In the second diagram we can see that the first diagram has been made transparent and that four vector arrows have been placed over Diagram 1.  These are the primary real forces that control the outcome of venture capital investments.  Look first at the red line.  The earlier the stage of a target company's development, the greater the risk because a progressively higher proportion fail the younger they are, and usually, the longer it will take to achieve an exit.  As the company grows and its identity and business model separate from the founders' heads and become established, the following things simultaneously happen: the balance sheet expands, the intellectual property becomes more refined, codified, and defined, the employees begin to operate as a system,  lessons are learned from the price paid of mistakes, stakeholders take on risk control positions (such as on Boards of Directors), inter-business relationships solidify, the experience of those involved deepens, and the business outcome becomes increasingly significant for more people and institutions.  Because of all of these things, among others, the Risk of Loss diminishes as a target matures and yet risk still never reaches zero.  Although Diagram 2 doesn't show it, the risk vector will turn horizontal to the right and continue off to infinity so long as the company exists. 

 

Balancing risk of loss is important from a portfolio management perspective because although some positions will inevitably lose all of their capital, that is merely part of the game where the winning strategy will diversify within a venture capital series of positions to spread risk around and do so in a way were exposures are hedged.  Example: one wouldn't want all their venture capital positions in one industry at the same time because commonality of any type greatly enhances the relative, potential, magnitude of risk.

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The brown vector is perhaps the most overlooked and yet perhaps the most highly determinative of how much money is actually made by respective investors upon exits.  The brown vector is labelled the "Rate of Dilution."  Rate of Dilution refers to the fact that successive investment rounds purchase additional equity and although they make the pie bigger by contributing more capital, they also reduce the overall percentage of the pie for all earlier investors.  When we talk about this internally we say "capital efficiency," and what we mean by that is that what is important is that investment capital be used to achieve development, growth, scaling, etc., because every inefficient use of capital wastes opportunity and diminishes one's percentage of ownership without adding equal or greater value to the enterprise.  If a target business changes course, fuel is burned: that fuel is capital, and you will feel it in watching the relative percentage of the company you own as additional investors are brought on board to pay the price.  In Diagram 2 the brown vector slopes down to the right because the diagram assumes that the enterprise value of the target company is growing as development proceeds.  Likewise, although later venture capital rounds tend to be bigger, they acquire less shares at higher prices and thus dilution occurs more slowly.  That is what we see in the force of the Rate of Dilution.  There is very real pressure in early stage companies to achieve and grow revenue because the runway to achieve liftoff is finite and as revenue comes in the door the need to dilute investors with additional capital diminishes. 

 

The third force vector is 'Revenue' in green.   For the reasons just discussed in the last paragraph, Revenue usually exerts a force opposite the force of the Rate of Dilution so long as capital efficiency is conserved.  The goal in owning any company is to achieve a gain and revenues are proof that perceived value is being sold to the world.   The relationship between capital on hand and the rate of loss per month is typically called "burn."  Development burns cash.  Scaling burns cash.  The goal, of course, is to lift the revenue vector disproportionately versus aggregate burn in the final analysis.  As revenue increases burn diminishes so long as the rate of scaling remains constant.  Hard decisions are made by early stage managers and directors in this period because as additional revenue is achieved there is great temptation to reduce the rate of burn but doing so extends the time to exit and therefore that siren's call to fiduciary conservatism is often an attraction to hidden peril.  In the most explosively growing companies the management and directors must apply growing revenues directly back into the rate of growth.  It can feel a bit harrowing.  

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And finally we have vector 4 which is the black line labelled "price per share" and is perhaps the place where most early stage founders and venture capitalists struggle the most.  As an enterprise progresses it is only right and justifiable that successive milestones achieved ought to add value to the enterprise not to mention the intervening time, goodwill and sweat equity.  In growing companies the share price is typically evidenced by the next priced round of investment and because discrete events cause recognition of share price readings they move in a step-wise fashion.  (May all your steps be upward.)  Sometimes share price steps are downward, which we call "down-rounds," and can happen for many reasons such as: the company pivoted its business model, the company lost a major external partner, or something that should be working already is not.  Invariably, the buyer of shares focuses on the negative while the management and existing investors focus on the cost to duplicate what has been done plus all the achievements and merits.  The company operates in round negotiating times in the Grand Courtship, at fear of losing its prospective investor, where the prospective investor has fear of losing out on a great opportunity.  What ultimately emerges as the share price of each round is as much a science, art, and battle of wills.  In the ideal the share price changes every instant but in the observable we only see those moments where new investment rounds are priced.  It is a process overloaded with nuance.  But the simple rule guiding the vector of share-price is that if the exit grows closer, the risk grows lower where there is correspondence with the expected rate of return, and then the share price ought rightfully to rise.

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As revenue becomes predictable, and the techniques of standard investment banking become applicable, (such as pricing the enterprise using prevailing multiples of EBITDA, among others) then the black line begins to follow a more predictable, calculatable course capable of qualifying for well priced debt.  Because of this, the black share price line evens out in slope toward the right of Diagram 2.   At this point of conversion of erratic slope to steady slope we see the very ground where venture capital ends and private equity continues on alone. 

 

All venture capital is private equity but not all private equity is venture capital.

 

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