Everything you've ever wanted to know about venture capital, but were too afraid to ask

Larry page sergey brin vinod khoslaScreenshotVinod Khosla, a venture capitalist, with Google cofounders Larry Page and Sergey Brin.

If you spend long enough in the world of tech, you end up immersed in a whole universe of jargon: Funding rounds. Down rounds. Valuations, acqui-hires, exits. The list goes on.

If you work in the tech or finance industry, it all makes perfect sense after a while.

But for everyone else, trying to figure out just what it means when we say that Uber’s raising $2 billion at a $62.5 billion valuation can make your head spin.

So if you’re curious, here’s how to think about money in Silicon Valley — where it comes from, and where it goes.

First, a definition. 'Venture capital' is simply the term for to the money given to young companies to help them grow, usually in exchange for a share of ownership in the company. You know, like on 'Shark Tank.'

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A venture-capital firm, like Andreessen Horowitz or Sequoia Capital, is a company that raises a whole bunch of money — like from the people who manage your mutual funds or pension fund, for instance — into a special venture fund, and then invests it in the startups it thinks will make the most money back.

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Venture capital, as a model, isn't unique to Silicon Valley tech companies. But the two have a relationship that goes back to the late 1950s, when pioneering San Jose-based circuit company Fairchild Semiconductor became the first-ever venture-backed startup.

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But the modern venture-capital business, which hinges solely on funding startups, really kicked off in 1972, when two financial types with tech-industry experience named Eugene Kleiner and Tom Perkins (pictured) raised their first fund.

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Entrepreneurs come to venture capitalists for the cash they need to take their really good ideas to fruition. Young Mark Zuckerberg may have started Facebook with cash out of his own pocket from a Harvard dorm room, but that only takes you so far.

Meanwhile, venture capitalists do these deals because it gives them both a financial stake and a lot of influence over what they hope is the next Google or Facebook. Besides, if any one company fails, the $25 million that a big venture capital firm might lose is a drop in the bucket -- and all it takes is one smash success to make that money right back.

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Investors expect that most startups will fail, so they're always looking for that '10x' investment, which will make up for a bunch of little losses.

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When entrepreneurs are starting out, the first step is often to raise the so-called seed round, usually a relatively small investment intended to help the startup get off the ground and build a first real version. It can come from friends and family, or from venture-capital firms. Snapchat raised a $485,000 seed round in 2012, for instance.

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Seed rounds offer investors the best deals: The earlier an investor gets into a company, the better, since you get a much bigger slice of ownership for a lot less cash. But it's also risky because plenty of startups implode before they get past this stage.

Photo: Shark Tank/ Facebook.

That's why there are so-called 'startup accelerator' programs, which invest a little bit of money and try to offer coaching and assistance to help them survive. Y Combinator, the most prominent of these programs, offers $120,000 and three months of intensive mentoring. Dropbox, Reddit, and Airbnb all came out of Y Combinator.

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Assuming a startup survives past the seed round, coming up with something that investors might really be interested in, the next stage is the 'Series A,' also called the 'growth round.' This is where things get sticky, because it's also where the money gets real. Instacart got $8.5 million in its 2013 Series A round.

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The 'Series A' gets its name because that's the class of ownership in the company. After that, it's the 'Series B,' the 'Series C,' and so on, theoretically forever.

This is also where you start having to worry about 'valuation,' which is a very tricky subject. Basically, it's an imaginary number that the startup and its investors agree on to decide how much a company is worth after a funding round closes.

Here's how I think about valuations. If I make a hot, delicious pizza and carve it up into eight slices, I might ask you how much you think one slice is worth. If we agreed on $3 for the first slice, then you just bought a 12.5% stake of my eight-slice pizza at a $24 valuation.

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Similarly, if my pizza is COMPLETELY AMAZING, and everybody wants some, and you offer me $4 per slice, I might laugh at you and find someone willing to pay $8, valuing my pizza at $64. Scale that up into the millions of dollars, and you get a sense of how this works.

This is also why investors want to get into the earliest stages of a startup. In simple terms, the later you get in, the more you might have to pay for an ever-dwindling supply of pizza.

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The thing about valuations is that they're very often chosen to look good -- in the heydey of the current market, it was so easy to raise venture capital funding that startups would go after a $1 billion valuation just to enter the unfortunately named 'unicorn club.'

courtesy of NYC Taxi Drivers 2014 Beefcake Calendar

'One billion is better than $800 million because it's the psychological threshold for potential customers, employees, and the press,' said Slack CEO Stewart Butterfield in January 2015, when his company passed that $1 billion threshold 9 months after launching.

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This is where what Alan Greenspan would call 'irrational exuberance' comes into play. The Apple App Store's launch in 2008 set off a whole new wave of tech speculation, with investors banking big that new apps would be worth a lot of money later ...

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...even if they're not making a lot of money now. Uber is a great example: Even though the ride hailing app reportedly loses hundreds of millions of dollars per quarter, investors have enough belief in Uber's future that they value it at $62.5 billion. That must be some good pizza.

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Apart from setting the price of a slice, valuations are also used in calculating the sale price of a startup -- something investors like, since it means they get their money back. The 'unicorn club' itself got its name in 2012 when Facebook bought Instagram for $1 billion. According to reports, VC firm Sequoia had just invested in Instagram at a $500 million valuation a few days before, effectively doubling the value of their investment almost overnight.

There are two types of desirable 'exits' for a startup, where the founders and investors do a victory lap. First, an acquisition where a buyer like Facebook or Google is willing to pay a price at or higher than the startups last valuation -- like when Apple paid $3 billion for Beats in 2013.

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But sometimes, a buyer is not willing to pay as much as the company was valued in its last round. In this case, some investors lose their money, and even the founders might end up with no windfall. A lot of these acquisitions are done only to bring new talent into a bigger company -- the so-called 'acqui-hire' -- and the buying company actually has no interest in the product the startup created. It's basically a draw, at best.

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The other good kind of exit is an initial public offering, or IPO. This lets investors and founders sell their shares on the public stock market, meaning they're happy, while letting the company raise more cash from the broad universe of public-market investors so it can keep growing.

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There are some dangers here, though. First, investors that are hungry to turn around their investment can rush a company that's not ready into a sale or IPO. This is what happened during the dot-com crash of 2000. A lot of the companies that went public turned out not to have the customers or revenue growth that investors expected, and went bust. Investors in the IPOs were wiped out.

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The other danger, and the one we find ourselves in now, is that the IPO market is cooling off — hot startups like Square and Box have fizzled on the public markets over the last year or so. With that potential exit closing off, investors are shy about putting more money into startups ...

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... meaning that startups have to make do with the cash they have, or accept new investments at a lower valuation.

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That's reportedly what just happened to DoorDash, a food delivery startup that tried to raise money at a $1 billion valuation, but could only find investors interested at a $700 million price tag. That's called a 'down round,' and more are coming.

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As for those startups that haven't been managing their venture capital money wisely, they're basically dead companies walking. The fancy offices and nice employee perks don't pay for themselves. If they can't raise another round, they will either have to sell for less than their last valuation or go out of business.

Regardless, history teaches us that this, too, will pass, even if it takes years. Startups will bloom again. And eventually, the pizzas will be in high demand. Bank on it.

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