Why is it profitable for venture capitalists to lose money on startups?

logo  5 September 2022

Venture capitalists seldom invest in startups. They do not seek to make money on them because such earnings are ‘boring.’ Today I want to explain how the profit model works and consider certain business scenarios to get my point clearer and easier to understand.

Allow me to provide examples of common tech startup acquisition scenarios and explain how they are different from each other and can be of greater interest than simply making a profit.

Some venture capital firms buy startups

Some venture capital firms buy startups out not so much because of their product, certainly not because of the revenue, but because of the founders’ talent.

The first example is a company called Fly Labs, founded by a couple of good friends. They made this excellent, simple video editing platform. Many people use it today, and it turned out to be rather helpful.

They enjoyed some success in the App Store and raised about $1.5 million, but it was clear that the project would need a lot more capital to storm the market.

The project gradually grew, attracting thousands of active users every month. Its creators had an income model in place, but they invested all of it in further growth, earning practically nothing for themselves.

Various organizations tried to buy Fly Labs, in no small part due to how useful the technology proved to be, but most importantly because the team that created such a powerful application would be handy for other projects. They ended up being purchased for an undisclosed amount by Google and assigned to work on Google Photos.

The fact that both companies do not disclose the transaction details suggests that it involved a significant sum of money, but this is not something to brag about. The offer that a company like Google will make should, of course, be enough for investors to accept it (meaning that they would recover everything they had previously invested) and for the founders, alongside the rest of their team, to stay motivated to work for Google during the next few years at least.

There is usually a combination of cash (to leave the investors happy) and providing stock or time bonuses for the team to keep them with the buyer.

The benchmark you will occasionally hear about is $1 million per engineer, which might sound crazy. It is not that every engineer gets paid that much, but a company is valued by how many engineers it brings to the table.

Why? The process behind finding a good specialist is complex, and getting them to work on your project can sometimes be even more difficult.

Suppose you can bring in a team with a rapport (which is extremely important for teamwork), one that has already proven competent in the given field. You can get a whole team to implement their technology into your project. This would eliminate many of the costs and risks associated with building a team from the ground up or by hiring strangers. Investors do not make much money from acquisitions and hires, as they are usually paid from x1 to x1.5 of their initial investment. Hiring the right cadres is extraordinarily difficult, but is mostly a soft landing.

Quip was a simple, well-designed office suite: a word processor and spreadsheet platform. Not as powerful as their Microsoft counterpart, but very intuitive and straightforward. It had a good market suitable for small businesses.

It boasted revenue and plenty of users at the time of the acquisition, so the $750 million price tag might have been a multiplier of their yearly productivity, but it had more to do with Salesforce’s ultimate goal of building up their OS for more sales.

At the time of the purchase, the company had raised $45 million in two funding rounds — Series A and Series B (according to Crunchbase).

Assuming that both rounds add up to about 30% of the company, these investors returned with vast sums of money in their pockets.

We are talking venture capital ROI: not percentages, but multipliers.

This becomes even more significant if the company is not acquired but goes public instead: when it is listed on the stock market, the value of the shares is collectively determined by traders, and sometimes the market values companies well above their actual earnings, based simply on their potential to change — both the world and future technological development.

Whether this change becomes real or not means little to initial investors. In the case of a public company, they can cash out and get x10, x50, or x100 of their original cheques, especially those who have invested early. All this is extremely risky, of course. Most startups fail (only 1% of all startups in the world turn into large corporations, with most closing during the first 5 years of operation). If a company does not make a profit, they will depend on more investors to bet on them to keep working on their vision, but one x100 contributor will pay for the remaining 90% of failed enterprises. This is cold, hard, realized, tangible money ripe for collecting. A startup victory changes many people’s lives, including its founders and the lucky early-stage investors.

As you can see, venture capitalists are more interested in the project than in the possible benefits. Quite often, they are ready to wait for years until the project is implemented at total capacity, and only after that will they receive a potential profit. If the project can change the IT industry, it deserves investment. The real question is to locate such a startup in the early stages of development, when the people behind it need money to implement the idea the most.