1.2.6 Venture Capital

Welcome to On Judgement. A profitable neighbourhood bakery and a loss-making medical software startup both want £1m. Does the more familiar or currently profitable business necessarily fit a venture fund better? Take a first view. You can change it when you have considered the evidence.

Venture investors provide equity or other agreed funding to businesses pursuing uncertain growth. The investor needs the possibility of sufficiently large outcomes across a portfolio, not simply a sensible small business. Venture can finance research, product development, hiring and expansion before cash generation supports the plan. A business may prefer retained profit, bank borrowing, customer funding or a slower path. A local service business can be excellent without fitting a venture fund’s required scale and exit model. Conversely, a huge market and impressive technology do not establish that a particular startup can acquire customers profitably or justify its valuation.

Pre-seed, seed and later series are flexible labels, not a compulsory sequence or guarantees of maturity. Investors seek evidence appropriate to the business: a validated problem, technical progress, paying customers, retention, regulatory milestones or improving economics. Later funding can reduce one uncertainty while introducing a higher price or new financing risks. Investors may provide board input, recruitment help, introductions and challenge. Rights and involvement vary. Trust and working relationships matter, but a famous founder or previous successful exit is not a substitute for diligence. Further funding can be required; reserves must be considered alongside new investments.

In a simple priced round, pre-money equity value plus new primary investment gives post-money equity value. The investor’s simple post-round percentage is new money divided by post-money value. Option pools, convertibles, secondary share sales and different share rights can change this calculation. When new shares are issued, a shareholder who does not participate can own a smaller percentage. The stake can nevertheless gain or lose in value depending on the business and valuation. Following on with more capital may maintain a percentage rather than increase it. Preference terms can affect distributions, so an ownership percentage is not always the percentage of every exit payment.

Venture outcomes can be highly uneven. Some investments fail; a few may contribute much of a fund’s value. No fixed failure rate or outcome distribution applies to every fund. Gross portfolio multiples omit the time taken, fees, carried interest, dilution and additional capital unless these are explicitly included. A useful pitch response identifies the problem, customer evidence, market access, team capability, defensibility, economics and cash runway. Separate a prototype or survey from paid repeat use. End with invest, decline or investigate further under stated conditions. A fashionable sector and a recent boom do not by themselves justify increasing exposure.

Let's work through Ownership and an uneven portfolio. A startup raises £2m at £6m pre-money value with no other changes. Separately, a fictional fund invests £1m each in ten companies: six return zero, three return £1m each and one returns £12m. No follow-ons or fees. Pause here and try the calculation or reasoning before continuing.

Simple post-money equity value = £6m + £2m = £8m. New investor ownership = £2m ÷ £8m = 25%; existing holders together retain 75%. Portfolio proceeds = £0 + £3m + £12m = £15m on £10m invested. Gross MOIC = 1.5×. With only one final payment after eight years, annual compound return would be 1.5^(1/8)−1 ≈5.20%, before fees.

The successful company does not make the portfolio return 12×. Ownership arithmetic assumes identical ordinary shares, a primary round, no option-pool change and no convertible claims.

Now try the choices in this lesson. If your answer changes, identify the reason. Evaluate a startup using evidence about problem, team, market, economics, terms and funding needs. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.