{"id":18264,"date":"2017-03-28T17:19:22","date_gmt":"2017-03-28T17:19:22","guid":{"rendered":"http:\/\/www.michaeldempsey.me\/?p=18264"},"modified":"2019-11-30T21:22:51","modified_gmt":"2019-11-30T21:22:51","slug":"why-your-startup-idea-isnt-big-enough-for-some-vcs-return-the-fund-analysis","status":"publish","type":"post","link":"https:\/\/www.michaeldempsey.me\/blog\/2017\/03\/28\/why-your-startup-idea-isnt-big-enough-for-some-vcs-return-the-fund-analysis\/","title":{"rendered":"Why your startup idea isn\u2019t big enough for some VCs"},"content":{"rendered":"<section class=\"section section--body section--first\">\n<div class=\"section-content\">\n<div class=\"section-inner sectionLayout--insetColumn\">\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignleft size-full wp-image-18282\" src=\"https:\/\/www.michaeldempsey.me\/blog\/wp-content\/uploads\/2017\/03\/startupideachart.png\" alt=\"\" width=\"500\" height=\"290\" \/><\/p>\n<p id=\"4922\" class=\"graf graf--p graf-after--figure\"><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"1f65f02da15c\"><img loading=\"lazy\" decoding=\"async\" class=\"aligncenter\" src=\"https:\/\/miro.medium.com\/max\/900\/1*JqBTfVZNdkwuGo1m4NwYuA.png\" width=\"515\" height=\"299\" \/>Venture Capital functions with a power law where the majority of a fund\u2019s returns come from a small percentage of investment<\/span>s. <strong class=\"markup--strong markup--p-strong\">Because of this, VCs need to know if a single investment can return the entire fund. <\/strong><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"2764cd320c5\">As Bill Gurley famously said <\/span><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"2764cd320c5 81ae626cb2\">\u201c<\/span><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"2764cd320c5 81ae626cb2 207c112d3d3a a1343f6ec680 c29ab517449a\">Venture capital is not even a home run business. It\u2019s a grand slam business<\/span><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"2764cd320c5 207c112d3d3a a1343f6ec680 c29ab517449a\">.<\/span><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"2764cd320c5 a1343f6ec680 c29ab517449a\">\u201d<\/span> This is where the <strong class=\"markup--strong markup--p-strong\">Return The Fund (RTF) analysis<\/strong> comes into play.<\/p>\n<figure id=\"1d90\" class=\"graf graf--figure graf--layoutOutsetLeft graf-after--p\" data-scroll=\"native\">\n<div class=\"aspectRatioPlaceholder is-locked\">\n<div class=\"progressiveMedia js-progressiveMedia graf-image is-canvasLoaded is-imageLoaded\" data-image-id=\"1*Ysz4WyXWgIs5tRCXO9cHmw.png\" data-width=\"838\" data-height=\"575\" data-action=\"zoom\" data-action-value=\"1*Ysz4WyXWgIs5tRCXO9cHmw.png\" data-scroll=\"native\">\n<figure style=\"width: 484px\" class=\"wp-caption alignleft\"><img loading=\"lazy\" decoding=\"async\" class=\"progressiveMedia-image js-progressiveMedia-image\" src=\"https:\/\/cdn-images-1.medium.com\/max\/1080\/1*Ysz4WyXWgIs5tRCXO9cHmw.png\" alt=\"\" width=\"484\" height=\"332\" data-src=\"https:\/\/cdn-images-1.medium.com\/max\/1080\/1*Ysz4WyXWgIs5tRCXO9cHmw.png\" \/><figcaption class=\"wp-caption-text\">http:\/\/www.sethlevine.com\/archives\/2014\/08\/venture-outcomes-are-even-more-skewed-than-you-think.html<\/figcaption><\/figure>\n<\/div>\n<\/div>\n<\/figure>\n<p id=\"5f8e\" class=\"graf graf--p graf-after--figure\"><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"4042b905c7a3\">If