Ask HN: How VC funding works?

If you look at the numbers of a service like Dropbox (which I know is not a direct comparison, but is at least in an approximate neighbourhood), then you can see why an $1.8m investment in this sort of service would make sense - it can theoretically be useful to tens, if not hundreds, of millions of users.

Yes the odd terrible company gets funded, but if you cannot see where the value in a new service lies then it might be down to a number of other factors:

1. You are not being shown the complete product (i.e. you are seeing a v1 or even an MVP, but internally the company is demoing a killer app)

2. You are applying your own tastes/needs when evaluating a service. A famous ad exec once said (roughly): "We are not our target market". Don't assume a new product is being marketed toward you, try to think who it is really for and whether or not they might think differently.

3. Your ability to forecast user numbers / revenue for a new service might not be as good as you think.

Generally speaking, VC's aren't interested in getting their money back with revenues from the company they're funding. They aim for a 'big exit', in the form of an IPO or acquisition by another company.

Imagine Kicksend gets to 10,000,000 paying customers in a few years. And you own 20% of that.

That's how VC's think.

The best way to understand how VC funding works is try to become one.

At least in the US, nearly all the money invested by VCs is from 'limited partners', and the usual suspects are employee pension funds, university endowments, life insurance companies, hedge funds, sovereign wealth funds (think a fund with Mideast state oil money), and wealthy individuals.

The VCs and/or LPs need some 'criteria' on how to invest the money. That is, one venture partner, at least before he has an astoundingly good track record, who has some very different ideas about how to invest money will likely fail to get approval from his other partners or the LPs. So, if you will, there is a 'herd'.

Here are some of the main points about the 'criteria':

(1) The Sexy Sectors.

The two biggest sectors for VC investing are 'information technology' (IT) and biomedical technology. There is also a little for 'clean tech', and then everything else is in the 'single digits' or the roundoff error. In IT, the sector splits into hardware and software. In software, the biggies now are the Web 2.0 and mobile.

(2) The Traction Thing.

It is fair to say that VC is just 'early stage private equity' (PE) investing. Well, in later stage PE, audited financial statements are important. Since in early stage asking for audited finacials is usually asking for nothing significant, the 'herd' likes to see a near substitute and that is the somewhat ill-defined but still quantitative 'traction'.

'Good traction' is, for say a Web 2.0 site, the number of 'unique users' ('uniques') per month significant, say, over 100,000 and growing rapidly. For a mobile app, 'traction' might be number of monthly downloads significant and growing rapidly.

Of course, 'traction' the accountants can count is better, e.g., revenue, and, of course, best of all, earnings.

(3) The Market Thing.

If do some arithmetic on how VC money flows, then can see that VC needs surprisingly big 'exits'. For that a good first guess is that an entrepreneur should be attacking a relatively large 'market'.

Hopefully that market already exists, but, of course, the entrepreneurs may be creating the market they are attacking. Or, e.g., well before the first iPhone, what was the 'market' for such a device? Well, that 'market' is big enough NOW, but Apple, with help from Nokia, RIM, Motorola, etc., created it.

The joke goes: The entrepreneur proposes building a toll bridge across the river. The skeptical investor notes that there is no traffic across the river at the entrepreneur's proposed location and, thus, concludes that there is no 'market'.

There is an old saying: "Selling new technology is hard. Attacking a new market is hard. Selling new technology for a new market is too hard.". This saying is mostly a joke but does describe some common, real concerns.

(4) The Money Thing.

A common assumption in IT VC is that a lot of 'traction' is very significant even if there is so far no revenue. So commonly it is assumed that if can get 100 million people a month to aim their eyeballs, then somehow there will be a way to extract money, that is, to execute 'monetization'.

(5) The UI/UX.

A definition of art is "the communication, interpretation of human experience, emotion". A lot of 'pop culture' art seeks to create an 'engaging user experience'. So, a Web 2.0 project might emphasize a good 'user interface' (UI) and 'user experience' (UX). Some VCs will 'play with' the product and evaluate how well millions of users might like the UI/UX.

(6) A Buffett 'Moat'.

Of course, W. Buffett likes each of his investments to have a 'moat' that keeps out competition like a medieval castle had a moat that kept out the roving barbarians, hungry peasants, greedy neighbors, etc.

Coveted moats used to be (A) crucial, core, technical 'secret sauce' that was powerful, gave especially valuable results, and was difficult to duplicate or equal, (B) patents for crucial, core, technical secret sauce, (C) user 'lock in', e.g., high user 'switching costs', (D) 'network effects', (E) deals for 'distribution channels', etc.

Now more popular is just, from F. W...

We are currently in a huge bubble. I wouldn't try to ascribe rational valuations to anything investors do in the middle of a bubble.

When a company like GRPN, who lies about its own revenue in its own S1 filing, loses money on every deal, and whose idea of scaling is "just add more sales people", pops off a wildly successful IPO in the middle of a very volatile public market, that's when you throw your hands in the air and stop trying to see rational behavior where there is none.

If you're old enough, you would remember this story from 1996-2001 repeating itself.

Of course, there's no end to the supply of twenty-something startup hipsters who will breathlessly inform you that this time it's different. Sure it is, kid. Sure it is.