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Fred Wilson from Union Square Ventures makes several great points in his posts on the Venture Capital math problem. (As you may remember, we were fortunate enough to have 2 members of USV speak during entrepreneur week: Albert Wenger and Andrew Parker)

But instead of rehashing how the venture capital model needs fixing, I thought it would be interesting to use the data to shed light into how an venture funds are set up and the financial metrics that drive equity  investments.

First lets talk about how a venture fund works:

Venture funds make investments into illiquid and risky investments with expectation of high returns over the long term.  Most funds are organized as limited partnerships in which the venture capital firm acts as the general partner (GP) and investment advisor and the investors serve as limited partners or (LPs).

The General Partner

The general partner is the person or entity that has control over management  (running day to day operations) and investment decision. Usually the GP is organized as an entity such as an LLC, in order to shield the individuals who are making investment decision from personal liability associated with acting as GPs.

General partners can compensated by the fund in several ways. The most common is though a management fee which can be a percentage of the value of the fund at the end of a relevant period or straight percentage on the paid in capital--usually 2%. Moreover, the GP is entitled to a percentage of the overall profits from a fund at some point in the future, such as when a liquidity event occurs or when the fund closes.  This is called carried interest and is usually 20%.  "2 and 20" is how this is commonly referred, where 2% represents the management fee and 20% represents the carried interest.

Often the 20% carried interest has a limitation: It is only allocated if the funds value exceeds a certain amount. This prevents the GP from receiving payment if the fund suffered a loss. VCs who are members of the LLC which serves as the GP are therefore doubly careful about the investment decision they make. Not only do they want to wisely invest the money of their investors, but want to make investments that maximize profits of their fund, so they can participate in the upside at the funds close.

The Limited partners

Limited partners are usually institutional investors or HNW individuals. Fund investors can be employee benefit plans, insurance companies, banks, pension plans, university endowments, family offices, trusts among others.  Limited partners cannot participate in the management of the fund without exposing themselves to personal liability and generally are prohibited from transferring their interests in the fund without consent of the general partner.

Lifespan and Capital calls

Venture funds usually are organized so that they have a life span between seven and ten years. Generally investors are not required to invest 100 percent of their capital in the initial closing of the fundraising round. Instead capital will be dispersed to the fund by investors on a pre-determined basis or when investments are made by the fund. The latter is known as a 'capital call' Many partnership agreements have penalties if LPs fail to meet their calls on a timely basis which can range from loss of rights to participate or exclusion from the funds profits going forward.

Economics

Because LPs typically make investments into high risk illiquid securities, they are looking for significant returns on their investments to compensate them for the increased risk. Fred Wilson does the math in his blog:

At a bare minimum

an investment needs to generate 2.5x net of fees and carry to the investors to deliver a decent return. Fees and carry bump that number to 3x gross returns.

So a 5 million dollar investment needs to generate 15MM in returns.

Looking at how much of a company a single VC owns at exit is next.

The number bandied about by most VCs is 20%. That means that each VC investor owns, on average 20% of each portfolio company. We'll use that number but to be honest I think it's lower, like 15% which makes the math even tougher.

Using the 20% number, a 5MM investment must generate 75MM (or 25X) at a minimum in order to make it worthwhile for the venture capital firm to satisfy the risk appetite of its limited partners.

As you can see VCs have to take into account the size of the potential market, and the probability of generating significant returns on their investment, not because they are greedy, but because of the metrics of success they need to meet in order run their own VIABLE businesses.

Do you agree or disagree? We'd love to hear your thoughts in the comments below.

--Jeevan Padiyar