we assume an exit distribution where over 60% of a fund\u2019s investments are 0\u20132x their money, with the remainder falling somewhere between 2\u20135x, a \u201cunicorn\u201d type 10x+ outcome can put a venture fund into the desired 3x fund returns that puts them among the top performers in VC. Your 1\u20133 investments that \u201creturn the fund\u201d and probably even more (the grand slam), is what will make or break you, while the other 2x-5x investments create additional alpha<\/span>.<\/p>\n<p id=\"eb5a\" class=\"graf graf--p graf-after--p\">The math for a RTF analysis is pretty simple:<\/p>\n<p id=\"7573\" class=\"graf graf--p graf-after--p\"><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"207c112d3d3a b5ef5d487806 40aa23af5681 anon 7e29992d1be 6d3266d9a2d7\"><strong class=\"markup--strong markup--p-strong\">Fund Size \/ % owned at exit = <\/strong><\/span><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"207c112d3d3a b5ef5d487806 40aa23af5681 anon 7e29992d1be 6d3266d9a2d7 459f680056f\"><strong class=\"markup--strong markup--p-strong\">Minimum Viable Exit<\/strong><\/span><\/p>\n<p id=\"dc74\" class=\"graf graf--p graf-after--p\">To show how this works, let\u2019s take the hottest new deep learning, autonomous vehicle startup built on the blockchain, XY.ai, as an example.<\/p>\n<p id=\"9751\" class=\"graf graf--p graf-after--p\"><strong class=\"markup--strong markup--p-strong\">XY.ai is raising a $2M seed round at a $10M post-money valuation (selling 20% of their company).<\/strong><\/p>\n<h4 id=\"199f\" class=\"graf graf--h4 graf-after--p\"><strong class=\"markup--strong markup--h4-strong\">VC Fund A is a $50M seed fund investing $1M<\/strong><\/h4>\n<ul class=\"postList\">\n<li id=\"d225\" class=\"graf graf--li graf-after--h4\">$1M\/$10M valuation = 10% ownership<\/li>\n<li id=\"d853\" class=\"graf graf--li graf-after--li\">In order to return the fund, XY.ai must exit for (50\/.1) = <strong class=\"markup--strong markup--li-strong\">$500M<\/strong><\/li>\n<li id=\"0916\" class=\"graf graf--li graf-after--li\">You can take it a step further and assume that a $50M fund will most likely not be able to fill their pro-rata across every subsequent round, thus their position could get diluted (we\u2019ll leave out the possibility of raising SPVs for pro-rata). If we assume 20% dilution over the lifetime of the investment, then the real return the fund number is <strong class=\"markup--strong markup--li-strong\">$625M<\/strong> ($50M\/.08).<\/li>\n<\/ul>\n<p id=\"ea92\" class=\"graf graf--p graf-after--li\"><strong class=\"markup--strong markup--p-strong\">So in order to pass the RTF analysis, VC Fund A must believe that XY.ai will exit for at least $500M and more realistically $625M.<\/strong><\/p>\n<p id=\"54c5\" class=\"graf graf--p graf-after--p\">Now let\u2019s look at a larger fund model.<\/p>\n<h4 id=\"6b9d\" class=\"graf graf--h4 graf-after--p\"><strong class=\"markup--strong markup--h4-strong\">VC Fund B is a $250M seed + series A fund investing $1M in\u00a0XY.ai.<\/strong><\/h4>\n<ul class=\"postList\">\n<li id=\"9836\" class=\"graf graf--li graf-after--h4\">Again, $1M\/$10M valuation = 10% ownership<\/li>\n<li id=\"c822\" class=\"graf graf--li graf-after--li\">In <span class=\"markup--quote markup--li-quote is-other\" data-creator-ids=\"e9b4a68d8d5f\">order to return the fund, <strong class=\"markup--strong markup--li-strong\">VC<\/strong><\/span><strong class=\"markup--strong markup--li-strong\"> Fund B has to believe that XY.ai will exit for $2.5B ($250M fund \/ 10% ownership).