Entrepreneurs usually ask me why VC’s take so much of their company when they are only providing money and the entrepreneurs themselves are doing all the work.

Its very simple actually. VC’s and other professional investors raise money from other people (usually funds and high net worth individuals) who are expecting a return on their investment.

Right now in India, fixed deposit rates hover around 10%. That means each year you are getting 10% return on your money as a “safe investor”. Real estate investing over the last 20 years has returned in India (not all but many) close to 15%. Granted both these are fairly “not very liquid” investment classes.

Venture investing though is less liquid. Until the companies “exit” they dont return any money to the investors.

So if you as an investor are willing to take a risk, you expect a higher rate of return. Some other asset classes return higher than real estate, but they would be more risky.

The term Venture rate of return is the % of money the investment will yield annually over a period of time in a venture fund. Used to be that period of time was 7 years, now it is close to 10 years.

Lets say for sake of discussion the rate of return you expect as an investor in a fund is 25%. It seems reasonable given the risk.

That means, the VC has to return 25% each year on money raised.

Lets say that the VC raises a $10 million fund. In year one that fund has to be “worth” $12.5 Million, $15.65 Million in year two and so on until in Year 7 when it has to be worth $47 Million and in Year 10 it has to be worth (and return) $93 Million.

So the $10 Million raised has to return 9.3 times its value over 10 years.

VC’s have operating costs as well so they take 2% of the fund every year as a management fee for say 4 years. That means they have $9.2 Million to invest and $93 Million to return over 10 years.

Ten Times the Money raised.

Now this money should not be in paper alone. It has to be funds returned to the investor. Which brings us to the “exit”.

If startups dont “exit” – go public or get bought, then the funds dont get their money back and everyone is unhappy.

Unhappy since VC’s wont make the return they have to for their investors and the investors in turn will stop putting money in VC funds, which means fewer startups will get funded.

What does this have to do with % ownership for VC’s? They have to own a significant % of your company so when the company exists, they can provide that return to their investors.

If you are a VC and you are investing the $10 Million in 10 companies (its not as simple as put $1 Million in each company BTW), you need to have at least 2-3 companies “exit” because 7-9 will close and die. Startups have a very slim chance of success. Success in this case is providing an exit.

Success, however for an entrepreneur is a growing, thriving business. That’s the dichotomy and a discussion for a later post.

Here is a spreadsheet for a review.

Fund Raised | $ 10,000,000 | |

Management Fees | 2% | |

Year 1 Mgmt fee | $ 200,000 | |

Year 2 Mgmt fee | $ 200,000 | |

Year 3 Mgmt fee | $ 200,000 | |

year 4 Mgmt fee | $ 200,000 | |

Total Management fee | $ 800,000 | |

Total available to invest | $ 9,200,000 | |

Expected Annual return | 25% | |

Fund Value | Fund Return | |

Year 1 | $ 12,500,000 | |

Year 2 | $ 15,625,000 | |

Year 3 | $ 19,531,250 | |

Year 4 | $ 24,414,063 | |

Year 5 | $ 30,517,578 | 3.05 |

Year 6 | $ 38,146,973 | 3.81 |

Year 7 | $ 47,683,716 | 4.77 |

Year 8 | $ 59,604,645 | 5.96 |

Year 9 | $ 74,505,806 | 7.45 |

Year 10 | $ 93,132,257 | 9.31 |

There are only a few people who invest time to grow a community selflessly. These blogs are good introductions for starters and easy read too. Thanks for these Mukund.

