The Math Of VC Funds – 2

Peter Rip of Leapfrog Ventures describes some of the math behind venture capital funds in a fascinating post titled ‘Traditional Venture Capital Sure Seems Broken – It’s About Time.’ It provides some outstanding insight into how the math behind venture capital funds affects the way venture capital fund managers make investments and how they behave after they invest.

This post is a high level summary of how the math works for a typical venture capital fund.

In a Typical Fund the Returns are From 20% of the Investments

In a typical VC portfolio, most of the returns are from 20% of the investments. This is just a statistical fact – a law of nature. Statistically, if a VC makes ten investments, two will be winners and create most of the gains in the fund.

The Minimum Respectable Return on a VC Fund is 20% per year

A minimum ‘respectable’ return for a VC fund is 20% per year. This is set by the expectations of the investors in VC funds, the relative risk levels compared to other investment classes and the performance achieved by other venture capital fund managers.

Another way to look at this is that a ten-year venture capital fund needs to repay investors six times (6x) their investment.

This means that those two winner investments have to make a 30x return (on average) to provide the venture capital fund a 20% compound return – and that’s just to generate a minimum respectable return.

This math is simplified but it’s more than accurate enough to illustrate this important point. If you are not familiar with the math behind an investment portfolio, I hope you will spend a few minutes with a spreadsheet so you are comfortable with these numbers.

And Most VCs Only Get to Invest the Capital Once

Even more interesting is that a traditional venture capital funds are usually limited partnerships. This means that the fund managers only get to invest the money once. If they make an investment and exit for a 3 to 4x return, they have to give the principle and gains back to the venture capital fund’s investors. They don’t get a chance to invest it again. From the VC partner’s perspective, this effectively guarantees they have failed.

One 10x and One 100x is More Likely

Of course, a successful venture capital fund is not likely to have exactly two 30x exits. It’s much more probable that a fund will have one 10x exit and one 100x exit.

What is important here is how the VC fund managers think, and act.

A VC Won’t Let You Sell for Less Than a 10x to 30x Return to Them

This minimum acceptable return has profound implications for entrepreneurs and angel investors. It means that if company has venture capital fund investors, they will almost certainly block an opportunity to sell the company unless the price gives the VCs a 10 to 30x return.

Future posts will explain how venture capital funds block good exit opportunities and what this means for the exit timelines in VC backed companies.

Source: AngelBlog


The Math Of VC Funds – 1

In a venture capital investment, the terminology and mathematics can seem confusing at first, particularly given that the investors are able to calculate the relevant numbers in their heads. The concepts are actually not complicated, and with a few simple algebraic tips you will be able to do the math in your head as well, leading to more effective negotiation.

The essence of a venture capital transaction is that the investor puts cash in the company in return for newly-issued shares in the company. The state of affairs immediately prior to the transaction is referred to as “pre-money,” and immediately after the transaction “post-money.”

The value of the whole company before the transaction, called the “pre-money valuation” (and similar to a market capitalization) is just the share price times the number of shares outstanding before the transaction:

Pre-money Valuation = Share Price * Pre-money Shares

The total amount invested is just the share price times the number of shares purchased:

Investment = Share Price * Shares Issued

Unlike when you buy publicly traded shares, however, the shares purchased in a venture capital investment are new shares, leading to a change in the number of shares outstanding:

Post-money Shares = Pre-money Shares + Shares Issued

And because the only immediate effect of the transaction on the value of the company is to increase the amount of cash it has, the valuation after the transaction is just increased by the amount of that cash:

Post-money Valuation = Pre-money Valuation + Investment

The portion of the company owned by the investors after the deal will just be the number of shares they purchased divided by the total shares outstanding:

Fraction Owned = Shares Issued /Post-money Shares

Using some simple algebra (substitute from the earlier equations), we find out that there is another way to view this:

Fraction Owned = Investment / Post-money Valuation = Investment / (Pre-money Valuation + Investment)

So when an investor proposes an investment of $2 million at $3 million “pre” (short for premoney valuation), this means that the investors will own 40% of the company after the transaction:

$2m / ($3m + $2m) = 2/5 = 40%

And if you have 1.5 million shares outstanding prior to the investment, you can calculate the price per share:

Share Price = Pre-money Valuation / Pre-money Shares = $3m / 1.5m = $2.00

As well as the number of shares issued:

Shares Issued = Investment /Share Price = $2m / $2.00 = 1m

The key trick to remember is that share price is easier to calculate with pre-money numbers, and fraction of ownership is easier to calculate with post-money numbers; you switch back and forth by adding or subtracting the amount of the investment. It is also important to note that the share price is the same before and after the deal, which can also be shown with some simple algebraic manipulations.

