Good for Founders, Bad For Investors
AI art by Midjourney
We get a lot of startup pitches. The most common response we have is “Good company, Bad investment”
There are many, many good companies to be built. And many great founders to build them. I’m psyched for all founders, and believe many ideas can be successful companies. But only a small set of those companies could provide the kind of return that fit the pattern of venture capital.
Just because a venture capitalist doesn’t invest, it does not mean you don’t have the start of a successful company.
It seems obvious said like this, but it’s lost in many conversations. Often founders seem upset when someone chooses not to invest, like it’s a judgement upon the quality of their company. It’s not.
The question investors answer with an investment decision is not “is this company going to succeed?” The question they are answering is “Will this business provide an effective return on the capital we invest? Does it fit within our fund’s strategy?”
There can be a huge gap between “successful company” and “successful investment” (and, conversely “successful for founders”)
Here is why, in an oversimplified example:
When a founder creates a new company, the cost for the stock is very very very low, nearly free. Founders typically get their stock for $0.0001/share. If the founder is issued 5,000,000 shares, the purchase price for all of their shares would be $500.
For a company with 10,000,000 initial shares (common), founders are basically buying in at a $1,000 company value.
If an investor puts their money in at a $10,000,000 valuation, the founder is already four orders of magnitude up in valuation. Their stock is worth $5,000,000 — on paper anyway. (In a normal business, this would be insane, but it seems to be how startups work these days.)
Now, if the company gets $2m from an investor, and is able to 5x their size, and sell for $50,000,000 the founder objectively does great. They take home $20,000,000 or more, on a basis of almost zero capital. Life-changing outcome.
But the investor didn’t do so well. Their $2m went up 5x, true. But they took a bunch of risk to get that. They gave up control, liquidity, and gave a big chunk of money for years to an unproven, unprofitable business. For kind of risk, they hope for a 50x or 100x return.
A 5x sounds great, but it doesn’t happen instantly, and the time is a huge factor. A 5x in 2 years is 123% annual return. A 5x over 6 years is only 30%. Still sounds good, right?
Remember that in a portfolio of venture bets, most will fail and go to zero. A winner that returns 5x is not sufficient to cover those losses. As an investor thinks, a 5x return is closer to zero than the 100x return they are seeking.
The 100x return might mean the whole fund returns 5x it’s capital — an excellent result for the General Partner and all of their investors.
(Oversimplified examples, I know. Just napkin math to get the idea.)
The potential of 100x+ returns are what early-stage VCs are looking for. That usually means a company needs to reach at least $1B valuation. Don’t be surprised if you get a lot of “no thank yous” if you go out pitching a company with a $100m vision.
Investing in founders who will accept exits or plateaus at $50m to $100m is not the point of venture capital, and is the path to shitty returns.
That’s why VCs look for outright zealots. The kind of nutcase who will laugh at a $100m offer and say “fuck your buyout, I’m coming for your whole industry.”
That’s where the $10B, $100B, and $1T companies come from. That’s where the real returns are. Most importantly, they drive real, lasting change in the world.
And now, that’s my bar for starting a company. What do I care about so much, where do I see so much potential, what technology gives me such an incredible advantage, that I would laugh at the offer of unfathomable wealth, turn it down, and choose to keep fighting.
If you’re a zealot with a vision future historians will marvel at, we’d love to invest in you. If you want to put your capital to work behind these founders, we’d love you to invest alongside us.
The good news is, going bigger is actually easier. More on that in the next post: The Paradox of “Easy Startups.”