Understanding the VC returns
When working with startup founders, inclusive in some DDs as a representative of a VC, it shocks me the little understanding the founders have of how a VC works. Let's get honest about this: understanding your counterpart is necessary to have your peer's best interests at heart.
And there are two crucial concepts: LPs vs GPs. Limited Partners (LPs) are the investors that invest in the VC fund; on the other hand, GPs stand for General Partners, the investment professionals vested with the responsibilities of making the investing decisions.
Here is where everything becomes interesting. The relationship between the LPs and the GPs impacts your company more than you think. Some people might disagree with me, but the primary responsibility of a VC is towards their investors, not their startups. The same is true if the startup fails to keep an investor happy, reduces the chance of maintaining operations, and raises the next round. A VC has to keep an LP happy. Otherwise, it won't raise another fund. Simple!
So, next time you don't understand what the VC Partner is thinking about or why they are pressing you to increase 20x your revenue… think they must also deliver 20x their investment on you!
Let me get into a more detailed and super simplified process (maybe too much, but I hope that helps you!) on how a VC gets their returns:
Imagine that a VC has created a fund of USD 100M and has deployed that capital over 25 companies, 4M invested in each company.
Imagine a super dramatic scenario where 24 of those 25 companies fail (0x return). The remaining company must return at least 25x the original investment so the VC does not lose LP's money!
Why 25x? The number of companies invested. Math makes it all simple: 4M invested * 25x = 100M. That 100M is the original value of the fund. Phew! This way, they didn't lose the LP's funds.
But now, if the LP doesn't get any extra from the 100M invested, they are losing money! On the one hand, they could have applied the money elsewhere and earned a higher return, or worse, they could be losing money to inflation!
Remember that public markets return, on average, 10% p/ annum (i.e., the S&P 500 index).
LPs need the VC to return above at least 12% p/ annum to cover the risk of private equity. 12% per annum in a fund length of 10 years, representing a net return of 3.10x the fund! Otherwise, LPs would allocate the funds to less risky assets. So, if the fund size is 100M, they expect 310M of return (let's keep it simple, 300M).
Do you see where I'm going? The 25x return I said above was to match the fund size, and now it's not enough! We need 3x the 25x return = 75x! So, the remaining company has to have a return multiple of 75x!
Back to the math:
- USD 4M of initial investment
- Return multiple expected: 75x
- 4M x 75x = 300M
The VC needs a 300M return from their 4M investment!
But hey! There is more! What about the VC operational costs? What carry interests? Listen, there is much more, but for the sake of this post, let's assume the VC cost is 0 to operate! I said many times that I was oversimplifying this example!
Again, the VC needs to exit with 300M on their investment! Considering that the VC might only possess 15% of your company, they need your company to be sold to 2B! Easy.
Of course, oversimplification has to be taken with a grain of salt… but the above goal is to help you have the right mindset when negotiating a deal with a VC and, importantly, understand that both have to win.
Next time you complain about the VC who didn't want to invest in your startup, think deeply about how you could provide a 2B exit to them! Maybe a VC was not your right partner, and you should resort to other sources of capital!
Typically, the top quartile or even the top decile of VC funds manage to reach or exceed the 3x return threshold. This indicates that such high levels of success are relatively rare in the VC industry.
In the above explanation, we assumed VC has 0 operational costs, no salaries to pay, computers to buy, etc. How do they pay for their operations? A topic for the future.
In the future, I can go into more detail about the two rules that rule VCs: the Pareto rule and Power Law.
PS: I hope you can better understand why everybody says that in today's market, it is hard to raise from VCs… it's all in the math! Oh, and in the interest rates as well!