by Xavier Lazarus
Introduction
These chapters around “the finance behind startup investing” aim at sharing learnings based on 20 years of experience gathered working at Elaia. In recent years, VC has gained quite the reputation with many SaaS startups reaching the stratosphere and becoming household names. Nevertheless, it is a domain that is sometimes oversimplified to putting in money, waiting for 10 years and hoping it makes us rich in the process. It is not made for the faint of heart or ones without discipline and thus requires some initiation to understand what each term or practice really means and implies.
This article is not a masterclass but rather aims at sharing guidelines and tips to people interested in backing startups, working in investment, entrepreneurs who want to gather a better understanding of the VC world, with an interest in tech and/or even investing as a business angel.
This article is also translated in French and published on Maddyness’ website.
In this chapter around “How to read a VC fund’s performance”, we will focus on the various rules to keep in mind:
- Focus on the Fund’s Multiple: the main performance indicator
- Avoid discussing gross performance, request net figures
- Understand how the VC computes its portfolio’s Fair Market Value
- Learn what the key indicators TVPI and DPI mean and how they work
- Be careful with a great DPI too early in the Fund’s life
- Check if the VC is optimistic or cautious using its Track Record
The finance behind startup investing
Chapter 1: How to read VC fund’s performance
Investing in early-stage tech companies has become a standard part of many asset allocations, whether you are an institutional investor, a corporate or an individual. Unless an Investor has enough time/energy/expertise, but also a clear view of its refinancing strategy and portfolio management engineering capacity to invest directly in startups, they usually address the opportunity by investing in a VC Fund. Nevertheless, the characteristics of VC Funds, especially their illiquidity, and the lingo VCs use to present their performance can make it quite hard to read. Here are a few explanations and tips to pull back the curtain.
Rule #1
Focus on the Fund’s Multiple — the main performance indicator
The most important indicator to understand a VC Fund’s performance is called its multiple. At the end of a Fund’s life, it is easy to read and understand. If an Investor invested €1m in the Fund and was returned €3m back, then the Fund returned 3x net to the Investor. As simple as that.
IRR — Internal Rate of Return — is the other performance indicator that can be used, but it is not as simply defined and is much harder to read in the VC world than in the Private Equity world due in part to longer investment holding periods, including several follow-on financings that affect the IRR number in the middle of a Fund’s & startup’s lifetime. In a nutshell, IRR could be misleading a bit whereas the Multiple (normally) doesn’t lie.
If you are not yet convinced that IRR per se could be misleading, let’s assume you invest €100m and 10 years later you receive only €50m as returns. Your investment shows a -7% IRR, which doesn’t look good but not that awful, while you DID lose half of your money! Worse, let’s say if it takes you 16 years to be repaid, your IRR gets better and is now at -4%. But you’ve still lost half of the money…
Of course, this is a theoretical example, but IRR could be misleading even with positive numbers, especially when you start to mix discussions at Portfolio Company level and overall Fund performance measurement.
As an example, a seed investment representing 1% of the Fund, could be exited 6 months later with a 2–3x return, leading to an IRR in hundreds of % for that given deal. Outstanding… but an Investor in the Fund would only get 2 to 3% of their invested capital back! This deal is thus nice for the VC’s ego but should be quite irrelevant eventually for the Fund’s overall performance. So what matters also is the size of capital exposure in regards to IRR and multiple performance measurements.
On the other hand, assume that the same company is not sold as quickly, then receives during the next decade, 9% more of the Fund for follow-on financing at growing valuations and is finally sold for the same 2–3x multiple. The IRR could fall anywhere between 15% and 30%, depending on the dates and sizes of the follow-ons. So, good but not that great… However, this deal, one of the 20–25 in the Fund, will return 20 to 30% of the Fund’s capital. It should therefore contribute significantly and have an above average effect on the Fund’s performance. All in all, the IRR makes much more sense when investments are predictable with time, money, etc. but at the end of the day, and indeed, at the end of a Fund, only the Multiple can show you the truth. Remember what I told you about IRR being misleading…
Rule #2
Avoid discussing gross performance — Request net figures
When a VC communicates their Gross Multiple, they are usually talking about the multiple on invested capital (MOIC) of their portfolio. For each company, MOIC means its current stake valuation — or received proceeds if exited — divided by the total investment in that company; an equivalent formula is used to estimate the MOIC of a portfolio.
