How VC fund mechanics create real hurdles for entrepreneurs
Understanding the mechanics of return is key to raising early stage venture funding
If it’s tough for me, it’s gonna be even tougher for you
As you face a mountain of pains across hiring, sales, cash burn, product strategy, pricing etc. in the race to build a successful venture, it is tempting to believe that the VCs waiting to back your ideas have it easy. After all they just need to sit back, wait for the ideas to flood in, rake in the fees and wait for the magical “2 and 20” model to fund their house in the country on the back of your endeavour?
In practice, the VC game is a lot harder than this, and these challenges have severe implications for your chances of raising funds.
It’s actually really hard to make money in VC
Typical fund cycles (cash raise to full pay out) are 7–10 years for an early stage fund. To accommodate the risk of the asset class and risk-weight their return to appreciably more than 10% pa, funds thus need to target 3–5x cash-on-cash returns to their shareholders (7 years to 5x would represent an average return of 26%pa, whereas a 10 year cycle delivering an impressive sounding 3x would represent just 12% pa).
The reality is that delivering 3–5x on a fund, without a significant amount of fortune, is a difficult exercise. The unknowns in the early stage (competitors, market changes, regulation, team issues, business model pivots, non-paying customers, cash flow etc.) rather trump any analysis of market opportunity and product/market fit (which are nonetheless still a hygiene factor for successful propositions) and lead to a surprisingly inviolate failure profile. In a typical fund therefore a third of the investments will fail, the next third will broadly return the capital invested, and the final third will determine the overall returns of the fund. Even if we assume that a fund is highly successful in spotting its winners early and manages to allocate 50% of its capital to the ultimately successful investments, it will need to return nearly 10x on average on each of these investments to deliver overall 5x fund returns.
Fig 1: Representative fund with typical failure profile
This theoretical picture correlates with real world data from Horsley Bridge, a leading LP investor in multiple European and US VC funds, which suggested that a fifth of investments need to deliver >10x to deliver world class fund returns (data from a post by First Republic’s Samir Kaji).
So what does this mean for the VC?
Given that VCs are generally restricted to c 10–15% of the fund’s capital into any single investment for risk management purposes, the real conclusion from this picture is that for a VC to invest in your business proposition they need to believe, in effect, that your business is capable of returning their whole fund (10% capital x 10x return). For an average sized Series A fund of $100m, this means a proposition that is capable of sustaining an exit value of $500m — $1bn (assuming typical investor exit ownership stakes of 10–20%). In other words, most VC investors are compelled to search for “Unicorns” in each and every one of their investments (leading to challenges in the industry, but that’s a different story).
What does this all mean for an entrepreneur?
Facing these kinds of hurdles, raising venture capital is still really tough despite a significant increase in capital over the last 5 years - for example in fintech in particular. A typical VC fund will see several thousand deal prospects every year. From these it is likely to meet with 100 or so teams, whittling these down quickly to 30 or so second meetings, and finally making 4 or 5 new investments to add to the portfolio each year. This means that the chances of investment from any individual VC are generally less than 0.2% - a steep funnel, even steeper when factoring in the proactive outward efforts of most VCs (i.e. they already have their eye on likely targets).
There are therefore five principal factors that any entrepreneur should consider before deciding to embark on a VC capital raise.
Firstly, to beat the odds requires an entrepreneur to convince any potential VC that the opportunity is capable of generating this scale of return. To deliver a $500m+ exit, a general rule of thumb is that the business needs to be capable of credibly delivering >$100m in revenue within a mid term window. To do this practically without needing to take unfeasibly large market share, the addressable market opportunity therefore needs to be growing quickly at demonstrably north of $1bn in value, or significantly larger depending on the sector you operate in, and the business you propose.
Secondly, in addressing these opportunities, the VC investor must be crystal clear that the solution proposed meets a real market need, and that the customer value proposition is robust (and succinct). As new technologies emerge it is surprising how frequently entrepreneurs develop a solution looking for a problem. With all the attendant risks in execution this brings, VCs are typically deterred.
Thirdly, reaching such scale generally requires significant levels of subsequent capital (to fund growth, for example “the 40% rule”), particularly if there is a capital investment, or inventory growth requirement. For this reason, and simply that software businesses scale and proliferate significantly easier, VCs predominate around high Gross Margin and software led business propositions.
Fourthly, getting to scale is going to invite fierce levels of competition, particularly as a concept gains traction in the market. Key to VC funding therefore is a key point of differentiation, be it product, technology or in the model and delivery itself. Brand led propositions in developed markets are rarely VC backed. A proposition will therefore generally need to demonstrate how competitive advantage can be sustained across the varied challenges that the business is inevitably going to experience.
Finally, like any industry, the VC industry is nuanced and funds have differing theses, focus on different sectors and technologies, support differing investment strategies, and target participation at different stages of a company’s life. Thorough market diligence is required prior to approaching any investor.
@holmanma
