VC Math 101 Understanding the VC fund's objectives

The reason why VCs must act in this way is because of how their business works. Entrepreneurs should really understand how a VC works before readily getting into bed with them a common and unforgivable mistake on the part of entrepreneur.

If you are happy to take vast sums of money from other people, then if it would stand to reason that you should understand what they need in return.

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Fact 1.

Investing instartupsis a very risky business. The reality is most of them don't go anywhereparticularlygreat VCs know this because they've been investing in startups for a long time. Entrepreneurs tend to be (understandably) insulated from this fact which is probably a good thing.

A good rule of thumb is:

      • 33% of the start ups do great and go all the way
      • 33% percent of them go 'sideways' (i.e. end up being worth the same as what was invested)
      • 33% failmiserablyand go to zero

Fact 2.

When Limited Partners (the people who give money to the VCs) invest in the General Partner (the VC) they expect returns.

And they don't expect shitty returns either because VC investing is risky so they want to be appropriately rewarded for taking that risk.

Generally they expect at least 20% return on their money per year .As Einstein reminds us, there is no greater force in the world thancompounding:

For this example we consider 7 years as the life of the fund. $1 compounded at 20% for 7 years requires a $3.58 to be paid back. ( I include the table out to 10 years since many funds go out that long $1 after 10 years pays 6.19x!).

The implication of these two facts combined

So let's imagine a fund is raised. The terms are:

          • $100million
          • Repaid in seven years
          • LPs expect a 20% return per year
          • We will ignore the effects of the 2% management fee and any hurdle rates. In reality these have considerable impact on the fund andexacerbatethe conclusion but we will ignore it as it isn'tnecessary to demonstrate the point.

We now know that a fund worth $100million on Day 1 will need to return at least $358million at the end of the seventh year. Anything less this will fail the LPs in fact the LPs will really expect more than that. For ease of math we will round it up to $400m. That is, the fund aims to return $400m by the end of the seventh year.

- As we know from Fact 1, 33% of investments will fail therefore $33million will be worth zero at the end.

- Another '33% will go sideway's and so will still be worth $33million at the end . Let's bank that we have $33million in cash in the bank. But we need $400million so another $367million which needs to be found. That's a shit ton o' money.

- Finally we are left with the 33% of investments that went well .These are the Facebooks and the Zyngas. The investments that really paid off. These are the investments we look to to raise the extra $367million to reach the target. We only put in $33million on these investments so they need to have huge return. They need to sell at a (367/33) = 11.1x multiple.

Thereinlies the reason why a VC will not be satisfied with a 4x return it simply won't do. If they did that for each of their successful investments then they will end up with a very poorly performing fund. If they think your business has the potential to go all the way and return 10x up to even 100x, then they must wait for that.

It also explains why VCs will not invest in seemingly viable businesses that, whilst might be moderately successful, won't be home runs. The portfolio requires that the VC aim for home runs.

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Posted in Health and Medical Post Date 11/06/2018


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