Ever wonder why a handful of founders in a select few spaces can seemingly raise massive rounds instantly in any market, while the laws of gravity apply to everyone else?
There are of course many aspects that drive this, but one key underlying factor relates to the magnitude of potential outcome that gets Venture Capitalists excited.
Let's unpack the basic VC calculus, how it is shaping the present fundraising environment, and what founders should do about it. In order to have a successful fundraise, engage with the right investors, and evaluate fundraising choices appropriately, this is critical information for seed and early-stage founders.
Here is the super simplified math. Top VCs are typically looking to return 3-5X+ on their entire fund to their LP investors over ~10 years. For this, they need multiple ‘fund mover’ outcomes in each fund, since many early-stage investments will eventually fail or return only a small % of the fund. A “fund returner” would be an investment that can return an amount to the VC around the size of their entire fund, or more. When VCs make an early-stage investment, they typically want to see some potential of that investment being a fund returner - if a lot of things go right over the next several years.
A typical VC fund may hold 5-20% of the equity of a company at the time of their eventual exit, depending on initial ownership, dilution over time, and follow-on investments. To return the entire fund, an outcome would thus need to be 5 to 20 times the size of the fund - 5 times if they hold 20% at exit, and 20 times if they hold 5%. Further, depending on the capital needs of the business, early investors may also need your company to be able to raise downstream capital from larger investors, which may further increase the magnitude of potential outcomes that they seek. These amounts may vary a bit based on fund strategy, number of investments per fund, entry stage, sector, expected holding time, and some other factors, but you get the directional idea.
Let’s simplify this and call it 5-10X fund size as an outcome size that is needed for an investment to be a fund returner for an early-stage VC.
So if you are pitching to a $100M fund, it is worth knowing that they may want to see potential for a $1B+ outcome, while $1B+ funds may only be truly excited about $5-10B+ outcomes. This can, in some cases, be orders of magnitude more than the 10X return on investment that some assume VCs are looking for. E.g. if you are raising a round at say $15M valuation, then a 10X return may be delivered at a $150-250M outcome (depending on dilution), but that exit will not be a fund returner or even a ‘fund mover’ for either of the fund sizes above. An exit like that is certainly commendable and rare (and potentially a life-changing outcome for the founders), but that’s not the ultimate home run your investors are aspiring for when they invest.
As a case in point, a very popular workplace video-sharing company was recently acquired for nearly a Billion dollars, but many were discussing whether that was a successful exit or not! The company had raised capital from several multi-billion dollar funds, and that is why it was a moot point.
Here is an illustrative chart of the kind of outcomes it might take to excite VCs more unambiguously:
The bar to deliver these fund returners has gotten significantly higher in the current market as valuation multiples and company growth rates have come down. This correlates directly with how the volume of Series A, B, and later rounds from larger funds has gone down dramatically over the past few quarters. Outside of certain types of companies in some spaces, it is much harder for larger funds to see a path to those mega outcomes that can be fund returners for them.
So what should you do with this information?
If you are a founder just starting out, give deep thought to whether institutional VC is the right path for you. There are other ways to build your business. Does the VC path align with your vision, ambition, and the potential of your approach, given this information?
If you do decide to embark on the venture capital path, focus on those firms where the fund size may align better with your current goals and the potential scale that the idea/approach lends itself to. It only makes sense to engage with a VC if you are passionate about building something of the scale that can deliver an outcome that is 5-10X+ their fund size.
Think granularly about how the legos would need to stack up for your company to get to a scale where it can eventually deliver that fund-returning outcome for the prospective investor. What are the larger opportunities that you might pursue after you solve the current problem you are working on? What would the realistic, bottom-up addressable market look like? How would you achieve this while being appropriately capital-efficient and ensuring the company stays funded through various market cycles? Once you have this clarity, communicate that underlying vision in depth when you pitch.
Armed with a clearer understanding of the VC model, you’d be better positioned to find the right partners who believe in your dream as much as you do. So, dream big, stay grounded, and forge ahead.
