VC Fund economics 101
VC funds seem to be constantly chasing 'Unicorns', but why don't they invest in multiple ventures providing middling-returns. We try to understand this through this post!
A typical VC fund model is called ‘two-twenty model’, that is a General Partner (GP) at a VC fund charges 2% management fee per year and 20% carry at the time of exit to their Limited Partners (LPs), basically their investors.
But why is it that VC funds are in constant search for Unicorns and why don’t they aim to invest in several ventures which are more stable and can provide them decent returns like any stock market investor would create their portfolio.
On a long enough timeline the survival rate for everyone is zero - Chuck, Fight club
For start-ups this timeline is actually very small, typically 50% of the startups don’t survive beyond their fifth year. Pretty brutal right, imagine you starting a business with stakes all-in, with all the grand optimism and after few years fighting the battle for life or death. To read more on why start-ups fail , here is a good research
Did you know , ~ 60% VCs don’t even return the money to their LPs !
This means that investors in a fund have a 60% probability they will receive -ve returns. Yes, this is not an asset class for the weak-hearted!
And all of this has implications for what kind of ventures VC funds are looking for. Let us understand this through an example:
Let us assume we have formed a $100 mn fund - Innovative Investments Fund (IIF), and assume that it is going to invest in 20 companies. So how much dry powder does our fund has? $ 100 mn ? No!
So a fund can typically invest only 80% of what they have raised and thus IIF would invest only $ 80 mn of what it has raised. To understand why, have a look at the management fees below. This fee may be required to setup the fund and run the operations.
Further, atleast 20% of funds fund keep for follow-on funding thus leaving actually $ 60 million to invest in 20 startups, which is $ 3 mn investment per startup.
If IIF fund thesis is to take ~15% stake in the startups when they invest than IIF would invest $ 3mn in startups at valuation of ~ $ 20 mn . Then for one of our investment to become a unicorn i.e. to reach a $ 1 bn valuation it has to be a 50X and considering ~20% dilution along the way it would be 40X for IIF.
Connecting the dots with the first argument that we made that in general 50% startups don’t survive more than 5 years. With the same logic we can say that 10 startups in which IIF has invested will shutdown and other 10 will return capital to the fund.
Let us look at a few scenarios :
Any VC fund has to return atleast 3-times “3X capital” for it to be qualified as a decent performance. And as we see in the above 3 scenarios IIF has to invest in atleast 2 successful Unicorn exits for it to return a 3X to their LPs which is not more than 12-13% IRR considering 8-10 years as the life of the fund.
Some may argue, why have such a portfolio where half of the companies go bust. As we discussed earlier , startups by nature are volatile and highly prone to mortality. Secondly while building their portfolio funds are not optimising for stability but for returns because if they don’t and all investments survive but none scale up, there is no way they can achieve their target of returning 3X to their LPs . Returning money to LPs become increasingly tough as the size of fund increases.
Some may also argue, why not aim for 10 exits which can give you 10X. This may sound logical on paper, but we need to understand the way VC industry is placed -investments are either a hit or miss. There are not many middling outcomes. Typically if a startup performs well, a fund wants to stay invested and ride the whole wave and thus you will either see some 20X + or some 5X+ but very few outcomes in between. Also the 1-5X kind of outcomes usually happen in only 2-3 situations when the startup is unable to scale up and it either gets acquihired or some strategic guy comes and buys it out.
Returns in VC Industry follow power law, and it is only the outliers that can change the fortunes of the fund. Thus the chase for the next Unicorn.
VC investing is very different from the other asset classes because of :
Mortality of investments
Uncertainty of returns
Illiquidity
Does it means all start-ups should aim for hypergrowth model to unicorn status?
While it may make sense for startups to operate in those markets where the outcomes can be large, it is not necessary for startups to always follow the path of hypergrowth. There are different paths to success, there have been many successful SAAS startups which have raised small amount of funds and have been able to grow multi-fold. The lacunas in the VC model is also giving birth to new funding models like revenue based financing (RBF) or venture debt which can support more profitable growth
Additional Reading :
I have started this newsletter to share my learning in venture investing with VC aspirants, fellow investors and entrepreneurs. Idea is to connect the dots in the data-scarce VC world.
Happy to hear your suggestions on what else I can cover in my writings, I can be reached here. I intend to write more on career in VC, on deciphering the mind of a VC investor & and sharing good resources that I come across. I would try to publish atleast one article each week.