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|
|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|