As a decade of growth in venture capital investment falters amid uncertain economic conditions, one thing remains constant: VCs will keep searching for companies that do business in a way that’s never been done before.
Venture capital has experienced a boom over the past decade.
Fueled by billion-dollar exits, the explosion of Silicon Valley startups, and massive raises from SoftBank’s $100B Vision Fund, annual capital invested worldwide increased by nearly 13x from 2010 to 2019 to reach over $160B. Meanwhile, mega-rounds (investments of $100M+) nearly tripled from 2016 to 2018.
However, the economic downturn brought on by Covid-19 has to some extent put the brakes on that growth. Fewer VCs are investing in seed-stage startups, and March 2020 saw a 22% year-over-year (YoY) decline in overall VC deals in the US.
It’s likely that VCs are being more selective in their investments, preferring more established companies that have proven themselves to be strong enough to weather the pandemic and grow when the economy ramps back up.
But venture capital is in many ways resistant to short-term changes, due to the simple fact that venture investments are long-term. VCs aren’t necessarily looking to invest in startups that will see huge growth in the immediate future; they are looking for ones that will grow into something extraordinary 10 years from now.
Overall, the fundamentals of venture capital haven’t changed. VCs place their bets on startups poised to jump-start a fundamental change in consumer or business behavior — and this fact is no different now than it was when the industry began.
In this report, we explore the foundations of venture capital by diving into its key terms and definitions, the motivations and thought processes of VCs, and what VCs — and startups — look for at each investment stage.
Table of contents
- How VCs source deals
- How VCs select investments
- The term sheet
What is venture capital?
Venture capital is a financing tool for companies and an investment vehicle for institutional investors and wealthy individuals. In other words, it’s a way for companies to receive money in the short term and for investors to grow wealth in the long term.
VC firms raise capital from investors to create venture funds, which are used to buy equity in early- or late-stage companies, depending on the firm’s specialization (although some VCs are stage-agnostic). These investments are locked in until a liquidity event, such as when the company is acquired or goes public, at which point VCs realize profits from their initial investment.
Venture capital is characterized by high risk, but also high reward. On the one hand, VCs must invest in emerging technologies and products that have massive potential to scale, but aren’t profitable yet — and over two-thirds of VC-backed startups fail. At the same time, VC investments can prove to be enormously profitable, depending on how successful a portfolio startup is.
For example, in 2005, Accel Partners invested $12.7M in Facebook for a ~10% equity stake. The firm sold a part of its shares in 2010 for around half a billion dollars, and went on to make over $9B when the company went public in 2012.
Mark Zuckerberg, Sheryl Sandberg, and Accel Partners partner Jim Breyer. Source: Jim Breyer via Medium
Another important characteristic of venture capital is that most investments are long-term. Startups often take 5 to 10 years to mature, and any money invested in a startup is difficult to pull out until the startup is robust enough to attract buyers in the mergers & acquisitions, secondary, or public markets. Venture funds have a 10-year lifetime, so VCs can see through these investments without the pressure to demonstrate short-term gains.
On the company side of VC transactions, venture capital allows startups to finance their operations without taking on the burden of debt. Because startups pay for venture capital in the form of shares, they don’t have to incur debt on their balance sheets or pay the money back. For startups looking to grow quickly, venture capital is an attractive financing option, potentially allowing startups to outpace the competition as they take in more investments at each growth stage.
Startups also take on venture capital to tap into VCs’ expertise, networks, and resources. VCs often have a wide network of investors and talent in the markets they operate in, as well as years of experience overseeing the growth of many startups. The mentorship VCs can bring is especially valuable for first-time founders.
Today, venture capital is most active in the B2C software, B2B software, life sciences, and direct-to-consumer (D2C) industries. The software industry is fertile grounds for VC investment because of its low up-front costs and huge addressable market. Companies like Google, Twitter, and Slack have risen to dominance thanks in part to venture financing.
The life sciences sector, while a more capital-intensive area for companies to start out in, also offers a giant addressable market and technological and regulatory moats to protect against competition. The sector is also attracting increased attention during the coronavirus pandemic.
