Venture Capital Funds - How the Math Works
Why the Size of Venture Capital Funds Matters to Angels and Entrepreneurs
My previous post was titled Venture Capital Firms Are Too Big. That post provides one important piece of data necessary to answer the really important question of why the size of venture capital funds matters to angel investors and entrepreneurs. This post describes the second key element.
Venture Capital Fund Math
Peter Rip of Leapfrog Ventures describes some of the math behind venture capital funds in a fascinating post titled ‘Traditional Venture Capital Sure Seems Broken – It's About Time.’ It provides some outstanding insight into how the math behind venture capital funds affects the way venture capital fund managers make investments and how they behave after they invest.
This post is a high level summary of how the math works for a typical venture capital fund.
In a Typical Fund the Returns are From 20% of the Investments
In a typical VC portfolio, most of the returns are from 20% of the investments. This is just a statistical fact - a law of nature. Statistically, if a VC makes ten investments, two will be winners and create most of the gains in the fund.
The Minimum Respectable Return on a VC Fund is 20% per year
A minimum 'respectable' return for a VC fund is 20% per year. This is set by the expectations of the investors in VC funds, the relative risk levels compared to other investment classes and the performance achieved by other venture capital fund managers.
Another way to look at this is that a ten-year venture capital fund needs to repay investors six times (6x) their investment.
This means that those two winner investments have to make a 30x return (on average) to provide the venture capital fund a 20% compound return – and that’s just to generate a minimum respectable return.
This math is simplified but it’s more than accurate enough to illustrate this important point. If you are not familiar with the math behind an investment portfolio, I hope you will spend a few minutes with a spreadsheet so you are comfortable with these numbers.
And Most VCs Only Get to Invest the Capital Once
Even more interesting is that a traditional venture capital funds are usually limited partnerships. This means that the fund managers only get to invest the money once. If they make an investment and exit for a 3 to 4x return, they have to give the principle and gains back to the venture capital fund's investors. They don’t get a chance to invest it again. From the VC partner’s perspective, this effectively guarantees they have failed.
One 10x and One 100x is More Likely
Of course, a successful venture capital fund is not likely to have exactly two 30x exits. It’s much more probable that a fund will have one 10x exit and one 100x exit.
What is important here is how the VC fund managers think, and act.
A VC Won't Let You Sell for Less Than a 10x to 30x Return to Them
This minimum acceptable return has profound implications for entrepreneurs and angel investors. It means that if company has venture capital fund investors, they will almost certainly block an opportunity to sell the company unless the price gives the VCs a 10 to 30x return.
Future posts will explain how venture capital funds block good exit opportunities and what this means for the exit timelines in VC backed companies.
This is also a main theme in my upcoming book "Early Exits - Exit Strategies for Entrepreneurs and Angel Investors - But Maybe Not VCs."