A few other points to note:

-Investors will almost always require that the company set aside additional shares for a stock option plan for employees. Investors will assume and require that these shares are set aside prior to the investment, thus diluting the founders.

-If there are multiple investors, they must be treated as one in the calculations above.

-To determine an individual ownership fraction, divide the individual investment by the post-money valuation for the entire deal.

-For a subsequent financing, to keep the share price flat the pre-money valuation of the new investment must be the same as the post-money valuation of the prior investment.

-For early-stage companies, venture investors are normally interested in owning a particular fraction of the company for an appropriate investment. The valuation is actually a derived number and does not really mean anything about what the business is “worth.”

Author: Bradley Feld

Classic How To: Set Up A Venture Fund

Generally, the first step in setting up a venture fund is finding a lawyer to prepare your legal documents. Your lawyer will help you decide a number of items. You will generally save some time and money by thinking about these issues before meeting with your lawyer.


Most venture capital funds are structured as limited partnerships. Limited partnerships generally have two types of investors: limited partners and a general partner. Limited partners are generally non-active investors who commit to invest a fixed amount of money to the fund (capital commitment) in exchange for a pro-rata share of the economics of the fund (e.g. proceeds from sales, dividend income, interest income). The liability of each limited partner is limited to his/her/its commitment to the fund. Fund’s generally have one general partner. The job of the general partner is to manage the fund’s investments. Generally, a general partner will make a capital commitment of one percent of the commitments of all partners. For example, if the limited partners were to commit $99 million to a fund, the general partner would commit $1 million.

I have seen funds that are structured as LLC’s and Small Business Investment Companies (SBICs) as well as Business Development Companies. You should speak with your lawyer about the pros and cons of each structure.


Generally the general partner gets paid in two ways:

Management Fee – The general partner (generally through its affiliate, the management company) receives an annual management fee equal to two to two-and-half percent of committed capital. For example, if the fund had total commitments of $100 million and a two percent managment fee, the fund would pay the management company $2 million per year. The management fee is intended to cover the operating costs of the management company including investment personnel salaries, rent, utilities, etc…

Carry – The general partner generally receives 20% of the profits of a fund. The general idea is that if the fund is profitable, the general partner will receive a reward. For example, if a fund was able to pay $200 million in distributions to investors who contributed $100 million, 20% of the $100 million gain ($200 million in distributions – $100 million in contributions) or $20 million would go to the general partner.

Some funds will have hurdle rates that require the fund pay back not only the contributions of the limited partners but also provide them with some return on their investment (e.g. 8% per year) before a carry allocation is paid.

Other expenses 

Some other expenses that are not related to the management company are as follows:

Audit and Tax Fees – These are the amounts paid to an outside CPA firm to have the fund audited and tax forms (referred to as schedule k-1’s) prepared. (Side note: Limited partnerships are passthrough entities for tax purposes meaning the income and expenses are passed on to the partners. The Schedule k-1’s tell each partner how much he or she owes.)

Due Diligence Expenses – These are out of pocket expenses for travel and advice that the employees and members of the management company or general partner incur when looking at companies to invest in.

Legal Fees – These are the legal fees incurred by the fund.

Organizational and Syndication Costs – These are the costs related to structuring a fund including legal costs and the costs of recruiting limited partners to invest in the fund.

Legal Documents

The lawyers usually prepare three main legal documents for a fund:

Partnership Agreement – This agreement spells out all of the operational rules of the partnership. It would include the formulas for calculating the carry and the management fees. It would also detail limitations in the amounts and types of investments that the general partner is allowed to make.

Offering Document (Private Placement Memo) – This is the marketing document for the fund. Unlike mutual funds which are heavily regulated, venture funds are generally not registed. In exchange for the lack of regulatory burden, venture funds must avoid marketing in general. Venture Funds are allowed to put together private placement memos which are designed to provide a potential investor with all of the information that such investor may require including explanations of the fund structure, its strategy and management.