The D2C industry has also been a large focus for VC funding, with companies like Warby Parker delivering affordable, well-made products at scale through online channels.
A game of home runs
Until 1964, Babe Ruth held the record for the most career strikeouts, at 1,330. Despite that, he also hit 714 home runs in his career, giving him the highest slugging percentage of all time. When Babe Ruth went to bat, he swung for the fences.
VCs espouse a similar strategy. By taking stakes in companies that have a small chance of becoming enormous, they make investments that tend to be either home runs or strikeouts. Chris Dixon, a general partner at Andreessen Horowitz, calls this the Babe Ruth Effect.
According to Dixon, great funds with a 5x or greater return rate tend to have more failed investments than good funds with 2-3x returns. In other words, great VCs are bigger risk-takers than good VCs: They make fewer bets on “safe” startups that do fairly well, and more bets on startups that will either flop or transform the industry.
Source: Chris Dixon
These great funds also have more home-run investments (investments that return more than 10x) and even home runs of greater magnitude (returning around 70x).
This is why Peter Thiel, an early investor in Facebook, looks for companies that create new technology, rather than companies that replicate something that already exists. He observes that these new technologies enable “vertical progress,” where something is transformed from “0 to 1.”
He cautions against “horizontal” or “1 to n” progress: taking an existing technology and spreading it elsewhere, such as by recreating a service in a new geographic location.
That said, many VCs do ride on trends and invest in incremental companies. One reason for this is that the reputational cost of failing on a contrarian bet is high: If a fund flops, its investors might be more forgiving of investments that were widely thought to be the next big thing.
Why startups seek VC funding
Generally speaking, bankers do not lend to startups the way they may offer traditional loans to other businesses (e.g. agreements where the borrower agrees to pay back a principal, plus a set level of interest).
Banks rely on financial models, income statements, and balance sheets to determine whether a business qualifies for a loan — documents that aren’t as useful when gauging an early-stage startup’s value. Furthermore, in the early stages, there is hardly anything for banks to hedge as collateral. Whereas an established company may have factories, equipment, and patents, which a bank could take in the event of a foreclosure, a software startup might leave behind a few laptops and office chairs.
VC firms are better attuned to evaluating early-stage startups, using metrics that go beyond financial statements — such as product, market-size estimates, and the startup’s founding team.
These tools are by no means perfect, and most investments will lose their value. However, because equity returns are uncapped, the high risk of investing in startups can be justified. While debts are structured so that a lender can only recuperate the principal and a set amount of interest, equity-based financing is structured so that there is no upper limit to how much an investor can earn.
Broadly, the equity financing model has served the startup ecosystem well. Startups can accelerate growth without slowing down to pay down debt, as they would with a traditional business loan, and VCs can capitalize on the rapid growth of startups upon their exits.
However, giving out equity in exchange does carry two main liabilities for companies: loss of upside and loss of control.
Because equity is partial ownership of the company, investors are paid a percentage share of the total price of the acquisition or IPO when the company exits. The more equity a startup gives out, the less is left for founders and employees. And if the company grows extremely valuable, the founding members may end up missing out on a much greater amount than what they would have paid if they had taken on regular debt financing, rather than equity funding.
Giving out equity can also mean ceding control. VCs become shareholders, often sitting as board members. They may apply pressure to important business decisions, from when products launch to how the company exits. Because VCs need big exits to boost their overall fund performance, they may even urge decisions that lower the chance of moderate success, while increasing the odds that the startup, if successful, returns 100x.
The venture capital food chain
VCs raise their money from limited partners (LPs), institutional investors who serve the interests of their client organizations.
The interests and incentives of LPs greatly influence VCs’ investment strategies. This section will examine the flow of influence and relationships across the chain, from the LPs’ institutions to the VC-backed startups.
Who are LPs?
LPs are typically large institutional investors, such as university endowments, pension funds, insurance companies, and nonprofit foundations. (Some LPs are wealthy individuals and family offices.) They can manage up to tens of billions of dollars, which they invest in diversified portfolios.
