My good friend and professional instigator David Crow sparked some reactions last week with this 100% on the money tweet.
Yes, it would always be great from an entrepreneur’s perspective for more capital to be available. Lets set aside whether that would be good for the VC industry for the moment. I have a theory about why founders perceive there to be a lack of capital:
The reason most founders think there is not enough capital is that they get rejected when they go looking for it. And one of the main reasons they get rejected is that their opportunity does not fit what VCs are looking for.
I’m not saying these people have bad businesses. They just don’t fit the narrow definition of what a VC needs in order to generate returns.
What I’d like to do in this post is give a high level overview of how VC fund math works since this in my view is a primary driver of VC behaviour and is the reason why most founders get rejected.
VC Math 101
Let’s take a typical $100M VC fund. That’s quite small, but is a nice round number for this exercise. The basic structure of a fund is as follows:
- Limited Partners (LPs) commit to invest $100M over a number of years
- The VCs (General Partners or GPs) call that capital over time as they need it in order to pay expenses and make investments
- The normal deal is 2% of the $100M per year in expenses and 20% of any profits (known as ‘carry’ or ‘carried interest’) after the entire $ 100M has been returned to LPs
- LPs sign up for a 10 year commitment. Meaning they need to keep funding (or they lose any capital contributed already) and they can’t sell their position since VCs invest in privately held companies.
- Because VC funds are illiquid and high risk they are expected to deliver higher returns to LPs than they could get from other, more liquid investments.
The typical target is to triple the size of a fund in 10 years. That sounds like a lot but it equates to a 20% annual return. Definitely higher than public stock markets (most of the time). That means that a $100M fund has to generate $ 300M in gross proceeds from the sale or IPO of its investments.
Consider the fact that a typical VC fund owns a minority stake in its portfolio companies. That means it needs to generate a huge amount of exit value in order to hit its target returns.
Here is a simple illustration of this math: If a fund owns on average 15% of each company it invests in, it needs to generate $ 2 billion in exit proceeds in order to pull out $ 300M for itself.
This is friggin’ hard to do. Let’s approach this from a Canadian VC context. Last year was a great year for exits in Canada:
Radian 6: $ 326M
Q1 Labs: $ 300M (estimate)
MKS: $ 292M
Adenyo: $ 100M
So, if I was running a $ 100M Canadian VC fund, I would have to had to be in all of these companies early enough to get to and keep 15% and would still be only 1/2 way towards what I need in order to deliver my target returns.
So why does this matter? Simply because this is why you’re getting rejected all the time. Every time you meet a VC he or she is assessing the probability that your idea could turn into something that would generate a huge outcome and that you have the potential to execute and build a big company.
Judged against this bar it’s easy to see why most opportunities get rejected. To be clear, the vast majority of outcomes are sub $ 100M. But VC is a business of outliers, not averages. If a VC doesn’t see potential for an outlier they will pass most of the time.