Sometimes entrepreneurs forget that (independent) venture capitalists have to raise money too. We know exactly how it feels to get rejected over and over and over again. Fundraising is hard! We know, because we have to raise a new fund every 2-3 years.
In venture capital, you can think of Fund I as the seed round, Fund II at the Series A, and Fund III as the Series B, and so on and so forth. For each fund we have to show traction. We have to deliver solid KPIs after each fundraise, just like how entrepreneurs have to do the same. But one thing that is challenging about venture capital is that the relevant KPIs in the short term are very different from the long term.
In the short term, what matters are mark-ups. Mark-ups are when you invest in a company at a certain valuation, and then another investor invests in the next round at a higher valuation. These are called “paper gains” because although the perceived value of the stock you own has gone up, you haven’t actually returned any money back to investors yet. So the increased value is only on paper. To actually return money to investors, our companies have to exit (the company has to get acquired or go public). However, exits take time. Companies of great value typically take 7 – 12 years before any liquidity event.
The challenge for venture capitalists is that we typically deploy capital over 2-3 years, and have to raise a new fund before we’ve gotten any cash distributions. Which means that when we raise Fund II, we are being evaluated based on mark-ups, or paper gains.
So the dilemma is… do we invest in trendy, sexy companies that will be able to raise money at higher valuations quickly, or do we invest in unsexy companies that may actually be better, viable businesses in the long-term? The answer may seem obvious to an outsider, but it is a very real dilemma that venture capitalists face.
This is one of the major reasons why there is so much herd mentality in venture capital, and why investors flock to buzzwords like “blockchain,” “AI,” and “virtual reality.” Or why former Googlers and Stanford grads are able to raise so easily. Even if you are an investor that sees through the facade, you know that these are some of the considerations for mark-ups.
Just like any other venture capital firm, we think about this dilemma at 500 Japan. The long-term KPI is actual cash distributions, which is what really matters, so we play the long game. High-impact companies typically take a long time to build. This is a get rich slowly business, and we’re patient.