How Venture Capitalists Operate

How Venture Capitalists Operate


Let's take a look at how venture capitalists operate today. Venture capital funds can be public or private (see Google Finance list of about 1000 funds). Some of the larger funds invest in 50 or more start-ups per year, and many of the private funds invest in roughly 5-30 companies per year.  In Guy Kawasaki's presentation, he estimates that roughly 3000 companies receive venture capital in a given year, as opposed to millions of companies that get funded in other ways.  VC funding comes from a lot of different sources-- pension funds, private investors, hedge funds, investment banks, etc. 

Today, most of these sources, especially hedge funds who were way over-committed to risk with credit default swaps, are having serious issues in the current financial crisis.  Those 3000 funded companies represented an aggregate of roughly $29 billion in 2008 and that will almost certainly decline going forward.  As the industry unwinds its massive leverage to more reasonable ratios, the Angel and VC market will likely be smaller for quite a long time (see recent article).  The good news is that many of those companies that were funded had similar business plans and this created an unnecessary redundancy within the start-up market.

John Talbott made an interesting observation regarding venture capitalists in his latest bookThe 86 Biggest Lies on Wall Street: "The number of success stories is so low in each case that to reward someone who has a 0.7 percent success ratio and to punish someone who has a 0.2 percent success ratio seems excessive."

The notion that a few funds are simply luckier than others does seem to gibe with common sense.  There is an interesting book on this topic called Fooled by Randomness which is one man's (apparent) rationalization on why he didn't succeed-- which has led to his success.  If you were an investor choosing among these VC funds, you may find that a quantitative approach to determine risk profiles is virtually impossible because it is unclear which funds are better and which are luckier.

Having said that, I believe there are good funds out there though which have produced viable vetting processes and valuation techniques and who seem to find winners more often than the others. Typically, these funds have one or a few people involved who really know what they're doing. The bad funds are essentially legalized gambling-- with other people's money, of course. These funds often have one or two people who have 'made it' as an entrepreneur and supposedly know what they're doing too (again, see Fooled by Randomness). Many of these bad funds basically troll for companies. They parade through conferences, groups, and schools and offer complicated and sometimes usurious terms to unwitting do-gooders who are often just happy to have someone show interest in their idea.

VCs use essentially two methods to determine valuation: 1) the unimaginatively named 'Venture Capital Method', 2) the much more commonly used 'Comparables Method'. The former is really an intuitive guess backed up with a complicated report, and the latter is an intuitive guess backed up by someone else's analysis. It's kind of like a 'comp' for houses in your neighborhood where the venture capitalists look at similar deals to get an idea of how to value the company. 

Talbott goes on to describe venture capitalists like this: "Venture capitalists are the classic example of a middleman. They really try not to benefit anyone other than themselves. If you have a good high-tech idea that you think will make you a lot of money and you bring it to a venture capital firm for a small infusion of capital, they will most likely end up grabbing a controlling position in the company and will eventually end up owning as much as 80 to 90 percent of your company. Your status will very quickly go from founder and owner to paid employee."

Seems a little excessive, but no doubt true in many cases.