Partner at sequoia capital and former cfo of paypal, and paul graham, partner and co founder of y combinator, joined this class as guest speakers. class 7 notes essay mdash follow the money many people who start businesses never deal with venture capitalists. If you do end up needing to raise a larger amount of capital, you need to know how vc works. Understanding how vcs think about money mdash or, in some cases, how they don rsquo t think about it and thus lose it mdash is important. Before that, wealthy individuals and families were investing in new ventures quite frequently.

But the idea of pooling funds that professionals would invest in early stage companies was a product of the lsquo 40s. The sand hill road, silicon valley version came in the late 1960s, with sequoia, kleiner perkins, and mayfield leading the field. Venture basically works like this: you pool a bunch of money that you get from people called limited partners. Then you take money from that pool and invest it in portfolio companies that you think are promising.

Hopefully those companies become more valuable over time and everybody makes money. So vcs have the dual role of encouraging lps to give them money and then finding hopefully successful companies to back. The typical model is called 2 and 20, which means that the vc firm charges an annual management fee of 2% of the fund and then gets 20% of the gains beyond the original investment. The 2% management fee is theoretically just enough to allow the vc firm to continue to operate. In practice, it can end up being a lot more than that a $200m fund would earn $4m in management fees under a 2 and 20 structure.

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But it rsquo s certainly true that the real payout that vcs look for come with the 20% cut of the gains, which is called the carry. Vc funds last for several years, because it usually takes years for the companies you invest in to grow in value. Many of the investments in a given fund either don rsquo t make money or go to zero. But the idea is that the companies that do well get you all your money back and then some you end up with more money in the fund at the end than lps put in to begin with. You have to be skilled at coming up with reasonable valuations, identifying great entrepreneurs, etc. But there rsquo s one dimension that is particularly important, yet surprisingly poorly understood.

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It is far and away the most important structural element of venture capital: exponential power. But just as 3 rd grade arithmetic mdash knowing not just how many shares you get, but dividing that by the shares outstanding mdash was crucial to understand equity, 7 th grade math mdash understanding exponents mdash is necessary to understand vc. The standard einstein line on this is that the most powerful force in universe is compound interest. But that model mdash some substantial period of exponential growth mdash is the core of any successful tech company. Since you start out underwater, the big question is when you make it above the water line. To answer that big question you have to ask another: what does the distribution of returns in venture fund look like? the na ve response is just to rank companies from best to worst according to their return in multiple of dollars invested.

But that model misses the key insight that actual returns are incredibly skewed. If you look at founders fund rsquo s 2005 fund, the best investment ended up being worth about as much as all the rest combined. And the investment in the second best company was about as valuable as number three through the rest. to a first approximation, a vc portfolio will only make money if your best company investment ends up being worth more than your whole fund.

In practice, it rsquo s quite hard to be profitable as a vc if you don rsquo t get to those numbers. Paypal rsquo s early stage investors had a large enough stake such that their investment was ultimately worth about the size of their fund. The rest of the fund rsquo s portfolio didn rsquo t do so well, so they more or less broke even riding on paypal.

But paypal rsquo s series b investors, despite doing quite well with the paypal investment, didn rsquo t break even on their fund. That investment returns take a power law distribution leads to a few important conclusions. First, you need to remember that, management fees aside, you only get paid if you return all the money invested plus more.

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So given power law distribution, you have to ask the question: ldquo is there a reasonable scenario where our stake in this company will be worth more than the whole fund? rdquo second is that, given a big power law distribution, you want to be fairly concentrated. If you invest in 100 companies to try and cover your bases through volume, there rsquo s probably sloppy thinking somewhere. There just aren rsquo t that many businesses that you can have the requisite high degree of conviction about. A better model is to invest in maybe 7 or 8 promising companies from which you think you can get a 10x return. It rsquo s true that in theory, the math works out the same if try investing in 100 different companies that you think will bring 100x returns. But in practice that starts looking less like investing and more like buying lottery tickets. We live in a world where we normally don rsquo t experience anything exponentially.