Venture capital: funding a journey
- Angel Investors, Bootstrapping, Funding, Peter Thiel, Power Law, Venture Capital
- December 3, 2020
Startups are dynamic organisations on a journey towards growth and profitability.
Much like travelling, most people (barring the trust-fund babies and a few others) cannot afford to go on this journey without funding.
How the journey starts
Each journey has a beginning and each startup its own genesis, so there is no one-size-fits-all when it comes to startup funding. Early-stage funding in the startup world is usually called pre-seed and seed stage funding.
Below, I’ve listed some funders that will usually be the first cheque(s) into the business (investor lingo is still to “write a cheque” even though nobody actually does that anymore).
- Bootstrapping: This is just startup speak for self-generated funding like personal savings, internally generated company cash flow and even (these days) prize-money from startup competitions.
- Family and friends: Many a business has been started by this group of trusted comrades, never afraid to shy away from an idea sketched on the back of a napkin; these might just be the most experienced amateur investors out there.
- Angel investors: Rather than being a celestial-being, these are high-net-worth individuals that fund early stage startups, either by themselves or as a host of angels (Jozi Angels is an example of such a host of Angels)
- Crowdfunding: These technology platforms, like Kickstarter and CircleUp, are not only used to fund your sister’s latest dog collage, but also allow startups to raise funding from a “crowd” of different people online.
- Accelerators: The easiest way to think of an accelerator is as an internship for startups, where a cohort of startups get accepted into the accelerator program for a set period of time (usually a couple of months). The accelerator will then provide these chosen startups with training, mentoring, funding, office space and many other business support services to allow them to accelerate their journey. In most cases, the finance provided by these accelerators is secondary to these value-added services. Grindstone, Knife Capital’s accelerator, is a great example of how valuable these services can be for fast tracking growth and creating jobs (for more information on the accelerator check out their website – https://grindstonexl.com/)
The above funders are not mutually exclusive and a startup may get funding from one or a combination of any of the above.
Long and winding road: a partner to fund the way
Although the list of funders above might seem extensive, none of these funders has the capacity to fund the entire journey, which often ends up being much tougher and more expensive than originally envisioned (very similar to backpacking for months on end).
This is where venture capitalists come in – their treasure chest (both financial and intellectual) is much larger than the early stage funders already listed.
It is thus apt that the origins (at least in theory) of venture capitalists are that of maritime explorers. These original venture funders provided boats and funding to venturing pioneers (startups) to go and explore (a fact-finding journey) unknown lands in the search of valuable goods (returns). No doubt this was a high risk enterprise, with only a select few journeys being successful, with success (as it is in startups) being dependent on the quantum of funding, luck, the ship crew (startup team) and the envisioned exploration area (market).
Like any other investor the ultimate goal of venture capitalists is to make money – but from the above analogy it is clear that they go about making money in a very different way.
Venture capital funds don’t make their returns on a normal distribution; rather they rely on a very skewed return profile called the Power Law. This might sound a little complicated, but the idea is simple – the fund makes returns on a few outliers (hyper) performers, with the rest of their investments going to zero.
This is very different to traditional asset management that targets a benchmark return (called an IRR) on each portfolio investment (i.e. more average performers and less outliers).
Peter Thiel, a venture capitalist and serial entrepreneur (Palantir and PayPal), famously said: “The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the rest of the fund combined.”
It is imperative then for venture capitalists to cast enough lines in the water to catch the critical fish. This means that venture capitalists can’t invest into only one or even a small number of investments per fund, as this does not allow the Power Law to take effect. The consequence of this is venture capitalists having a larger portfolio of smaller investments (and ownership percentages) when compared to more traditional investors like private equity,
You will often hear people citing the sheer number of startup failures as evidence that venture investing is a fool’s errand – but understanding Power Law is the venture capitalist’s rebuttal.
There are many other factors that make venture capital funds unique – in particular the stage and sectors (mostly technology) in which they invest, both contributing to the high risk and low survival rate of investee companies.
Different venture firms all have their own unique investment strategies focused on different stages in the startup life cycle and different industries. This is part of what makes this space so exciting!