Venture Fund Economics
When I write about venture fund returns, there are always comments and questions that lead me to believe that the economics of a venture fund are not well understood. And since most of the readers and commenters on this blog are people who work in the startup ecosystem, I think its important that the economics are better understood. So I am planning on some posts on this topic in the coming weeks.
The first thing I’d like to tackle is how returns are calculated and why the reported returns are often higher than people might think.
Unlike hedge funds or other investments you might be familiar with, venture funds do not call all of the committed capital upfront. If you commit $1mm to a venture fund, you will receive capital calls about once a quarter for anywhere from 3% of your commitment to 10% of your commitment. That is because it takes time for a venture firm to put the money to work and they’d rather leave it in your bank account than have in in their bank account.
And because venture investments are generally made in a number of rounds staged out over a three to six year period, even when the venture firm finds an investment, the amount they invest in the company upfront is a percentage of what they will eventually put to work.
So the money flows into venture funds slowly.
The money also flows out slowly. When a company is sold, the proceeds are distributed. There are some situations when the money is not distributed, but they are not that common and it’s not useful to dwell on them right now. Venture investments require long hold periods, typically five to seven years. So it’s common for a venture fund to have to wait five or six years to make its first distribution. Most venture funds have a ten year life and are often extended a few more years to get all the distributions out.
The low end of acceptable performance for a venture fund is to return two times invested capital to its limited partners (investors). If you put all the money in day one and waited ten years to get 2x back, that wouldn’t be a particularly interesting rate of return. It’s 8% to be exact, not the kind of return an investor would think is acceptable for a ten year illiquid investment.
But if you map out the cash flows that I described in this post, they look something like this:
So, if you invest $1mm into a ten year fund and get back $2mm, you will likely be earning something closer to 13% than 8% just because the $1mm wasn’t tied up in the fund for the entire ten years.
I’d like to make a couple points about this to be clear. First, as I said before, I think getting 2x invested capital back is the absolute low end of acceptable performance in a venture fund and I sure hope and expect we can do better for our investors. But I needed to use a simple number and so I went with 2x.
Second, these cash flows are conservative in my mind. Our 2004 fund has called about 65% of committed capital about four years into its history. This model shows 75% called after four years. So, money can often be called even more slowly than I showed. And waiting for years 8, 9, and 10 to get your distributions is also very conservative. Our 2004 fund returned about 40% of committed capital in its first three years which is likely to happen when you get some companies sold early on in their development. And we are seeing more of that kind of thing these days.
If you model capital being called over a slower pace and distributions coming back earlier, you could theoretically get to annual returns of over 40% for a fund that only delivers 2x on committed capital.
Of course, annual rates of return are not the only measure that investors look for in a fund. They want to get the highest absolute returns they can get. And 2x is just not that exciting. I think 3x or better is what it takes to deliver top tier performance in the venture capital business and that’s what we shoot for.
I’ll post tomorrow a bit more on the 2x vs 3x issue. It’s something I am constantly thinking about.
Hmm… where are the management fees and carried interest? A 2x return over 10 years wouldn’t even get you fixed-income like returns with the fees being included.
All of these numbers are assumed to be net of fees and carryI am sorry I wasn’t more clear about thatfred
i’d love to see you explicitly show/factor in the management fees and carry, and i think your readership will really benefit from understanding that critical component of the businessto wit – for the theoretical you use, the fund presumably did much much better than one would gather looking at the numbers as presented (because 14%-20% of the funds capital went to management fees plus a bunch to carry (depending on how the carry fees are calculated)so the fees are so huge (arguably venture and private equity charge the biggest fees of any investment vehicle, period) that performance has to be truly outstanding to also give LPs satisfactory returns. a point not made clear by simply assuming fees paid beforehand
Well many funds recycle funds to cover the mgmt fees so they are paid for out of additional investments. That’s the nuance I mentioned about not always distributing proceedsI will work on a model that shows all of thisFred
Based on the “Our 2004 fund returned about 40% of committed capital in its first three years” comment, does that mean that those investors made the 2x-3x return? Or they got a limited return because their investment was only for a few years? Just curious. Looking forward to the rest of the posts.
