welcome to money is freedom
a podcast
exploring how finance and freedom connect in our lives
created from thoughtful research
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this series brings you clear
meaningful insights into finance and beyond
episode 32 analyzes the challenges
and low success rates in venture capital
using y Combinator and Lightspeed Venture Partners
as case studies data reveals that
although some firms produce massive successes
the vast majority of startups fail
and even top tier firms experience
low returns on many investments
this is attributed to a power law
distribution of returns high failure rates
lengthy investment horizons and market volatility
accompanying podcasts and blog posts
discuss the related topic of fiscal dominance
and its economic impact
alright so today
we're gonna be
diving into the world of venture capital okay
um and you know
something that I know
a lot of our listeners are really interested in yeah
we're gonna be looking at an article called
Venture Capital Is Harder Than You think
here's the data to prove it
uh huh and this is from Crypto Daily interesting
it's easy to see you know
all this hype around getting rich
oh yeah backing the next big thing
absolutely but
we're gonna kind of pull back the curtain a little bit
yeah on on VC really see what the truth is
love it so
the article starts off by kind of shattering this myth
okay that VC is like a guaranteed path to riches right
and it talks about this idea of the power law okay
which basically says that
you know a small handful of companies drive
you know the lion's sheriff returns
yeah it's kind of a winter take all situation
exactly and that has major implications for how
investors approach VC
you wouldn't put all your eggs in one basket
if you're building a portfolio right
same principle here yeah
diversification is key yeah
but even then
the power law suggests that most investments will yield
minimal returns
so even if you have a VC firm and they invest in
let's say 100 companies yeah
their success might just depend on one or two
right becoming like the next Google or Amazon
exactly and so the article uses y Combinator
the y C as a case study interesting
there are a very prestigious startup accelerator
for sure that backed companies like Airbnb and stripe
wow but what's really surprising is that only 4
5% of those companies that y see backs
actually reach that coveted unicorn status
yeah which is
you know valued over $1 billion
wow that's a remarkably low percentage
great
especially considering YC's reputation for selecting
promising startups exactly
yeah and it gets even more interesting
when you look at the successful exits okay
like ipos or acquisitions
only about 10% of YC companies achieve those milestones
that means the vast majority
don't reach those levels of success
that investors typically hope for
yeah that was pretty eye opening
and the article goes on to say that just four companies
yeah Airbnb Coinbase
Reddit and instacart
wow account for 85% of YC's total returns
oh my gosh think about that for a second yeah
out of all the innovative companies that YC has backed
a mere four
are responsible for the vast majority of their success
yeah it really drives home that power law dynamic
we were just talking about
it makes you wonder like how do they
how do these vcs navigate this landscape
knowing that most of these investments won't yield
a significant return absolutely
it highlights the importance of due diligence
yeah and rigorous evaluation right
vcs need to be incredibly discerning
yeah when choosing which companies to back yeah
recognizing that even the most promising ventures
face an uphill battle the article then shifts gears
and talks about Light Speed
Venture Partners okay
which is another big player in the VC world right
and especially in the AI space yeah
they've backed companies like anthropic
okay Mistral AI
interesting open AI
wow but what was really interesting was
there was this table
that showed their fund performance over time
and it showed some really intriguing insights
yeah about the volatility of VC returns okay
so their older funds yeah
the ones that were launched between 2006 and 2012
performed exceptionally well okay
generated really impressive DPI multiples
now hold on
for those of us who aren't fluent in VC jargon right
can you break down what DPI means yes please
and why it's important yeah
DPI stands for distributions to paid in capital
okay in simple terms
uh huh it's your report card for AVC Fund
I like that
it tells you how much actual cash you're getting back
yeah compared to what you initially invested
a high DPI indicates strong returns
right which is what every investor hopes for yeah
so
Lightspe's older funds were delivering impressive DPI
meaning investors were seeing
substantial returns on their investment right
but then the article goes on to say okay
that their more recent funds
yeah from 2018 to 2022
okay they're showing much lower DPI interesting
so what's the reason for this shift
well it's a reflection of
the inherent unpredictability of venture capital
uh huh even establish firms like light speed
yeah with a proven track record
right aren't immune to market fluctuations
