Invest Like A Venture Capitalist: How To Find The Next Big Thing

From Whales To WhatsApp

It’s the stuff dreams are made of: a 4900% return in a few short years. But for investors at Sequoia Capital, it wasn’t a dream at all. It was the reality of one well-made investment in a little-known company called WhatsApp.

Venture capital (VC) firms like Sequoia play in the most exciting part of the finance industry: they make big, speculative bets on small companies with the potential to become superstars. That’s a far cry from their humble beginnings in the 1800s, when they funded whaling expeditions. But the idea was the same then as it is now: even if a few of your boats sink, those that bring home a whale or two will more than make up for it. And if any of those boats pick themselves up a Moby Dick, your timbers will well and truly be shivered…

Things have changed in one big way, mind you. The whaling firms of old decimated the global whale population, while today’s VCs are the whole reason companies like Facebook, Uber, Google, and Spotify are more prolific than ever. In fact, the VC industry – which now has over $850 billion under management – is almost single-handedly responsible for the technology boom of the 2010s.

In the last decade alone, US venture capital funds have averaged a 14.5% annual return. That’s upped to 34% if you include the 15 years before. But here’s the kicker: most of us can’t invest directly into venture capital funds, with legal restrictions making them off-limits to all but the very rich. What you can do, though, is teach yourself to invest like a venture capitalist, and use their techniques to make your own bets.

That’s what we’ll help you do in this Pack. You’ll get an insight into a VC’s unique mindset, and explore how they analyze companies and structure deals to make money. But like all good VCs, you’ll need to don your Patagonia fleece vest, crack out your copy of Sapiens, and subscribe to wine-oriented newsletters before you get started. Ready? Phew. First off: how VCs actually make money.

The takeaway: Venture capital is all about funding high-risk, high-return projects, and it’s fuelled the tech boom of recent years.

How Venture Capital Works

While venture capitalists are often seen as investors themselves, their firms actually work on behalf of other investors. VCs often manage billions, if not tens of billions, in capital – most of which they raise from outside investors. Those people, known as “limited partners”, could be rich individuals looking for somewhere to put their money, or they could be institutions – pensions funds, endowments, insurance firms etc. – that want to diversify their portfolios away from stock and bond markets.

Once a VC has raised enough for a particular fund, it then has to find something to invest in. The typical strategy is to buy small stakes in a large number of businesses: investing in 20 early-stage companies, after all, isn’t quite as risky as investing in just two of them.

But the math isn’t in their favor: research suggests 75% of venture-backed businesses fail to return investors’ money. So let’s say you’re invested across 50 companies, and the fund loses money on 37 of them. You’d need four times the returns from the 13 left over just to break even on the overall fund. To make triple the return on the fund over 10 years – as your limited partners will expect – you’d need the survivors to return 11x your initial investment.

The hunt for that elusive 10x or more return is why VCs won’t invest in just any company: they’re specifically looking for those with the potential to deliver gigantic returns. In short, companies operating in big markets, ideally with the ability to scale fast. That’s one reason tech companies – which can grow incredibly quickly without much capital – are a firm favorite. A business that only has a limited number of potential customers (even lucrative ones) probably wouldn’t be of much interest to VCs. It might make money, sure, but it wouldn’t make enough.

VCs will do all they can to help promote that growth, often focusing on individual sectors to which they think they can add value. One might, for example, specialize in biotech investments, while another might be more interested in fintech firms. That specialization allows VCs to act like a member of the startups’ teams: they’ll advise on strategy, make connections with customers, and help recruit executives to boost the business. It also gives them a better understanding of a particular industry, so they can do a better job of finding the hits and avoiding the duds.

If all goes well, the startup will grow, and so should the VC’s investment – on paper at least. But even then, you can’t easily sell shares in private companies like you can public firms (in finance jargon, private company investments are “illiquid”). But the VC needs to be able to cash out: a typical fund comes with the promise that its limited partners will get their money back within ten years.

So toward the end of that timeframe, you’ll get VCs pushing for an “exit”. That normally translates as either an acquisition – where the startup gets bought out by some other company – or as a public stock listing, which allows the VC to sell its shares to other investors. Sometimes you’ll also see later-stage investors buying out early-stage investors – as well as all the investments underneath them – in a game of financial pass-the-parcel.

Whatever the exit of choice, the fund’s investors should get their cash back, and hopefully with some hefty returns on top. As for the VCs themselves, they’ll typically have some of their own money in the fund. That, plus 2% annual management fees and a 20% cut of the fund’s profits, makes them pretty happy, too.

Laid out like this, venture capital sounds fairly straightforward. But the complicated bit is in deciding which investments to choose. Next, we’ll look at just how VCs pick companies, and just what you can learn from it.

The takeaway*: VCs expect* to lose money on startups – which is why they invest in so many of them – but huge, one-off returns from IPOs or acquisitions should make up for those losses.

How VCs Pick Companies

In finance as in life, it’s about who you know, not what you know. Imagine being the VC who missed out on Uber not because you didn’t fancy the company’s chances, but because you never even knew it existed. It’s the cardinal sin in the world of venture capital, where you’re investing in companies before anyone’s ever heard of them.