An LP’s portfolio must serve the needs of the institution by growing its asset base year-over-year, while also funding expenses of the institution.
For example, Harvard’s endowment funds a large portion of the school’s annual operation. If its $40B+ endowment grows at 5% annually, but the university’s expenses on average cost 6% of the endowment, the asset base will shrink by 1% every year. A weakening endowment can endanger the institution’s standing and hamper its ability to hire the best professors, attract top students, and fund leading research.
Similarly, pension funds are responsible for funding pensioners’ retirements; insurance company reserves are responsible for payouts; and nonprofit foundation reserves are responsible for financing their organizations’ grants.
As LPs manage risk and grow their asset base at a sustainable rate, venture capital’s role in their portfolio is to (hopefully) produce the investment’s alpha — excess returns relative to a benchmark index.
LPs to VCs
LPs invest in venture capital by pledging a certain amount in VC funds. The size of these funds can range from $50M to, in some cases, billions.
Over the past few years, greater influxes of capital into VC firms have led to the rise of $1B+ mega-funds and an increased number of sub-$100M micro-funds.
In 2018, for example, Sequoia Capital raised $8B for its Global Growth Fund III, $1.5B of which it has dispersed in 15 growth-stage startups (as of January 2020). The fund’s largest investment so far was $384M to China-based Bytedance, the TikTok parent company.
On the other end of the spectrum, Catapult Ventures raised a $55M fund in 2019 that targets seed-stage startups specializing in AI, automation, and internet of things (IoT). In April 2020, the firm participated in a $3.3M seed round for Strella Biotechnology, a company that optimizes supply chains for fresh produce.
VCs raise capital from LPs by pitching their track record, projections into the fund’s performance, and hypotheses on promising areas of growth.
Fundraising can take a long time, so VCs will often do a “first close” after hitting 25-50% of the target amount and then start investing those funds before the final close.
Most funds have a 2-20 structure: 2% management fee and 20% carry. The 2% fee covers the firm’s operating expenses — employee salaries, rent, day-to-day operations.
The “carry,” meanwhile, is the essence of VC compensation — VCs take 20% of the profit their funds make. While investing in a potential Google or Facebook can generate more than enough profit to go around for both VCs and their LPs, a 20% carry can become a pain point for LPs when a VC delivers thin margins.
In return for high fees, high risk, and long-term illiquidity, LPs expect VCs to deliver market-beating returns. Generally speaking, they expect VCs to return 500 to 800 basis points higher than the index. For example, if the S&P 500 returned 7% annually, LPs would expect venture capital to return at least 12%.
The higher a VCs’ returns, the more prestige the firm gains. Some of the most well-known funds include:
- Andreessen Horowitz’s Andreessen Fund I, which performed in the top 5% of funds raised in 2009, with a 2.6x return on investment (ROI)
- Sequoia Capital’s 2003 and 2006 funds, which brought 8x in returns, net of fees
- Benchmark’s 2011 fund, which carried 11x in returns, net of fees
If VCs fail to deliver market-beating returns or even lose LPs’ money, their reputation takes a hit, making it difficult to raise new funds to cover expenses. To stay in business, VCs need to invest in high-performing startups that yield returns that will keep their LPs happy, while still leaving the fund with a generous carry to take home.
VCs to startups
For VC funds to yield market-beating rates of returns, VCs need companies that return 10 to 100 times their investment.
Because 67% of VC-backed startups fail, and there is only a slim chance — at most 1.28% — of a billion-dollar company being created, VCs need startups that return astronomically to make up for the inevitable failures.
A closer look at how VC returns are distributed demonstrates how extremely disproportionate investment performance is across VC-backed startups.
VC returns follow a power-law curve: one quantity varies with the power of another. This means the highest performer has exponentially greater returns compared to the second highest, and so on.
As a result, distribution is heavily skewed, with a few top investments bringing in the lion’s share of the returns. (The rest, called the “long tail,” generate only a fraction.)
The cost of missing an investment at the high-return end is enormous, while netting one has the potential to return the fund many times over, even if the rest of the portfolio flounders.
