How Do VCs Make Money?
An important realization for entrepreneurs and innovators in the tech industry
I had an interesting conversation with a friend. It got to the point I had to ask:
How do VCs make money?
It is not that I don’t know, I just wanted to hear someone say it out loud to hear how it sounds. And it sounded funny. I was told:
They don’t care about profit, all they care about is growth, revenue and higher valuation. In time, they will get their exit and cash out.
So I pressed further:
How do they live? How do they cover their everyday expenses if they are waiting for this “exit” that will happen in the future?
My friend responded.
VCs are wealthy people in the first place. Plus, they can always raise money when they need it. And just one exit can pay for their 5-year expense.
Then I asked.
Is it not possible for the company they invested in to fail? I mean, what if the company declares bankruptcy?
Yes, that is possible. In fact, many companies fail this way. But the VC can make all the money back on just one company that succeeds.
I had to cut in.
What if none succeeds? I know a guy that invested in 10 tech startups and all 10 failed!
Then he said.
Well, that’s the risk of the job and why due diligence is required before the investment is made.
I then went forward.
What about the founders? Are they not holding the short end of the stick when they seek funding from VCs?
My friend grinned.
The founders have to understand the terms of the VC. If it is not convenient, they would not accept it. Of course, the VC makes the most money when the startup gets acquired or goes public.
I had to chip this in.
Isn’t that why the VC is more interested in growth than profit? Is that even okay business-wise?
Friend: VCs don’t care about profit. Being profitable doesn’t help their goals. All they want to see is growth. They want a higher valuation. Profit is none of their business since their aim is to exit at some point.
Me: So, what happens after they exit? At least, the business will need to start generating profit at some point?
Friend: Well, yes. But that is not the headache of the VC.
Me: So, is it safe to say that VC encourages business without the aim of profit? This is because come to think of it, this starts a vicious spiral. Ideas are funded without a profit model. The funds pull in resources to create the product. The funds also pull in customers who are probably not paying at all or paying very little compared to the worth of the product (based on how much it takes to create it). Then, the exit happens and customers begin to really pay. Isn’t this unfair to the customers? Doesn’t this promote creating unnecessary products or products that what it costs outweighs its value?
Friend: Look at the great companies that have been created using that model. There will always be a negative side to everything.
Me: What I am trying to say is that the world can survive without that model. Majority of what stems out of it is not good. It just puts everyone involved under undue pressure. Also, it encourages the hiding of the true cost of a product or solution. I prefer the straightforward model where the company comes out clean from the onset. And with that, profit is very important to the business.
Friend: Apparently, most VCs disagree with you. And they will keep running on this model of investing. And founders will keep flooding to them.
Me: Well, you have a point. That is to say that most founders are not solving real problems, they are just creating imaginary ideas, hoping to get enough people hooked on it before their VC money runs out.
Friend: That’s one mean way to look at it.
Me: It’s not mean, it’s a sad reality.
VC is not evil. I like VC. But how VC is being run by most firms is not something I approve of or find responsible. If the business is really a business, let it thrive on its own feet and grow organically.
Failure doesn’t have to be embarrassing
(Tweet it when you get it). Cheers!