Subscription Documents – These are the documents an investor must fill out in order to invest in the fund. It includes personal information including contact information and tax identification numbers. It also includes the investors commitment amount. It includes a questionaire designed to determine whether or not the investor is qualified to invest in the fund.

It is important that you hire lawyers with fund knowledge and experience to get this document right.

Source: Wiki,  Author unknown.

Venture Capital Risk Models

VC expects Equity Participation through the use of Stock Ownership, Warrants, Options and Convertible Securities/ Debt.

Venture Capital Risk Models

Venture capital wants to balance control with the amount of investment risk in a deal. Here are two ways VC firms asses and determine investment risk.

The Risk / Return Evaluation

– At the Product or Service Level:

  • Level 1:  Idea Stage.  Not Operable.  Market Assumptions.
  • Level 2:  Pilot/ Test Stage.  Market refined.
  • Level 3:  Fully Developed.  Few Customers.  Market defined.
  • Level 4:  Satisfied Customers.  Market Established.

– At the Management Level:

  • Level 1:  Entrepreneur.
  • Level 2:  Few Founders.
  • Level 3:  Partial Management Team.
  • Level 4:  Full Management Team.  Highly Experienced.

Note: The higher the Level from both Determinants (Product or Service & Management), the less Risk for a higher Return.  4/4 would be most desirable and cost the Entrepreneur the least.  1/1 would be the least desirable and cost the Entrepreneur the most.  A 2/2 or 3/3 are good Level Combinations to shoot for prior to approaching Venture Capital if financially viable.

The Present Value / Future Value Evaluation

– Scenario: Expected ROI is 35% per year, without inflation, over 5 years.  Present Value of Earnings is $4.5M.  Future Value Earnings in 5 years is $15M.

  • VC Equity Share is calculated:  $4.5M divided by $15M = 30%.
  • Maximum Investment is 10 times first year gross (expected) earnings, which in this example is about $500,000.
  • Conclusions: $5M maximum investment for 30% of the Company at 3/3 Level over a 3 year period.  A 1/1 Level, Seed/Start Up Investment would be a 45-50% Equity Stake, with an expected ROI of 60%.

Venture Capital Objectives

It is important to research your potential Venture Capital Funds to determine exactly what they look for in an investment, what their parameters are and what they specialize in.  A VC Fund will have a detailed website which will layout their Fund’s Objectives.  You can also find this information in their Offering Prospectus/ Memorandum to their Investors.  Below is an outline of a VC firm’s Objectives to give you an idea what to look for.

Investment Objectives

  • Rate of Return expectations.
  • Long- term or short- term capital appreciation.
  • Early, Middle or Late Stage Companies.
  • Sectors interested in.
  • High growth potential.
  • Liquidity Options.
  • Expertise, Experience & Reputation of the Fund.
  • Advisory Board Members.
  • Members of the Fund.

Investment Criteria

  • Evaluate in terms of Management, Product, Markets, Financials, and Business Stage.
  • Highly competent and motivated management team.
  • Proprietary Product or service that:  meets a strong market need:  Favorable price and cost relationship.
  • A market which has a favorable mix of Size, Growth, Competitive Barriers and the potential for high volume sales.
  • Management:
  • People are the most important component in a Company’s success
  • Balanced Team
  • Superior Skills
  • Team leader with a track record
  • Ability to keep on and attract talent
  • Understands Planning & Control
  • Can make difficult decisions
  • Can work with professional advisors
  • Accept assistance from the Fund Members
  • Commitment to the Venture
  • Clearly understands the Funds’ outlook on liquidity, rate of return and investment objectives.
  • Above all, integrity, character, accountability and high business ethics

Product or Service

  • Types of Products and Services in the Fund’s Sectors which are of interest.
  • Competitive Edge:  Cost, Quality & Performance.
  • Premium prices achievable?
  • High Yield Profit Margins.
  • Dominate or Control a significant market share.


  • Young, growing fast and provides opportunity
  • Defined market niche.
  • Dominance in that niche.
  • Niche market should be small enough not to attract big company competitors, yet has a strong potential for expansion.
  • Realistic Marketing Plan.
  • Marketing Team Leaders should have broad industry contacts with sales people, sales reps and distributors.

