What is Venture Capital

On Sunday, SpaceX successfully caught the Super Heavy rocket after launching Starship into orbit. This was their first attempt at ‘catching’ the rocket and an insane achievement. It is also another example of how inept Boeing, United Launch Alliance (a Boeing and Lockheed Martin joint venture), and Blue Origin (Bezos’s space company) are at actually making space travel reliable, cheap, and safe. Any discussion about sustainable space travel that ditches the most expensive part (the rocket) every flight no longer has a seat at the table. SpaceX is playing 3D chess with robots in space while everyone else can’t figure out how to open the checkers box.

If private equity is the risk-averse, older brother, venture capital is the wild card, middle child. Venture capital (VC) invests money into early stage businesses that have long-term or rapid growth potential. VC firms typically require large equity positions in the business to justify their higher risk and more control over the direction of the business.

If you missed Mike’s letter about private equity, check it out, because 1. Mike is a good writer and made a funny meme and 2. A lot of people think private equity = venture capital, but they are very different. 

VCs typically invest in three different phases:

1. Pre-Seed: this is the riskiest and earliest investment stage. 

   1. At this stage, the business is just two rebellious friends talking about how they hated not talking to strangers on the internet or getting into rando’s cars. So, they decide it would be a good idea to make an app that allows you to use the internet to summon strangers and get in their car. 

   2. Their friend’s parents buy them suits and a computer for 40% of whatever the company becomes. 

2. Seed Funding: this is risky and early, but the company has been founded, has a name, and a slide deck for presentations.

   1. At this point, the friends have an initial version of the app. They found some strangers with cars and extra time who are willing to drive around San Francisco and pick up other strangers… probably best to avoid the background checks. 

   2. They need $250,000 to convince other people to use the internet to summon strangers to pick them up (shockingly easy, like holy cow easy), hire said strangers to drive around, and launch the app. 

   3. A few suits give them $250,000 for 20% of the company, a seat on the board, and the ability to call them any time of day and tell them what to do (hopefully it’s about the company but no promises). 

3. Early-Stage Funding: the least risky (but still extremely risky) phase of VC.

   1. At this phase, the company is barely operating, burning through cash, lost the suits from the pre-seed round, and dropped out of college to their parents’ dismay. They have insane demand in one or two cities but have no friends in other cities to hire.

   2. They need $10 million to hire people in new cities, lawyers to handle the mounting problems, background checks to prevent new problems, and, most importantly, more strangers to drive around other strangers. 

   3. A boardroom of suits give them $20 million, want 15% of the company, three board seats, and are secretly planning to immediately fire the founders.

Don’t quote me on the specifics, but that is basically the story of Uber. The ultimate, VC backed startup that really shouldn’t exist. 

VC firms and funds invest in companies and ideas that other private equity firms wouldn’t touch with a 39-½ foot pole. They epitomize the phrase “you gotta risk it to get the biscuit.” Estimates vary, but VC firms lose money on their investments 50-75% of the time! That is an insane risk tolerance to accept. Since they invest at the early phase and receive a lot of equity, it only takes one winner to make up for nine losses. 

For example, let’s say a VC firm invests $10 million between ten different companies. They do identical deals with each company: $1 million for 20%. This values each company at $5 million dollars. The VC then needs one company to 10x in size to break even on all investments. If one company grows to $500 million, the VC firm profits $90 million.

VC firms are looking for the needle in the haystack. They know most investments will fail, but after famous firms (and Mark Cuban) passed on Uber, nobody wants to miss the next ‘big one.’ 

In addition to cash, VCs usually bring on advisors and business experts to help coach the new founders through the pains of growing a company. They don’t ‘fire and forget’ on investments. VC firms typically play a large role in the direction of the startup. 

In 2021, there was a record shattering $643 billion in VC investment. Ever since then, VC funding has steadily decreased. This is due to a slower economy in 2022 and the infamous rate hikes that we have talked about. However, 2024 is on track to reverse that trend with VC funding in AI on pace to beat 2023 totals.

Last word on VCs, they fill a gap that no other financial institution is willing to cover, and they charge a high price. Equity is the most expensive form of capital. When starting a business, selling equity for capital is far more expensive than debt financing (taking a loan) because you never know the future value of the equity. If you sold 10% of Uber for $1 million in 2012, that 10% actually cost you $18 billion with today’s $181 billion valuation. You lost $17,999,000,000 on the deal. You know the cost of debt, on the other hand, from the moment you sign the paper.

Don’t be scared of taking debt, be scared of selling equity.

What We’re Reading/Listening To:

The Joel Klatt Show: A College Football Podcast. Joel Klatt is a host on Fox Sports, and my current college football mentor. Like I have said previously, I am new to caring about football, and Joel is helping me understand the game. Great show, 10/10, made me feel better about Georgia’s loss to Alabama (and even better about Alabama’s loss to Vanderbilt).

Debrief on Deck

Next week, we talk about futures trading and how it caused the price of oil to literally become negative, meaning people were paying other people to take their oil. It’s also more proof how everything in the financial world is made up.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on Instagram.

Until then, stay the course.

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