Venture-CapitalEasy

3 min read · 591 words

What the seat actually does

Venture capital funds young companies in exchange for a minority stake, usually alongside other investors, in a series of rounds as the company grows. The economics are unlike anything else on this map because the outcomes are.

The distribution is the strategy. Most investments return nothing or little; a small number return many times the money; and the fund is built so that the second group can pay for the first. That single fact explains behaviour that looks irrational from a portfolio-theory seat: chasing outcomes that are unlikely, tolerating total losses without changing approach, and caring far more about how large the best case is than how likely it is.

• Sourcing — seeing enough, early enough, which is what networks are actually for.
• Judging — a team and a market, with financial statements that do not yet say anything.
• Structuring the round — the price, the preference, the board seat, the protective provisions.
• Helping, or claiming to — hiring, introductions, and the next round.

A day, and where it goes

• Meetings — a great many, most of which end nowhere and none of which can be skipped.
• Diligence at low information — references, product, and whether the market being described exists.
• Terms — a term sheet whose economics live in clauses rather than in the headline number.
• The portfolio — mostly the companies in trouble, because the ones working need less.

What it is measured on

• Fund multiple, over ten years or more. Nothing shorter means anything: the losses arrive early and the winners are marked long before they are sold.
• Whether the best investment was large enough. Being early in the winner and owning two per cent of it is a story, not a return.
• Follow-on discipline — the reserve deployed into the companies working rather than the ones needing rescue.
• Marks that are somebody else's price. A holding is carried at the last round, which was set by whoever was most optimistic that quarter.

What it touches on this site

• The instruments — venture funds, convertibles in structure if not in name, and alternatives as the class it sits in.
• Where it ends — a listing, a sale, or nothing.
• What a valuation means here — valuation, which mostly does not apply, and that is the point.
• What happens when the story ends — 2019.

How it goes wrong

• The headline valuation is not a valuation. A round priced with a liquidation preference gives the new money its capital back first, so the "value" of the ordinary shares is far below the number in the announcement.
• Dilution across rounds. Owning ten per cent of something early is owning three per cent of it later, and only the later number pays.
• Marking to the last round in a market that has moved. A private portfolio that did not fall when public comparables halved has not avoided the fall.
• Governance thin by design. Minority stakes, founder control and diligence at low information is the combination behind most of the frauds in this corner.

Concepts to master

• Power law, not a normal distribution. The mean outcome is meaningless; the shape of the tail is the whole business.
• Preference stacks decide who gets paid. In any exit below the top, the ordinary shares are the residual and often nothing.
• Ownership at exit is what matters, not ownership at entry — which makes reserves for follow-on a first-order decision.
• A mark is a transaction somebody else did. It is information, not a value.