Think Like a VC

The intent of this post is to save you time. Pitching to VCs takes a lot of energy, and it’s easier if you prepare correctly. More importantly, you must know whether it makes sense to do it given what you have to offer.

Suppose you’re a VC. Your job is to maximize the return of an investment fund over a period of time. The whole premise of a VC fund is that as an asset class it’s riskier than diversified funds, and it should outperform them in the long run. Let’s not argue whether that actually happens, let’s assume the premise make sense and keep going.

A typical VC fund is in the hundreds of millions. That means that over the course of the investment horizon (say, ten years) it must generate a return in that order of magnitude. A VC fund will invest in tens or even hundreds of companies, usually amounts in the order of millions to tens of millions. Some (probably most) of these companies will produce a negative return, some will generate modest returns and a few will be “home runs.” These home runs are the head of the distribution, and they make or break the fund. 

Why is it important to know this? Because VCs need home runs, they care deeply about whether an investment has the potential to be one.

This has several implications. The first one should be obvious but I found out that it isn’t to many entrepreneurs.

– When you first meet a VC, he/she will be trying to assess whether you are looking for a home run, or would be content with an early exit. If you are a first-time entrepreneur for whom a few million dollars would be life-changing, VCs would want you to be slightly irrational and overly ambitious. They would want you to be in it to change the world. When they ask you questions such as “how does your company get to make tens of millions a year” they want to know that you are seriously considering building something big. They don’t care so much about the response. They are interested in your reaction, your body language, and the fact that you’ve spent brain cycles on this.

Other implications:

– An already successul entrepreneur is more aligned with a VC’s goals. If you have millions of dollars in the bank, making a few more won’t change your life just like it won’t make a huge difference to the investment fund. If Evan Williams goes to raise money, you can be sure he’s trying to build a world-changing company that would generate billions of dollars in value.

– The flipside of this: if you are a first-time entrepreneur and you’d be happy with an “early exit” that would give you enough money to not worry about bills, you must seriously consider whether you want VCs involved in your company. A VC will accept an early exit if the company looks very unlikely to become a home run. If you are close to running out of cash and not making revenue, they will take the “base hit” and move on. But if your company looks like it has a chance to become huge, a VC will be very reluctant to sell. A 10% chance of 100M in two years is better than a 100% chance of 5M now to a VC. This lack of alignment between entrepreneurs and VCs is not uncommon, and it shouldn’t be a surprise.

– Single founders are also slightly less attractive to VCs because they have more equity than each of two or more co-founders. I would expect a team of three first-time cofounders to be happy with an exit that’s 3x what a single founder would take.

Here’s an interesting exercise: spend an hour pretending to be a VC. You have 1B dollars and you need to turn it into 3B over 10 years. Would you consider your own company? What companies would you invest in? What do they have in common? Would you want your company to be more like one of those? If so, can you do it?

Isn’t this a fun game.

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