In frank conversations with my founder friends, entrepreneurs, and even just the startup-curious, I often hear questions along the same general theme:

• My company is growing well, why aren’t any VC’s interested?
• VC’s keep telling me this is a “lifestyle” business, what the hell is that?

There are also a bunch of darker things I hear (and dark tales of VC’s of yore that I’m sure you’ve heard), that, once you dig into it, you’ll also realize are related to this same theme, e.g.

“It was completely crazy, the company just needed a small bridge round, and we could have gotten to an exit, but instead the investors let it die even though they’d invested millions of dollars previously, they just let it all go down the toilet.”

or

“ The VC board members just completely checked out. The company was doing ok, but they didn’t really seem to care.”

or even:

“The company could have been sold and gotten a decent exit, but instead the investors pushed for it to raise another round and swing for the fences, but then it failed and went to zero.”

The common theme behind all of these seemingly unrelated questions and stories is that VC’s seem to do some weird, odd, and apparently irrational things.

It turns out it’s because they need some crazy math to work out for their funds to pay off. That crazy math heavily impacts their actions:

• at the top of the funnel (the companies they are willing to invest in);
• in the middle of the funnel (how they act while they are board members);
• and most egregiously at the bottom of the funnel (when thinking about and pushing for exit opportunities.)

So herewith a breakdown of the math that drives VC’s funds sometimes bizarre behavior, and some of the ramifications it can have for you as a startup founder.

The Black Magic Math

Note: There’s a full cheatsheet spreadsheet at the bottom if you want to skip all the explanation

The simplest piece of the puzzle to understand is that VC’s are trying to maximize the returns of their fund. That’s for two somewhat obvious reasons:

1. They get a percentage of those profits of the fund (carried interest) and hence are pushing to maximize their take.
2. Secondly, they want to raise another fund in the future, and to do so they will need to court investors (Limited Partners, or LPs); and to best guaranty their likelihood of getting those investors for the next fund, they want this fund to be performing in the top quartile of funds. What does that mean in real terms? A top quartile VC fund returns on average ~20% IRR annually¹. If you compound that for ~7 years (the average amount of time that the money is “out the door” for the investor) you get a Multiple On Investment (MOI) of 3.6x². So, in basic math the VC needs to return 3.6x their entire fund in order to be considered “top quartile”. I.e. a \$100M fund needs to return \$360M to investors.

So the VC you are pitching is looking to AT LEAST 3.6x their fund.

“But my company is growing fast. I will 3.6x in the next year, so why is this investor not interested?”

Well — this is where the math starts to get really fun. Let’s get to some real world data:

By stage, deal sizes range from an average of ~\$1.6M to ~\$24M (Seed to Series D). But each of those rounds has DRASTICALLY different risk associated with them. For example, a traditional Series D is the round just prior to the IPO, so the likelihood of the company failing at that stage is essentially zero (though it does happen!); whereas 97.6% of Seed Round companies fail to make it to an exit!

So that means that each deal is by no-means a winner. In fact, the VC has to do multiple deals in order to get a winner. An A round investor needs to do ~6 deals to get a single winner (There are definitely investors with better batting averages than this, but most investors are not Barry Bonds.) Whereas a Seed round investor needs to do more than 40 deals to get a single win!

This really starts to get silly when you take into account the dollars that the investor has to “put out the door” to finance all of those investments:

To put this into perspective, that poor Seed round investor (who likely has a ~\$50M fund) will probably have to deploy their entire fund just to get 2 winners!

Now, if you just had to 3.6x the money you put out the door, that wouldn’t be completely outlandish. But instead we have to take into account how much of that money the investor puts out the door will actually go to zero:

Again, picking on that Seed investor, out of the ~\$20M they put out the door, only ~\$500k is left when you take out all the companies that will go to zero.

So now the burden of getting to 3.6x isn’t on the ~\$20M they put out the door, but instead on the remaining \$500k of “good” dollars. Those good dollars need to return enough to 3.6x the entire \$20M that went out the door. The \$500k remaining needs to return >\$70M!

That means the required return multiples on each winning deal can be outlandish:

And this is where the weird behavior of VC’s starts to become clearer — if they are “early stage” investors (e.g Seed and A round) they need your company to be between a ~20x to a ~150x deal for the math to even start to make sense for their fund.

There are some pretty straight forward ramifications of this. For a start, your “fast” growing company that doubled or even tripled revenue last year probably still isn’t interesting, because you are working off a small base, and the VC needs their investment to return 20x to 150x their money. Your company just doesn’t cut the mustard!

But let’s examine some of the really dark incentives that happen later on in the life of a company, after the VC has invested, because of this math.

What this math tells us is that when your company hits some struggles along the way, or the growth seems to be flattening out, the VC has to do the calculation on the marginal cost of spending more time on your company, or potentially investing more money. If their estimation at that stage is that your company has no chance of getting to that >20x for them, then the rational thing for them to do is to take their money, and their attention, and instead focus it on finding a new investment that does have the chance of reaching those thresholds.

In essence, because of this math VC’s are incented to declare you dead (or at least dead to them) even if you are a viable company, because you won’t get them to the large return multiple they require.

“The reports of my death have been greatly exaggerated.” — Mark Twain

In real terms this can manifest itself in a few ways:

1. A VC may not give you the bridge financing you need to get to your next stage of growth and rather let you die, because (in their estimation) you won’t get to the return multiple they need so that money is better spent betting on someone else who could be a 100x.
2. A VC may fully “check out” of your company, no longer attending your board meetings (or only attending in body not in spirit) → the “zombie board member”
3. If you have an exit acquisition offer on the table that may be good for you as a founder, and the employees, but won’t get the VC to the return threshold they need, they may push you to not take it and instead talk you into “swinging for the fences.” If you fail while trying that doesn’t matter, because you’re in the failure pile in their mind already.

The Cheat Sheet

[1] Cambridge Associates data

[2] I’m glossing over a TON of stuff on Gross Returns vs Returns Net Of Fees for simplicity.

[3] I’m also ignoring a bunch of math of follow-on investments and future-round dilution for simplicity.

[4] There are a bunch of different sources for this data with slightly different estimations of failure rates by stage. They don’t meaningfully change the math, and therefor the ramifications for the VC.

Special thanks to our summer MBA intern Shyam Allam for doing the research and analysis for this post.

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