Venture capital economics

Why VCs look for 10X returns

VCs want to invest at least $5M in startups that have potential 10X returns. That is because it takes as much time to manage a $1M investment as it does to manage $5M. Secondly, every startup looks like a winner when they write the check, but Fred Wilson suggests that 33% will fail, 33% will break even, and 33% will be big winners. VCs start out hoping for a 10X return on every deal but average about 3X to 4X after all is said and done.

VC Firm Partners - If a VC firm raises a $250M fund they will probably have 5 partners in the firm, with each partner managing about $50M. If they invest about $5M in each company over several rounds, then each partner will sit on 10 company boards. That is about all a single partner can handle and still do a good job for the portfolio companies.

VC Firm Investors - VC firms raise money from Limited Partner investors like insurance companies, pension funds, university endowments, and wealthy individuals. These investors know that venture investing is risky and expect higher returns to compensate for the risk, typically 3X their money over the 10 year life of the fund, or a net IRR of 30%. More on this later.

VC Firm Economics - VCs usually take a 2% - 3% annual management fee and 20% to 25% (carried interest) of any capital gains on exits. So, when you take out the VC fees and gains, and factor in the LP investor expectations, what does the VC fund have to return? Fred Wilson of Union Square Ventures did a great post on this and provided some real numbers on his model.

There are a lot of numbers here, but if you study them carefully they explain almost every question you might have about how a VC firm works.

VC Fees and Gains - Note that on a typical $100M fund management fees can take $20M off the top, so there is only $80M left to invest. That 2% annual management fee over the 10 year life of a fund really adds up. Also note that if the fund returns 4X on invested capital (4 X $80M = $320M) that the VC gets 20% of the gain or $44M ($320M - $80M = $240M, less the $20M in fees = $220M. The VC gets 20% of that gain or $44M.

On a $100M fund the VC gets $20M in fees and $44M in gains over the 10 year life of the fund. Now you know why everyone wants to be a VC.

VC Limited Partner Returns - In this case the LPs invest $100M and get back $256M, or about 2.5 times their money. Because they invest their money over the first 4 years of the fund, and collect their returns over the last 5 years of the fund, their Internal Rate of Return (IRR) averages about 30%.

What does this mean to entrepreneurs? - When you pitch to a VC you need to show the "potential" for a 10X return. The truth is that no VC knows which company will return 10X and which one will fail and lose all the money. Believe me, if they knew...they would only invest in the winners. Like I said, they all look like winners when they write the checks.

VCs will not invest in startups that address a small niche market, or companies that are profitable but don't look like they can bring 10X returns. They are not interested in potential 4X returns because they know that on average 66% of all investments will either fail or break even. If a company starts out looking like a 4X return, chances are, given the long VC history, it will break even at best. It is like probabilities in poker.

So, here is the inside secret to all of this. Build your plan on a 10X return, expect a 4X return, and hope you don't end up in the 33% failure category.