October 15, 2018
Let´s talk about VC math. I recently wrote about startup valuations — this is the follow-on as promised. The topic can be quite complex but every entrepreneur consider raising money from the VC´s should understand the basics. Why? Because it will be easier for you to understand how and why VC´s work the way they do. So here goes…
The first thing is to understand what is the major difference between business angels and VC´s when they invest. It is not the stage or the size of the investment. Or the terms as such. The major difference is that where Angels invest their own money, VC`s typically invest mostly someone else´s. A regular VC fund consists of money from institutional investors (e.g. pension funds, fund of funds and other financial institutions) and wealthy individuals. This difference lays the ground on how VC´s operate compared to Business Angels. As VC´s invest someone else´s money, they need to have a solid rationale for the investment. Therefore VC`s quite often require some kind of quantifiable traction. Angels on the other hand can invest into anything they desire since they are accountable only to themselves… or to their spouses. The VC -rationale for investment directs how, when and why a VC fund might invest into your startup.
A Venture Capital fund is typically an investment vehicle with pre-defined size, investment period and investment focus. A management company (called General Partner) for the fund (like us @ Superhero Capital) raises a fund from a selected group of professional investors (called Limited Partners). The fund is then closed and the investment period begins. A typical fund cycle is 10 years with the first 4–5 years reserved for new investments and the rest for follow-ons. Some funds may run until 15 years or so. The target number of investments per fund can have a large variation, but a typical fund will invest into 20–30 companies. Some even invest into 100 companies. All funds aim for sufficient diversification.
A VC -fund usually aims to return the money they raise 3x for investors. Statistics show that the best VC -funds have been able to do that but only the best 20–25% of them. The money invested from a typical VC fund goes out once and when it (hopefully) comes back it will be distributed back to investors until the fund has been completely returned. In addition, funds typically have a hurdle rate (e.g. 7% per annum, other models exist also) which is the risk factor (or price tag for money) they will also return to the fund LP´s. Any returns after that are typically split 80/20 (or sometimes 75/25) creating the upside for General Partner (called carried interest). Some other models do exist also. The logic is that General Partner for VC fund will only get an upside if they are successful.
When a fund invests into e.g. 20 companies, the General Partner will assume that not all investments will be successful. A typical split in a fund portfolio of 20 companies would be 4–5 successful investments, 4–5 with money back but no upside and 10–12 write-offs or only minimal returns. It means that the fund will focus it´s attention into the best companies to maximize the returns. After all the return requirement of 3x is very high. It also means that the investments not reaching the mutually agreed targets will not receive follow-on investments from the existing VC´s. That will be especially lethal for entrepreneurs should they try to raise additional follow-on funding since the “signalling effect” is quite strong in the VC community. A new investor will typically expect existing investors to follow-up since they should have more insight into the target company. If they do not invest, a new, potential investor most likely will not do so either.
The above means that every entrepreneur in the portfolio of a VC fund, should always understand where they stand in the portfolio. No VC will follow-on invest into all companies in their portfolio. Entrepreneurs should always have a close relationship with their existing lead investor (well… all of their investors actually). Communication is vital, there is nothing worse than entrepreneurs who only actively communicate with their investors when they need more money. If you do not communicate with us, we expect you to be dead. No-one is funding a corpse.
Now you know how VC funds typically operate, but there is more than meets they eye. The high return requirement for a VC fund will affect strongly on what kind of investments a fund is looking for. The bigger the fund, the larger the investments and larger exits needed. VC funds typically want to commit a minimum 1,5% of their fund when they invest should they aim for 20–25 investments in the fund. So a 100 M€ fund will aim for 1,5–2 M€ initial investments. And a billion € fund will aim to make 15–20 M€. This is due to the capital efficiency requirement. So do not approach the big guys with 1 M€ request. So let´s do the math:
As the return expectation is 3x, a 100 M€ fund will aim to return 300 M€ to it´s investors. Since a typical ownership at the time of the exit for such fund is let´s say around 20%, the total exit value of the portfolio would have be 1,5 bn €. Let´s assume 5/20 investments in the fund are returning the money, the average exit must then be 300 M€. That is much larger than the median exit of 61 M$ in 2017. So in practise they need at least one unicorn exit. Should the fund size be 1 bn€, the math becomes even more challenging.
Now why does this matter? It does, because the fund size defines the game the investors must play. If you raise funding from a fund having 500 M€ or more under mgmt, every investment they make is a unicorn play. You should be aware of this and agree. Otherwise the love affair between you and your VC´s might have a bitter end. There are a lot of stories where entrepreneurs would have been very satisfied with a lower exit, but the investors declined. Not just because your investors are greedy a-holes, but because of the math defined above.
Every entrepreneur should understand the basics of VC math in order to understand how and why VC´s think like they do. The math will guide the General Partner of the fund to 1) focus attention and investments to the best companies in the fund, 2) aim for large enough exits (in relation to the fund size) and 3) will actively manage the portfolio discontinuing the unsuccessful investments. Many people argue that the VC model is broken. Might be, but as long as the model works as described above, every entrepreneur raising funding should play along to maximize their chances of becoming a success story. Happy hunting!
Juha Ruohonen, Partner