What keeps VCs up at night isn’t the portfolio companies that go bust — it’s the wildly successful ones that got away.
VCs to VCs
The VC industry as a whole follows the power-law curve, just as VC investments do.
In other words, funds managed by a few elite firms generate most of the wealth, and the long tail is littered with funds that don’t make the industry average rate of return.
Top investment opportunities are scarce. While there may be more financing rounds, there is only one Facebook Series A round. Once that window closes, it’s closed for good: There’s no way to invest under the same terms and conditions.
VCs compete with one another to get a seat at the table in these highly sought-out rounds, where the lead investor is usually an elite firm, such as Sequoia Capital, Accel Partners, or Kleiner Perkins.
The venture deal
Because of the Babe Ruth Effect, closing the right deal is the most important activity a VC does. In a survey of nearly 900 early- and late-stage VCs, deal flow and selection together were reported to make up about 71% of the value VCs create.
Source: Antoine Buteau via Medium
No amount of mentorship or cash can transform a mediocre company into the next Google. That’s why VCs spend the bulk of their time and effort gaining access to the best deals, evaluating and selecting their investments, and hammering out the details in the term sheet (more on this below).
How VCs source deals
Steady access to high-quality deals is crucial for a VC to succeed. Without healthy deal flow, a VC can miss out on high-profile investment rounds and fail to discover high-potential startups in their infancy. Each time a VC fails in this regard, its fund is at risk of underperforming against the competition.
Therefore, VCs will go to great lengths to improve the quality of their deal flow. Successful VCs have a strong network that helps them capture investment opportunities, as well as a strong brand that generates a steady stream of inbound deals.
Tips and sources
A rich and diverse network is often a VC’s best source of deals. VCs rely on their network to connect to promising founders whose startups fit the investment thesis.
Firstly, VCs network with one another by investing jointly in companies, sitting on boards together, and attending industry events. VCs will often invite others in their network to investment rounds or refer startups that aren’t a match to their firm.
VC firms also rely on a professional network of entrepreneurs, investment bankers, M&A lawyers, LPs, and others they’ve worked with in growing and selling startups.
Accelerators — which offer a kind of entrepreneurship boot camp for founders — also maintain close relationships with VCs, often becoming joint investors. In 2009, Paul Graham of accelerator Y Combinator tried to loop Fred Wilson of Union Square Ventures into investing with him in Airbnb — and Wilson famously declined.
Lastly, MBA programs and university entrepreneurship centers are also good deal sources for VCs. One example is DoorDash, which started as a Stanford Business School project, and went on to raise more than $2B of capital and be valued at nearly $13B.
If there isn’t a good bridge in their network to connect with a promising startup, however, VCs will resort to the tried-and-true method of cold emails to express interest in partnering.
Building a robust network isn’t enough for a VC to gain maximum exposure to the highest-quality deals. Given the scarcity of unicorn startups and the intensity of competition, VCs need to build a strong brand to improve the flow of inbound deals.
There are largely two ways in which VCs differentiate their brand and offerings: thought leadership marketing and “value-add” services.
By becoming thought leaders, VCs attract a community of entrepreneurs and other investors that look to them for expertise and authority. VCs build their platforms by writing, blogging, tweeting, and speaking publicly at various events.
First Round Capital publishes long-form articles on leadership, management, and teamwork for early-stage entrepreneurs. Fred Wilson of Union Square Ventures has run a daily blog since 2003 where he shares various behind-the-scenes insights into the industry. Bedrock Capital brands itself as a firm that discovers “narrative violations” — companies challenging a commonly accepted narrative.
Pairing thought leadership expertise with an enticing “value-add” service can be a powerful way to lure top startups. VCs add value to their portfolio companies beyond just offering capital; they deliver mentorship, network, and technical support.
Andreessen Horowitz provides its companies with a full-stack marketing and accounting service. GV, the VC arm of Alphabet, has an operations team dedicated to helping startups with product design and marketing. First Round Capital holds leadership conferences and mentorship programs specifically geared toward early-stage founders, offering a community of relationships beyond just the firm itself.
