Behind the Scenes of Venture Capital: The Laws Supporting High Risk and High Return
Venture capital (VC) is known as a high-risk, high-return investment method, but behind it lies a complex mechanism involving "investment laws," "market cycles," and the "technical evolution of fundraising." In this article, based on a conversation between Stu Elman, co-founder of the long-standing NY-based VC firm RRE Ventures, and renowned investor Steve Eisman, we unravel everything from the profit structure of VC to historical crises and the latest trends, incorporating specific examples and quotes.
1. Venture Capital Profit Structure and Laws of Success
1-1. The Law of Thirds
The typical return distribution in VC is that "one-third of invested companies result in a total loss," "one-third struggle to even recover capital," and "the final third produces a massive success."
One-third lose their entire investment, and another third cannot even recover their principal. In the end, everything is left to the final third.
1-2. Portfolio Diversification and the Carry Mechanism
Generally, about 25 investments are made per fund, and one "home run" covers almost all of the fund's total returns. The reward for investors (carry) is typically 20% of the successful profits.
2. Market Ups and Downs and Lessons from Historical Crises
2-1. The Dot-com Bubble (around 2000)
At that time, when massive investments in hardware and software licenses were required, companies ran out of cash one after another because they could not reduce server maintenance costs.
Stocks like Yahoo fell from $260 to $3.
2-2. The 2008 Financial Crisis
The collapse of financial institutions spread to tech companies. While VCs had significant room to cut costs at their portfolio companies, those that were over-leveraged found it difficult to survive.
You couldn't cut all expenses to zero, because you had to pay for everything.
2-3. The 2010s Recovery and the Rise of NY Tech
With the support of former Mayor Bloomberg and others, NY became the "second tech center after Silicon Valley." RRE was founded in 1994, and its first fund of $94 million in 1997 was called "huge" at the time.
In 1997, we formed our first fund with institutional investors as limited partners. The size was $94 million.
3. Fundraising Dynamics and Changes in Evaluation Criteria
3-1. Cost Structure from Seed to Series C
In the 90s, the initial round was at least $5 million, and before the cloud, expensive hardware/software was essential. Since the shift to the cloud, cases where $1-2 million is sufficient for a seed round have increased.
"Seed investments at that time required more capital compared to today."
3-2. The Overheating of the "Go-Go" Market (2017–2021)
Some major VCs decided that "valuation is no object for a good deal," leading to overheating where $100 million valuations were offered in a single day.
3-3. Valuation Normalization and Washouts
Asset value mark-to-model valuations can be frozen until a new round. Rapid valuation compression can lead to existing investors being wiped out via "pay-to-play" clauses, resulting in a washout.
"If you don't put in capital, you get washed out... your holdings are diluted by a factor of ten and converted to common stock... effectively becoming worthless."
4. The Rise of New York VCs and the Journey of RRE Ventures
4-1. Background of RRE's Founding
Founded in 1994, right after the release of Netscape, alongside former American Express CEO James Robinson III and others.
"We decided to launch the fund the very month Netscape was released as a browser."
4-2. Approach to Fortune 500 Companies
Leveraging "building connections with large corporations" as a strength, they achieved results in financial services software investment.
"Our firm became very good at introducing our portfolio companies to Fortune 500 contacts we knew."
4-3. Over 30 Years of Experience with Crashes
Having survived the three major crashes—the dot-com bubble, the financial crisis, and pre-COVID—they currently manage 10 institutional funds.
5. Future Areas of Focus: AI and Tokenization
5-1. Application AI and Physical AI
Large Language Models (LLMs) are for funds with massive capital. Small and medium-sized VCs are focusing on industry-specific AI (medical billing, import/export, etc.) and "physical AI" linked with IoT sensors.
5-2. The Potential of Tokenization
Tokenizing portions of real estate or cash flow rights on the blockchain to achieve improved liquidity and decentralized rights.
Conclusion
Venture capital has evolved in line with market cycles and technological innovation, while maintaining the dual nature of "many failures" and "a few successes supporting the whole." With the addition of new trends like AI and tokenization, there is a greater need for risk management and fundraising strategies than ever before, even while aiming for high returns. Let's understand the reality of VC and apply it to your own investment and entrepreneurship strategies.
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