The only industry that pays you millions even if you lose money

Venture Capital is probably one of the few industries in the world — if not the only one — that, on average, loses money.

A TechCrunch article from 2017 reported that 50% of venture capital funds make less than a penny on what they invested.

From the outside-in perspective, it’s perplexing to see how such an industry works and how it operates. I mean, why does it even exist? How do they make so much money? Why are they in the headlines in the tech world? These are the questions I’ll be attempting to answer in this piece.

Here’s my attempt at a Venture Capital 101 crash course.

Venture capital is money dedicated to investing in companies. In finance, that’s what funds are. It’s money pooled dedicated to investing in certain, pre-defined things. Venture capital specifically invests in companies that are designed to grow quickly — we call these startups. There is a reason most startups are technology-based. Technology is easy to scale. For example, some startups like Deel and Brex became billion-dollar companies or “unicorns” in three years. Once you build the software product, the incremental cost of adding one, hundred, million users doesn’t cost much.

Because of the mechanism, it takes money upfront to build the product before the product can be sold and scaled to generate revenue. This typically means startups will lose money in the beginning when building the product, and scale massively when it’s successful.

Let’s take an example. Figma was acquired by Adobe for $20bn in 2022.

Figma helps people do collaborative work on UI/UX — it’s what color the buttons are and what the buttons do on every app or website you’ve used. Figma started in 2012, opened its product in 2015 to a small group of people, and then publicly in 2016. It wasn’t until 2021 that they started charging money for their services. But in their first year of charging, they made $200m in revenue and doubled that to $400m in 2022.

So for about a decade, this thing wasn’t generating money, but then exploded, reaching a $20bn valuation. This is why Figma raised money from VCs to pay themselves, hire people, run servers, and so and so forth.

Unfortunately, if you go to banks or traditional investors for money before you start generating money, it’s really hard. Sometimes, founders of these companies have to personally guarantee loans. So only people with a network of wealthy people could really get started.

Now some people came along and said, “Well, if I invest in stocks, maybe I’ll make 10–15% a year. But if one of my startups do well, I see that I can make 10,000% in a year. Chances of that is better than buying lottery tickets”. I describe these return profiles as asymmetric odds, which I’ve explained in detail. To briefly talk about the math, if you invest $1,000 into 100 companies, you only need two of your investments to do well to cover your loss and double your money. So if you were right 2%-5% of the time, you’d do well.

That’s venture capital.

Household technology companies like Google, Facebook, Uber, and Airbnb started as startups and received venture funding. That means a lot of people got rich: The founders, employees (who got to own pieces of the company), and investors. Venture capital quickly became popular, formalized, and high-profile in this world.

Venture Capital can come in many forms. It can be a qualified individual (the US has rules about who can invest), which we call “angels,” a group of individuals who pool their funds, which we call “syndicates,” or a formalized institution, which we call Venture Capital funds.

Softbank, Sequoia, and Tiger are all venture capital funds. A VC fund isn’t some person but an entity made up of several roles.

Here are the most notable ones:

• General Partners (GPs). GPs “start” the fund. They are the first investors and put some money into a fund, which is pooled money dedicated to investing in startups. GPs put in about 1–2% of the total fund. So a $100m fund means you put in at least $1m. GPs then raise the remaining $99m from other investors called LPs.
• Limited Partners (LPs). Once the GP starts the fund, they say, “Hey I’m starting a fund, you should join. I’ll make you money”. LPs put in the other 99%. LPs can be large asset managers, funds of funds, or affluent individuals.
• Management. Usually, these are the people depicted in the media as venture capitalists. They are hired by the GPs to go find cool companies to invest in. GPs are usually the end goal for these guys.
• Portfolio companies (Portcos). They are the startups.

Let’s see how the industry makes money.

Here, I’ll breakdown the section into the following:

1. The pie — How do they make money?
2. Splitting the pie — who gets what?

For the sake of brevity, I’ll simplify and ignore some real-life details for now to get an 80% accurate picture of things.

The pie

For any legal contract to be valid, there has to be something for both sides. That’s called consideration. Startups receive money from VCs. VCs receive partial ownership of the startup. Typically, the target ownership is 10–20%.

VCs make money when startups increase in valuation, typically driven by the company’s growth rate.

Let’s take the Figma example again. The table below is the history of all “rounds” of funding Figma has received since it was founded in 2012. The first “round” of money startups raise is called a pre-seed or seed round. Every other round after that is referred to as “Series + The letter of the alphabet starting with A.”

At the risk of oversimplification, the valuation of a startup is some function risk and potential (to generate cash) of startups. Early-stage investors risk more and get more, while late-stage investors take on less risk.

Say you worked at a VC fund and invested in Series B. You would put in $25m at a $90m valuation. So you own 27.8% ($25m/$90m). We mentioned that Figma was acquired for $20bn. 27.8% of $20bn is roughly $5.6bn.

Your $25m would’ve been worth $5.6bn — a 222x return.

That’s how VC funds make huge amounts of money investing a small amount. If you had put in $1,000, that would’ve got you almost a quarter million dollars.

