Private Equity firms are about making money. They buy companies and then extract cash from them at the expense of everyone around them. Nothing wrong about that, it is what it is.
Venture Capital is about a shared risk between the entrepreneur and the venture capital firm. The firm puts the capital, the entrepreneur the sweat and the outcome is either great wealth or middling results or nada.
The emergence of Unicorns and their liquidation preferences and the ability of entrepreneurs to cash out during the investment has transformed the start-up scene considerably into something that feels a lot more like private equity.
Let’s walk you through the numbers.
In a private equity (PE) deal, the company is bought at some value X. Employees are then given signing bonuses to stick around for a period of time while the PE firm tries to extract either a better selling price or enough cash to make a significant return on the initial investment.
In a Unicorn billion dollar investment we have turned VC investment into a PE deal.
VC’s are not investing money they are buying companies with liquidation preferences guaranteeing their X. Why do I say that? Because if the company is sold for X, then the only group that makes any money is the VC firm. Consider a company that gets a 160 million dollar investment at 3 billion dollar valuation. That company, if it gets sold for 160 million dollars, then every cent will go to theVC’s. That’s what I call buying a company for 160 million dollars, not investing 160 million dollars in a company. There is no shared downside risk.
The founders meanwhile are given a one time signing bonus – basically they are allowed to cash out some amount of money and are allowed to keep a certain amount of equity. The bonus acts as a massive salary bump, and the equity should keep them somewhat motivated.
So what do we have:
A VC firm buys a company. Founders get paid to run the company. Sounds like a purchase not an investment.
This is not how VC investment has typically worked, I am told.
The real interesting insight is that because these are really just PE deals masquerading as VC investments is what makes these kind of deals so frigging attractive to investors. If you could buy some of these Unicorns for less than 300 million dollars, wouldn’t you? They are all good bets. The problem isn’t that the investors are making real money, or that the founders are making real money, the problem is that these deals are opaque and the market for them is illiquid and that this can create a serious problem when the market gets somewhat less frothy.
In the nightmare scenario where the market appetite for investments in illiquid early stage startups with excellent growth potential declines, the VC firms might find their customers looking to cash out. Essentially the guys investing in the VC firms may start wanting their money. And then we have this dichotomy between the VC firm that wants the money now and can get a decent return for a sale pre-IPO and the founders who have to sell to make real money. If the firm can IPO, then they will and if they can not then the company will get sold and then the employees will get nada. Because the company is structured in such a way where the VC firm owns the company, but employees owns an option to sell shares in a publicly traded company that is currently private (in other words, worthless stock) they do not own a piece of the company they are currently working at.
Fun times… Love to learn I am wrong.