<\/strong><\/li>\n<li id=\"1351\" class=\"graf graf--li graf-after--li\">More likely than not, a fund of this size is investing for future ownership as well, so assume that they will not fall below 10% ownership at any time, and if things progress favorably, will own somewhere on average of an additional 5% of the company when all is said and done. <strong class=\"markup--strong markup--li-strong\">Still, VC Fund B has to believe that XY.ai will exit for $1.66B ($250M\/15%) in that increased ownership scenario.<\/strong><\/li>\n<\/ul>\n<p id=\"83db\" class=\"graf graf--p graf-after--li\"><em class=\"markup--em markup--p-em\">For more data of equity ownership at exits check out <\/em><a class=\"markup--anchor markup--p-anchor\" href=\"https:\/\/equityzen.com\/path-to-ipo\/\" target=\"_blank\" rel=\"nofollow noopener noreferrer\" data-href=\"https:\/\/equityzen.com\/path-to-ipo\/\"><em class=\"markup--em markup--p-em\">EquityZen\u2019s Path to IPO<\/em><\/a><em class=\"markup--em markup--p-em\">.<\/em><\/p>\n<figure id=\"f07a\" class=\"graf graf--figure graf-after--p\">\n<div class=\"aspectRatioPlaceholder is-locked\">\n<div class=\"progressiveMedia js-progressiveMedia graf-image is-canvasLoaded is-imageLoaded\" data-image-id=\"1*FHDMt76uGFvdXQelMZX93g.png\" data-width=\"1640\" data-height=\"650\" data-action=\"zoom\" data-action-value=\"1*FHDMt76uGFvdXQelMZX93g.png\" data-scroll=\"native\"><canvas class=\"progressiveMedia-canvas js-progressiveMedia-canvas\" width=\"75\" height=\"29\"><\/canvas><img loading=\"lazy\" decoding=\"async\" class=\"progressiveMedia-image js-progressiveMedia-image aligncenter\" src=\"https:\/\/cdn-images-1.medium.com\/max\/1440\/1*FHDMt76uGFvdXQelMZX93g.png\" alt=\"\" width=\"729\" height=\"288\" data-src=\"https:\/\/cdn-images-1.medium.com\/max\/1440\/1*FHDMt76uGFvdXQelMZX93g.png\" \/><\/div>\n<\/div>\n<\/figure>\n<p id=\"62e4\" class=\"graf graf--p graf-after--figure\"><strong class=\"markup--strong markup--p-strong\">As an investor, <\/strong>the difference between a company exiting for $500M vs. $2.5B is not trivial. Less than 10% of all VC-backed exits in 2016 were $500M+, per CB Insights. Jet.com was the only US-based VC-backed tech company to exit for over $2.5B.<\/p>\n<p id=\"678f\" class=\"graf graf--p graf-after--p\"><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"4ba60ec1cd42\"><strong class=\"markup--strong markup--p-strong\">As a founder,<\/strong> this trickles down to thinking about their potential investor\u2019s philosophy. While some businesses are best built to exit in the hundreds of millions of dollars,<\/span> <span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"4ba60ec1cd42 1caeac30ea2b e8947ef46b7c 90f52633d1f1\">larger funds could push startups through their natural inflection\/exit points<\/span><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"4ba60ec1cd42 e8947ef46b7c 90f52633d1f1\"> in order to go for broke and hit a grand slam that is very unlikely to occur<\/span><span class=\"markup--quote markup--p-quote is-other\" data-creator-ids=\"4ba60ec1cd42 e8947ef46b7c\">.