Venture Capital Math – It’s me, not you!
While a necessary exercise, embarking on the fundraising path for most is no more enjoyable than a trip to the dentist. Aside from being distracting, fundraising can an incredibly difficult process to navigate through.
Recently, I spoke with a founder who after two weeks of pitching to VC’s, lamented to me “I don’t get it – they should be falling all over this idea!”
Well, of course they should. In this case, I think she was actually right. She had a great team, solid technology, and some early traction in a quickly expanding market. The problem of course was that her business in its current phase wasn’t perceived to align with the type of return necessary for fund managers.
This comes back to my title of “It’s me, not you!”.
As difficult as it is to build a successful company, it’s also incredibly difficult to consistently achieve returns to investors commensurate with the risks associated in venture investing. Don’t believe me? Check out these returns.
When raising capital from VC’s, it’s imperative that you understand the other side of the table, both on a macro and micro level, to successfully navigate the game of raising institutional capital. A key component to understanding the other side is being aware of the economics. After all, VC’s are in effect, just money managers.
Let’s take a typical $100MM early stage focused Venture fund. Let’s assume that the fund economics are a standard 2/20 (2% annual management fee/20% Carry on fund profits).
To attract investors (Limited Partners) into the fund, the fund managers are expected to clear a minimum risk-adjusted return rate. Given the high risk and long-term illiquid nature of venture, this hurdle return is usually an IRR on contributed capital of ~15%.
Assuming an average holding period for investments of ~7 years, a 15% hurdle return works out to a ~2.75x net return to Limited Partners from the fund.
In other words, that $100MM fund needs to return $275MM in capital to Limited Partners to meet a minimum 15% return hurdle.
If that’s not daunting enough, $20MM of the fund will go toward management fees, leaving only $80MM in capital that’s invested into companies (in the interest of keeping it simple, I’m ignoring recycling effects). This means that a 3.4x multiple on invested capital is required to meet the return hurdle to LP’s. ($275MM/$80MM).
Oh, I almost forgot there is something called Carry. Remember, the GP’s of this fund get 20% of each dollar of profit above $100MM. So to achieve a net return of $275MM to Limited Partners, the fund needs to realize $343MM in total liquidity proceeds – a 4.29x of invested capital!
If the fund on average holds a 15% ownership position at exit (not easy to with likely dilution), $2.2B in total exit value needs to be realized. from the Portfolio. Put another way, 2 Tumblr’s! Doesn’t sound like much until you realize there are typically <10 Venture backed companies per year that are billion dollar outcomes.
Illustrated below is the math in table form.
|Total Fund Return||
|Carry paid to GP’s||
|Return to LP’s||
|Multiple on invested capital need||
|Avg. Ownership at exit||
|Aggregate exit outcomes needed||
|IRR (7 year holding period)||
Aside from highlighting why it’s so easy to see why the Venture Capital “asset class” has underperformed, this summary was also to provide some insight into VC decision-making. Although very few companies are “home runs”, it’s clear to see why VC’s invest in companies that they believe have at least as shot and a big exit.
Founders , if you goal is to raise VC money (and it’s not right for everyone), think about the above as you put together your pitch deck. By putting yourselves in the shoes of the investor, you’ll be better prepared to anticipate and prepare for those investor meetings.
P.s. The entrepreneur I reference above? She ended up raising $1MM – from Angels.