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.
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.