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Why Do Most Venture Funds Chase After the Same Types of Startups?

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photo courtesy Ian Parker upon unsplash

Sorry to many VC friends. I never intend to insult or demean you. Not only are you smart, creative, and successful, you are caring and generous people (for the most part).

It’s not a personal question why venture funds chase startups in the same few trendy sectors. This is a function of how the VC system works. Despite the buzz around innovation and disruption, the venture capital system fosters groupthink across the industry.

Having worked with many founders, I often hear similar complaints. Why do they all invest in the same few things?”

Founders have an important point. If you are in a hot sector, VCs will vie for investment opportunities. If you’re in an unattractive field, it can be difficult to attract investors’ attention.

Before we can understand strategies for attracting venture capital, we need to understand what funds are looking for and why.

What is a venture capital fund?

A common misconception is heard by young entrepreneurs who believe that venture capital funds are a group of wealthy people looking for investments. There’s some truth to this, but to understand what VCs invest in, you have to think about it. business.

Like any business, there are managers (general partners) and employees. Aims to benefit the owner. It does it by investing other people’s money.

The first job of a VC firm is to raise money from investors, called investors. limited partner or LPs. Once they raise the amount they need, let’s say $100 million ( assets under management again assets under management), the fund is closed to new investments and the team begins investing the funds.

A portion of the funding comes from the fund’s general partner, usually 2-3%. Most of the investment capital comes from:

  • Institutional Investors: Insurance companies, retirement funds, college endowments, and other organizations that need to invest large sums of money for long-term returns.
  • Corporate investors: large companies investing their surplus funds
  • Family Office: The ultra-rich who set up a professional organization to invest their family’s money

These organizations invest most of their money in fixed income, public equity, and real estate, but often allocate a small percentage to high-risk, high-return investments such as venture capital. . Rather than investing in the startup itself, which requires time and expertise, invest in a venture fund that finds and manages startup investments.

Venture company as a business

To pay for the fund’s operating expenses, the fund pays a 2% management fee each year, primarily for employees who have to review all these pitch decks, evaluate potential investments, and work with the startups they invest in. We charge a fee. For a $100 million AUM fund, that would be $2 million a year to run your business.

On top of this management fee, there is a fee called a success fee. bring, which is typically 20% of the revenue. If his $10 million investment in a startup gives the fund a 20x return on his $200 million, the venture company will keep his $40 million and invest $160 million in the fund’s investment. distributed to homes.

Once a company puts all its money into a fund (which usually takes 2-4 years), there isn’t much to do other than attend the occasional board meeting and wait for the startups you invested in to be acquired or die.

Now that the VC firm already has a team in place and good deals are flowing, it’s time to open a second fund that typically raises money from the same LP group and their referrals.

However, there is a small problem known as J-Curve. Failure comes quickly, but success takes a long time to generate returns. Unlike equity and real estate funds, it’s hard for him to know how an investment in a VC fund is doing until 7-10 years from now.

But the same LP and his friends need to invest more in the second and third funds before they can get anything back from the first. That is, they should be excited about the investment you made, even though many are failing.

GroupSync as a Service

Venture companies must keep their current investors happy if they want to raise new money and maintain lucrative work. To do so, he must demonstrate two things.

  • They invested in hot startups in hot spaces.
  • Failure wasn’t a bad investment, even if it didn’t work out.

Imagine sending out a portfolio report every quarter. With 90% of investments failing, it’s highly likely that one of the companies in your portfolio will close quarterly at a complete loss or at a steep price.

If the failed investment was in something like SaaS, the fund could argue it was a good investment, but unfortunately it didn’t pan out as the industry hit unexpected tailwinds from the economic slowdown.

Investors are likely to shrug their shoulders. They understand that most investments in funds fail. oh well. Luckily, the rest of the portfolio is doing well.

Imagine instead that the failed startup was developing something more radical, say teleportation. Had he succeeded, the world would have been different. The founder was a brilliant physicist. The foundation hired a respected scientist to reaffirm the theory. Sure, it was a no-brainer, but hopefully, it was the biggest investment ever, easily worth trillions of dollars.

But it didn’t work. And now the fund needs to report to the LP that the portfolio teleportation startup has failed.

If they’re like me, their reaction is what? ? ? Teleportation??? What did you invest in with my money? I’m not going to give you another cent.

And that would be the end of another fundraiser.

So if you want to keep your LP happy, every VC knows: Never invest in something that looks stupid if it failsAnd suppose all investments fail.

LPs don’t pay close attention to specific investments in their portfolios, but they read the Wall Street Journal daily and talk to other investors.

They don’t know why the fund decided to invest in a particular start-up developing silicon-enhanced lithium-ion batteries rather than one of its many competitors. But they will understand that batteries are the key to electric vehicles, and what makes batteries lighter, cheaper, and safer must be a good investment. They are happy to invest in this fund, which invests in leaders in the battery space, and will be happy to invest further in the next fund, which sees great opportunities in sustainability.

But it’s not. The fund did not compete with 12 other funds for the opportunity to invest in overhyped and overpriced battery startups. they were smart They invested in less attractive sectors that were unpopular and where they could find low-priced opportunities. They invested in Horrors, a beaten-up startup that uses cryptocurrencies to solve tough problems in industrial chemicals, software testing tools, and real estate.

Now, three years later, when they’re raising their next round of funding, their LP is asking where’s the AI ​​startup, self-driving car software, and diabetes cure? Why didn’t they invest in batteries, quantum computing, and Canva? Next time, these investors will put their money into another venture fund that understands the right sectors to invest in.

In other words, investing in the hottest sectors that everyone else is investing in means that fund managers and employees are more likely to keep their jobs, no matter how bad the returns are. If they stick their neck out and invest in unpopular startups, their first fund could be their last job in venture capital unless those startups become hugely successful very quickly.

Use Groupthink to your advantage

As a founder of a startup seeking VC funding, understanding what VCs want and how they think will help you craft a successful pitch.

Know which sectors are getting attention. It will be easier for VCs to invest in startups if they can find ways to position themselves as part of these sectors.

For example, at the moment, climate technology is red hot. Every fund wants to include climate-related startups in any portfolio they can find. If your startup has a way to reduce CO2 footprint or be more sustainable, make that the first slide in the material. Introduce yourself as a climate tech startup, even if it’s a stretch.

If you belong to the unpopular and unsexy category and there is no other way to spin it, don’t waste your time on funds playing according to the leader.

  • Smaller funds, contrarian investors, and funds with papers that closely match what you’re doing.
  • A corporate venture fund that matches the company’s mission and business.
  • An angel investor who does not need to justify an investment to anyone other than himself.
  • A strategic partner who sees your success as a business opportunity, not just a financial investment.

Another strategy is to make money as quickly as possible because MRR trumps everything. As the company expands rapidly, the pitch will be on growth rates, CAC, and other financial metrics. When you have a lot of cash coming in and satisfied customers ready to buy more, it’s easy to find investors looking at nothing but a spreadsheet. , or manufactures women’s handbags, it hardly matters when revenue is growing rapidly.

Finally, remember that venture capital is just one way to fund a startup. There are many other sources of funding, from government grants to small business loans to customer pre-orders. These may be suitable for good business that is not attractive to VCs who need to justify their investments on a quarterly basis.

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