Now, this isn’t quite accurate. Here are some critical details:

1. Companies, not company. VCs invest in several companies, and many don’t turn out well. So the good investments subsidize the bad ones before anyone splits the pie. This means your gains and wins become more moderate as a whole.
2. Dilution. In this example, we assumed you still owned 27.8%. In reality, your ownership decreases as other investors come into the round. For example, in Series C, Figma raises $40m on a $400m valuation. That means Figma gave up another 10% of ownership, and your ownership will also be decreased, or “be diluted”, by 10%. The same thing would happen for Series D and E unless you put in more capital to keep your 27.8%.
3. Liquidity event. You don’t make money until someone pays cash for the company. Even though Figma was valued at $10bn in Series E, you wouldn’t make money because no liquidity event has happened. These are mergers and acquisitions or IPOs. In less common cases, there is a secondary purchase, which means someone offers to buy your shares at a discount to the latest valuation.

Splitting the pie

After the annoying details of reality, let’s say the fund ends up with about $3bn in returns after all the gains and losses. This pie is exclusive of the returns founders and employees would’ve made.

How do they split the pie? The first split is between LPs and everyone else. While splits can vary by LPA (Limited Partner Agreement), a typical split is 80/20 for the LPs and everyone else.

• LPs take 80% of the pie ($2.4bn). LPs invest their money and take risks.
• GPs take almost the whole 20% ($600m). Remember that GPs put in 1–2% of their own money and get their share of the LP returns. GPs coordinate all this.
• Management takes a flat salary and bonus set by the GP like any other employee. Few senior management, typically called partners, share a small portion of the 20% above. This is called“carry” compensation. To be clear, these crumbs are still sizeable. Imagine that the GPs share 4% of the 20%. That’s still $120m. If there are six partners with an equal split, that’s still $20m per person.

Of course, this isn’t exactly how it works either. There are a few annoying details here as well.

1. The famous “2/20 structure”. If you’ve been following, you might be curious about how VCs operate if they make returns after they invested the money? The answer to that is management fees. LPs pay 2% of their managed money to GPs annually. So if the fund is $500m, the LPs would pay $10m a year in management fees regardless of performance. Management fees are the “2” of the famous “2/20 structure”. The other 20 is what we’ve already discussed, which is the split of the fund returns.
2. Hurdle rate. Some might look at think this is not a fair deal for LPs. Well, LPs also have a way to protect themselves. The hurdle rate is a minimum return on investment that must be met before GPs can take their 20% interest. The hurdle rate is typically set between 5–15%, with 7–8% being the norm. It serves as a safeguard for LPs to ensure that GPs only receive carried interest when the investments have been successful. There are several other clauses, like clawbacks, but we can hold off on this for now.
3. Seniority. Related to the above, there is a formalized order of who gets what when things aren’t going so well. The stack is who gets paid first. The first in line are debt providers (convertibles or loans), which we haven’t discussed in our structure. Imagine a bank. Second in line are LPs who demand their hurdle rate. Then it’s the GPs & management through clauses like liquidation preferences. Then it’s the founders and employees. We call stack seniority.

HBR once made commentary about this structure.

VCs have a great gig. They raise a fund, and lock in a minimum of 10 years of fixed, fee-based compensation. Three or four years later they raise a second fund, based largely on unrealized returns of the existing fund.

Usually the subsequent fund is larger, so the VC locks in another 10 years of larger, fixed, fee-based compensation in addition to the remaining fees from the current fund. And so on…partners make high six, and more often seven, figures in fixed cash compensation.

While I agree some structural problems may exist, venture capital remains an important part of the startup ecosystem and innovation. Some of the largest companies that we use like Airbnb, Uber, Robinhood, and Coinbase were all funded by VCs. And these are just companies that target individuals as consumers. There are companies like Stripe that processes payments globally for thousands of businesses.

For those who want to go deeper, here are some terms to understand.

• Life of the fund is how long the GPs have to return the money to LPs, and ultimately close out the fund. Usually, this is 7–12 years, where about 40–60% of the money is deployed in the first 2–3 years, and the remaining is typically used to double down on winners.
• Dry powder is how much the fund has left to invest in companies. If the fund is $500m, and they invested $100m, then dry powder would be $400m — again, a bit simplified.
• Capital calls is when the GP asks for money from LPs. GPs don’t hold all of the money and leave it. That would be a waste. For example, Softbank Vision Fund, where I worked, was a $100bn fund. We didn’t have $100bn lying around in some bank account. LPs had the fund, and we’d do a “capital call” when making specific investments. Why? Even vanilla bank deposits yield 3–4% interest these days. 3% of $100bn is $3bn. They’re not going to leave it uninvested.
• Returns are how much a fund generates relative to the size of the fund. Usually, it’s described as a multiple of a fund or “money on money” (MoM) or an annualized return called IRR (Internal Rate of Returns). For example, if you doubled your money over two years, you 2x MoM with a roughly 40% IRR. Why isn’t it 50% (100%/2 years?), because you take into account the time value of money. It’s as if you put your money in an account that yields 40% a year. In two years, you’d double your money.
• Investment committee is the meeting made up of a few senior decision-makers who make the final call on making an investment. Usually, it can include LPs, GPs, and senior management. Depending on the fund, an investment may take a few days to several weeks to get to this stage.

This was my attempt at Venture Capital 101, designed for people unfamiliar with the industry. Like many industries, there are many other topics that could be covered. For example, what do all these titles of IR, EIR, Venture Partner and the like mean? How do VCs find companies and make decisions? What is a data room and due diligence? What are instruments like SAFEs, notes, preferred and common shares? Why are some funds billions of dollars while others tens of millions?

If you have questions like this, then I succeeded in what I tried to do — to help you change your unknown unknowns into known unknowns. It means you know what to look for. Subscribe to see more content on venture capital and startups.