Venture capital investors are looking for a compelling return on investment and because of the inherent risk associated with investing in early stage companies, expect a 10x or greater return in 5 years. This puts tremendous pressure on new businesses and their founders. An investor has to believe in the project, the founder and a particular industry to justify investing money. Most startups will not meet these criteria, and quite frankly, it’s often not the best option despite the press attention.
Let’s briefly analyze the costs of venture capital. A 10x return translates into an internal rate of return (IRR) of ~60% over 5 years. Essentially a VC investor is betting that the startup can generate 60% returns for her every year! For most founders, paying 60% annual interest for 5 years and having someone else telling them how they should run their business is not particularly appealing. Because of the massive returns VCs need to justify their investment model, they will often force founders to run their business to IPO or be acquired by a competitor, regardless of whether that is an outcome the founder desires or not. If the founder is not running the business the way the VC would like or not meeting projections, she can easily be ousted. In addition, VC money comes structured as preferred equity with a liquidation preference that grows over time. Put simply, in an exit they get paid first and what’s leftover is for the founders and employees (other common VC terms and provisions).