As the “New Space” industry emerged over the last two decades it required a class of capital to fund the expensive development programs necessary to bring space products to market. Reluctantly at first, and more enthusiastically over the last ten or so years, venture capital has become that funding source. Today, venture is the first place most space entrepreneurs look to when capitalizing their startup ambitions, for better or worse.

The relationship with venture capital is nothing less than fundamental to the future of the space industry. Venture financing has empowered nearly every new space project over the last 10 years and makes the majority of the innovation in this industry possible. Given this trend, it’s important to understand that there are incentives and expectations that come with raising venture financing.

As the market soared from late 2020 to early 2022, it was easy for founders to overlook the implications of raising capital from the venture community. But now that valuations have come back to Earth and investors are no longer deploying investment capital based on an tacit expectation of ever-rising valuations, those implications are back in focus.

Over the past 12 months, there has been a re-emphasis on the incentives that come with taking venture capital. In this newsletter, I aim to explicitly discuss those incentives and the positive and negative consequences that they typically create.

I’ll address how venture capital funds are structured, why companies taking venture capital are incentivized to go big or fail, who makes money in an exit event for a venture capital-funded startup, and what dropping valuations mean for companies that have already taken venture investments.

Let’s dig in.

How venture capital is structured

There are three main parties in the venture capital world; the Limited Partners, the General Partners, and the portfolio companies.

Limited Partners (those who give venture capital investors money)

The Limited Partners, or LPs, are where the money comes from that ultimately gets invested into startups. LP’s are typically organizations like pension funds, high net worth individuals, sovereign wealth funds and endowments, and other professional investors. These days venture capitalists often raise hundreds of millions to billions of dollars for each fund, and while some LPs may be wealthy individuals or even successful former entrepreneurs, many LPs manage billions of dollars and are some of the world’s biggest sources of private capital. Depending on their own mandate, the LPs will have a diversified investment strategy and Venture Capital will represent a small portion of that overall strategy, usually a single-digit percentage; even a small percentage of a $50 billion fund is a huge dollar amount. These are organizations like the Harvard University endowment ($50+ billion as of 2022) and the Ontario Teachers Pension Fund ($240+ billion as of 2022). These LPs, who are themselves professional investors, need to decide where to invest their capital, who to invest with and how to provide stability and long-term growth that satisfies their own mandates.

General Partners (the venture capital investors)

The next major players are the General Partners or GPs. The GPs are owners, general managers and usually the lead investors for the venture capital fund. Not to overcomplicate this, but not all venture capital investors are GPs but all GPs are investors. Junior members of a Venture Capital fund may be on the investment team, sourcing and doing diligence on startup investment opportunities and supporting portfolio companies, but they may not be one of the General Partners. A good analogy to this would be a law firm. Most law firms have swaths of junior lawyers but only a handful of named partners (or General Partners) who actually have their own money at risk.

The GPs raise the money from their LPs and decide which startup investments to make. After making investments into startups, they support the startups in their growth journey with the goal that the original investment will eventually return a larger amount of money back than originally invested.

While the LPs represent the majority of capital contributed to a venture fund, the GPs will always put up some personal capital to invest alongside the LPs. This helps align incentives between LPs and GPs. A rule of thumb is that GPs will invest their own personal money that accounts for between 1% and 2% of total funds raised. For example, if the VC raises a $100 million fund, $98 million will come from the LPs and $2 million will come from the GPs.

Portfolio Companies

Finally, there are the portfolio companies, who receive investments from the Venture Capital funds. In the case of an investment in a successful startup, the VC will receive a future return on their original investment (ideally a multiple of it) through an “exit” or “liquidity event”, such as being acquired or IPO. In a perfect world, the GPs invest their funds into a bunch of portfolio companies and between 7 and 10 years later the GPs receive a much larger amount of money returned from those investments. Then the GPs take a percent of the gain on the investment return (known as carried interest) and distribute the remainder of the positive return back to their LPs, and everyone is happy!

