VC economics is very dire and requires a disciplined approach to provide satisfactory returns. The dirty little secret of the VC business is that most of the returns are made by top 10% of the funds, remaining 90% funds barely return the capital back after 10 years. Let’s do some math here…
Assume an early stage VC fund of $100 million, with typical 2% annual fee and 20% carry. It has a 10 year life, so it siphons off 20% fee over 10 years and will invest only $80 million, unless it recycles the profits from the early winners. A typical early stage fund invests in about 20 companies, and in this case on average about $4 million each, and will easily lose all its capital in at least half of its investments. So for it to return 5X to its investors after the carry, a good but not great return, it must produce 6X overall or 12X on its winners. But, since only 80% of the money is invested, it must produce 15X on its 10 winners. That means each have to produce $60 million return to produce $600 million so, $500 million can be returned to investors.
It is hard to imagine that all winners will produce that kind of uniform returns. As a matter of fact, fund returns are driven by a few winners, producing outsized returns. History shows that one or two winners producing 50 to 100X produce all the returns in the fund.
A good fund manager starts to starve its early laggards and nurture its winners. The goal is to deploy most capital in the emerging winners to maximize returns. This requires VC to watch their investments like hawks for early signs of trouble. IT requires discipline to make hard decisions of not spending limited resources of time and money, on your troubled investments. Resources are much better spent on your emerging winners to increase their odds and size of winning.
VC business is simple but heartless. You push your losers to fail fast without consuming much capital and you push your winners to achieve their full potential.