How VCs select investments
Evaluating a startup presents a unique challenge. Often, there aren’t comparable businesses, accurate market-size estimates, or predictable models. As a result, VCs rely on a mix of intuition and data to assess whether the startup is worth investing in and how much it should be valued at.
VCs chase after opportunities with a large total addressable market (TAM). If the TAM is small, there is a limit to the returns the VC can reap when the company exits — which is no good for VCs that need companies exiting at 10-100x in order to be recognized as one of the elites.
But VCs don’t just want to invest in companies situated within large addressable markets from the get-go. They also want to bet on companies that grow their addressable markets over time.
Uber’s TAM grew 70x over 10 years, from a $4B black-car market to a near $300B cab and car ownership market. As the product matured, its cheaper, more convenient service converted customers, starting a network effect in which costs decreased as ride availability increased.
Bill Gurley, general partner at Benchmark (which has invested in Uber), sees the company eventually taking on the entire auto market, as ride hailing becomes preferable to owning a car.
Another example is Airbnb, which started in 2009 as a couch-surfing website for college students. At the time, its own pitch deck told investors that there were only 630,000 global listings on couchsurfing.com. But by 2017, Airbnb had 4M listings — more rooms than the 5 biggest hotel groups combined. Its TAM had grown with it.
It’s challenging to predict the magnitude of the impact a product will have on its market. According to Scott Kupor, managing partner at Andreessen Horowitz and author of “Secrets of Sand Hill Road,” VCs must be able to “think creatively about the role of technology in developing new markets” to seize great investments, rather than take TAM at face value.
Another key consideration is product-market fit, a nebulous idea that refers to the point when a product sufficiently meets a need in a market, such that adoption grows quickly, while churn remains low. The majority of startups fail because they don’t find product-market fit, which is why many venture capitalists hold that it is the most important goal for an early-stage company.
There isn’t a particular point at which product-market fit occurs; rather, it happens through a gradual process that could take from several months to several years. Neither is it permanent once it’s reached: Customer expectations are constantly changing, and products that once had strong product-market fit can fall out of it without proper adjustments.
It’s also important to understand that product-market fit doesn’t equate to growth. A spike in usage driven by early adopters may look impressive on a dashboard, but if the numbers drop off in a few weeks, it’s not a good indicator of product-market fit.
Founders have gone to extreme lengths to nail product-market fit, from Stewart Butterfield scrapping his mobile game company before arriving at Slack to Tobias Lütke using his online snowboarding shop’s infrastructure to build the e-commerce platform Shopify.
These startups succeeded in scaling exponentially because they were able to reach product-market fit before ramping up sales and marketing. (What is dangerous is scaling prematurely before hitting product-market fit, as about 70% of startups do, according to Startup Genome.)
Product-market fit can be difficult to measure because a product could be anywhere from a few iterations to a significant pivot away from achieving it. However, there are a few quantitative benchmarks that can show a startup’s progress.
A high Net Promoter Score (NPS), for instance, shows that customers not only recognize the value of the product, but are willing to go out of their way to recommend it to other people.
Similarly, for angel investor Sean Ellis, product-market fit can be reduced to the question, “How would you feel if you could no longer use [the product]?” The users who respond “Very disappointed” make up the market for that product.
Another simple framework looks for strong top-line growth accompanied by high retention and meaningful usage.
Source: Brian Balfour
Strong product-market fit is a compelling sign that a startup will become successful. VCs look for startups that have already achieved it or have a concrete road map toward it. By the Series A stage, a startup generally needs to show investors that it has achieved or made visible progress toward product-market fit.
At the seed stage, a startup is nothing more than a pitch deck. Josh Kopelman of First Round Capital says that, at the seed stage, it’s likely that a startup’s product is wrong, its strategy is off, its team is incomplete, or it hasn’t built the technology. In those cases, what he bets on is not the startup idea, but the founder.
When a VC invests in a startup, the VC is wagering that the company will become what Scott Kupor calls the “de facto winner in the space.” VCs must therefore prudently decide whether a founding team is the best team to tackle this market problem over any others that may come to them for funding at a later time.