It’s too early to say what the returns on the 2004 fund will be, but getting40% back early on (when they had about the same amount invested) is a verygood thing in a venture fund. It really helps the returns
Think the fees argument is the most pernicious. I still slave away to feed to mortgage and part in parcel as i (and no-one else) was foolish enough to invest in a passel of 1999-era mega funds (well, “side funds”), all of which certainly paid out huge for the GPs, and none of which has returned (10 years on, so no chance now) anywhere above 80% of the money. Not an 80% return…. I’m talking not a return of capital. Now add in the 2.5% (or more) per annum on the WHOLE amount (not just as drawn as used) from day one, and wonder where the money goes for a $400MM-$3BB fund typical in the waning days of a bubble? The model works, and works well, but avarice wins at the bubbles.
Fascinating stuff- and complex! The standard line one hears about whether a company may be venture-fundable is whether it has the ability to return 5-10x the investment, so the focus on 2-3x for the fund as a whole is quite interesting.I suppose as an investor one needs to shoot for 5-10x in individual investments, knowing that many may fall short and the net may be 2-3x for the fund as a whole. it would be great to hear how these two performance criteria (individual company returns vs. overall fund performance) work together- or don’t- and how they affect the way you think about your portfolio and the companies to work with.
jay – i’ve talked about that in the past. i’ll see if i can find the specific posts. but my rule of thumb is 1/3, 1/3, 1/3 – meaning at 1/3 of the investments you lose money on, most often everything, 1/3 you get your money back to a double, and only 1/3 of the investments pay off, generally on average of 4-5x. if you take the weighted average of that, you’ll get 1.5 to 2x on your money. but most VCs realize their losses early and are able to invest more of the fund in the winners, so that helps get above 2x and hopefully 3x. more on this tomorrow.
How often do investors not answer the call for additional funds and what happens then? What if an investor called you today and said “I’m good for the next 10% or six months but beyond that I’m not so sure.” (Yes, the answer probably depends on the age of the fund.)Do you call from all investors the same way? What if an investor asked you to take (most of) their money earlier or later?
yes, you call all investors the same way and they have no choice to meet the callif they do not, they often lose their entire investment. it’s very punitive.i do not believe our fund is quite that punitive, but the penalty for not meeting a capital is always very harsh.
“most VCs realize their losses early and are able to invest more of the fund in the winners, so that helps get above 2x and hopefully 3x. more on this tomorrow”Big impact of cutting your losers early and letting your winners run – was going to be my comment.One other thing I have been wondering: if in venture (rarely elsewhere) historical performance is a good indication of future returns, then this industry should tend towards consolidation. Yet I’ve always thought that venture “scales badly”, i.e. you can’t really leverage a partner with a “pyramid” as you can in fee-driven services or even other asset management sectors. So will top tier VC migrate naturally toward very large funds (no doubt helped by the implication of higher fees)? What does such size mean for the stability of partnerships? What does it mean for the structure of early stage (there are a much larger number of new funds addressing the angel-VC equity gap in the US than in Europe)?
venture does scale badly and early stage venture requires fairly small fund sizes so when the best firms scale up and move toward later stage investing, it’s generally not a good thing for their LPs. some firms have made the transition work but many have not.
