puts money into a specific fund".

mindfulplay 6y ago

Quote: "Being a VC is fing hard". But what he won't tell you is much much harder to be a founder/engineer who actually does stuff. It's not clear how different this is from say hedge fund? I would imagine it's the same set of people who just found a nice, easy alternative?

nmfisher 6y ago
> But what he won't tell you is much much harder to be a founder/engineer who actually does stuff. No idea how hard VCs work, but I suspect this isn't a fair comment. Sounds strikingly similar to engineers' opinions of salespeople - "their job isn't so hard, my job is much harder because I actually have to build something". To me, dealing with people is a lot more difficult than dealing with machines. I think I would bomb spectacularly if my job was mostly wining, dining and cajoling investors.
clairity 6y ago
being a VC is hard, but the surprising part is how and where. it's not in picking investments, as we might imagine at first blush, but in constantly securing funding, accessing good deal flow, building relationships, making connections/deals (partners, companies, customers, employees, etc.), gathering (private) information, etc. once you do all that hard stuff, picking the investments is relatively easy, and mostly a numbers game, because any (large enough, ~60+) portfolio of not-unviable investments will perform reasonably, assuming you do, and keep doing, all the hard things noted above. it's mostly tending to people and being proximate to both talent and wealth. only a small slice of the job is picking investments.
jasode 6y ago
>It's not clear how different this is from say hedge fund? I would imagine it's the same set of people Although a hedge fund and a venture capital fund look superficially the same, they attract very different types of people because they specialize in different aspects of finance. I wrote a previous comment on this.[0] Many folks who start hedge funds or join hedge funds come from traditional banking sectors like ex-Goldman Sachs, ex-Citi, ex-MorganStanley, etc. Their mental model is arbitrage and finding inefficiencies in financial markets. In contrast, the type of people who start VC funds often come from the tech industry. E.g. ex-Intel, ex-Google, ex-Netscape etc. Their dominant perspective is growing new startups that beat the competition. E.g. The VC Marc Andreessen was not an ex-banker. He was the Netscape wunderkind programmer. Yes, sometimes some lower-level VC partners come from Wall Street (e.g. KPCB partner Mary Meeker was analyst at Morgan Stanley) but the prominent names in VC came from the technology sector. Likewise, the next generation of VCs will come from employees of today's tech unicorns. The disposition and personality of a venture capitalist is closer to an angel investor rather than a hedge fund partner. The angel is just investing his own money to grow a hot new company whereas the VC is investing others' money. [0] https://news.ycombinator.com/item?id=21365966 https://news.ycombinator.com/item?id=21365966

tasuki 6y ago

> VCs are expected to generate a 25-35% annualized return compared to the 12-15% that public equity markets generate and much higher than the 8-10% return that debt markets give. What does "expected to generate a 25-35% annualized return" mean here? Is that the mean/average annualized return of a VC fund? Or the "wished for" annualized return?

xmot7 6y ago
It's a very aspirational target. 25% annualized return (after fees) is a top decile fund. I've heard that number as a target before, but rarely and from investors that weren't used to the market. 12-15% from public markets is a top quartile hedge fund, still a great return but a little less aggressive than the VC number.
- pbk1 6y ago
  Under this definition, it would seem as if Andreesen Horowitz is not anywhere close to a top decile fund[1]. Does anyone know which ones are? Data on VC returns seems hard to come by. [1] https://www.theinformation.com/articles/andreessen-horowitz-returns-slip-according-to-internal-data https://www.theinformation.com/articles/andreessen-horowitz-...
  - xmot7 6y ago
    For industry wide statistics, something like https://www.cambridgeassociates.com/wp-content/uploads/2018/05/WEB-2017-Q4-USVC-Benchmark-Book.pdf https://www.cambridgeassociates.com/wp-content/uploads/2018/... is pretty good. All returns there are gross, not net, but they show top quartile funds returning 15-20% gross over the last decade, varying a bit year to year. For specific fund performance, I don't know of anything public. Most of the big names have had some funds with >20% returns, usually as they get bigger those get harder to maintain.

jashmenn 6y ago

Even though a lot of engineers want to raise VC (or work for companies that have) the incentives are weird and it can influence your work/job in ways you might not expect. When you take VC, you're given millions of dollars to build something huge, but it's also a Faustian bargain because you're limiting your range of outcomes. You might grow a nice, profitable business, but if you can't 100x (or 1000x) their investment, your investors will be unhappy. shameless self-plug: I just interviewed Sumukh Sridhara (AngelList Engineer, @vcstarterkit on Twitter) about VC from a programmers perspective on our podcast [1] and he's really, really good. If you're a dev looking to learn more about this, give it a listen. [1]: https://podcast.newline.co/episodes/a-software-engineers-guide-to-venture-capital-with-angellist-engineer-sumukh-sridhara https://podcast.newline.co/episodes/a-software-engineers-gui...

xmot7 6y ago
The return profile depends a lot on the stage of VC you're at - while a 100x return might be plausible for an early angel investor (who also expects 90% of their investments to go to zero), lots of later stage VC's will be quite happy with the more consistent 5x outcome.