# By the numbers: Why early-stage VCs are greedy bastards

I had yet another conversation with a talented entrepreneur today in which I tried to explain why early-stage venture investors (as distinct from angel investors) can’t afford to bet on “small” opportunities — where “small” is defined as exit values in the single- or low-double-digit millions of dollars.

I remember being puzzled and annoyed by this attitude when I was the entrepreneur asking for money, and it’s taken several years of hard-won experience as a “professional” seed investor to really grok the truth of it:

Venture math is brutally hard — especially so for early-stage investors — and if you’re raising seed money that math will probably find its way into your term sheet and cap table.

Rather than just wave my hands over this, I decided to try to lay out the economics of a hypothetical seed fund in a very simple Google Spreadsheet that anyone can play with: you can find it here.

The goal of this exercise was not to model in full detail how a seed-stage venture fund works, but rather to offer a simple, interactive visualization of just why seed investors get so hung up over valuations and ownership stakes (at the beginning) and exit valuations (for that happy few that make it all the way to the end).

If you like, you can save a copy and play with the assumptions to your heart’s content (they’re in blue) — and if you make enhancements (or corrections) just let me know and I’ll recirculate (UPDATED: see Brad Feld’s comment below + revised model reflecting his comments here) — but the headlines are pretty easy to see.

First, here are the basic assumptions:

• Our hypothetical \$10MM Seed Fund has the capacity to make ~16 investments of \$500K each over a 10-year fund life (after netting out the 2% annual expense burden)
• The average funded company raises a first round of \$500K at a \$3.5MM pre-money valuation (pace the YC valuation bubble, this is a realistic — even lofty — historical average for seed-stage software deals)
• For its \$250K initial investment, the fund’s average ownership stake starts at about 6%, and gets diluted down by 33% over the life of the investment (even allowing for a 1:1 reserve ratio for follow-on investment — i.e., \$250K of reserve for every first \$250K investment — later rounds, option pool increases and tuck-in acquisitions inevitably whittle away your early stake)
• A third of the companies fail outright and another third return capital, leaving just five companies to produce the bulk of the fund’s returns.
• The target returns that venture fund LPs demand to participate in such a risky and illiquid asset class are steep: 3x at a minimum, 5x for (moderate) outperformance
Use these assumptions to backsolve for total required fund return, and here’s what you’ll see:
The total shareholder value that the fund’s five “winners” have to return just to hit the 3x minimum returns hurdle is over \$650 million.

The average exit valuation for each of the fund’s 5 “winning” deals has to exceed \$120 million. And that’s just for acceptable performance.
This isn’t an extreme case — if anything my assumptions about the percentage of winners to losers is on the generous side, and the current seed valuation trend (especially for Valley/YC deals) makes things look dramatically worse.
So, as it turns out, there’s a very good reason why professional investors screen out deals that don’t at least have a shot at a nine-figure exit valuation — they can’t stay in business without them.
General Partners that don’t meet Limited Partner expectations in their current fund (usually) aren’t able to raise their next one. And a VC without a fund is just another out-of-work guy in khakis and a blue shirt.
The only real levers fund managers have to manage these lofty expectations are:
• Owning more — both by lowering entry valuations and investing more aggressively in the first round (which adds risk by reducing follow-on reserves); and
• Winning more — by being smarter, luckier + harder-working than anyone else in the business.
Creating winners happens over time — years and years of focused effort — long after that first check clears.

Which explains why investors tend to favor deals with bigger potential outcomes, and also get hung up on the few things they *can* control (or at least influence) at the time of the investment — things like price, pro rata rights, option pool, board seats, etc.

Don’t weep for the professional seed investor — all the ones I know (myself included) do it because they love it and can’t imagine doing anything else.
But if you want to raise money from these folks, take a minute to think about how their business works, and don’t be offended when they tell you that you’re not thinking big enough — from where they sit, it just might be true.

1. bfeld

Chris – a few suggestions to model and see what happens – I couldn’t do these because the spreadsheet was locked as read only.

1. Recycle your fees. So instead of investing \$8m, you invest the full \$10m. As an investor in your fund, I want you to recycle your fees. As a GP, you should want to recycle your fees – the numbers improve a lot when you have 20% more to play with.

2. Stop doing follow ons. As a seed investor, you get 2x the at bats if you don’t follow on 1:1. That’ll make a big difference in opportunities.

3. I hope you don’t expect that you won’t have at least 1 true home run outlier. You’ve modelled all the success cases to be the same – what if you modelled 1 to be a real winner (at least 10x, but really 50x or more).

1. Chris DeVore

Great comments Brad, thanks for taking the time (and definitely don’t infer that this sheet is a direct lift from Founders Co-op’s model, it’s not — my goal was simplicity for discussion purposes, not real-world fidelity)
Recycling returns to invest 100% is critical — losing 20% of your capacity off the top has a linear negative impact on expected returns.

