👋 Hey everyone and welcome to this newsletter. Today we are exploring venture capital economics and its importance for founders.
Thanks to the 107 people who joined us last week! If you’re new here, I’m Hugo Rauch, and my goal is to help founders accelerate their growth, successfully fundraise and find inspirations from startup stories.
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Podcast of the week - Sam Wen
This week, I released episode 2/2 with Sam Wen, the co-founder of Square. Last week, we discussed the story of Square from idea to a $38B business.
In today’s episode we talked about Sam’s second startup and role as a venture capital. We delved into the challenges of pivoting as a VC-backed startup, how Sam secured an acquisition to save the company, the value of having a strong engineering-led team, the importance of scalability in startups, what makes a good venture capitalist and much more!
Listen on 🟢Spotify, on 🟣Apple Podcast, or on 🟠Substack.
The game founders are playing 👇
Here is how VCs work and why it's important to understand.
First thing first: this visual is oversimplified. We're trying to make things simple.
First let's look at the structure of a venture capital fund.
Limited partners
They are the source of capital. Without them, the VC doesn't exist. On average they want 3x returns from their VC investment. And their timeline is usually over 10 years.
General partners
They are allocating capital (investing in startups) and are working towards this 3x returns. They are compensated in two ways following the 2/20 rules.
➤ The 2% fee for salaries and operations
GPs take about ~2% of the fund per year to pay for salaries and operations. For example, if a GPs raises a $100M fund, they will take 2%*$100M = $2M/year.
Hence their goal is to generate great returns, to convince LPs to invest more money.
➤ The 20% carry to choose great deals
The carry is a bonus when returns exceeds a threshold. Usually this bonus is 20% on everything above this threshold. This is done deal-by-deal, meaning that for each deal, GPs are looking to increase their own compensation.
For example, if a VC invest $10M in a company and sell that investment for $100M. Considering a 20% carry, they will get: 20% * ($100M-$10M) = $18M carry.
Why does it matter?
Understanding VCs economics and compensation is critical to your pitch. If we come back to the fund economics as a whole, to generate a 3x return over 10 years, GPs usually need a 100x exit.
Why?
Because in their portfolio:
→ a lot of companies will fail
→ some will bring average returns (1-3x)
→ a few will bring incredible results (10-100x)
But how do you get a 100x exit?
The most basic math would lead you to think that you need a $1B+ exit. Because if a VC invests $1M for 10% and the company is valued $1B at exit, VC makes $100M = 100x. This is oversimplified. In reality, a $1M early stage investment would usually be diluted by quite a margin. But let’s keep things simple.
How does a startup get to a $1B valuation?
Usually SaaS companies are valued somewhere around 10x their revenue. Meaning that if you are aiming for a $1B valuation, you need at least $100M in ARR.
Now, $100M ARR looks very different depending on your business model.
For consumers, considering a revenue per users of $10, you need 10M users
For commercial, considering a revenue per customer of $100, you need 1k clients
In both cases, you won’t make $100M ARR unless you have a large market. VCs will also want you to grow fast, remember that 10 years timeline from LPs, and they’d love to invest as few dollars as possible hence low capital businesses are preferred.
What does it mean for you?
When pitching to VCs, show them your high potential. They know that there is a high chance of failure. But if you succeed, it needs to be big. They are looking for the next $100M ARR - $1B valuation company.
You need to show how your..
→ market
→ team
→ idea
→ traction
..can support the fund economics.
Thanks for your support! 🙏
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Hugo 👋
Excellent post! Super insightful 😁