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    Understanding How VCs Think

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    Korp Consulting

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    Understanding How VCs Think

    Uploaded by

    Korp Consulting
    6 views16 pages

    Original Title

    Understanding how VCs think

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    6 views16 pages

    Understanding How VCs Think

    Uploaded by

    Korp Consulting

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    © All Rights Reserved
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    Understanding how VCs think

    (The Math behind Venture Capital)

    Guhesh Ramanathan
    Typical VC Firm structure
    Role: Investors

    • Investors (also called Limited Partners or LPs) are typically large family o ces,
    or pension funds that have signi cant capital to deploy.

    • Typically, they park their available capital across di erent asset classes
    (bonds, listed equity, real estate, and venture capital)

    • VC component is the riskiest, but o ers highest potential return


    • Typically 2-5% of the overall available capital.
    fi
    ff
    ff
    ffi
    Role: GP (Or General Partners)

    • Manage the fund management company (typically an LLP) as well as the fund
    • Obtain “commits” from the LPs, in exchange for a promised return
    • Assisted by analysts, EIRs and other “mentors”; salaried
    • Manage the operations of the fund through a “fund management fee” which is
    meant to meet ALL operating expenses (salaries, rent, electricity, travel,
    entertainment …. )

    • GPs also earn a “carry” when the exit in an investment happens.


    The 2 - 20 “Rule”

    • A VC rm takes 2% as management fee per year. Thus, for a $100 Million, 10


    year fund, they use up to $2M per year for operations (overall $20M).

    • This leaves a total “investible” capital of $80M.


    • They can earn a “carry” of 20% if, and ONLY if, they exceed the returns
    demanded by the LPs.

    • A typical return demanded by LPs? About 12% PA.


    fi
    Now for the Math

    Assumptions:

    - 10 year period for fun


    - Annual return of 12% for LP
    - Fund size: $100M

    Remember Pareto (80:20)?

    80% of your returns will come from 20% of your companies.

    A more common scenario:


    Now make your investments

    Assume:

    • You make 10 investments (across Seed, Series A and Series B); all equal
    • $8 M each (spread across Seed, A and B rounds)
    • Why not $10 M? (Remember your management fee of 2%!)
    • At exit stage, you hold 25% in each company
    Scenario 1
    All exit at an average of $50M

    Return

    - 10X12.5 = $125
    - No where near $310M
    s

    Scenario 2
    5 exit at $50M, 5 at $100M

    Return

    - 5*12.5M + 5*25M =
    $187.5
    - Still no where near
    $310M
    s

    Scenario 3
    Throw in an over achiever

    Return

    - Added up .. $287.5
    - Almost there!
    s

    Scenario 4
    We NEED a Unicorn!

    Return

    - Finally: $362.5
    - But is this REALISTIC?
    s

    The Reality
    5 fail, 3 small exits, 1 medium exit and 1 large exit

    Return

    - $318
    - How many funds can
    you think of who
    actually did this?
    M

    How VCs think …


    What do I do to reduce the risk for my investment?

    • Development Risk
    • Market Risk
    • Execution Risk
    • Finance Risk
    And hence the focus:
    5 Ts you should remember

    • Team: Is the team cohesive, capable of execution?


    • TAM: Is the total addressable market really, really huge?
    • Technology: Is this something that can be leveraged, and used to scale?
    • Traction: What is the company showing now? Rapidly growing?
    • Trenches: What are the defensive positions that the company has?
    Questions?

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