hmm
their recent funds are showing slower liquidity events
okay meaning it's taking longer
yeah for investments to mature
and generate cash returns through ipos or acquisitions
so even if a fund is invested in promising companies
yeah there's no guarantee
of when those investments will actually turn into like
tangible returns yeah
for investors exactly
it seems like patience is key in VC
it seems like there's a lot more to VC
yes than meets the
I totally agree
it's not just about throwing money at the next
shiny startup right
it's a complex ecosystem it is with its own rules
yeah challenges
the sure and rewards absolutely
and it's fascinating how
they talk about Lightspeed's AI
investment strategy yeah
they're clearly betting big on the future of AI
but they also say you know
this is still early days right
a lot of these ventures could fizzle out
absolutely
unpredictable nature seems to be like a constant theme
definitely it's like surfing
you're riding the wave of innovation right
but you never know when it might crash
yeah
even with all the data analysis and the due diligence
yeah there's an element a chance involved
the article lists a bunch of other things that make VC
so tricky yeah
it's not just market volatility right
things like long investment horizons
the difficulty of getting your money out
should we maybe unpack those a bit more
absolutely let's unpack those
okay first you got the long investment horizon
yeah we touched on this a little earlier
yeah but it's worth emphasizing
VC isn't like buying a stock
and hoping it goes up next week right
this is about planting seeds that might take years
yeah maybe even a decade to bear fruit
which must be tough
for both investors and entrepreneurs
absolutely the investors have to be patient
yeah and the entrepreneurs have to keep pushing forward
even when the pay off is so far down the road
exactly and then there's the issue of liquidity
or rather the lack of it okay
you might see a fund with a great tvpi
meaning
the total value of their investments looks fantastic
okay on paper right
but that doesn't mean investors can easily cash out
another acronym alert tvpi
okay break that one down for me
think of tvpi is the total value to Pating Capital okay
basically a snapshot yeah
of the current value of the fund's holdings
but here's the catch okay
it doesn't reflect the actual cash
yeah that investors can access
so tvpi might look promising yeah
but until those investments are actually sold right
whether through an IPO or acquisition
hmm investors are essentially holding ill liquid assets
yeah precisely
it's like owning a beautiful house yeah
okay you could appreciate its value yeah
but you can't easily spend that value right
until you actually sell it
so patience and understanding the long game are crucial
absolutely for VC investors yeah
what about some of those other challenges
the article lists well
we talked about the power law
distribution and the high failure rate
but beyond that yeah
you've got marketcyclicality
tech downturns AI hype cycles
yeah even broader economic conditions right
all of these can impact valuations yeah
they make exits harder it's like navigating a ship
okay through unpredictable waters
it makes you realize how external forces
can really impact a startup's fate
absolutely no matter how brilliant the idea or team is
exactly and then
there's the risk associated with Fallawon Capital yep
even those startups
that manage to secure that initial funding right
often struggle to raise subsequent rounds as they grow
yeah you know
Series a Series B
and so on yeah
those hurdles can be incredibly tough to clear
you know it's interesting
because they talk about
not just the numbers in the data
but they also talk about like right
the psychological factors at play
absolutely they talk about this optimism bias
yeah where both entrepreneurs
and investors
tend to overestimate their chances of success
hmm what are your thoughts on that
I think it's a fascinating aspect of the VC world okay
there's a certain allure yeah
a sense of possibility right
that draws people in
entrepreneurs
dream of building the next billion dollar company
yeah and investors are enticed by that potential
for massive returns
but the reality is
most startups don't achieve those lofty goals
it's like that old lottery saying
you can't win if you don't play
but in the case of VC yeah
the odds of hitting the Jackpot are incredibly slim
exactly
and that's where the importance of due diligence
comes in right
for investors yeah
it's about conducting thorough research
looking beyond the hype yeah
really understanding the fundamentals of the business
okay are they solving a real problem right
do they have a sustainable business model
what's their competitive landscape like
it seems like
separating the signal from the noise is crucial
in a field like this yeah
especially in a fast moving area like AI
right where there's so much hype and buzz
investors need to be able to critically evaluate
those claims and projections yeah
understanding that early stage companies right
often operate with limited data
and high degree of uncertainty yeah
what about for entrepreneurs
