In the previous post, I covered a lot of ground. Explaining the basic mechanics - even if they were ridiculously simplified - turned out to be a lot more complicated than I initially thought.
I showed the rules of the game, and calculated some ballpark numbers. Those are:
Fund size of 100,000,000 (for a maximum seed round of 500,000)
Three ventures generating returns for the fund
<10% stake for our model VC in those winners
Now we can check how successful our model VC can be, and what it expects from its bets.
What our VC needs to win
A venture returns money to their investors in 5-10 years. So we will assume that the lifetime of our fund is 10 years.
Apart from the investments, our VC needs to have enough to cover their costs for their partners, associates, offices, and expenses. This is called a management fee, and it is around 2% of the fund size per annum. That’s 20,000,000 over the lifetime of the fund.
Venture Capital is a risky investment, which means investors (this time investors into the fund; it’s turtles all the way down) expect a return of at least 25% per annum.
100,000,000 * (1,25 ^ 10)
So after 10 years, our fund should be worth ~ 931,322,574 to make the investors happy.
We will add the management fee as well. The partners in the VC will also take a cut (usually around 20%) of all winnings, so let’s round up to 1,000,000,000.
Our three most promising ventures need to have a combined value of 10,000,000,000 (at 10% stake in each), to make our fund successful.
Conclusion
Of course our VC wants to maximize its potential. It would happily have more than three successful horses in its stable. But it is limited by how much it has allocated towards the later rounds.
It could also bet on being able to spot promising ventures early. And every VC does have a clear set of criteria by which they assess potential investment targets.
It could also skip the very first stage when the risk is highest, and decide to join later. This is indeed a trend we can observe. VCs do have multiple funds they manage - pipelining their efforts. It seems successful funds tend to focus more on later stages.
From what we have derived - and especially taking the power law into account -, I assume the biggest difference between successful and less successful funds depends on the size of the most successful venture. A 2-4% stake in a 100 Billion company is what VCs are aiming for.
What does it mean for startups?
This two-part series was meant to learn more about the perspective of the investor. Startups need to build great relationships with everyone involved. Understanding the partners is necessary for a good partnership.
The main takeaway is probably this: Either your startup is in the category of the 10 successful bets, or your investor will keep a courteous but slightly distant relationship with you.
How can you tell if you are one of the chosen ones? The quick tongue-in-cheek answer is: If you have to ask, you are probably not one of those.
You will know. Either because you are struggling to keep up with customers beating on your doors, or because the investor will actively discuss the next steps with you.