You’re a gods gift to the layman

You’re a god’s gift to the layman

Your post seems cunningly written about return , no instrument can give more than 8 %-10 % return in safe mode like bank or other as on date , surprisingly you have written in such a way that it looks that 25 % expectation on money invested is worth but practically it is next to impossible to have such huge return expectation in initial years , though always it is lower in initial years and keep on increasing , more than 95 % of initial venture fail because of high expectation in initial years , if money holder can come in contact of entrepreneur hardly any business would fail, but entrepreneur have to earn not only for money owners but also for smart people like you and banks, there lie a catch , end result is closure that is why more than 95% venture fails in initial years……………

Hi Mukund- These ‘venture returns’ calculation look simple above but most fund managers calculate & report their fund performance data to their LPs (quarterly reports for example) in a slightly complex manner. This is because, different LPs use different metrics to assess their investments in venture funds. The compounded returns metric you highlighted above is good from an IRR perspective but again, different funds who operate at different stages have varying degrees of operating performance and hence their annualized returns also vary vastly. For example; an early stage fund will be making capital calls to their LPs for the first 2-3 years and this would be their heavy investment period and because it’s an early stage investment, they won’t see any real returns for another 3-5 years. These funds would rely on next stage financial valuations to compute their annualized returns. Then there are some LPs who like to see paid-in capital distribution (DPI) metric which closely resembles Cash-on-cash in terms of multiples of cash invested by them in the fund.

But I think your point is to explain entrepreneurs why VCs like sizable ownership on their investment and hence the math behind these returns. Btw. a VC fund returning 25% IRR would be a top quartile fund and highly sought after 🙂

Nilesh, point well taken. I did simple math so I can at least start a discussion around why. I also got some feedback that 25% is rather high. If that’s the case, then 15% returns will be 2 times in 5 years and 4 times in 10 years.

I also don’t know any fund that’s not trying to be in the top quartile. Which is why many funds are shutting down. If they cant deliver, they should not be in that business.

Mukund,

I am reasonably sure that a fund returning 3 times the cap invested over a 10 year period would be in the top quartile and would more than satisfy the returns expectations of LPs.

That aside, what exactly is the key takeaway from your post – am not quite sure where all the math (voodoo or otherwise) is leading to…would you mind explaining?

Thanks

Sumanth

One of the main issues and which is being talked about in the LP community (I have classmates from Booth and friends who are investment managers in VC invested family offices, pension funds and hedge funds) a lot now-a-days is the GP-LP incentive alignment. The dreaded 2:20 ratio. 2% management fees create misaligned incentives because it is directly tied to fund size. In my view, fund managers with smaller fund sizes, assuming they indeed have the skills to deploy efficient capital, will see better than 17% returns from the 2009/10 vintage forward. The larger funds will struggle. It’s my hypothesis based on what I see on the valuation debacle VCs have been creating in the past 2-3 years.

As far as I understand the multiples are lower than you have here but 25% for an IRR is a reasonable estimate. The lower multiples are mostly because drawdowns happen over 4 years and capital is returned immediately after exits, which changes the calculations vs. taking a compounded rate of 25% for a full 10 years. From my limited reading, 25% IRR typically corresponds to a ~3x multiple of invested capital. Sample model from Fred Wilson: http://www.avc.com/a_vc/2008/08/venture-fund–1.html

Don’t think the math is voodoo at all. Point was there are significant return expectations, which 90% of entrepreneurs (you may be an exception) don’t understand. So they believe that VC’s are *only* trying to make money for themselves, and hence want higher % of company.

Would be glad to explain why the math might be voodoo over a coffee/beer!

But be that as it may, most VC bets are indeed “shoot for the moon” type of things and startups looking to raise VC money need to provision for these both in their pitch and if you are successful in your fund-raise, in your operational plans (aim for growth rather than profitability for instance).

What would perhaps be more interesting to break out what the specific imperatives and motivations are for each VC that you are pitching to and align your fund raising strategy accordingly – for instance, a fund with a $10 million corpus is a vastly different one from one with $200 million…similarly a fund that has just been closed and is starting off its investments has significantly different perspectives that one that is in its third or fourth year of operations. I wonder though how many Indian entrepreneurs do any sort of due diligence themselves when they assess VC firms…

http://www.kauffman.org/newsroom/institutional-limited-partners-must-accept-blame-for-poor-long-term-returns-from-venture-capital.aspx

Mukund, any reliable aggregate data on how much return the VC industry has actually been generating? Would be very interesting to compare it with stocks/bonds/deposits, especially in the Indian context.