Venture Returns

Chomp! Chomp!

The Founder-VC tussle over valuations is probably one of the more opaque aspects of the startup world. It’s often a classic case of one party not understanding where the other is coming from, in which case there is no hope of building empathy.

As part of Ada Ventures commitment to Open Venture, I’m going to describe our approach here to valuations, which is based our our returns expectations for our fund.

Ada Ventures I LP is a £30M fund. The underlying investors (those amazing folk that believed in what we’re doing and entrusted their capital with us) are called Limited Partners (LPs). Typically LPs exposure to VC might be 5% of their total assets under management (institution) or net worth (individual). They will probably have much more capital invested in lower risk/return asset classes such as stocks, bonds, cash or real restate. Financially therefore they are investing in a venture capital fund to generate a higher return (to compensate them for the risk) than they would expect from the stock market for example.

For us, as General Partners (GPs) managing this fund, this means that we are doing everything we can to generate at least 3.0X (cash-on-cash, or multiple of capital) on the fund. In other words, over the ten year life of the fund, Check and I are expecting to turn £30M into at least £90M, which would represent an IRR (annual rate of return) of 11.6%. Returns in the venture industry were discussed recently here, and “good” is 3.0X.

In order to do this, we’re going to need to back some tiny startups that become huge companies and can get liquid after many years of toil. So, let’s break down the maths on our hypothetical (or maybe not so!) £30M portfolio. For purposes of simplification, there are several unrealistic assumptions in the portfolio below, but you can see that our ownership gets heavily diluted over subsequent rounds and we have 5 companies exit (out of 30) at various values.

Hypothetical example venture portfolio, for the purpose of illustrating some of the key points.

So, even with 5 exits out of 30 companies, and with one unicorn, this example portfolio delivers a suboptimal return to investors, compared with what LPs expect from such a high risk profile investment (when compared with other asset classes they may invest in).

The purpose of presenting this example here is to illustrate some of the background considerations that VCs have when negotiating pre- and post-money valuations with founders. To summarise, in the case of Ada Ventures, when we’re thinking about the right round size (in our opinion) and the pre-money we’re prepared to invest at, we’re acutely aware that:

1. As a (pre) seed stage investor, we are likely to be diluted over 4–5 subsequent rounds in companies that go all the way to a successful exit
2. Our initial ownership targets form a core part of our own investment proposition, both to the LPs that backed us in Fund 1, and to those that are tracking us for Fund 2
3. Terminal Values (exit value) are almost impossible to accurately forecast. Whilst we all want to find or build the next unicorn, most successful M&A exits in Europe are ±£250M

What this means is that we have to be as disciplined as possible when we’re negotiating entry prices. At Ada, we’re principally targeting two rounds:

1. Pre-seed rounds where ±£500K buys 20–25% (i.e. a pre-money of £1.5–2.0M), where we will lead with a cheque of £250K, thus buying 10 — 12.5% in the fund;
2. Seed rounds where £1.5M buys a similar 20–25% (i.e. a pre-money of £4.5 — 6.0M), where we will lead with a cheque of £1.0M, thus buying 13.3 — 16.7% in the fund.

Again, there is flexibility here: these hard numbers are to illustrate the point, but are fairly accurate.

This is written in the spirit of openness. It will be easy to challenge the assumptions, or raise unanswered questions. Please do just that if you’d like to continue this conversation.