On the other hand, Net Multiple is the Net Asset Value of the Fund or NAV (which is equal to the portfolio’s current value and available cash in the Fund minus provisions for carried interests and any other debt) added to distributions, divided by the capital that was invested from the Investors’ pocket.
Clearly MOIC is slightly higher than net multiple, but a good MOIC should always lead to a good net multiple, right? This is kind of true for Funds giving great returns. What’s the catch then?
Take the following case:
It’s crisis time, a VC claims that they performed well despite the bad weather and managed to reach 1.25x MOIC on its portfolio. Not great but still a profit.
However, imagine that the Fund was €100m, that the VC paid themselves €20m of fees during the fund’s life (2% a year for 10 years for the sake of simplification) and that it didn’t manage to invest the last €10m of the Fund.
Therefore, the VC actually only invested 100–20–10=70m, returning 1.25x70=87.5m and the unused 10m could be seen as canceled. Aggregate distribution to the Investors was €87.5m for €90m called, or a 0.97x net multiple. Investors lost money on that Fund despite a positive MOIC…
So never get fooled and only look at net indicators, i.e., seen from the Investor’s pocket.
Rule #3
Understand how the VC computes its portfolio’s Fair Market Value
The regulators demand VCs to evaluate their Fund’s NAV every quarter following the concept of Fair Market Value (FMV) for the non-exited companies. Usually in the VC world, FMV is based on the latest round’s valuation out of which, the VC could uplift its valuation due to positive signals, or take some provisions for risks (risks of bankruptcy, of economical underperformance, of market valuation multiples etc.).
But even if FMVs and NAV are reviewed by external auditors on a quarterly basis, their values are mostly a decision made by the VC and could be quite debatable. The main issue arises when the FMVs and thus the NAV are overvalued leading to a potential very bad surprise when the assets are sold. The other way round could also happen, but it’s not that common that investors complain about being richer than expected!
There is no right or wrong formula when valuing a stake in a startup. Investors usually regret that different VCs who invested in the same company have different FMVs in their books at the same time. Worse, even if they don’t disagree on the FMV of a given company, VCs could have different views on their stake value depending on how they account for their protective rights (ratchets, anti-dilution, liquidation preferences etc.). Being cautious would mean to never overestimate one’s value, hence never considering that one is protected by any contract or warrant, while always considering which other stakeholders rights could have a significant negative impact at exit.
In a nutshell, there are as many ways of valuing a portfolio as there are VCs; an explanation is usually more than welcome…
Rule #4
Learn what the key indicators TVPI & DPI mean and how they work
There is another issue associated with the long lifespan of VC funds: it takes at least 10 years (and sometimes unfortunately much more than that) to completely liquidate a VC fund. The final Multiple will be set or at least accurately forecasted very late in the Fund’s life.
So how can an investor judge the performance of a Fund before its lifecycle has ended?
For that matter, VCs communicate two indicators in addition to IRR, on a quarterly basis: TVPI and DPI.
TVPI stands for Total Value to Paid-In Capital and is the ratio between the Fund’s past distributions + current NAV, and the capital Paid-In by the Investor.
DPI stands for Distributed Value to Paid-In capital and is the ratio between the Fund’s past distributions, and the capital Paid-In by the Investor.
When the Fund is being liquidated, TVPI and DPI converge to the same number. In the interim, TVPI is always greater than DPI.
To illustrate these indicators, let’s take a simple and theoretical example, with all the calculations (including IRR).
How to read TVPI and DPI ?
First, TVPI is what we previously called the Fund’s Multiple, it’s the main performance indicator, as discussed. Before a Fund is totally finished, it partly shows an unrealized capital gain (on paper since it has not materialized yet). It thus displays a certain potential, while some risk is still on the table: TVPI may not fully materialize in DPI. Conversely, there is also the possibility that TVPI will grow over time and that the end multiple of a Fund is higher than intermediary TVPI(s). The higher the difference between TVPI and DPI, the stronger the potential evolution and the associated risks are.