Half the time when we talk to investors, we have to explain Internal Rate of Return, which is more or less the only way to correctly calculate the type of return you describe (partial outflows and inflows over time of a varying amount). Everybody wants to apply the Rule of 72 because it’s relatively easy, but in a case like this (or a case like our project), the low number which results from that method is simply wrong…
wow- this IRR math point is such an interesting point that few folks would ever notice unless they’ve been an LP (and even then might not know).It’s also notable to contrast that the capital call and distro schedules are in sharp contrast with the more predictable annual mgt fee (often 2% of total fund size, as in a 2/20 fund: 2% mgt fee, 20% carry).Fred, just a thought: from the comments so far, even though you’ve made it clear that this will be a series on this topic, might help to write the basic high level “101” chapters first, and then dig into nuances like I think this post highlights. Otherwise, we’ll get a ton of jumping ahead comments, which is already happening. Or if you don’t feel like reciting Gompers and Lerner from scratch, might just say, “OK if you wanna understand this series, go read [resources here] first”…
Thanks for the insight Fred. Very useful information.
Paul Margolis (Longworth Ventures) did a post on venture economics a while back that is pretty eye opening.http://www.longworthblog.co…According to Paul, a 2x (gross) return would put a firm in the basement. A top quartile fund returns over 4x. That’s a tall task, particularly for the big funds.
wow, that’s a great post and very on target in his conclusions.however, i am not talking gross returns, i am talking net returns in this post, so 2x gross would be pretty bad because fees and carry would cut that down to below 1.5x net to LPs. and 4x gross nets to about 3x to the LPs which is what we target.
This is an important point.Venture Xpert etc have no way of measuring net returns, they can only look at a money invested vs. exit volume multiple. This is highly misleading. It ignores transaction costs (lawyers, bankers, etc), the shares that goes to founders and management, and it ignores management fees and carry. I have put together a quick spreadsheet that includes the costs here:http://jenslapinski.wordpre…Would love to hear your view on this.
Here’s what I wrote this morninghttp://avc.blogs.com/a_vc/2…
Interesting post Fred. Thanks.But one thing that I’ve always wondered about is, why do people write $1million as ‘$1mm’ instead of ‘$1m’ ? It doesn’t make sense, especially as ‘million’ only has one ‘m’. 😉
It’s a habit of mineMaybe a bad oneI’ve been doing it since I was taught to do that by the first venture firm Iworked for in 1986
😉 thanks. I’ve seen it elsewhere too. Thanks for clearing that up. Always seemed odd.
I believe that $1MM comes from the practice of using “M” to stand for 1,000. That’s why we use the term “CPM” for cost per thousand.My guess is that “M” actually comes from the Roman numeral.
which pisses me off since I am an Engineer and have become use to using “K” to describe measures of 1,000 …..yes the “M” likely comes from the roman numerals….as in engineering “M” is mega or million….so I wince every time I see “CPM” 😉
I think it’s because M stands for a thousand, so MM is a thosand times a thousand
in roman numerals I meant to say
Interesting. I actually have a degree in Economics but my course in Corporate Finance was only one quarter long (10 weeks!). We spent most of our time on International Development and zip on Personal Finance. Lots of macro, almost no micro beyond Accounting. So, I’ll be interested in reading your series. I’m still basically a Marxist but it helps to know the other side ; ) . A Marxist who uses smiley faces (you’re looking for diversity, right?).
Very useful and illuminating post.I am not a VC so am not sure the standard practice, but it seems to me that while, far from being completely scientific and predictable, a VC firm could (potentially) model well potential rates of return from an investment with a well developed (and finely tuned) (set of) algorithms that take into consideration, among other factors, current and historical returns in that sector, types of exit(s) available and predicted, predicted strength of team and operations, market opportunity filtered by assessed competence relative to competitors etc.Not to say that investing isn’t also an art, but in any complex phenomenon being able to quantify into (accurate) predictivfe models is important.Techmeme is used because it distills what is important/popular with readers, and people argue about how well and accurately it does this.EFFECTIVE ALGORITHMS SEPARATE VALUE FROM NOISE. One thing that they do not inherently do, however, is integrate vision and disruption, those types of variables – highly important – need to be included as well.