Here are some examples of high-profile names in each of these categories.

An important thing to note; venture capital funds are raised and invested in discrete amounts, often called XYZ Fund 1, 2, 3…. For example, a GP will raise money for their first fund, i.e. Fund 1, and then spend about two years investing money from that fund. When all the money from Fund 1 is fully invested, the fund will basically sit for another eight years while the companies it invested in continue developing. After that two-year investment window ends for Fund 1, and assuming some level of success by the investments, the GPs then go raise Fund 2 and invest that capital in a similar manner. As a result, a single venture capital firm may have many funds that are simultaneously active, but only one that they are typically investing out of at any given time. The other funds are holding ownership in a bunch of companies that hopefully grow in value.

It’s worth quickly noting that many VCs will reserve a portion of each fund for a follow-on investment in their portfolio companies. This can be an investment in a portfolio company that is doing well and wants to raise growth capital at a higher valuation, or a company that isn’t doing as well as hoped and needs to raise additional capital, sometimes called “bridge” capital, in order to reach their original goals.

So great, now that we know the players involved, let’s dive a little deeper into the numbers that broadly define the incentive structure.

Go Big or Go Home

First of all, venture capital is one of the riskier asset classes and the majority of investments don’t succeed. Spoiler alert, it turns out that it’s extremely hard to identify and invest in the early-stage companies that will grow to become the next Google or Apple. But thanks to the natural laws of investing, riskiness doesn’t mean uninvestable. Since most investments don’t succeed, investors (LPs) expect a high return from the venture funds in order to compensate for the added risk. If they weren’t being rewarded with higher returns, they would just put their money into a safer investment.

So what is considered a reasonable return for venture capital? Well, the market has decided that about 12%-15% annually is about right, which is solidly above the S&P’s average yearly growth of around 8-10% per year. Return expectations will vary by investment stage as well. For example, Seed stage investors would require a higher expected return than later stage investors (such as a Series E investor) since there is far higher risk when investing in seed stage startups compared to more mature businesses that have been derisked over time. Over 10 years, the life of a fund vintage, 12%-15% annual growth comes to about 3-5X increase in value. So for the sake of simplicity going forward, let’s call that 4X.

Simply stated, a GP’s goal is to raise money from their LPs, invest that money in great businesses, and in 10 years return 4X the original money back to their LPs. So how do they give themselves the best chance to do that? Well, this is where the incentives start to really drive the dynamics between the GPs and the portfolio companies.

Let’s take for example a VC that specializes in Seed stage companies and is investing out of a $100M fund. Let’s say that out of that fund, the GPs will make on average about 25 investments of around $4M each (in practice this is an oversimplification because, as alluded to earlier, venture investors typically hold onto a portion of the fund for follow-on rounds and there are also management fees that get paid with these funds). Let’s also say that each $4M investment gives the fund a 20% ownership position in each of the 25 companies, meaning that each company was valued at $20M when the investments are completed.

A note about dilution: We’ll have to account for one small but important factor here, which is ownership dilution. A Seed round is usually the first investment round with institutional investors (i.e. VC’s), and any subsequent rounds will invariably dilute the early investors. Dilution isn’t necessarily a bad thing; early investors in any successful company face dilution at one point or another. If a company succeeds and completes later-stage investment funding rounds, a reasonable assumption is that the earliest investors’ ownership will be diluted by about 50%. So, for our example’s sake, by the time ten years have passed and the company has probably raised two to four more rounds of funding, the Seed fund’s 20% ownership gets diluted down to around 10%.

1X Fund

So let’s see what happens if a bunch of those companies do really well, maybe 5 of them become worth $200M. That sounds like a pretty big win, picking ten companies that have gone up 10 times in value each.