<\/span><\/p>\n<p id=\"5d29\" class=\"graf graf--p graf-after--p graf--trailing\">While the RTF analysis is a good barometer for investments, it is indeed just one data point in the larger diligence process. It is a quick way to gut check ownership and investment size, and also allows investors to think about how they will need to build their positions over time. But while this thought process is generally useful, like all things in startups, there are outliers.<\/p>\n<\/div>\n<\/div>\n<\/section>\n<section class=\"section section--body section--last\">\n<div class=\"section-divider\">\n<hr class=\"section-divider\" \/>\n<\/div>\n<div class=\"section-content\">\n<div class=\"postArticle-content js-postField js-notesSource js-trackedPost\" data-post-id=\"2440b61f6d36\" data-source=\"post_page\" data-tracking-context=\"postPage\" data-scroll=\"native\">\n<section class=\"section section--body section--last\">\n<div class=\"section-content\">\n<div class=\"section-inner sectionLayout--insetColumn\">\n<p id=\"43cc\" class=\"graf graf--p graf--leading\"><strong class=\"markup--strong markup--p-strong\">For further reading + data on investment processes and exits, see below:<\/strong><\/p>\n<div id=\"80e1\" class=\"graf graf--mixtapeEmbed graf-after--p\"><a class=\"markup--anchor markup--mixtapeEmbed-anchor\" title=\"http:\/\/nextviewventures.com\/blog\/the-investment-memo\/\" href=\"http:\/\/nextviewventures.com\/blog\/the-investment-memo\/\" rel=\"nofollow\" data-href=\"http:\/\/nextviewventures.com\/blog\/the-investment-memo\/\"><strong class=\"markup--strong markup--mixtapeEmbed-strong\">The Investment Memo &#8211; NextView Ventures<\/strong><br \/>\n<\/a><a class=\"markup--anchor markup--mixtapeEmbed-anchor\" title=\"http:\/\/avc.com\/2017\/03\/convertible-and-safe-notes\/\" href=\"http:\/\/avc.com\/2017\/03\/convertible-and-safe-notes\/\" rel=\"nofollow\" data-href=\"http:\/\/avc.com\/2017\/03\/convertible-and-safe-notes\/\"><strong class=\"markup--strong markup--mixtapeEmbed-strong\">Convertible and SAFE Notes<\/strong><br \/>\n<\/a><\/div>\n<div id=\"fd47\" class=\"graf graf--mixtapeEmbed graf-after--mixtapeEmbed\"><a class=\"markup--anchor markup--mixtapeEmbed-anchor\" title=\"http:\/\/cdixon.org\/2015\/06\/07\/the-babe-ruth-effect-in-venture-capital\/\" href=\"http:\/\/cdixon.org\/2015\/06\/07\/the-babe-ruth-effect-in-venture-capital\/\" rel=\"nofollow\" data-href=\"http:\/\/cdixon.org\/2015\/06\/07\/the-babe-ruth-effect-in-venture-capital\/\"><strong class=\"markup--strong markup--mixtapeEmbed-strong\">The Babe Ruth Effect in Venture Capital<\/strong><br \/>\n<\/a><\/div>\n<div id=\"c4dc\" class=\"graf graf--mixtapeEmbed graf-after--mixtapeEmbed\"><a class=\"markup--anchor markup--mixtapeEmbed-anchor\" title=\"http:\/\/reactionwheel.net\/2015\/06\/power-laws-in-venture.html\" href=\"http:\/\/reactionwheel.net\/2015\/06\/power-laws-in-venture.html\" rel=\"nofollow\" data-href=\"http:\/\/reactionwheel.net\/2015\/06\/power-laws-in-venture.html\"><strong class=\"markup--strong markup--mixtapeEmbed-strong\">Power Laws in Venture<\/strong><br \/>\n<\/a><\/div>\n<div id=\"0d6d\" class=\"graf graf--mixtapeEmbed graf-after--mixtapeEmbed\"><a class=\"markup--anchor markup--mixtapeEmbed-anchor\" title=\"https:\/\/www.cbinsights.com\/blog\/global-tech-exits\/\" href=\"https:\/\/www.cbinsights.com\/blog\/global-tech-exits\/\" rel=\"nofollow\" data-href=\"https:\/\/www.cbinsights.com\/blog\/global-tech-exits\/\"><strong class=\"markup--strong markup--mixtapeEmbed-strong\">Analyzing $100 Million