Financial Outlook

(these are some example numbers that are based on a technology company)

  • $20M in Sales & Earnings, after taxes, within 5 years.  Generate Return on Assets greater than 20%.
  • Venture is not capital intensive.
  • Project prices & profit margins that can cushion early round obstacles.
  • Reaching Break Even in 2 years.
  • If it is a capital intensive deal, should be capable of adding substantial value early on and attract later rounds of financing at higher pricing.
  • Maximum of 10 to 1 return on investment for startups.
  • Liquidity in 5 years for startups.
  • Later stage companies: ROI of 5 to 1 in 5 years or 3 to 1 in 3 years.


  • Mostly early stage but will consider later stage with high growth opportunities.
  • Consider small public companies as well as private.
  • Spin offs as a result of re-structuring and rejuvenation.

Operating Policies

  • Can change at the fund’s discretion
  • Geography:
  • Any geographic area but most companies are in the West and Silicon Valley, China, Taiwan and Singapore.
  • Monitoring Investments:
  • Free access to management
  • Fund receives Business Plan updates regularly
  • Fund will not seek majority ownership or run the venture
  • Help the venture attract Management to fill gaps and develop its business plan in the early stages of investment
  • Board Representation
  • Fund will provide expertise and assistance with securing key employees, filling management gaps, operational planning, key customer and supplier relationships, joint ventures, financing, security offerings, acquisitions and harvest strategies

Source here …

Numbers: startup deals in Brazil vs VC investment deals in the U.S. 2012

Croudsourced compilation of Brazilian  investments in startups by Diego Gomes (Everwrite) Startup Dealbook Brazil data shows number of deals last year to previous year  increased 346%.

In Brazil 50 deals officially announced by the end of 2012/07.  Total sum of USD 258,54 m ( USD 130,3 m and BRL 259,6 m (USD 128,24 m)) invested in 12 deals and 38 deals investment amount undisclosed.

In the second quarter of 2012 according to NVCA & PwC MoneyTree Report  venture capitalists in the United States  invested $7.0 billion in 898 deals.

Cambridge Associates: U.S. Venture Capital Index and Benchmark Statistics

U.S. Venture Capital

  • Fund Index Analysis
  • Fund Since Inception Analysis
  • Company Analysis

Venture Capital Index

Cambridge Associates U.S. Private Equity and Venture Capital Benchmark Commentary Quarter Ending June 30, 2012

Second Quarter 2012 Highlights:

  •  As of June 30, 2012, the private equity benchmark outperformed indices tracking large and small public companies in six of the nine time horizons listed in the table above with the exceptions being the year-to-date, one-year, and three-year periods ended June 30, 2012. For two of those time periods, the one-year and three year horizons, the results were mixed against the public markets. Similarly, the venture capital index beat out the public markets in six of the nine time periods, with shortfalls in the year-to-date, three-year, and ten-year time horizons. The recent mixed performance of the private equity and venture capital indices relative to the public markets is worth monitoring. Over the ten-year period, the venture index’s performance against public equities was mixed. It equaled the S&P 500 but trailed the small company index, the Russell 2000, and the technology heavy NASDAQ Composite.
  • The ten-year return for the venture capital index has improved as the poor performance from the technology bust starting in 2000 gets removed from the ten-year calculation. In the first quarter of 2012, the ten-year return hit its highest mark since September 30, 2009 when it was 6.7%. Since bottoming out at -4.6% during the third quarter of 2010, the ten-year return has risen 9.9%.
  • The spread between the private equity and venture capital ten-year returns stood at 7.5% as of the second quarter, down from 12.7% when the venture index hit its nadir in the third quarter 2010.
  • As of June 30, 2012, public companies accounted for about 20.7% of the private equity index, a decrease of nearly 2.0% from the first quarter. Public company representation in the venture capital index dropped to 17.0% from about 21.8% last quarter. Non-U.S. company exposures in the private equity and venture capital indices remained about the same as they were during the prior three quarters, 18.8% in the private equity benchmark and approximately 9.6% in the venture index

Second Quarter 2012 USPE and VC Benchmark Commentary

NESTA and BBAA Siding with the Angels Report 2009

Siding with the Angels Report was published by the National Endowment for Science, Technology and the Arts (NESTA) and the British Business Angels Association (BBAA) in May 2009. It analyse 1,080 angel investments made between 1998 and 2008, and shows an overall internal rate of return (IRR) of 22%. Full Report 21 – Business Angel Inv v11.