VCs look for founders with strong problem-solving skills. They ask questions to get a glimpse of how the founder thinks through certain problems. They get a sense of whether the founder has the flexibility to navigate through challenges, adapt to changes in the market, and even pivot the product when necessary.
They also look for founders that have a coherent connection to the space they’re looking to disrupt. Chris Dixon says that he looks at whether founders have industry, cultural, or academic knowledge that led them to their idea.
Emily Weiss, founder of Glossier, worked in fashion before launching the DTC beauty company. Airbnb’s founders understood the culture of a generation willing to share homes and experiences. Konstantin Guericke, co-founder of LinkedIn, studied software engineering at Stanford before arriving at the idea that professional networking could be done online.
VCs also favor founders who have previously founded unicorn startups. These founders have the experience of taking a company from zero dollars in revenue to billions, and they understand what it takes to transition the company at each level. They also have media coverage and a robust network — all contributing to recruiting talent and attracting resources.
For example, a group of early PayPal employees, called the PayPal Mafia, went on to start a number of highly successful startups, including Yelp, Palantir, LinkedIn, and Tesla. Other startup “mafias” — made up of early employees-turned-founders — continue to branch off from mature startups like Uber and Airbnb, in turn attracting additional VC attention and funding.
The term sheet
The term sheet is a nonbinding agreement between VCs and startups about the conditions of investing in the company. It covers a number of provisions, the most important being valuation, pro rata rights, and liquidation preference.
The valuation of the startup determines how much equity investors will own from a certain amount of investment. If a startup is valued at $100M, a $10M round of investment will give the investors 10% of the company.
$100M would be the pre-money valuation of the company — how much the company is worth before the investment — and $110M would be the post-money valuation.
A higher valuation allows the founder to sell less of the company for the same amount of money. Existing shareholders — founders, employees, and any previous investors — experience less share dilution, which means greater compensation when the company is eventually sold. Selling less of the company in a given investment round also means the founder can raise more money down the line while keeping the level of dilution in check.
However, a high valuation comes with high expectations and pressure from investors. Founders who have pushed investors to the brink of what they’re comfortable paying will have little room for mistakes. Each round generally needs to yield at least double the valuation of the previous one, so a high valuation will also be harder to overshoot.
Another downside to a high valuation is that investors may veto moderate exits because their stake in the company requires a bigger exit to be worthwhile. Investors may not allow a company with a valuation over $100M to exit for anything less than $300M, while they might be okay with a lower-valued company being acquired for a more moderate sum.
Pro rata rights
Pro rata rights give an investor the ability to participate in future financing rounds and secure the amount of equity they own.
If earlier VCs don’t follow on in their investments, their shares get progressively diluted with each financing round. If they owned 10% of the company upon investment, they will lose 10% of that initial ownership each time the startup offers up 10% to new investors.
Exercising previously secured pro rata rights can become a source of tension between early VCs that want to pitch in and protect against share dilution and downstream VCs who want to buy as much of the company as possible.
The liquidation preference in a financing contract is a clause that determines who gets how much in the event that a company liquidates.
VCs, the preferred shareholders, are prioritized in the event of a payout.
A 1x multiple guarantees the investor will be paid at least the investment principal before others are paid out. The seniority structure determines the order in which preferences are paid. “Pari passu” seniority pays all preferred shareholders at the same time, while standard seniority honors preferences in reverse order, starting with the most recent investor.
As rounds get bigger and more investors get involved, a company should pay attention to managing its liquidation stack so that investors aren’t disproportionately rewarded in a payout without leaving much behind for founders and employees.
The venture capital financing cycle: seed to exit
The average VC-backed startup goes through multiple rounds of funding in its lifetime.
At the initial or seed stage, most of the capital is allocated to developing the minimum viable product (MVP). Angel investors and the founder’s friends and family often play a big role in funding the startup at the seed stage.
At the early stages, capital is used for growth: developing the product, discovering new business channels, finding customer segments, and expanding into new markets.
At the later stages, the startup continues to scale revenue growth, although it may not yet be profitable. Funding is generally used to expand internationally, acquire competitors, or prepare for an IPO.
