This is Kristen O'Brien, Managing Editor at NFX, and this is the founder list. Audible versions of essays from technology's most important leaders selected by the founder community. This is how VCs think, the psychology that drives investing decisions, read by NFX. Like so many founders we work with today, When we were founding and advising companies, we always felt a disconnect between the way we saw reality and the realities of VCs we met along the way.
It sometimes felt as if we were not speaking the same language. Looking back, it made sense. We were deep in the trenches of the founder ecosystem. Didn't really know the VC mindset and didn't always understand them. We weren't speaking the same language, but over the years, we learned the hard truth. For a startup, understanding VC's mindsets is often as important as understanding the mindsets of your customers. With no capital, most founders will not win, so you Beller learn the language.
A few years past and we're now VCs, we now see the interaction from the other side of the table and it clear that the disconnect is still around, no different than it was when we started our own journey. To help bridge the gap, today we're sharing a few psychological drivers that predictably dictate many VC's mindsets and decision making processes.
These are patterns we often fail to see back when we were building companies and our hope is that founders can learn them to master the skill or founder VC communications. To begin, perhaps the most efficient pathway to understanding anyone's mindset is understanding their pain points, Now while everyone assumes the VC life is all rosy, in reality, it's not always a simple role. I will elaborate. How VCs make money? The first thing to understand is the economics around a VC.
The partners in a VC hold an entity called the GP general partner, The money for investments comes from limited partners who are mostly institutional investors, which GPs invest on their behalf. The GP only makes money once the LPs return their initial investments. Once this happens, the GPs get a percent of the profits called carried interest usually around 20 percent of the profit.
So if a $100,000,000 fund, for example, returns only $90,000,000, the GP gets nothing At $200,000,000 return, the original $100,000,000 plus an additional $100,000,000 of profit, the GP would get $20,000,000 of carried interest, That's all the partners together, of course. At three times, which is what great funds return, the profit is 200,000,000 and the GP gets 40,000,000. That sounds great, right?
But when we look at the holding percentages, early stage VCs would get to the exit event usually with 10% or less given dilution along the way. So to return 300,000,000, a fund would have to be invested in companies with an aggregate exit value north of 3,000,000,000. Not tough if you happen to be the investor in a Facebook or an Airbnb, but as most exits are much smaller than 1,000,000,000, the chances of any fund getting the 3,000,000,000 of exit value are not high.
What's the outcome of these numbers? Essentially, 2 little known VC's guidelines which are critical to understand. VCs need really large exits. It is true that some VCs try to focus on smaller startups with lower expected outcomes. But in general, it's incredibly tough to return the fund multiple times with that type of strategy. Most VCs you meet will be very serious when they tell you. I can see your startup turning into a business worth a $100,000,000, but not Morgan, so it's not for us.
This is tough to understand. If a VC can invest now at, for example, an $8,000,000 valuation exiting at $100,000,000 would seem to be a good investment, especially if you look personally at your stake in the company. Selling it for a $100,000,000 seems to you like an amazing outcome, but what we didn't understand when we were entrepreneurs ourselves was this reality.
The $100,000,000 VC invests $2,000,000 for 20 percent then has to add more capital and subsequent rounds in order to get $20,000,000 at the $100,000,000 exit, assuming no further dilution. This doesn't move the needle for the $100,000,000 VC they need to get to $300,000,000 of returns. This is why VCs really must aim for huge outcomes. VCs need a big stake. 15 to 25%. The venture business is a hit driven business.
Every successful fund will have 1 or 2 big hit companies that make the fund While everyone is smart in retrospect, clearly the VC didn't know which company would be the most successful at the time of investment. Otherwise, they would have only invested in the hits. The outcome is that VCs need to get to sufficient holding, usually 10 to 15% for a seed fund in any company. Imagine the pain resulting from the fund holding only 3% in the company that could have returned the entire fund.
And at lower percentages of holding, you need even higher overall exit value. Big stakes are critical for VCs. VCs need to maintain good relationships. Now that we understand the numbers and the pressure to get sufficient holdings in companies that can be huge, let's try to understand how tough it is to actually find these companies.
The VC partner role is all about one screening potential investments 2, diving deeper into the better deals and 3, eventually choosing the right companies to invest in. Not a horrible job, you probably think, but it's also not an easy one. VCs can get tens of meeting investment requests per day, and it's never clear where the next great company will come from so they need to review all of them.
Even though there are many decent ideas and impressive teams, VCs only get to invest in, say, 1 in every 100 companies they see. And that's without even touching the really hard part of the job, which is having to say no more than 99% of the time. Not fun. The 2 psychological drivers of VCs. So what are the key psychological drivers VC partners develop to cope with those pain points? They're actually pretty basic. 1, FOMO. Fear of missing out. Every VC likes sharing their big wins.
But what we underestimated when we were founders was that every VC also has stories of their big losses. The deals that got away come with deep personal regret, And while some of this is based on the lost financial benefits, of course, more often those regrets go a lot deeper Big hits are so far apart that seeing one having the option to invest in it and missing out is the VC's biggest fear. I personally missed out, for example, on a great company called Yacht Po.
