Tuesday, July 20, 2010

VC Economics – Why Your $50 Million Exit Means Nothing

A friend of mine is working on one of the coolest startups I have heard about in a while.  We discussed whether he should have VCs  invest in his seed round.  He is thinking he may want to have the option to exit early and was curious why a VC wouldn’t want to put in $1 million for 20% of the company and get out $10 million (at a $50 million exit) – a 10X return.

The Economics of Big Funds
The reason is the economics of large funds.  Suppose you are a venture fund with $500 million under management.  If you are a top tier fund, you want an internal rate of return (IRR) of say 20-25% a year to your investors over the 5-10 year horizon of the fund (say 3-5 years of active investing, followed by another 3-5 years pro-rata/follow on investments in the company).

This means over the life-time of the fund, the fund will need to return $1.5 billion from investments.  I.e. the VC needs to make back the original $500 million that was invested, and then make an additional $1 billion on top of that.

This calculation does not include additional details, e.g. if you charge 2% in management fees per year for 5 years, that is another 10% of the fund you need to make up ($50 million).

So, the $10 million you returned to the VC as part of your startup’s $50 million exit is 1% of the total money they need to return the fund.  Clearly not worth the opportunity cost of the partner’s time who is looking to make $100s of millions per successful investment.

This is why some VCs have a “go big or go home” mentality.  The $50 million base hits won’t move the needle for a big fund.  This is why some VCs will push for the additional dilution of ongoing fundraising over a quick exit – a company that exists for $1 billion post dilution will still return more money to the fund than a small exit.  Unfortunately many companies go under during this process.

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