Venture Capitalists Make Long-Term Investments
When venture capital firms invest, they intend to keep that company in their portfolios for four to seven years, effectively tying up their money even longer — in some cases for up to ten years. And ten years is a long time for an investor to be separated from his capital.
Think about investing in the stock market. You can take your money out whenever you want. If you invest in a certificate of deposit (CD), you leave your money in until the certificate matures, which can be a few months to a few years.
Being venture capitalist backed
When a company has sold equity to a venture capital firm, that company is called VC backed. During the years that a company is VC backed, it is supported by the firm through business and industry expertise and high-caliber network connections, as well as capital. This relationship can be a very powerful one for a start-up company.
So what is a VC firm looking for in a company? VC-backed companies have quick growth potential, large growth potential, and a smart and flexible team — attributes that the VC believes will generate a large return on investment. The general rule is to aim for at least 10X return on investment in five years.
Achieving 10X return on investment in five years
In selecting companies, VCs look for the kind of growth potential that makes at least 10X return on investment possible. For example, if an investor puts $8 million in your company, she is hoping that you’ll be able to give her $80 million back fairly soon. Of course, not all VC-backed companies will return 10X the investors’ money in fewer than five years, but it’s the benchmark many investors aim for.
To have a growth potential this large, a company must be in a perfect storm of desirable attributes:
Large market: Are there enough people (or businesses) with enough money willing to buy the product(s) that this company sells?
Growing market: Is the number of people (or businesses) that will be willing to buy this product in the future increasing?
Game changer: Is the product or technology going to change the way people or businesses do things?
Team experience: Is the team able to execute to grow the business at least in the short term?
Achieving 10X in five years is not a requirement for actual execution. It’s more of a lofty goal that has to be possible before the deal will move forward. If a company can return 3X an investor’s money in five years, the investor and shareholders will all be thrilled at the company’s performance, which would represent an internal rate of return of 25 percent.
The goal: raise money for their next round
A significant part of the VC’s potential income comes to her when the companies she’s invested in have liquidation events. This payment is called the carry, and it’s contingent on returning money to the limited partners. The better your company performs, the better the fund performs, and the VC’s carry will be a larger sum of money.
But more than that, if the VC is unable to return a reasonable sum to the limited partners, she will have a lot of trouble raising another fund when the time comes. The limited partners involved in the last fund won’t be interested in working with someone who just lost their money or failed to make their money perform very well.