I loved the team, but not the product, and I was wrong. I said no, and, other than losing a potentially amazing financial outcome, I also missed out on being part of a phenomenal journey. And this was not my only big loss. So when a VC partner sees a company which could be huge with a great team in a field they like and a good idea, it's tough not to invest. That's the first psychological driver. 2. Foles. Fear of looking stupid.
It's common knowledge that VCs are programmed to increase profits, but few people talk about the way VCs are programmed to avoid looking stupid and hearing, I told you so, What can make you look stupid? Bending on a company that competes with a very successful company, example, who wants to invest in a new social network today?
Investing in a field where a top fund has already invested in a competitor, even if the field is still not dominated by anyone yet, once a top fund marks the winner, Other companies consistently find it tougher to raise Morgan investing in a field where a competitor raised a very high amount of money. We've seen funding dry out for other competitors after soft bank invests a mega round in a field. The outcome? VCs don't want to invest anywhere they can end up looking stupid.
How'd you invest in an Uber competitor after Uber already raised $5,000,000,000 is not a question you want your LPs to ask you? The FOMO Full's diad. These two psychological drivers represent the entire story. The stories VCs tell themselves. With their need to screen 100 of companies and choose the winners that can turn into huge companies, VCs are constantly balancing their FOMO and their foals. Morgan other words, VCs want to find a very safe deal at the low price of a very risky deal.
Once you understand this, you can start using this mindset in your favor. Need for speed. One other nuance to understand about interfacing with VCs is that time is the VC's friend, not yours. The VC will always prefer to wait to make their investment decisions. The longer they wait, the more data they will gather about your business, and the more they will get to know you. And this data means lower risk. It's in the VC's best interest to keep the optionality. They can always say no later.
You on the other hand need the funding now to grow your company and move fast, of course, but you should also know that every day that passes gives the investor an opportunity to hear a negative or a mixed review of your company or your field. And that could give them cold feet. You want to close fast and the only way to get investors to move at your pace is by going back to FOMO because a VC usually only moves fast, only when other VCs are also interested.
Using the VC mindset in your favor, To use this understanding to flip the odds in your favor, you simply need to convince the VC of the following 3 narratives. The better you portray these narratives, the more term sheets you will get, It's as simple as that. 1, convince the VC you are low risk. Start by learning how VCs see your numbers. We've shared playbooks for this before, see our how VCs see your KPIs and ladder of proof essays.
From there, you can work backwards to find the right data points that will communicate your narrative in the best possible way. Pete product it can start with. Our founders are very experienced and have worked in these top startups, equals, we're not just a strong team, but we also know how startups move fast and scale from our past experience. We worked together a few years before founding the company, equals no team risk, we know each other well, Pete.
Post product it around the different KPIs. We already have 10,000 engaged users who use the app daily equals retention and engagement. We started monetizing and the conversion of payment is 3%. Equals no risk that this can only be a free app. The more data points you can present to prove you are low risk, the better. And the main thing as most funding processes take time is to ensure you provide the updates to the investors that show you're progressing.
Nothing like fast progress to prove your low risk. One last thing on risk. Know your competition. Analyze them well. The better you know your competition, the easier it will be to convince investors that you're low risk. 2. Prove that you have a huge potential. Numbers play a big part improving yourself. Master your TAM and Sam and come repair with the data.
Nobody believes you can take 50% of your market, so ensure that even if you're talking about 5% that you have a huge story to Beller, Using references from other industries can be helpful to illustrate your point. The SaaS platform for this vertical created a multi $1,000,000,000 business, the vertical we are after is similar size so we can build a similar sized business. Present your potential not just top down, but also bottom up.
We aim to capture 5% of the industry's IT spend, Bottom down this means that we will need 10% of the potential customers to pay us a $1000 a month, which makes sense. When you lock down the numbers both bottom up and top down, your story becomes a lot more credible. Do the numbers have to be precise? Not really. Nobody expects your numbers to be accurate years ahead. But remember, if you project only $5,000,000 revenues in 5 years, you are usually not interesting Morgan VC.
The VC isn't questioning whether you can be a $5,000,000 or $6,000,000 business, they're questioning whether you can be a $50,000,000 revenue business. 3, show the VC that others are very interested. This deserves a post of its own, but in general, founders should always aim to convey a sense of momentum. Mention you're speaking to others, without disclosing James, you don't want them to talk to each other. When you get a term sheet, let others know to get them to move faster.
The hotter your deal seems the more likely you are to be interesting to more investors. Sentences like, no pressure, but we are about to get a term sheet early next week and would love to know where you stand are a great tool so long as you can stand behind them. VCs speak a different language. To sum up, VCs speak a different language, one that founders must learn to be able to raise capital. Understand the psychological drivers and use them to evaluate your counterpart's state of mind.
And repeat the core narratives. We are low risk. We will be huge. Others are interested in moving forward. Go get funded. For more audio essays from the people who've built companies like Instacart, Facebook, Trello, HubSpot, and Dropbox, visit the founder Flint. Atnfx.com, or subscribe to the NFX podcast at podcast.nfx.com, or wherever you get your podcasts. I'm Kristen O'Brien, and this is the founder list.