Fundraising in 2023 (4/5)
The Fundamentals of VC Investing
Initially, this should have been the final part of the Fundraising Series with the title ‘How to tell your Equity Story’, but as I was writing this, I found myself repeatedly adding context to the investment theory of VCs.
Considering the importance of understanding the psychology of VCs and their decision making I decided to take a quick detour to demystify this very important topic. The final part of the Series will follow next week.
So here goes the fundamentals of VC investing.
What do Venture Capital funds do?
Venture Capital funds collect funding from investors to in turn invest this money into startups to help form and grow innovative products/companies. VC funds differentiate a lot based on their funding behavior (e.g. lead vs follow-on investor), industry (e.g. health tech, fintech, generalist, deep tech etc.) but most importantly based on their maturity stages (e.g. early- and growth-stage).
How do VCs operate?
The usual VC fund has a fixed time horizon of 10 years + 1 extra year +1 extra year (allowing for an additional buffer as not all assets can or want to be sold at the hard 10-year stop — e.g. when there is a promising IPO coming).
During this time, a VC will charge a 2% annual management fee (to fund its costs, e.g. legal, salaries, office, etc) of the total fund size and a 20% success fee (Carried Interest also called ‘Carry’), charged on the gain over the initial fund size after a certain minimum of return has been achieved (Hurdle Rate).
It is to be noted that the investors of the fund (Limited Partners or LPs) don’t invest the whole fund size as a lump sum upfront but usually transfer their pro rata share of individual investments as they occur. This is important, as LPs always calculate the opportunity cost of their investments, e.g. if the LP provides €15 today, but the VC fund only puts €5 to work, the LP would lose the opportunity to work with the remaining €10, thus VC funds only calls capital when they need to invest it.
What performance is expected from Venture Capital Funds?
The rule of thumb for a good VC (top 25%) performance is a ~3x Return on Investment (ROI), e.g. return a net return of >€300m on a €100m fund. As you can see in the chart from Sifted, about 50% of (VC-invested) startups fail or return less than 2x. Considering the high fail rate, every single VC investment must thus provide the promise to return a significant part of the fund — if not the whole fund multiple times over.
The simple explanation for this is that per statistical rule, a minority of portfolio companies contribute the majority of fund returns (the rule is called the Power Law), e.g. in the above data about 10% of portfolio companies return >10x of their total investment.
To provide a sample calculation of what a fund like this could look like I modeled a simplified fund portfolio and displayed the contribution of each investment based on the numbers provided by Sifted.
The sample fund achieves a 3.22x net return (excl. management fee and carry) with the following assumptions:
- €100m fund size
- 2% p.a. management fee (meaning that €80m is actually invested)
- 20% Carry
- 50% of the investable capital for initial investments and 50% for Follow-Ons.
- Investments in 10 portfolio companies
- The investment per portfolio company is optimized to achieve a fully diluted target shareholding of 15% for each company at the exit
- An investment return profile similar to the numbers provided by Sifted
Please note that this is just a descriptive portfolio calculation based on the averages provided by Sifted. A real portfolio will of course look different and have more complex dynamics that were not included for simplicities sake.
You can find the underlying calculation and logic in this GSheet.
As you can see, the majority of returns are provided by the top two companies, together accounting for €300m (€225m + €75m) of the total €377m returns (or ~80%).
Why is this important for your startup and fundraising?
Each VC investment needs to have the potential to return the fund. The rule of thumb is that your company needs to be able to achieve a >€1bn valuation — at the assumed 15% shareholding at exit this would mean a €150m return.
Valuations at mature companies are often calculated based on a multiple on Annual Recurring Revenue (ARR), at an assumed 10x multiple, a company needs to be able to achieve >€100m in ARR. This boils down to the question: Can your startup achieve €100m in ARR within the 10+1+1 year lifecycle of a fund?
Depending on the stage of your company and the investment focus of the VCs, the above will compute into different qualitative and quantitative Points of Proof a VC will be looking for in your startup.
What these Proof Points are and how they evolve with the increasing maturity of your startup will be the subject of the fifth and final piece of the Fundraising Series:
(5/5) How to tell your Equity Story?