As we saw, TVPI is mostly based on portfolio companies’ FMV and stake valuations. It could therefore be quite debatable. Remember that TVPI shouldn’t be read without a fully detailed valuation of the portfolio.
Second, DPI is indubitable; it measures the cash given back to Investors and it is the only safe value on the table. When the DPI climbs towards 1, it is a good indicator of the derisking of the Fund. When the DPI is above 1, then the capital of the Fund is safe (hence money invested has been given back already), and investors should expect a profit eventually. Also, DPI could be easily rolled over by Investors to a new fund while TVPI, which is not yet converted into DPI, can’t, since it is not cash back and is still at risk.
Would it be true that only DPI should matter and TVPI should be kept low to sleep well? Not that simple… TVPI is still an indicator of performance potential and is also the value Institutional investors have in their books. Investors thus like to see it growing and compare the same vintage funds’ TVPI to pick the best VC to fund.
Therefore, these interim TVPIs are also marketing tools to convince the investors to re-invest in the new vintages of the VC; sometimes transparency will not be the only principle followed when measuring interim performance, as always when marketing is involved!
Recent history showed TVPIs peaking and made the simple cautionary principles stated above look outdated. To keep competing and show good numbers, VCs started to pump their TVPI even higher. Now that the market has crashed, reading TVPI has become harder than ever.
The multi-billion-euro question is: how many of these inflated TVPIs will convert into DPI?
Rule #5
Be careful with a great DPI too early in the Fund’s life
We saw earlier that DPI is an indubitable value. Well, this is true but there is a caveat when the fund is young.
Imagine that a Fund of €100m is only called at 40%, then Boom!, a big exit happens and €40m are returned to investors. DPI would be 40m/(40%*100m)=1. The fund looks derisked! Well, if the other €60m are poorly invested and the remaining portfolio is written off, then DPI will be degraded down to 40m/100m=0.4. A total drama.
The tip here is to only look at DPI (and also TVPI) when the Fund is close to being totally invested or say that at least 80% of its capital is called. Before that, it could be quite misleading too.
There is another issue with a strong DPI early in the Fund’s life. To maximize performance, VC should invest as close as it can to 100% of the Fund, hence it should recycle early exits to pay fees instead of using the Fund’s capital. Distributing every penny made from exits could become counterproductive for that matter and an early strong DPI could be a sign that Fund deployment might not be optimal.
Rule #6
Check if the VC is optimistic or cautious using its Track Record
Here is another tip to understand the “conservative” or “bullish” approach of a VC when analyzing its TVPI: look at its last exits and ask for the book value of the investment in the exited companies a quarter before, and a year before.
You would expect that a quarter before exit, the book value is very close if not equal to exit value, and that a year before, you would somehow be smaller in book value than exit value especially for well-performing companies, even if not too far away.
It would not be a great signal if the book value was recently much higher than exit value, unless something unexpected and materially negative happened in the quarters preceding the exit.
We could also argue that having a much lower book value than exit value a year before exit is not the sign of great valuation skills but being a bit too cautious is easier to forgive. Remember that Investors will not complain about being eventually richer than they thought.
In the special case of Elaia, if we look at our last 11 exits, the ones we did in 2022, at a moment where book values were heavily questioned by the investors, most of our book values were in line with the expected outcome of the previous test. We only had one case where we were slightly above exit value a year before, but the company didn’t perform that well that year, and one case where the book value was significantly lower the year before. In the latter case, the company surfed an unexpected technological wave in the previous quarters, thanks to its unique IP assets and was preemptively acquired by a large tech company at a very high value. Much higher than what a reasonable valuation would have indicated. We are clearly of the cautious kind! It also means that our Investors were not only happy to receive cash but also to see the Fund’s TVPI improve while DPI was raising.
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My final tip: remember that numbers are not always as clear as mathematicians would like them to be. If as an Investor, you don’t understand a number, ask for explanations, and if it is still not clear after getting them, then ask again. After all, it’s a mathematician speaking :)
As we always say to young VCs that we train: Valuation is an art, and an ethic, not an exact science… Therefore, reading valuations and fund performance indicators should be considered art too!