In the final stage of the cycle, the company exits through a public offering or an M&A transaction, and shareholders have the opportunity to realize gains from their equity ownership.
Seed- to early-stage investments are inherently more risky than late-stage investments, because startups at these stages don’t yet have a commercially scalable product in place. At the same time, these earlier investments also generate higher returns, as early-stage startups with low valuations have much more room to grow.
Later-stage investments tend to be safer because startups at this stage are usually more established. This isn’t necessarily true in every case: Some technologies take longer to mature, and late-stage investors may still be betting on them to hit mass-market adoption.
Not all companies proceed down this funnel. Some founders choose not to raise further rounds of venture capital, instead financing the startup with debt, cash flow, or savings.
Two big reasons founders choose to “bootstrap” are to maintain ownership of the company’s direction and build at a sustainable pace. Because venture capital comes with investor expectations that the company will grow rapidly month-to-month, VC-backed startups can fall into the trap of burning cash for more customers.
This short-term pressure to produce can lead startups to lose sight of their long-term creative vision. Recognizing this setback, founders of the video-sharing platform Wistia, for one, chose to take on debt instead, writing in a blog post that they “felt confident that the profitability constraints the debt imposed would be healthy for the business.”
On the flip side, Facebook is an example of a company that has successfully scaled through various stages of the venture capital cycle. The startup’s trajectory culminated in a $16B IPO at a $104B valuation, making it one of the most successful VC-backed exits of all time.
To some extent, Facebook’s rise to the top seems inevitable. Its monthly active users grew exponentially from 2004 to 2012, from just 1M to over 1B. In 2010, it surpassed Google as the most-visited website in the US, accounting for over 7% of weekly traffic.
But in the first few years of its founding, Facebook was considered overvalued. In 2005, Facebook’s Series A $87M valuation was thought to be too high, and investor Peter Thiel chose not to follow on. In 2006, Facebook’s users were still limited to 12M college students, and investors expected the service to fizzle out when it was released to a broader user base.
This section will cover the basic objectives of each venture funding stage, while examining the specific steps Facebook took toward a successful exit that created billions in wealth for its investors.
At the seed stage, a startup is no more than the founders and the idea. The purpose of the seed round is for the startup to figure out its product, market, and user base.
As the product starts to gain more users, the company may then look to raise a Series A. However, most startups fail to gain traction before the money runs out, and end up folding at this stage.
Seed-stage investments typically range from $250,000 to $2M, with a median between $750,000 and $1M. Angel investors, accelerators, and seed-stage VCs, such as Y Combinator, First Round Capital, and Founders Fund, invest in these rounds.
When Facebook raised its seed round, Peter Thiel, who had co-founded PayPal and had turned to angel investing, became the company’s first outside investor, buying 10.2% stake for $500,000. This put Facebook’s valuation at $5M.
LinkedIn co-founder Reid Hoffman, who also invested in the round, recalled that Zuckerberg was painfully quiet and awkward, with “a lot of staring at the desk” during their meeting. Nonetheless, Facebook’s “unreal” user engagement levels on college campuses tipped Thiel and Hoffman over the edge to invest.
Facebook used the funding to relocate to an office a few blocks away from the Stanford campus and hire more than 100 employees, many of whom were graduates of the college’s engineering program.
By the time a startup raises a Series A, it has developed a product and a business model to prove to investors that it will generate profit in the long run. The purpose of fundraising in this round is to optimize the user base and scale distribution.
Some startups skip the seed round and start by raising a Series A. This tends to happen if the founder has established credibility, prior experience in the market, or a product that has a high chance of scaling quickly with the right execution (e.g. enterprise software).
Series A rounds range from $2M-$15M, with a median of $3M-$7M. Traditional VCs such as Sequoia Capital, Benchmark, and Greylock tend to lead these rounds. While angels may co-invest, they don’t have the power to set the price or impact the round.
Accel and Breyer Capital led Facebook’s Series A in 2005, bringing its post-money valuation to nearly $100M.
