A reminder on the economics of venture capital

By February 8, 2010Venture Capital

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Bill Bryant, former entrepreneur and now one of our US venture partners, recently described the maths of venture investing at a conference in Seattle.  This write up is from the Xconomy blog, and in it Bill it explains why VCs need to price in 10x returns:

Bryant explained that “Despite doing extensive diligence that leads to the conclusion that every investment we eventually make is going to succeed—otherwise we wouldn’t make the investment to begin with—for every 10 deals we do, we lose all of our money on 5 to 6, we make a modest multiple on 2 or 3, but we make a lot of money on 1 or 2.” Those two successes need to deliver at least a 10x return to compensate for all the losers.

“Unfortunately I have to penalize the winners because of all the losers—we basically price them all the same at the start since we don’t really know which one will end up in the winner category. I don’t plan for this. I make every investment fully believing that it will be a winner, otherwise I would not invest, but the reality is 5 to 6 out of every 10 will lose all the money we invest,” he reiterated. “When an entrepreneur tells me they are trying to raise $2 million for 15 percent of their company, the way I translate that request is that I now need to believe they have a reasonable chance of reaching at least a $90-$100 million exit, otherwise it doesn’t pencil out.”

Our model here at DFJ Esprit is more a third make good money, a third return the investment (plus maybe a little bit) and a third return pennies on the pound than the half-quarter-quarter model that Bill describes, but the story is still the same.  The difference comes because in the US DFJ makes more very early stage investments than we do in Europe.

Bill also talked about the relationship between VCs and the investors who put money into our funds:

Entrepreneurs should realize that VCs have investors too and must produce results. VCs raise money from institutional investors such as pensions, foundations, and endowments for whom the VC investment is just a tiny part of their portfolio. “We are to these very large institutional investors what art collections, luxury boats, and sports teams are to super high-net-worth individuals,” said Bryant. “We need to produce competitive returns to maintain our place in the asset allocation of these investors.”

Having been closely involved with a successful VC fundraising process for the first time recently I can tell you that a) fundraising is a really important part of our business, and b) the parallels between the startup fundraising process and the VC fundraising process are legion.

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