ACTIVIST VC BLOG
When a VC firm turns down an investment claiming that there is not good potential for 10x return, the reaction is sometimes pretty incredulous. From a founder’s perspective, building a business that creates a 5x return on investment might sound very good.
To understand why VCs seem to seek very high multiple returns, we need to look into the VC business model.
The ‘two and twenty’ model
Most VC business models have three key elements:
- A management fee
- Profit share (called often carry or carried interest)
- VC firms own direct investment to the fund
This model tries to balance the need to generate good returns for the investors of the VC fund (often called “Limited Partners” or “LPs”) and the necessity for the VC firm to cover its operational expenses.
1. The management fee: An annual fee covering the cost of daily activities but does not generate profit for the VC firm: during the investment period typically a bit more than 2% of the total fund size – hence “two”.
2. Carry – the profit share: The profit of a VC fund (i.e. returns in excess of the original investments) is typically divided between the Limited Partners and the VC firm in an 80/20 split (the “twenty”). Additionally, most funds have a hurdle rate; an internal annual rate of return the VC firm must deliver to LPs before starting to receive any profit. Hurdle rates are typically around 7-8%.
3. Direct investment: Investors sometimes insist the VC firm co-invests substantial amount capital into the fund. By having some real skin in the game and sharing also the risk element in the business, the VC team’s incentives are better aligned with the investor’s.
Wait, that’s not all
The typical lifetime of a VC fund is 10 years. The management fee and other fund costs during those ten years take almost 20% of the fund capital and only 80% is left for investments.
And startup investing is inherently risky; not all investments are successful. A very rough rule of thumb is that:
- one third of investments fail altogether
- one third returns just the capital invested
- one third is successful
(The risk profile of the investment strategy naturally impacts the success ratio. The predicted success ratio has again a direct impact on targeted return multiples – and the meaningful minimum size of the portfolio – when defining the investment strategy for a fund.)
So, 5x gives us nothing*
If a VC firm returns 5x on its successful investments, the VC firm will get nothing: the internal rate of return (IRR) of the fund is 8 % and all of the profit would go to LPs to cover the hurdle rate. The 8% IRR is not optimal result from the LP perspective either: VC funds are a high risk asset class and should generate better returns to justify the risk.
But if the return on successful exits is 10x, the fund returns 3x the fund size and IRR goes up to 20%. The LPs get a good return on their investment and the VC firm gets reasonable profit. And, obviously, the founders of the company have their payday.
So, the 10x target is not a matter of greed – the high risk profiles of startups combined with the VC business model simply requires this level of returns.
In fact, many professional early stage investors state that their targeted return is 30x, reflecting the even higher risk levels faced by these very early stage investors. This also results in fairly large portfolios – maximizing odds catching at least one or two of those so scarce winners or even unicorns…
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* These scenarios assume:
- 20/80 split between fund costs and money invested in portfolio companies
- an even 1/3 distribution between failures / even money / successful exits
- a 6-year average holding period for the capital
- 8% hurdle rate