What is Venture Capital Really ft. Sachin Bansal

After his not-very-nice exit from Flipkart, Sachin Bansal has moved on to do what many storied entrepreneurs do – announce a $1Bn VC fund. 

Messr Bansal made more than $1Bn from his Flipkart exit, after leading the golden light of the startup ecosystem for more than a decade. In his time at Flipkart, Mr. Bansal invested in his personal capacity in 8-9 rounds across a few startups.

His most recent one was in the healthcare analytics company Sigtuple, and by the news release, seems in line with his preference for AI. What is unusual for the fund-in-works is that Bansal plans to commit $400MM of his own wealth into it (40% of fund), while most VC partners personally commit 2-3% of the fund size.

If this fund materializes, Mr. Bansal will be a General Partner with a commitment like a Limited Partner (more on what that these are later).

Sachin Bansal is not doing something new.

The entrepreneur turned VC twirl is a well-charted path, a second innings to win again in the startup ecosystem. eBay’s multi-billionaire founder Pierre Omidyar setup the impact VC fund Omidyar Network, and the fund only invests from Omidyar’s wealth.

Netscape’s Marc Andreessen started the now gigantic a16z, which is on its way to being one of the most prolific VC investors of all time. Peter Thiel exited Paypal and launched the Founders Fund, which has backed stars like AirBnB. Closer home, Narayana Murthy founded Catamaran Ventures.

While some of these founder-VCs may not be managing day to day anymore, the line between an entrepreneur and investor is evidently blurred. One individual could be a founder, VC investor and board member all at once. 

But why did venture capital come up in the first place?

Venture, evidently, arises from the word adventure and originates from “to risk the loss” of something. Young companies are fairly risky propositions, and they are more likely to die than to survive to maturity (this is the basis of the cliche VC quote 90% startups fail).

These young companies have a great business plan, an exciting team, an interesting business model but usually few customers. To keep the company going, while it looks for customers, is usually unprofitable.

Salaries, day to day expenses and marketing are usually larger than revenue to start with. Most founders can’t fund the losses and growth forever, so they look for partners in the adventure – enter venture capital firms. 

Venture capital firms are essentially money managers, investing capital in young companies in exchange for equity.

The VC firms work hard with the founders to make this equity more valuable, by necessarily helping make the company more valuable. Companies become more valuable by adding talented people, serving customers, creating products and generating profit in the process.

But then, one may ask, none of these startup “unicorns” is making a profit even after so many years, so where’s the value? It took 7 years for Amazon to first hit profitability, and successfully IPO in the US. India’s complex (and profit requiring) IPO rules make it hard to go public, so Indian startups need to be private longer.

From an Indian VC investor perspective, exiting by selling to a larger player (e.g. Walmart-Flipkart) is more likely. The value perceived by the acquirer is clearly there, and the VC has completed their goal of making the company more valuable while selling their equity to the acquirer. 

But why do VCs have these goals, and where does the money of a VC come from?

VCs raise the money to invest from high net-worth individuals (HNIs) or institutions looking to invest in an “alternative” asset class i.e. not bonds or public equities.

These folks are called Limited Partners (LPs), that I had alluded to earlier. This capital is raised by General Partners (GPs), i.e. partners at VC firms who make day-to-day decisions and decide which startups to fund. VCs are successful if they return more money than they raised from their LPs.

Let’s say a VC raises $100M (fund size) to invest over 5 years (fund life) with a target annualized return of 10% (fund hurdle). The fund should, therefore, at least grow to 100*(1.1^5) = $160MM of liquid cash before it makes any profit.

Funds usually charge a 2% management fee (on the fund size) and 20% carried interest (on the fund profit). Therefore if a fund grows to more than $160MM, 20% of any additional profit goes to the VC firm.

Due to this structure, VC firms like getting exits (converting equity to cash) and like getting big ones. Sequoia’s $68MM investment in Whatsapp resulted in a $3Bn return, that one deal itself returned the whole $1.3Bn fund twiceover.

These exits, though, are outliers and most funds don’t even see the light of their second fundraise. 

VC investing is therefore pretty hard, and the question for Mr. Bansal is – do great operators always make great investors?

There is an interesting similarity between running a company and running a VC fund. Running a company involves deciding where to put capital to use so that you get the best return on investment (i.e. profit), and VC is also similarly a capital allocation problem.

Where they diverge, though, is that an operator requires a lot of day to day decision making and is driven by a sort of impatience. Being a VC investor requires much less frequent decision making and an enormous amount of patience.

As an operator, you only know about your own company really well, but as a VC you need to know many more.

From a performance perspective, let’s circle back to the $160MM target.

Say you invest $10MM in 10 companies and 5 go bust. Your remaining 5 companies should be $32MM each. The usual structure is 5 bust, 4 average ($20MM) and one rockstar ($100MM+ i.e. larger than fund).

For a $1Bn fund that Mr. Bansal plans to raise, he needs to definitely, therefore, generate one unicorn.

Given the size of the fund, and a likelihood of 20 investments a year over 5 years, the fund will also have to cut decently large check sizes (~$10MM). Therefore, the larger the fund, the harder it is going to be, and this is assuming Mr. Bansal finds LPs to back the rest of $600MM (you realize it’s not that easy anymore). 

Will Mr. Bansal succeed or will Flipkart be his last hurrah?