Preqin Special Report: Venture Capital 2012

Preqin Special Report: Venture Capital draws exclusively on the following sources of information:Venture Deals Analyst – The most extensive, detailed source of information on venture capital deals in the world.
This comprehensive product contains in-depth data for over 21,000 venture capital transactions across the globe and comprehensive portfolios for the top 50 VC firms. Deal profiles include information on value, buyers, sellers, financing, financial and legal advisors, exit details and more.
Investor Intelligence – The most comprehensive database of current and potential institutional investors in private equity, featuring in-depth profiles of more than 4,000 actively investing LPs, and over 1,000 that have put their investments on
hold, including investment preferences, future plans, key contact details and more.
Funds in Market – This constantly updated resource includes details for 1,850 funds of all types being raised worldwide, with key information on strategy, target sizes, interim closes, placement agents, lawyers, and LPs.
Fund Manager Profiles – With detailed profiles for over 6,250 GPs, including key strategic and investment preferences, Fund Manager Profiles is the foremost source of data on private equity and venture capital fund managers worldwide.

Performance Analyst – The industry’s most extensive and transparent source of net-to-LP private equity fund performance, with full metrics for over 5,800 named vehicles. In terms of capital raised, Performance Analyst contains data for over 70% of all funds raised historically.


Ernst & Young: Globalizing Venture Capital. Global Venture Capital Insights And Trends Report 2011

Amid the fragile economic recovery and highly volatile capital markets of 2011, the venture capital (VC) sector is becoming increasingly globalized. A shift toward the emerging markets
can be seen in geographic VC patterns and the growth of new global VC hotbeds. Although the United States will likely remain at the leading edge of VC-backed innovation for many years to come, US VC fund-raising continues its decade-long decline.
Elsewhere, in China, India and other emerging markets, vibrant innovation hotbeds and entrepreneurial talents are arising, and investors are focused on less risky, later-stage deals, at least for now.
Although unrealistic valuations may dampen future returns, China’s VC industry reached record heights in 2011 and will soon surpass Europe as the second-largest venture hub for
fund-raising in the world. Both China’s and India’s strong VC industries are expected to continue their rapid growth and development as they capitalize on strong GDP growth,
growing domestic consumption and a dynamic entrepreneurial ecosystem. At the same time, due to Europe’s sovereign debt crisis and its muted medium-term growth potential, Europe’s VC industry has lost some of its robustness.
Globally, companies are staying private longer, due to large corporations seeking proven business models prior to an acquisition and investors that prefer companies with a proven profitability path both before and after the IPO. As angel investors have become major investors in early-stage start-ups, particularly in the US, the competition has nudged VCs toward later-stage, high-growth ventures.
Broadly speaking, the more mature VC markets of the US and Europe favor earlier–stage investments, while the emerging markets of China and India generally prefer later-stage
companies. In China and India, IPOs represent the vast majority of exits for VC-backed companies. But in the US, Europe and Israel, the main exit route for VC-backed companies is
acquisitions (M&A), representing more than 90% of all exits.
Furthermore, VC fi rms are also selling companies to private equity fi rms as a third path to liquidity.
Contrary to the popular perception that global VC investment has been concentrated primarily in the frothy digital media sector, VC funding has been quite evenly spread across sectors and life-cycle stages and has progressed at a reasonable pace.
Worldwide, the VC universe continues to shrink as limited partners focus on top performers or forego VC altogether.
However, the sector’s continued long-term consolidation is viewed as good for the sector, with fewer players investing smaller amounts in companies that will reach profitability faster
than they do today. Large corporations striving to maintain market leadership are partnering with VC fi rms to access external innovation and a pipeline of new products and services.

This report explores these themes in articles and interviews, including:

• Interviews with top VC investors and entrepreneurs from
around the globe
• “Paradigm shifts in venture capital,” our keynote article with
insights on VC investment, IPO, M&A and valuations, based on
data from 2005 to 2011
• Key trends in the global digital media and biotechnology
sectors and from global corporate venturing
• An in-depth analysis of the key global VC hotbeds of the US,
China, Europe, India and Israel