VC Economics 101: A Guide for Founders

Understanding Venture Capital (VC) economics is key to increasing your startup’s chances of getting investment, yet many founders often miss key points about the economics of VCs. At Mountside Ventures, we’ve supported hundreds of founders looking for VC investment, so let’s dive into it together:

How it started:

Many founders don’t realise that the most important part of a VC’s job isn’t raising a fund or investing capital, it’s returning capital. Without returns, the VC is unlikely to receive much interest from Limited Parters (LPs), Family Offices (FOs), or High Net Worth Individuals (HNWI). Without future investments from LPs, FOs, or HNWIs, there is no more VC firm.

Without the right context, founders can feel surprised or frustrated when VCs don’t offer them the terms they were hoping for, and can also get impatient when investors ask countless, detailed due diligence questions about their startup’s financial model, defensibility, marketing strategy, and any other elements of their business plan that help prove a big exit. In reality, isn’t it just anyone’s best guess?

This disconnect highlights a common issue: a lack of understanding the unit economics of a VC. In order to prepare yourself for fundraising, it’s crucial to consider the mechanics of a VC fund’s investments over time.

Here’s a breakdown:

• ☄️ Imagine a £125m fund. After deducting the standard 20% for management fees, £100m is left. 60% of this may go into new investments — the rest is for follow-on investments. So, we’re talking about £60m for new portfolio investments.
• ☄️ Assuming they’ll invest in 20 new companies with this fund, that’s an average investment of £3m per company
• ☄️ Assuming they acquire a 15% ownership for £3m at the time of investment, and with a simple assumption that they do not get diluted, would maintain their 15% ownership until exit

Now, let’s calculate the required exit values for these investments to achieve a typical VC internal rate of return (IRR) of 20–30%, assuming the fund operates over a 10-year period (a common duration for VC funds):

• ⚖️ If the fund targets a 20% IRR — meaning that all investments are expected to achieve a cumulative compounded annual growth rate of 20%, the future value of the £125m fund after 10 years should be around £775m (c. 6x, which is certainly at the upper range)

Getting that 100x

Large established VCs often mention they are looking for a “100x” fund return. Assuming the fund invests £3m in 20 companies, and would like to meet a 100x multiple across its entire portfolio, this means getting 100 times that £3 million investment back each time:

• 🧮 A total £60m invested and aiming for a 100x return means the fund seeks to turn its overall investment into £6 billion.
• 🧮 However, this doesn’t mean each company needs to return 100 times its individual investment. Instead, the fund hopes that the collective exits of its portfolio reach this multiple, recognising that some investments will fail, while others might achieve significantly high returns, possibly including a unicorn that could substantially contribute towards achieving the 100x target.

Factoring dilution in

But things aren’t even that straightforward. Typically, a VC investing £3m for 15% in a company today does not hold that same equity stake 10 years later, when the exit happens. So let’s factor in dilution, with the scenario that only half the equity is maintained, which means 7.5% upon the exit event.

• 📈 If the VC aims for a 100x return on a £3m investment but gets diluted to 7.5% by the exit event, a single portfolio company would need to exit at £4bn.

Finding that unicorn

The reality is that very few portfolio companies exit. According to Jenson Funding Partners:

Only 5% of portfolio investments will deliver all the returns of the fund. For a small fund less than £50m AUM, this can be about 1–2 companies.

• 💰 In the event that only one portfolio company exits, this company must achieve an £800 million exit for the 7.5% share held by the VC to return the entire £60 million invested across new portfolio companies from a single investment.
• 💰 To break even on the entire fund, a single company’s exit would need to reach £2 billion for the 7.5% share held by the VC, ensuring the return of the entire £125 million fund.

So, what’s the takeaway for fundraising startups?

• 📊 The larger the fund, the bigger your exit will need to be to make the numbers work
• 📊 The larger the fund, the more they will focus on ownership percentage to ensure the maths add up
• 📊 Our calculations here show the exit valuations needed for a 100x return; however, many VCs are happy with a return of 50x (and some, tax-efficient funds, a much lower return)
• 📊 2024 shows more optimism in revenue multiples compared to 2023. The Q1 2023 median revenue multiple dipped to 6.7x, but by Q4 it rebounded to approximately 7.8x

“It doesn’t matter how well you pick and nurture startups if you can’t maximise the value of your investments through an exit”

Evelina Anttila, Managing partner at Wellstreet VC

How to reflect this in your financial model

• 💸 Seed stage startups — don’t go for the unrealistic £800m ARR projection in year 5. Instead, show a T2D3 growth curve. This acronym stands for tripling your ARR for two consecutive years (T2) and then doubling it consecutively for three (D3)💸 Series A startups, target reaching a £100m ARR, before Series B
• 💸 Target 60–70% gross margins in 4–5 Years, indicating efficient growth and profitability
• 💸 Target a 50% customer expansion rate. Surpass 2023’s B2B SaaS median customer expansion growth rate of 42%, by optimising upselling and cross-selling approaches
• 💸 Target a 50% customer expansion rate. Surpass 2023’s B2B SaaS median customer expansion growth rate of 42%, by optimising upselling and cross-selling approaches
• 💸 Increase sales and marketing spending: 2023 data indicates a direct link between increased S&M expenditures and higher growth rates, which in turn correlates with higher valuations.
• 💸 Plan a realistic 10-year exit strategy, align with growth projections and market conditions, ensuring investor confidence in the long-term viability of your business

Tech Crunch, 2022

Understanding the dynamics of fund economics and the influence of multiple returns within the 2024 landscape is essential for your fundraising journey. At Mountside Ventures, we provide strategic guidance to align your financial objectives with VC expectations and B2B SaaS market trends. Our investment readiness accelerator prepares seed-stage startups to raise their next rounds. For Series A to B stages, our finance team offers fractional CFO solutions, developing and refining your financial models to ensure they align with VC standards and making your business truly investor-ready! Reach out to us here

Sources:

Maxio Institute Growth Index Report, 2024

Cesar Faucheur, Jenson Funding Partners, 2024.

Salomon Aiach, Early Bird, 2024.

Greg Raiz, Raiz Capital, 2023.

Stijn Hendrikse, T2D3, 2021.

Jason Atkins, Cake Equity, 2023