After 10 years the fund actually owns 10% of 5 companies valued at $200M each. Wait, so that means their ownership is worth $100M and since the original fund size was $100M, it is only back to its starting value. We know the GPs are really looking for a 4X return, so 1X is pretty awful.

I’m about to start sharing some homemade pictures, please forgive me for the horrors of how ugly these are and the sins of building them in PowerPoint.

2.6X Fund

But wait, what if out of those 5 companies, two of them do really well, and go up 5X more to $1B while the other 3 remain at $200M. Then you’ve got two companies representing $200M in fund value ($1B x 2 companies x 10% ownership in each company), while the other three are only representing $60M ($200M x 3 companies x 10% ownership in each company). Now the total fund return is $260M, or 2.6X. Even having invested in two companies that become “unicorns” (a private company valued at or above a billion dollars), the fund is still underperforming LP expectations.

6.6X Fund

Next, what if one of those two top companies did even better and increased in value 5X again, to $5B. Then you’ve got one portfolio company at $5B, one at $1B, and three at $200M. With 10% ownership that corresponds to $660M in value to the fund. That’s an amazing return of 6.6X, and you have some extremely happy LP’s.

5X Fund

Now let’s really drive the point home of what I’ve been progressing us towards - the power law of venture investing and the fact that one really big win is all a fund needs to hit its goals. Let’s say that the best performing company is still worth $5B, but all the others actually went completely belly up and are worth $0. With 10% ownership, the fund’s investment in that one company is worth $500M, or a 5X return on the whole fund, which means it still performed incredibly well.

The Takeaways

Here’s the real lesson: the returns from that one top-performing company (worth $5B) completely dwarfed the returns of all the others, even the other really good companies (worth $1B and $200M). In fact, without that best company in the portfolio, the 6.6X fund drops to a 1.6X fund.

And when you compare the returns from only one massive winner (worth $5B and a 5X fund return) in the portfolio versus having 5 good winners (worth $200M each or $1B total and 1X fund return), the difference is even more stark. While this may seem obvious, clearly having a portfolio value of $500M is better than a portfolio value of $100M, it can feel a bit counterintuitive that you just want one massive winner rather than a more diversified group of great winners. What makes it even more counterintuitive is that picking one massive winner may be more likely than picking 5 great winners.

Building any successful company is really really hard, and the challenges don’t necessarily scale by the size of the company. In fact, in a weird way, it might even be easier to build a $5B company than a $200M one if the $5B company is in a growing, uncompetitive market while the $200M one is building in a stagnant and highly competitive market.

When accounting for all of these factors, the point I’m trying to make is that as a founder, your job is to convince the fund’s General Partners that you can be that one massive winner. To take it a step further, it is also important to note that if you convince them that you can be one of the great companies, but not a massive company, you are essentially doing nothing for them, because the great companies will never generate the outsized return they need to make their LP’s happy.

Why Fund Size Matters

I know this may seem frustrating. You can build a multi-hundred million dollar company and still be considered a poor investment by venture capital investors. However, there’s something important to recognize here. The size of your company is not the only part of this equation that is within your control. You also get to choose your investor, which means you can also choose the size of the fund investing in your company.

This is important because the math that underlies the above example can conversely work in your favor as well. For the $100M fund, a 10% ownership in a portfolio company worth $2B (corresponding to $200M in value owned by the fund) means a 2X return on that fund’s value, which as we said, is below their target return. However, for a $50M fund, a 10% ownership in that same $2B portfolio company means a 4X return on that fund’s value, which is an amazing return!

Therein lies another critical point: bigger funds need to have much bigger winners in their portfolios or own a larger percentage of their winners, which isn’t typically realistic. As a founder, you get to choose the metrics by which you’re measured when you choose the size of the fund you’re taking money from. That means you get to choose the incentives of the game you’re playing. This matters a lot, because those incentives are going to drive the behavior of your investors both before and after you take their funding.

