wtf is Venture Capital?

Imagine giving two ambitious college students $500,000, and they turn it into Facebook. Or investing $250,000 into a startup that rents out air mattresses, only to cash out billions when that startup becomes Airbnb. Welcome to the world of venture capital, where you place bets with other people's money, fail nine times out of ten, and still make billions along the way. But how do these investors turn average kids into startup billionaires? Why do some venture capitalists (VCs) end up wealthier than the founders themselves, and how do they choose the winners? I'm going to answer all of these questions and more.

At its core, venture capital is a form of investment where money from wealthy individuals, pension funds, and institutions is put into risky early-stage startups. The goal? To make massive returns—think 10, 50, or even 100 times the original investment. But, as with all high-risk ventures, there's a catch: most startups fail, meaning most VC investments lose money. In many ways, venture investing resembles betting at a roulette table, except you're allowed to bet on specific numbers. You might bet on an entire industry or a particular technology, but ultimately, it's a game with very few winners.

So why would anyone still invest in this way? The answer is simple: it only takes one massive win. Take Jason Kalkanis, for example. He built his career on a single investment. He put $25,000 into Uber during its seed round when the company was valued at $4–5 million, and later invested another $300,000. When Uber went public in 2019 at an $82 billion valuation, Jason’s initial investment was worth around $100 million.

It’s important to note that Jason is an angel investor, not a venture capitalist. Angel investors are wealthy individuals who invest their own money, while VCs use other people's funds. Here's a breakdown of the differences if you want to dive deeper into the subject.

Now, how do VCs make their money? If you've watched my video on hedge funds, you might already know the fee structure is similar. VCs charge an annual management fee of around 2%, and they take 20% of the profits they generate. This is called "carried interest" or "carry," and it’s how they make their big bucks. However, it's a risky business. For a VC to turn their stake in a startup into actual cash, the company has to "exit"—meaning it’s bought by another company or it goes public. But do you know how few companies actually make it to this stage? About 1 to 3%. And even fewer ever go public.

This is what makes venture capital so different from public equity trading. In VC, you're expected to lose most of the time. But when you finally hit a big one, the rewards are enormous.

So, how do VCs structure their deals to ensure they maximize their returns on the rare home-run companies? Once a startup pitches a VC and they agree to invest, it’s not just about handing over the cash. Each deal comes with what's known as a term sheet. This document outlines key details, including the startup's valuation, the equity stake the VC gets, liquidation preferences (which ensure VCs are paid first if the startup sells or goes bankrupt), anti-dilution clauses (which protect the VC's stake if future fundraising rounds happen at lower valuations), and board seats (so VCs can have a say in key decisions). These deals aren't just about money—they’re about power and control.

Now, let’s talk about when VCs typically enter the picture. There are different stages in a startup’s life where VCs might decide to invest. The earlier they invest, the riskier it is. The later they come in, the higher the valuation, and the more money they need to pay. Here's a breakdown:

Seed Stage: This is the "garage startup" phase. It’s usually just a good idea, maybe a rough prototype, and zero revenue. Investments here range from $50,000 to a few million dollars.

Series A: At this stage, startups have an actual product, real customers, and steady growth, though they may not be profitable yet. Series A rounds typically range from $5 million to $15 million.

Series B: At this point, things get serious. The startup has traction, found its product-market fit, and its revenue is climbing. It’s time to scale. Series B rounds typically range from $15 million to $50 million.

Series C and Beyond: These are late-stage rounds for companies preparing to go public or get acquired. Funding here can range from $50 million to a billion dollars.

So, we now know what VCs are, how they get paid, how they structure deals, and when they typically invest. But what do they actually do all day? If you picture a VC lounging around, throwing millions at companies, waiting to cash in, you're not entirely wrong. But there’s more to it. Most of their time is spent doing three things:

Listening to pitches: VCs listen to dozens, if not hundreds, of pitches from overly confident founders. They sift through all the hype to find the hidden gems.

Due diligence: If a startup catches their attention, it’s time to dig deep. They analyze the numbers, grill the founders, assess the market, and check references to see if there’s a billion-dollar company hiding inside the startup.

Managing their portfolio: After investing, VCs act as advisors, cheerleaders, therapists, and sometimes executioners. They help startups navigate growth, manage crises, raise follow-up rounds, and hopefully exit successfully.

So, how do VCs decide where to place their bets? As I mentioned earlier, it's a bit like gambling, but there’s a strategy involved. They invest widely, because while it’s a risky game, they have criteria that tilt the odds in their favor. Here’s what VCs look for in a startup:

The Team: Without solid financials or historical data, the people behind the startup become the most important factor. Great founders can pivot when things aren’t working, changing a bad idea into a winner.

Market Size (TAM): VCs are looking for markets worth billions of dollars. If your market is too small, the potential for growth will be limited.

Product-Market Fit: Does your product solve a real, painful problem, or is it just a solution looking for a problem? VCs want to see proof that your product is solving a genuine issue.

Traction: Are sales growing? Are users loving the product? VCs love momentum. The more your user base and revenue grow, the easier it will be to pitch your company to other investors or buyers.

Competitive Advantage (Moat): Can your startup defend its position, or will it be easily copied and overtaken by giants like Amazon or Google?

Ultimately, VCs are looking for startups that have the highest likelihood of becoming billion-dollar companies. They only need to find one massive winner to make the whole venture worthwhile.

Now, who are the most successful VCs, and what were their biggest wins? Let's take a look at some of the legends in the field:

Chris Sacca: Known for his first fund, Lowercase Capital, Chris became famous for delivering a 250x return on investment. He invested in companies like Uber, Twitter, Instagram, and Stripe, and his fund earned investors around $200 million from an initial $1 million investment.

Mark Andreessen: Co-founder of the legendary VC firm Andreessen Horowitz, Mark is behind major investments in Facebook, Airbnb, Coinbase, and Slack. The firm now manages over $35 billion in assets.

Chamath Palihapitiya: Chamath turned a $20 million investment in Slack into around $1 billion after its IPO. He also bought $1 million worth of Bitcoin back in 2012, when it was valued at around $80 per coin.

Venture capital is an exciting, high-risk, high-reward game that can turn small investments into massive returns. The world of VCs is full of opportunity for those with the skills, knowledge, and willingness to take on the risks.