Understanding how VCs think
(The Math behind Venture Capital)
Guhesh Ramanathan
Typical VC Firm structure
Role: Investors
• Investors (also called Limited Partners or LPs) are typically large family o ces,
or pension funds that have signi cant capital to deploy.
• Typically, they park their available capital across di erent asset classes
(bonds, listed equity, real estate, and venture capital)
• VC component is the riskiest, but o ers highest potential return
• Typically 2-5% of the overall available capital.
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Role: GP (Or General Partners)
• Manage the fund management company (typically an LLP) as well as the fund
• Obtain “commits” from the LPs, in exchange for a promised return
• Assisted by analysts, EIRs and other “mentors”; salaried
• Manage the operations of the fund through a “fund management fee” which is
meant to meet ALL operating expenses (salaries, rent, electricity, travel,
entertainment …. )
• GPs also earn a “carry” when the exit in an investment happens.
The 2 - 20 “Rule”
• A VC rm takes 2% as management fee per year. Thus, for a $100 Million, 10
year fund, they use up to $2M per year for operations (overall $20M).
• This leaves a total “investible” capital of $80M.
• They can earn a “carry” of 20% if, and ONLY if, they exceed the returns
demanded by the LPs.
• A typical return demanded by LPs? About 12% PA.
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Now for the Math
Assumptions:
- 10 year period for fun
- Annual return of 12% for LP
- Fund size: $100M
Remember Pareto (80:20)?
80% of your returns will come from 20% of your companies.
A more common scenario:
Now make your investments
Assume:
• You make 10 investments (across Seed, Series A and Series B); all equal
• $8 M each (spread across Seed, A and B rounds)
• Why not $10 M? (Remember your management fee of 2%!)
• At exit stage, you hold 25% in each company
Scenario 1
All exit at an average of $50M
Return
- 10X12.5 = $125
- No where near $310M
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Scenario 2
5 exit at $50M, 5 at $100M
Return
- 5*12.5M + 5*25M =
$187.5
- Still no where near
$310M
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Scenario 3
Throw in an over achiever
Return
- Added up .. $287.5
- Almost there!
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Scenario 4
We NEED a Unicorn!
Return
- Finally: $362.5
- But is this REALISTIC?
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The Reality
5 fail, 3 small exits, 1 medium exit and 1 large exit
Return
- $318
- How many funds can
you think of who
actually did this?
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How VCs think …
What do I do to reduce the risk for my investment?
• Development Risk
• Market Risk
• Execution Risk
• Finance Risk
And hence the focus:
5 Ts you should remember
• Team: Is the team cohesive, capable of execution?
• TAM: Is the total addressable market really, really huge?
• Technology: Is this something that can be leveraged, and used to scale?
• Traction: What is the company showing now? Rapidly growing?
• Trenches: What are the defensive positions that the company has?
Questions?