Theoretically, such algorithms can be devised via reverse-engineering. You look at the ROI results of your or others investments, and then you work to identify and quantify the contributing elements to that result. You keep tweaking the algorithm until it best fits (predicts) the result. Then you move on to other results to see whether the algorithm just created also (best) predicts this other result, whether it needs to be further modified, or whether this new result requires its own separate (but perhaps related) alogorithm
Fred, if the LPs can be called to make capital contributions on short notice, or at least must have the money liquid to live up to their commitment to the fund, would they not have to have such funds in low-return liquid vehicles which would lower their total return for the money over the time frame even if the VC is using the capital productively while in its possession?
…you will likely be earning something closer to 13% than 8% just because the $1mm wasn’t tied up in the fund for the entire ten years.Yeah but… Since that capital is contractually committed, wouldn’t a prudent investor put the money somewhere safe like treasury bills in the interim? Or is there no penalty if that money gets blown away in a riskier investment and, therefore, the investor declines to meet your capital call?If you assume they keep it somewhere safe, then I don’t think it’s a sound argument for you to assume returns will be higher. Likely they are the same or lower, esp on a risk-adjusted basis.
Fred / Disqus Team:I clicked through to this original post to follow the link from today’s post. It seems that all but 2 comments have disappeared. Seems to be a consistent situation in other posts. Thought I’d give you the heads up that comments aren’t showing up in Disqus, although the current post seems to be OK.
ThanksIt was caused when I changed my domain to avc.comWhen I saw it I realized what happened and fixed itThanksfred
As a participant in a fund of fund, vintage 2000, I would be delighted to get to 2x at the end of 2010. Another factor that is not mentioned is that at some point the distributions are used to fulfill the cash calls so while you are contractually bound, by pretty severe terms, for the full amount most performing funds will stop taking your money after 4-6 years.
Although the VC investor doesn’t relinquish all of the committed cash up front, but instead distributes it over a series of capital calls over several years, shouldn’t the investor consider the opportunity cost that results from the liquidity requirements of this commitment when measuring return?
Thanks, FredI have a couple of questions:1. What happens to private shares at the end of a fund’s life? I assume they get distributed, correct? How would this impact the carry? Are they at all counted in calculating the carry? Can you reallocate your distribution, where for example you take out your carry only as cash/public shares and stick the LPs with all the private shares? That would really suck for the LPs. This issue is probably very relevant in today’s “scarce exits” environment.2. How are the LP’s protected from fund managers that optimize the risk profile of the fund towards their own interests. Here is a hypothetical example: you have a venture fund (let’s call it hypothetically OVP) that is way underwater. They get a buyout offer for a portfolio company of $100M, which would still keep them underwater (no carry either way). The GP’s interests are to hold out for a better deal, say $500M, even though it is very unlikely, which would put the fund in the black and allow them to collect some carry. The chances of the company being bought for $500M are super-small, but since there is no downside for the manager, their incentive is to hold out for this lottery shot. On the other hand the LPs would like to at least get some of their money back. What are their recourses?Thanks again for this series!
The answer to the first question is ³it depends². There are secondary sharebuyers who often will pay cash for the remaining illiquid shares in aventure portfolio and I believe that is the best way to liquidate a fund.But yes, LPs sometimes do get illiquid stock. It’s not a good idea in mymind though.The answer to the second question is that will only work once. If you dothat, you’ll never raise another fund from LPs. It’s a small world andreputations last a long time.
Do you ever get pressure from LPs who would like their money put to work sooner? Since they have to invest it productively until you make a capital call
Yes but its not the IRR/idle cash issue. Its that they want to get their money to work to meet their allocation targets
If the management fees are calculated on committed capital, but it is not yet called don’t you end up with a disproportionate share of money going to the fund managers early relative to investments?Thanks
Yes you doThe theory is it takes a lot of work to source and close the investments. I’m not sure I buy that argument but that’s how its done
I rank this and the follow up post as the #3 VC posts of All-Time. Thank you, Fred!!http://vc-brazil.com/blog/2…