Tech Exits in Asia, Europe and the US<\/strong><br \/>\n<\/a><\/div>\n<div id=\"cf30\" class=\"graf graf--mixtapeEmbed graf-after--mixtapeEmbed\"><a class=\"markup--anchor markup--mixtapeEmbed-anchor\" title=\"https:\/\/www.cbinsights.com\/blog\/unicorn-venture-capital-performance\/\" href=\"https:\/\/www.cbinsights.com\/blog\/unicorn-venture-capital-performance\/\" rel=\"nofollow\" data-href=\"https:\/\/www.cbinsights.com\/blog\/unicorn-venture-capital-performance\/\"><strong class=\"markup--strong markup--mixtapeEmbed-strong\">Brains or a Bull Market? It&#8217;s a Good Time to Be a Venture Capitalist<\/strong><br \/>\n<\/a><\/div>\n<div id=\"1004\" class=\"graf graf--mixtapeEmbed graf-after--mixtapeEmbed graf--trailing\">\n<p><a class=\"markup--anchor markup--mixtapeEmbed-anchor\" title=\"https:\/\/www.cbinsights.com\/blog\/venture-capital-firms-largest-exits\/\" href=\"https:\/\/www.cbinsights.com\/blog\/venture-capital-firms-largest-exits\/\" rel=\"nofollow\" data-href=\"https:\/\/www.cbinsights.com\/blog\/venture-capital-firms-largest-exits\/\"><strong class=\"markup--strong markup--mixtapeEmbed-strong\">Which Venture Capital Firms Are Consistently In The Largest Tech Exits?<\/strong><\/a><\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/section>\n<\/div>\n<footer class=\"u-paddingTop10\">\n<div class=\"container u-maxWidth740\"><\/div>\n<\/footer>\n<\/div>\n<\/section>\n","protected":false},"excerpt":{"rendered":"<p>Venture Capital functions with a power law where the majority of a fund\u2019s returns come from a small percentage of investments. Because of this, VCs need to know if a single investment can return the entire fund. As Bill Gurley famously said \u201cVenture capital is not even a home run business. It\u2019s a grand slam business.\u201d This is where the Return The Fund (RTF) analysis comes into play.<\/p>\n","protected":false},"author":1,"featured_media":18455,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_jetpack_newsletter_access":"","_jetpack_dont_email_post_to_subs":false,"_jetpack_newsletter_tier_id":0,"_jetpack_memberships_contains_paywalled_content":false,"_jetpack_feature_clip_id":0,"_jetpack_memberships_contains_paid_content":false,"footnotes":"","jetpack_post_was_ever_published":false},"categories":[11,16],"tags":[161,216,235,4,7],"class_list":["post-18264","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-finance","category-vc","tag-math","tag-return-the-fund-analysis","tag-startups","tag-vc","tag-venture-capital"],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v28.5 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Why your startup idea isn\u2019t big enough for some VCs - Michael Dempsey: Blog<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/www.michaeldempsey.me\/blog\/2017\/03\/28\/why-your-startup-idea-isnt-big-enough-for-some-vcs-return-the-fund-analysis\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Why your startup idea isn\u2019t big enough for some VCs - Michael Dempsey: Blog\" \/>\n<meta property=\"og:description\" content=\"Venture Capital functions with a power law where the majority of a fund\u2019s returns come from a small percentage of investments. Because of this, VCs need to know if a single investment can return the entire fund. As Bill Gurley famously said \u201cVenture capital is not even a home run business. 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