That’s why VCs spend so much of their time generating leads, keeping abreast of developments, and making themselves the firm startups want to work with. That means building a strong brand, a good reputation, and a sprawling contact network that’ll spot the next opportunity on your behalf. And if you’re keen to dabble in private markets – more on exactly how to go about it next session – you’d be wise to follow their playbook.

But where to start? Well, lots of investors assume the most important part of a business is its idea: you need a product so magnificent everyone’s going to need it. But VCs approach things differently. In the words of one major investor:

If a company has a good idea, it’s almost a foregone conclusion someone else will do too. What sets, say, Tesla apart isn’t really its electric cars: there are plenty of carmakers with the infrastructure to compete on that front. No, what really matters is its ability to execute that idea. There’s an industry adage that it’s better to back a bad idea with a good team than a good idea with a bad team. That’s why VCs interrogate managers, founders, and engineers to work out whether a company has the team to make their idea a success.

They’ll also spend time looking at the company’s “market opportunity”. If they were looking to invest in an early-stage Uber, for instance, they’d want to know the total global value of the taxi market (known as “total addressable market”, or “TAM”), and the percentage of that market the company can reasonably expect to win over. To figure out the latter, VCs will look at the product’s competitive advantage – patents, industry connections, network effects – that might ward off competitors. They’ll also evaluate risks that might prevent the product from succeeding, like legal, financial, or technical challenges.

If success seems like it might be on the cards, VCs will use financial models to calculate how much the company might be able to make. Of course, there are so many unknowns when you’re an early investor, it’s next to impossible to get them right. But they’re still a useful way to get a sense of a path to success.

All of the above feeds into a probability model that shows how much the startup might be worth in future. A VC might estimate a 5% chance of a $1 billion exit, a 10% chance of $700 million, and a 50% chance of $100 million. By multiplying the probabilities by the returns, and then adding them together, you get an expected future company valuation of $170 million. It’s then up to the investor to decide if it’s worth it. And that, comes down to how much an investment costs.

In this case, if the VC is looking for 10x returns, they’ll want to invest when the company is valued at no more than $17 million dollars. If the startup’s priced too highly, the potential returns might not be enough to justify the risks. VCs will also try to protect themselves by negotiating “liquidation preferences”. That means they can make sure they’re the first to be paid in the event of everything going wrong.

Now you know how a VC thinks, it’s time to put that analytical mind into practice to bag some returns of your own…

The takeaway: VCs will evaluate a company’s team, the market opportunity, potential risks, and expected returns to make sure they’re balancing risk with reward.

Putting It Into Practice

The techniques VCs use are useful for what they’re doing: investing in private markets where chances of success are low and potential returns are astronomical. But more often than not, you’ll run into some problems if you try to apply those same techniques to investing in publicly listed stocks. Most listed companies are mature, meaning you can’t expect them to climb 10x in value in just a few years. Growth in line with the broader stock market – at maybe 7 or 8% a year – is all you should expect. Of course, mature companies are far less likely to go to zero, so you have that in your favor.

Still, let’s say you want to throw caution to the wind. You can invest in private markets – albeit in a slightly different way to a regular VC.

The most obvious parallel is angel investing, where a group of wealthy individuals come together to fund a startup (we have a Pack on that, too). It’s incredibly risky, but using VC principles is a smart way to go about it. Much like a VC, you’ll want a network that’ll bring you opportunities when valuations are cheap. And you can also try to add value as a VC would – by building partnerships with your industry contacts, say, or offering your insights into a particular industry.

A less direct way of investing in private companies is equity crowdfunding (ahem, we have a Pack on that, as well). It involves buying shares in small, private companies alongside thousands of other small investors, rather than just a few rich ones. Again, the VC approach could help you here. Just remember to pay attention to your shares’ conditions: even if the company exits successfully, you might buy shares that are worth less than you’d think due to other investors or lenders who’ve negotiated better terms.

You could also use secondary share platforms – like SharesPost and Forge – to buy shares in private companies from VCs and other shareholders. The platforms pair up buyers and sellers, giving you access to deals that would otherwise be off limits. But you should always ask yourself why the seller is cashing out: are they simply looking to free up some money, or have they noticed something no one else has?

That’s the lesson any VC would share with you: no matter how you choose to invest, you need to do your due diligence to make sure a company is all it’s cracked up to be. Break down the valuation of the company, and do the math to assess whether you’re getting a good deal compared to what other investors are getting. And remember to think about how you’re going to exit the deal. Keep in mind that it’s not easy to sell private company shares, so you need to be prepared to have your money tied up in the company for the next few years.

Or, if all that sounds too tricky, you could just invest your money with a venture capital fund. For now, you need to be fairly wealthy to do so: a minimum income of $200,000, or a net worth of over $1 million. But with regulators thinking about opening up the market to allow more investors to benefit, that may soon change. If you do invest, be smart: most professionals think you should have no more than a couple of percent of your money in venture capital, and you may already have a stake via your pension fund.

Take all this on board, and you’ll be knocking back kombucha in your Patagonia fleece in no time.