Venture Capital Funds like other money managers get an annual % of the amount of money invested in their fund. The best way to attract new investors is to demonstrate success. If a VC invests in a company at $1 per share and the company goes public at $10 per share then the VC’s success is easy to calculate. If none of the companies in a VC’s portfolio actually go public, the VC’s success is harder to demonstrate.
To solve the problem, VCs have created a metric called “pre-revenue or pre-earnings valuation”. You will not find it in peer reviewed journals. It is the closest thing finance has to an oxy-moron.
It works like this. Ten VC funds each invest in a seed round of 10 companies. Then some will invest in a Series A round of some of the companies in the other VC’s portfolios, then others will invest in the Series B round, etc. Inthe end these VC funds have cross funded each other’s deals at different levels. Each level is priced higher than the one before.
In the seed round a VC invested $10 million for 10 million shares of the outstanding shares of each company. By the Series C, D or E round those shares are being sold to the other VCs and now cost $50 each.
Does that make the original shares purchased in the seed round worth $500 million? If the company has now issued 200 million shares is the company worth $10 billion? Not in the real world and especially not if the company is still not profitable.
However the VC can now claim that its original investment is worth much more and use that “fact” to attract more investors into its fund. The VC will receive a % of the amount invested yearly for a decade or more.
WeWork and the other unicorns will be the subject of business school case studies for at least the next generation. They are the most recent example of what may be the oldest theorem in finance: you can fool some of the people all of the time.
Capital for new and smaller ventures is essential to the entire system of finance. Investment crowdfunding is actually a response to the failures of VCs in the dotcom era. The arrogance displayed by VCs in this current market has probably done more to cement the place for investment crowdfunding than anything else. It is up to the crowdfunding platforms and professionals not to make the same mistakes.