Venture Math is Hard

Seed fund Portfolio construction reminder- if you own <10pct at seed, it’s virtually impossible to get a 2.5x net fund return without at least one unicorn exit.

— samir kaji (@Samirkaji) April 19, 2019

If you are into entrepreneurship and venture capital and not following Samir Kaji on Twitter you should. He tweets out some cool and thought-provoking stuff. Above is one of his tweets.

Venture math is really unforgiving.  Here are a few equations to keep in mind.

1. Return on Investment = percentage ownership*exit value/amount invested.  Percentage ownership isn’t only affected by your investment.  It’s also affected by the terms in term sheets like liquidation preferences and dividends.
2. Seed math is a bit different than big fund math.  In seed, figure 50% of your investments will go to 0.  10%-40% will return 2x to 4x.  That means you need 10% to hit 30x to get a nice return.  If you figure only a five-year holding period which is not realistic, the IRR is around 27%.
3. Bigger funds need bigger hits to return money to LPs.
4. The distribution to returns is not close to normally distributed.  It’s skewed.
5. Most companies exit at less than $100MM in valuation.

This is why when you raise a fund, figuring out how much to invest and at what stage to invest breaks down into math combined with some probability and statistics.  I will not for the life of me ever figure out why a seed fund writes a smallish check.  There is no efficient market theory in venture capital.  Small checks from funds just show no conviction. Even if it’s a good deal, you are better off not being in the deal if you can’t write a big enough check.  Better to find another good deal.

When you have a small fund size, you don’t need a unicorn to win given the math above.  However, you do need to invest in companies that will break out of the averages. If you invest in a bunch of successful companies that exit at $100MM or below, you won’t get venture sized returns.  That’s not why you are in the game and it shouldn’t be why your LPs are in the game.  As a fund manager investing at Seed or Series A, you must swing for the fences and hit home runs.

As an angel, it’s different.