What we do in DILA Capital: a simplified explanation of venture capital.
Since my first blog post I have had a lot people writing to me saying that they are really interested in the venture capital space, but that they don’t fully understand it. So, this post is for those that want to understand what we do as venture funds.
Every single company needs money to start. Every single company needs additional money to prove out their business model. And every single company needs even money to grow. Every single company you know, every product or service you consume, has received some form of funding. There are many forms of funding and each stage of a company’s life has different options of funding.
When you are just getting started, you usually put your own cash, time and sweat into your company; this is known as bootstrapping. When your cash and time is not enough to get going you usually raise money from people that know and trust you; we call these people friends, family and fools (because they either know you well enough to consider you a friend or family member, or they are fools for in investing in such early stages). Once you have past the idea stage of your business and you are ready to get it off the ground, there are many forms of funding: government grants, angel investors, incubators, accelerators, crowdfunding platforms, among others. These investors will help you get your business from very early stages to actually having some traction and proving your idea is somewhat viable. This is when venture capital comes in.
Before going into more detail about venture capital, it is important to mention that in most cases all of these forms of funding come in the form of equity: that is, you have to give up an ownership position in your company in exchange for the money you received. It is also important to mention that I am oversimplifying things to make it easy for readers and for first time entrepreneurs. For example, in many cases, startups raise money in the form of convertible notes or convertible debt, but I will leave that for another post. Another example is small business loans, provided by banks, but this has not been the case in Latin America, so I will also leave this out.
Venture Capital is that equity financing instrument. Venture investors (also known as VCs) invest capital in exchange for equity in businesses. We get paid for the risk we are taking in the form of appreciation of the value of the companies we invest in. Let me explain: DILA invests US$1M in a company we valued at US$4M, so the total company value after our investment is US$5M, and we therefore bought 20% of the company’s equity. In 5 years, we sell the company for $40M, since we own 20% of the company, our equity is worth US$8M. We invested US$1M and sold the same stock for US$8M, that is 8X our investment, not bad, right?
That would be the case if all of our investments behaved this way, but because we invest in such early stages, the risk we are taking in every single investment is very high and therefore many of the investments VCs make fail. VC investments follow what we call power law: few investments will return most of the capital. In a typical VC portfolio 50% of investments will fail, 30% will return close to the capital invested and 20% will give good returns. Those few successes have to be large enough as to compensate for the losses, and more.
So, again in a tremendous simplification, our job as VCs consists of four pillars:
1) Raise money from investors into our funds
2) Look for great companies to invest in
3) Analyze the investment opportunity and convince the founders to sell you a piece of their company
4) Help founders grow their business, mitigate risks and eventually sell the company.
Those successes not only represent a huge return for VCs and their investors but have extreme impact in the economy in general https://medium.com/@adiezbarroso/dila-development-in-latin-america-fc1d8b283ff2.
While it is a lot of hard work and can be a very stressful job (given that 50% of the companies you invest in will probably fail), I can say that I have the best job in the world. . . I truly and absolutely love my job and am very fortunate to work in the VC space. I constantly meet amazing entrepreneurs that are building businesses that are changing the world, I invest in people that are a lot smarter than me and challenge me intellectually and strategically, I learn about new industries and technologies and I have the privilege of partnering with the most amazing people across the world.
I truly hope this post will lead to many questions and conversations I am looking forward to having with all of you. Please comment below or write to me on Twitter @adiezbarroso.