VC Math

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Why aren’t VC’s interested in my 4X business?In the world of early stage tech, entrepreneurs’ regularly beef about why venture capitalists and angels will only invest in companies that offer the potential for a 10X return. They don’t get what’s so pathetic about the odd 3 – 4X company among a portfolio of 10 baggers.

Alright entrepreneurs, imagine yourself in the well-polished shoes of your favorite VC for a minute.

SO, you are a VC and you have a $100M fund; your job is to deploy that capital and provide $150M of value to your shareholders (a 50% return). To do so, you must invest in companies within a pretty skinny profile: the potential to generate 35 – 50M in revenue in about 5 years. (There are one or two other key factors, but let’s keep it simple for now).

And here’s why.

Given a portfolio of 10 companies, the win/loss ratio for most VC’s follows some variation of the 2:6:2 Rule. Meaning 2 companies never return any capital (the Dogs), 6 companies break-even (the Living Dead) and 2 win big (the Stars).

If you invest $100M into 10 companies and expect a 50% IRR on your fund, the numbers wash out as follows:

($20M) from the Dogs
$60M from the Living Dead

Since you’ve only generated $40M on the Dogs and the Living Dead, you now need to generate $110M on your Stars in order to meet your shareholder’s return expectations.

Each Star = $55M

And you probably only own max 50% of each company so each Star needs a $110M exit in order for you to hit your return expectations and pay back the losses from the Dogs. This means you need to ensure that every company in the portfolio has the chance to sell for well over $100M to make up for the fact that odds are, only 2 actually will. And if we assume the company sells for 2-3x revenues (a big generalization), you can see how the profile must include a company able to hit a $35 – 50M run rate in the lifetime of the fund (~ 7 years).

Simple right? This explains why VC’s have such a narrow investment profile and why they avoid small markets, niche technology and inexperienced management teams that don’t shoot for the moon.

November 29, 2007 | Unregistered CommenterKerri Knull

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