Here’s an interesting example of those incentives playing out. In the past few months that market valuations have dropped, some investors have recognized that it’s harder than ever to have high multiple funds with really big fund sizes. As a result, some investors are actually choosing to decrease the size of their funds in order to reset the expectations for the fund’s performance.

Liquidation Preferences in Venture Investing

One more topic of note that is fairly ubiquitous in the venture community, but not always appreciated amongst founders is liquidation preferences. Liquidation preferences are terms that are denoted in venture investment term sheets. A venture capital term sheet is an offer made by a venture investor that details the terms of a funding agreement. There are a number of terms that are often included in venture investments, including board seats, anti-dilution provisions, pro-rata rights, and others. You could write an entire book on the terms of venture investments (in fact people have, and there’s a great one I recommend called Venture Deals). However, there’s one term I’d like to address because it tends to be the most standard and it has clear implications on incentives. What I’m referring to are liquidation preferences.

It turns out that not all company shares are created equal. The founders and employees of a tech company will typically have what’s called common stock in the company. These are what you would think of as plain company equity ownership. What investors tend to get though is a special class of shares, called preferred stock. Now preferred stock always has the option to convert into common stock if the owner chooses. But if it remains as preferred stock, it has liquidation preferences over common stock owners. That means preferred stock owners have the right to be paid out first in the case of a liquidation event.

Consider a situation where a company raised $200M from investors in exchange for 50% ownership of the company in the form of preferred stock, valuing the company at $400M. A few years later, let’s say markets get worse, valuations come down, and the company ends up getting acquired at a $200M. You might think the company founders and employees would be pretty happy, they still get to split 50% of those $200M. However, because of the preferences of the investor stock, the first $200M goes back to the investors and nothing remains for the common stock-holding founders and employees.

Now, reconsider that case and say that the company instead does amazingly well and gets acquired for $10B. Now of course it doesn’t make sense for the investors to just take their $200M and leave the remaining $9.8B for the common stockholders. Instead, the preferred shareholders will exercise their option to convert to common shares, and take their 50% of the $10B.

To even further emphasize the impact of preferred stock, it’s important to note that preferred shareholders might have the right to be paid out even more than the money they invested. It’s not completely uncommon for investors to have 2x preferences (and in very rare occasions even more), where they have a right to be paid out from a liquidation event up to 2x the amount of money they originally invested. When markets were high on easy money from near 0% interest rates, companies didn’t really need to worry about such unfriendly terms. Now that markets have slowed substantially, expect to see more investor-friendly terms like increased liquidation preference to make it into term sheets, especially for companies that are in desperate need of capital.

This is why, when you raise venture capital you are essentially signing a contract that your company is going to be worth significantly more in the future when you exit. You’re taking money that gives you the opportunity to build a really huge company, but in turn you’re signing away the upside (for you and your employees) if you only build a pretty good company.

Here’s a tweet that details the consequences of that even further.

What This All Means With Dropping Valuations

From mid-2020 to early 2022, the tech world got a little drunk on venture capital financing and the space industry was no exception. In 2021, a company that raised money at a $100M valuation may only now be valued closer to $20M. That means the company has to increase 5x in value just to get back to where it was at the previous funding round. Then, you have to do way better than that to make your investors from that funding round happy. The challenge is that you had set expectations for your company’s performance during a time when there was a lot more optimism in the world.

The reality is that these problems can be resolved, although the solutions are typically painful. Companies raising funding today are accepting much lower valuations than they did 12 to 18 months ago. That means more dilution than might have been previously anticipated and/or cutting costs enough to delay the fundraising long enough to extend runway and improve the company’s valuation.

The implications are further reaching than this, but rather than go into more detail myself, I’ll point you to others who I think do a great job writing regularly about this.

For example, Jason Yeh is an investor who writes a great newsletter helping entrepreneurs improve their fundraising which I highly recommend. You can check it out here:

Anyway, that’s a wrap! If you enjoyed this newsletter, respond to this email and let me know!