At the time, Facebook was still limited to college students, with fewer than 3M users, while rival network Myspace had more than four times that. Securing this second round of capital allowed Facebook to expand to 1,400 colleges nationwide and improve the user experience with better features. While the full-scale Facebook Ads platform wouldn’t be developed until 2007, Facebook began to experiment with sponsored links and banner ads at this stage.
By the time a startup raises a Series B, it will have ideally established itself in a principal market and is looking to scale rapidly. It will use the money to ramp up sales and marketing efforts, expand geographically, and even acquire smaller companies.
The size of Series B rounds can go upwards of tens of millions. They are led by the same investors as Series A, and some later-stage firms, such as IVP, start to get involved.
In 2006, Greylock Partners and Meritech Capital Partners joined in Facebook’s $27.5M Series B. By then, Facebook’s user base had grown exponentially to more than 7M users. It ranked as the seventh most-visited website at this point.
Soon after the round, Facebook opened its website to the broader public, allowing anyone with a valid email address to join. Open registration was a huge success, bringing the number of users from 9M in September 2006 to 14M in January 2007.
When a startup raises a Series C, it is often getting ready for M&A opportunities or for an IPO. The money raised in this round will continue to finance its expansion efforts from its Series B stage, including expanding geographically (even internationally), acquiring competitors, and developing new products.
A Series C can range from tens to hundreds of millions. Early-stage VCs may invest in this round, but late-stage investors, including private equity firms, hedge funds, late-stage arms of investment banks, and big secondary market firms also participate.
In October 2007, Microsoft bought a 1.6% stake in Facebook for $240M, putting Facebook’s valuation at $15B.
The deal was a strategic partnership: Microsoft would sell Facebook’s banner ads shown outside the US and split the revenue. Facebook used the capital to hire more employees, expand overseas, and launch Facebook Ads, a comprehensive advertising platform for businesses of all sizes.
By the time a company is raising late-stage rounds, it is usually looking to go public. Capital from late-stage investments is used to drive down prices, suppress competitors, and create favorable conditions for an IPO.
In the past few years, many companies have been spending more time at this stage, rather than moving forward with an IPO. A number of tech unicorns, such as Postmates and Stripe, are all pending IPOs, despite posting billions in revenues.
Unfavorable market conditions coupled with easy access to private capital are fueling the trend toward larger, later exits. The disappointing public market debuts of Uber and Lyft in 2019 have led big startups to reconsider their exit strategies. Larger venture funds and bigger rounds mean that they can afford to stay private longer and build bigger war chests.
In 2009, Facebook raised a $200M Series D round from the Russia-based internet company Digital Sky Technologies (DST), putting its valuation at $10B. Then, in 2011, Facebook raised $1.5B at a $50B valuation in a Series E round with participation from DST and Goldman Sachs’ venture arm.
During an IPO, a company that’s been funded by private investors sells public shares for the first time. IPOs are often thought of as the ideal exit scenario, because founders keep control of the company while shareholders enjoy high payoffs.
An alternative exit strategy is a merger or acquisition. Acquisitions can also be highly profitable, but founders often have to give up control. For instance, Instagram was acquired by Facebook for $1B in 2012, but its co-founders left the company in 2018 when they couldn’t see eye-to-eye with Mark Zuckerberg.
Facebook turned down many acquisition offers throughout the years, including a $1B offer from Yahoo! in 2006.
Zuckerberg floated the idea of an IPO in 2010, but at the time said the company was “in no rush.” By 2012, Facebook had more than 500 round-lot stockholders, subjecting it to SEC disclosure rules despite its status as a private company. Facebook took steps toward an IPO by buying up smaller companies to enhance its offerings and solidify its foothold in the consumer internet space.
In May 2012, Facebook raised $16B in its IPO, putting the company’s valuation at $104B and producing net profits in billions for early investors like Thiel, Accel Partners, and Breyer Capital.
Facebook’s continued success, however, would go on to make its IPO look like a bargain. As its revenue continued to grow — from around $5B in 2012 to over $70B in 2019 — its stock price also climbed, trading at over 6 times its IPO price as of May 2020.
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