How VCs make money, and why you should know

Every VC has their own particular tastes when it comes to investing: the sector, the stage, b2b vs b2c, geographical focus and the colour of the founder’s hair. But there is one commonality that governs all: how we make money. Understanding this is key to raising money from VCs, but too oft’ founders are ignorant to the fundamentals.

Introducing the Power Law, and the theory of exponential growth.

Quickly though before we get stuck in, a VC fund is essentially a pool of money committed by limited partners (LPs) which the VC invests in a variety of companies. A small percentage of that money is taken as a management fee by the VC to cover costs, and then we keep a percentage of any gains made by the fund. Generally this is a 2-and-20 rule: 2% management fee and 20% of the gains.

Anyway, back to the good stuff.

The Power Law governs that the best investment ends up being worth the rest of the fund combined; and the second best investment is worth as much as number three through the rest, and so on. Basically, those investments that succeed do so on an exponential hockey stick curve similar to the one you’ve put in your pitch deck.

So we expect one of our investments to return the entire fund. We don’t know which one, but we do need to be confident that each investment we make has the potential to do so. It’s here that founders and VCs have a different perspective as to what constitutes ‘success’.

For a founder, a 1x return is a success: you double your money. But a VC only makes money when the fund as a whole makes money, so success is a company that returns the entire fund.

The Power Law means that we only need one company to succeed, so when we invest we have to be confident that the company has the potential to return big. We’re not looking for a portfolio of 1x companies, we’re looking for that one big winner.

The general rule (we love rules) is 50:30:20. 50% of VC investments return the money we invest, 30% return nothing, and 20% return enough to be considered a success.

What does this mean in practice?

Let’s take an example: a VC fund has £20 million to invest and is expected to provide returns to its LPs in 6-7 years. It invests £1m in 20 companies. One of those companies needs to return the full £20 million (and more if possible). Of course the VC only owns a percentage of the company. So if on exit it holds 10% of the company, the company needs to be worth £200 million; if it owns 5%, £400 million; 1%, £2 billion.  

Now ultimately the VC wants the company to return more than £20 million so that there are some profits for us to divide around, meaning we want even higher valuations than listed above.

Starting to see the picture? Whilst a £50 million exit might seem appealing to you the founder(s), unless this particular VC owns 40% of your company, they can’t count that exit as a success.

Lesson to take away

When pitching to VCs, you need to convince us that in 6-7 years time your company will be worth enough that our percentage share, even after dilution in future rounds, will be large enough to cover all the money we invested across the portfolio, and some.

Eeswaran Navaratnam