Statistically speaking, you have approximately the same odds of playing professional baseball as you do of becoming a venture capitalist. You hear the names of venture capital elite mentioned alongside the likes of Uber, Twitter, Snap Inc., Google, and almost every other disruptive tech company of the last twenty-five years. But what do venture capitalists actually do? What sets them apart?
Venture Capitalist: n. An investor who either provides capital to startup ventures or supports small companies that wish to expand but do not have access to equity markets
True to their name, venture capitalists provide capital to startups (ventures). They provide the funds that young companies need to gain traction in exchange for a percentage of ownership in the company. This exchange of ownership usually happens a number of times over the early life of a company, taking place in “fundraising rounds” or “series”. The earliest round is referred to as seed funding and is usually less than $500,000. After that, startups move on to a larger “Series A” round of funding, followed by any number of series after that. Snap Inc., for example, just recently closed a $1.8 billion “Series F” round. Although venture capital funds can participate in later rounds of funding, they are more commonly associated with the first few.
Venture capitalists also have to raise money themselves. Private investors seeking high returns are recruited to contribute to venture capital funds. Thus, startups, venture capitalists, and private investors form a complex ecosystem that is connected by a process we will refer to as “the flow of money”. The flow of money looks something like this: private investors pool money into venture capital funds; venture capitalists invest the money into select startups; ideally, the startups grow rapidly and eventually are either purchased or go public; venture capitalists keep some portion of the return on investment, and the rest is distributed back to the private investors.
But don’t most startups fail?
Obviously, the critical step in the flow of money is the startup growing rapidly and eventually obtaining some sort of exit (either a sale or an IPO). While private investors and venture capitalists do provide some value to the process, it is in the context of helping the startup achieve liftoff. With the right environment and access to sufficient resources, the successful startup is able to create new wealth at unprecedented scale and pace. But here’s the rub: the majority of startups fail.
If the majority of possible investments fail, the venture capitalist’s contribution to the flow of money becomes much more difficult and much more important. They need to protect their investors’ money from the bottomless pit of unsuccessful startups, while at the same time trying to maximize returns. So how do they do it? What is it that enables them to pick winners?
There are two common misconceptions about how elite venture capitalists pick winning startups. The first is the idea that venture capitalists use some type of complicated projection modeling or financial analysis in order to determine how a company will perform in the future. While many venture capitalists, especially those making later-stage investments, do run some sort of financial analysis, it is rarely the most important factor in an investment decision. In fact, many venture capitalists don’t pay any attention to financial projections. They understand that such projections are mostly conjecture–many startups haven’t had enough time to accumulate any meaningful financial data.
The second misconception is the idea that venture capitalists know exactly what a successful startup looks like. It’s easy to fall into the trap of thinking that there’s a recipe for startups, that there are certain ingredients that you can combine and everything will work out. It’s true that there are factors that are more likely to result in success; the mistake comes from thinking that recognition of those ingredients is what sets elite venture capitalists apart. There are many people capable of recognizing a dynamic founder, a resourceful team, and product-market fit–insinuating that such recognition is the most important asset of a venture capitalist is a disservice to the difficulty of the job.
What does it take?
A VC’s most important asset is a large and dynamic network. Even if they can recognize all of the key ingredients of a successful startup, even if they can accurately project out future financials, they still need to find opportunities while companies are young. They still need the very best founders walking into their office saying “I have an idea.” Without that, they’ll be late to every party.
A widespread and active network can do much of the heavy lifting for a VC. It can reach out and find a huge number of promising founders, funneling them inwards, sifting through them, screening them, until only the very best show up at the door looking for funding. It increases a VC’s geographic range and cuts back on the time needed to make decisions. Because there are so many opportunities to consider, the pre-screening provided by a network is especially valuable.
Also, the most successful people in the startup world gravitate towards each other. This is evidenced by the rise of entrepreneurial hotbeds, places like Silicon Valley, New York, and Boston, where talent and ideas are highly concentrated. A VC needs access to the core of those hotbeds in order to make successful investments. They need to be on the front lines. You will find the elite venture capitalists in the heart of the startup world, surrounded by the best and brightest programmers, designers, marketers, and innovators.
I like to draw a parallel between this idea–that a widespread and active network is a more important asset than financial modeling or instinctive recognition–and what separates top tier universities from their competition. It is a common misconception (especially among parents and college counselors) that you should go to a top tier university because the quality of the classes is significantly higher. They believe that prestigious universities provide better lectures, teach more effectively, impart a greater wealth of knowledge. I don’t believe that this is true. I’m sure that some difference in the quality of academia exists, but I don’t believe that it is significant. Rather, the individuals that make up the community are what set top tier institutions apart. Students at elite universities are passionate, hard-working, attracted to creative ideas, and willing to challenge each other. The quality of classes is important to an extent, there’s no doubt. But not as important as your peers. It’s the same with venture capital–it’s not the technicals that separate the elite, but rather the environment that they are able to cultivate.
Why does it work?
Venture capitalists create powerful networks by providing value to founders. This seems obvious–they’re the ones giving the company the money that it needs to grow. But there are a surprising number of people willing to hand out money to startups, and it is relatively rare to find individuals capable of providing value beyond that. The best VCs are the ones that understand a startup’s industry, that know the challenges and struggles ahead. They are able to provide guidance and advice without being overbearing. The best VCs can help founders make connections with industry experts, prospective clients, and high-quality hires. They buy into a company with all of their resources, not just their money.
This creates a compounding effect. Providing unparalleled value to startups gives them a higher likelihood of success. The more successful startups a VC invests in, the easier it is to grow their network. A larger and more successful network means that they are able to provide more value to future portfolio companies.
If a strong network is a venture capitalist’s most important asset, then elite VCs are those that are particularly adroit at cultivating such an environment. They are able to jump-start the compounding effects described above by providing value to founders. The best venture capitalists roll up their sleeves and work with companies to create a culture of innovation, value creation, and shared success.