Types of Assets and Expectations

There exist different types of assets. Venture capital assumes high risk but can surpass other asset classes in terms of returns in the medium or long term. An added bonus of venture investments is creating new economic value: they facilitate a positive-sum game unlike, for instance, the stock market, where one person's gain is typically another's loss.

Venture capital investments can significantly impact your wealth, either depleting or increasing it. As a result, venture capital managers must develop effective strategies and models. Their primary goal is to ensure that these high-risk investments yield higher returns compared to more conservative options like government bonds, debt instrument investments, and real estate in established markets. Given a scenario where venture capital and public markets might offer a 10% annual return while bonds yield 0% when adjusted for inflation, the allure of venture capital becomes quite tempting.

When Venture Capital Investments Are Rational

Major investors want to increase profitability without high risk. Say you have $1 billion in assets. You invest $10 million in venture capital, and the remaining $990 million brings you 1%. Even if the venture investment fails and burns out completely, you will still have $999.9 million versus the initial $1,000. But if this venture capital bet plays and brings a 4x return, then the increase in the entire portfolio will be 4% instead of 1%, which is quite significant.

Conservative strategies do not work for investors who cannot wait 15-20 years and are looking for opportunities to make 3-5x in the foreseeable future.

If the goal is to ensure a chance to earn 5x in several years, then we need to choose a strategy for how to do it. The task of venture managers is to search for new technologies and business models that can potentially give high profits quickly. Those venture capitalists who work with HNWIs aim for 3-5x in 6-8 years, and those who work with longer institutional money can expect more extended payback periods.

A VC's Strategy by the Example of a $100 million Fund

Imagine managing a $100 million fund with a goal of generating a 4x return. This involves distributing the $100 million across various companies, while accounting for assorted costs like administrative and legal expenses. Therefore, the actual return needed on the invested capital must exceed 4x. For simplicity, let’s assume all the funds are invested (though this is never the case). The success of this endeavor hinges on strategic planning.

One approach could be to invest the entire $100 million in a single company, hoping it will quadruple in value. If you invest $100 million for a 50% stake, the company's post-money valuation should be at least $200 million. To achieve a 4x return, the company's valuation would need to reach $800 million. What are the chances that this could happen? They seem to be low.

Alternatively, investing $50 million in two companies, each for a 50% stake, seems more feasible. This would value each company at $100 million upon entry, with a target exit valuation of around $400 million. But if one company fails and goes bankrupt, the entire $50 million investment is lost. The other company would then need to exceed expectations and be valued at $800 million to achieve the overall 4x return. The probability of success in this scenario is not high, although there are occasional successes.

A more diversified approach might involve investing $10 million in 10 companies, acquiring a 10% stake in each. This strategy carries the risk of some startups failing or not scaling as hoped. To hit a home run in this scenario, at least one company must become a unicorn, and this doesn't even guarantee the desired 4x return if others are performers.

Moreover, remember that these investments only realize their value when companies/shares are sold or go public. Without a liquidity event, these valuations remain theoretical. Given the low probability of success, a venture capital manager should not only seek potential 'moonshot' companies but also effectively manage transaction factors that can impact the entire fund.

Startup’s valuation

Company valuation is a very relative concept, and it reflects market expectations regarding the company's potential growth. Revenue "here and now" is an essential factor but not the best-selling point.

If you had a factory or a store 50 years ago, it generated a relatively predictable cash flow. You could have produced 1,000 cars a year, prices would have raised, margins would have remained predictable, and supply and demand would have been balanced. The cash flow was visible for 15 years ahead. It means that it was possible to calculate its value and the value of the company's capital and, as a result, to pay a certain amount for it. Past profits and current revenue were data for forecasting and model construction. In the real sector, with established business models, this approach works (or at least has worked), but for startups, past growth does not guarantee future growth and vice versa.

That's why growth expectations and valuations should correlate. The founder needs to ask himself: Why do funds trade for valuation? It happens because managers also want to earn and make 10x in the most realistic scenario. It is always more realistic to multiply your investment if the initial valuation is smaller than the valuation at the exit time. Simple mathematics.