General Rule of Thumb

If you plan to raise investment from Venture Capitalists (VCs) for your tech company, you need to understand the 10x return model practised by most of the VCs.

As you very well know, tech startup investing is inherently risky. The general rule of thumb for early-stage investment is that:

  1. 1/3rd of investments would fail.
  2. 1/3rd of investments would return the capital invested.
  3. 1/3rd of investments would be successful.

According to Fred Wilson of Union Square Ventures, if the return on the middle 1/3rd is 1.5x of the investment, then the final 1/3rd needs to average 7.5x of the investment to produce 9x of the fund.

However, in order to improve the odds, one of the investments is expected to return the entire fund. This way, you achieve breakeven if rest of the investments fail. However, Limited Partners (LPs), who the VCs raise investment capital from to invest into tech companies expects at least 3x gross. To achieve this goal, it’s best to consider:

  1. One deal returns the fund.
  2. Another 3 to 4 collectively returns the fund.
  3. Rest collectively returns the fund (obviously quite a few not returning any).

 

Let’s explore a £100m fund

Let’s explore a £100m VC Fund over a 10 year period. Typically, management fee for administering the fund is about 2% per year. Over 10 years, this becomes 20% of the fund or £20m. This leaves £80m to be invested. Let’s assume the £80m will be invested into 9 tech companies equally, i.e. each investment of £8.89m.

In order to return 3x of the total fund size for LPs:

  1. First 1/3rd – 3 companies return £0.
  2. Second 1/3rd – 3 companies return £100m, i.e. 3.75x
  3. Third 1/3rd – 2 companies returns £100m, i.e 5.62x. One company return £100m, i.e. 11.25x

After 10 years the fund exit at £300m, of which:

  1. £20m drawn as management fees by the VC.
  2. Return the original investment of £100m to LP.
  3. Remaining £180m is split between the VC and the LP, typically VC retaining 20% as the carry.
  4. So in the end, VC has earned £20m (management fee) plus £36m (the carry), i.e. a total of £56m. LPs were returned £244m net, which turns out to be 2.4x (nett) instead of the 3x (gross) expected.

 

Exit price based on VC 10x Return

In the above example, the investment which returned the fund generated 11.25x. At the point of investment, no one will know which investment out of the fund would return the initial value of the fund. So it makes sense to invest expecting each investment to make 10x to improve the odds.

If the VC invested £8.89m into your tech company for 20% of the company post money, then the company needs to return £88.9m to the VC at the exit for VC to achieve a 10x return. To achieve this, the company needs to exit at a minimum of £444.5m.

Of course, in reality, achieving anything north of the original investment is a plus, if the company did not perform as expected at the time of investment.

 

Resources (Fred Wilson):

Image Credits: Image Credits: Samir Kaji