yeah what role does do diligence play for them
for entrepreneurs yeah
due diligence means understanding the VC landscape
knowing which firms invest in their industry
what stage of development they focus on
right and what their investment philosophy is
so it's not just about finding money right
it's about finding the right partners
exactly okay
and it also involves being prepared
yeah to answer tough questions about your business okay
investors wanna see yeah
a solid teen uh huh
a compelling vision right
and a clear path to profitability
it's about building trust
yeah and demonstrating that you're not just
chasing the next round of funding right
but you're building a sustainable business
exactly for the long haul
and remember yeah
investors are betting on people as much as ideas right
they wanna see passion mmm hmm
expertise and a willingness to learn and adapt
which makes sense
given all the challenges that we've talked about
market volatility yeah
long investment horizons absolutely intense competent
right it takes a special kind of resilience
it does to navigate the world of VC for sure
it sounds like to really make it in VC
you need vision and determination
oh yeah
and a pre thick skin for sure
but even with all the right qualities
this article emphasizes that timing plays a huge role
it does so we've talked about
you know it's a long game right
but recognizing that VC operates in cycles exactly
there's these periods of exuberance yeah
like what we're seeing now with AI yeah
followed by these periods of correction
and reevaluation for sure
so even if you have a great company
yeah hitting the market at the wrong time
uh huh could make all the difference absolutely yeah
it underscores the need yeah
for both investors and entrepreneurs
right to be realistic
uh huh and not get swept up in the hype right
a solid business idea with strong fundamentals
yeah will weather those cycles
better than one built on hype alone
it all ties back to this idea of follow on capital risk
the article says
even startups that secure initial funding right
often struggle to raise those subsequent rounds
as they grow uh huh
why is that such a critical hurdle
well imagine a startup is like a rocket ship okay
the initial funding gets it off the ground
uh huh but reaching orbit yeah
requires multiple stages uh huh
with increasingly powerful engines exactly
each follow on funding round
Series a Series B
and so on right
represents a critical stage in that journey absolutely
so it's not just about getting that first check
it's about maintaining that momentum
yes and convincing investors right
that the company is on a trajectory towards
substantial growth exactly
and eventual probability
the stakes get higher with each round
yeah later stage
investors are looking for more
then just a promising idea right
they want to see results proof of traction
okay revenue growth
right and a clear path to market dominance
so
it sounds like a constant pressure cooker for startups
they're not just building a product or a service
but they're constantly having to prove their worth
to potential investors
that's the reality of the VC game yeah
it's a highly competitive environment
right where only the strongest
right and most adaptable survive for sure
and that's why for entrepreneurs yeah
focusing on building that strong foundation
is Paramount what does that look like in practice
it starts with solving a real problem
okay for a defined market
yeah
building a product or service that people actually need
right and are willing to pay for right
then
it's about assembling a talented and dedicated team
yeah people who share the vision
and are in it for the long haul right
and finally
it's about developing a sustainable business model okay
one that can generate revenue right
managed costs yeah
and ultimately turn a profit
so it's about focusing on the fundamentals
it is not getting distracted by short term trends
or trying to be the next overnight sensation
and being adaptable yeah
and resourceful
the start up journey is rarely a straight line okay
there will be setbacks mm hmm
unexpected challenges right
moments where you have to pivot and adjust course
this deep dive has been really eye opening for me
I'm glad you know
going behind the curtain of the VC world
and all complexities and nuances
for sure
it's clear that VC is not for the faint of heart
I think that's a fair assessment
yeah it's a high stakes
high reward environment that demands
you know a really unique blend yeah
a vision resilience
and a deep understanding of the game
so for anyone listening
who's thinking about entering this world
yeah whether as an entrepreneur or an investor
what advice would you leave them with
I would say go in with your eyes wide open okay
understand the risks challenges
the sheer amount of work involved
yeah but also embrace the potential
the excitement of innovation
yeah and the possibility of contributing to something
truly groundbreaking that's a great note to end on
thanks you know
being realistic yeah
but not losing sight of that passion and that dream
right that drives the entrepreneurial spirit absolutely
thanks for joining us today
on this deep dive into the world of venture capital
my pleasure