VC Math

So I just read an ebook titled “Early Exits” by Basil Peters. The book argues that VCs are spurring on companies to go for the “home runs” when it may not be in best interest of the entrepreneurs or angel investors . The book argues that companies should be wary of taking VC money as their business models are reliant to go for huge return exits versus going for “singles” or “doubles”. These singles and doubles can offer very rewarding returns for their shareholders payed out much earlier and with greater probability.

To illustrate the point about the VC business model, he writes the following:

“An Outline of the VC Math

Peter Rip of Leapfrog Ventures describes the math behind VC funds in a fascinating post titled ‘Traditional Venture Capital Sure Seems Broken—It’s About Time.’ This is a high level summary of
how the math works for a VC fund.

In a typical VC portfolio, all the returns are from 20% of the investments. These are the two out of ten investments that are winners. A minimum respectable return for a VC fund is a 20% compound return. For a ten-year VC fund, the fund needs to pay investors 6x their investment to generate a 20% compound return. So those two winners each have to make a 30x return on average to provide investors with the 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 feel comfortable with these numbers.

Even more interesting is that a traditional venture fund is usually a limited partnership. This means that the fund managers only get to invest the money once. So if they make an investment and exit for a 3-4x return, they give the principal and gains back to their institutional investors. They don’t get a chance to invest it again. From the VC partner’s perspective, this effectively guarantees they have failed.”

This is probably a bit exaggerated. In speaking with some other friends that are either VCs or been VCs there are plenty of situations where they would be very content to take a 3 or 4x return. This is especially true if they are a later stage venture capital firm where that type of return would be considered a home run. However, for early stage VCs, I do believe that their model definitely has them put on rose colored glasses if they see that their portfolio company may be able to achieve that home run. This is because the personal risk/reward scenarios for the stakeholders involved.

Think about it this way, for a basic “single” or “double” exit, you can see entrepreneurs making single digit millions of dollars and angels would make anywhere between 3 to 5x from their original investment. Each of them would probably be pretty happy with that. As for the VCs personally (not the funds investor but them personally), it is a very different story. Let’s say they put $3 million in and could exit with a 3x exit. That would mean that they had a $6 million gain ($9 million for original investment of $3 million). The VC would take 20% of the carry being about $1.2 million ($6 million x 20%). Split that among 5 general partners and that is less than $250k each. After tax, that is really not much at all for them personally. So if they have a chance to go for a home run which they could make millions or tens of million of dollars individually and all they had to risk is something like $125k after tax. I think they are more inclined to “go for it”. This is the danger of taking VC money. The shareholders may not be aligned given the very different economic incentives. So bottomline, if you do take VC money, be ready to realign your personal incentives to more closely match theirs or set your terms so they don’t get to completely control your destiny.

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