ExplainersIntermediate· 7 min read

How venture capital works

The one thing to remember

VC is not a business of picking winners. It is a business of surviving long enough to be in one.

The question

Understand why an investor is happy for most of their portfolio to go to zero.

Figure

How venture capital works works, in one picture

The same argument as the text, as a chain. Each step is what makes the next one possible.

Figure

One investment is the fund

Most go to zero and that is not a failure of selection, it is the shape of the asset class. It is why a venture investor has no use for a company that will merely do quite well.

1
Returns follow a power law, not an average
In a typical fund, most investments return nothing, a few return the money, and one returns everything. The fund's entire result is decided by that one. This is not a failure of selection, it is the shape of the asset class.
2
Which changes what you optimise for
If one investment must return the whole fund, you cannot back companies that might do modestly well. You must back companies that could be enormous, accepting that most will not be. A safe startup is useless to a VC.
This is why VCs push for aggressive growth even when it endangers the company. A likely modest success is worth almost nothing to them, and a small chance of a giant one is worth a great deal.
3
Dilution across rounds is the real arithmetic
Each funding round issues new shares, so every existing holder's slice shrinks. A founder with 100% at the start may hold 15% at exit, and that is normal rather than a swindle.
4
And the fee structure survives the failures
Two and twenty again: 2% of the fund annually regardless of performance. A manager running a large fund is paid substantially even if every company fails, which is worth remembering when reading anyone's advice about risk.

Try it

The recovery curveInteractive

Loss suffered50%

You lost

-50%

Gain needed just to get back

+100%

Losses and gains are not mirror images. Past about 50% the curve turns near vertical, which is the whole argument for never risking ruin.

You have got it when

You can explain why a VC would reject a company that is certain to be moderately profitable.

How venture capital works

How venture capital works works, in one picture

One investment is the fund

Returns follow a power law, not an average

Which changes what you optimise for

Dilution across rounds is the real arithmetic

And the fee structure survives the failures

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