In Spite of the glamor associated with it, VC business is a tough business. Most VCs don’t even in provide market returns to their investors, let alone outsized returns! VC investments are risky investments and a majority of them fizzle out where the total invested capital is lost. The remaining companies have to provide big returns to overcome those losses and provide good returns overall. Dirty little secret of the VC business is that almost 80% of the funds don’t even return the invested capital let alone any ROI.

Most of the funds are organized as partnerships where the Limited Partners (LPs) provide the capital and General Partners (GPs) manage the money. A typical partnership provides for 80-20 split of the profits, where the LPs who provide all the capital get 80% of the profits and GPs pocket 20%. Further 2% is allowed every year as the fund expense. Funds have a 10 year life. For a VC fund to provide 5X return, which is less than 18% per year, on a $100 million dollar fund, it will have to produce total value of $600 million, of which $500 million would be returned to the LPs (hence 5X) and $100 million will be retained by GPs as their share of the profits. For this to happen, every investment will have to produce 6X return. If half the investments fail, then the remaining half will have to produce 12X returns. VCs typically invest only 80% of the capital as they spend about 20% on expenses over 10 years. That says winners will have to produce 15X on winners. Math gets worse if more than half the companies fail. Also, 15X winners are not that common.

For VCs to return 5X, they have to have a couple of super-hits, meaning 50X or even 100X returns. For this kind of returns, the initial valuations have to be reasonable. Higher the valuation in the beginning, lower the chances of making big hits. Also capital efficiency plays a big part too. Lower the capital efficiency, meaning high burn rates, results in more capital raised; diluting all stakeholders. This requires much bigger win to get those multibagger returns.

The situations gets dire very quickly. VCs and entrepreneurs who do not focus on profitability sooner rather than later discover that even a win does not give any satisfaction.

Like I said in the beginning, most VCs lose money. In India all the VC capital invested in last 20 years has not been returned to LPs. India has proven to be a bottomless pit. There just have not been any big hits to speak of. Microsoft was profitable after only $1 million of capital raised and Google was profitable at $2 million. They turned out to be big winners for everybody involved.

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