I have a bad case of “investor mentor whiplash” on the follow-on reserve topic — I’ve heard everything from 20 cents on the dollar to 4:1 reserves from people I respect (and who’ve been at it a lot longer than I have). Your suggestion to eliminate reserves entirely is the most aggressive I’ve heard yet, but then you’ve driven more return than all the other guys I’m talking to combined 😉

And on the home-run deal, I absolutely want to see one in every fund, but the more I do this the more I appreciate how hard they are to spot when it’s still just three guys and a dog. From a planning perspective I’ll take an upside surprise any time, but I don’t want to be banking on it to make the business work.

1. bfeld

As a seed or angel investor, I think the rational strategy if you have limited capital is to maximize the number of companies you have in play.

So – either:

1. Never follow on. If you never follow on, you will not have a signaling issue as it’s known that you won’t.

2. Only follow on in cases where you believe the company is making progress but they haven’t made enough process to raise an institutional “post-seed” round. In these cases, the typical deal is an extension of the existing deal – same terms, same price.

As you get more capital under management, you can start to opportunistically follow on your winners / stronger seed investments.
The mistake I’ve seen seed / angels make over and over again is to keep pouring money into the ones that aren’t going anywhere, or to play prorata and limit their numbers of investments since they are exhausting their capital.

1. Chris DeVore

This is fantastic feedback, Brad — specific, actionable, rational and pattern-based. Thank you (yet again) for all your advice + support — it means a lot and I *am* listening.

2. Chris DeVore

Hey Brad (and anyone else reading the comments), following up on your comment, I just published a revised model here. The only changes were to:
– Eliminate management fees (assuming a gross-up from investment returns) – Eliminate the follow-on reserve

The net effect is to allow the fund to make 40 total investments rather than the 16 shown in the earlier model. The total required shareholder return doesn’t change much — falling from 650MM to 570MM — but the required return from the winners falls dramatically, from over 120MM to just 44MM.

Again, both models are radically oversimplified, but the obvious conclusion is to find ways to take more (high-quality) at-bats, and don’t try too hard to manage follow-on financing risks with reserves (relying instead on relationships with syndication partners, and a healthy measure of luck!).

3. Informerly

Very through-provoking post and response. Question on @bfeld, is the typical fee structure 2/20 where 2% AUM and 20% of profits? At least in this example if the fund starts at \$10mm they’d have 9.9mm to spend? Sorry if nitpicking but have never actually thought through the numbers on the other side and the post definitely has me curious?

1. Chris DeVore

Hi Ranjan, don’t know if Disqus will notify Brad on your note but quickly: the “typical” fee structure is an expense load of 2% annually over the life of the fund, plus “carried interest” (the General Partner’s share of total profits after capital is returned) of 20%. Brad’s point re: expenses is that you always want to structure your fund agreement so you have the ability to reinvest returns to offset the management fee, so you can actually invest the full \$10MM raised, not just the \$8MM net of expenses.

2. bfeld

2/20 is pretty typical. However, I don’t know the \$10m / \$9.9m demarcation in your note.

If it’s a \$10m fund, then the 2% fee is going to be \$200k / year. Most funds charge a flat fee for 5 years and then start declining based on a fixed percentage or a shift to % of cost of active deals for year 6 – 10.

Either way, the fee load averages out to about 15% of the committed capital over the 10 year period. So – if you have \$10m committed, you end up with \$8.5m of “net cash to invest” before you recycle.
If you recycle (which you should), it means that the first \$1.5m of proceeds will likely NOT be distributed back to your investors but reinvested (or recycled) in companies (either new or existing ones in the portfolio) to get to a full \$10m invested.

4. Kevin Nakao

Chris, super-informative post and transparency Chris & great to see  Brad’s point of view.  Brad, I have a question on point 2 you suggest that the early stage fund not participate in a follow-on to have more swings at bat.  Does that hurt the perception of the companies being invested in if an early stage VC doesn’t ante up for the next round or needs some bridge funding to get there?

1. bfeld

If you position yourself as a seed VC (which is what Founders Co-op is) then it’s not a signaling issue. Most angels and seed VCs are not expected to follow on.

There are three strategies that I’ve seen be effective:

2. Only follow when you are doubling down early before the company gets to an external funding event.
3. Play pro-rata or more in the follow on round if it is outside led and there is strong momentum.

Option 3 only works if you have a meaningful amount (> \$10m) of capital in the fund. Otherwise, you are better off playing 1 and only playing 2 in cases where you believe things are working but just need a little more time.

5. nikiscevak

One softer version of point 2 is that only a fraction of companies will raise follow on rounds of funding (you’re assuming 1:1). Charles River Idisclosed that they invested in 1 in 3 of their seed investments at the series A level.

So if the strategy was to take pro-rata as much as you could up to \$250k then you’d only do that 33% of the time. I know there is a lot of the extension rounds pre-series A that you might put the \$250k into but you’d likely be getting the same \$3.5m cap as Brad suggested.

On the straight 1:3 series A follow on, you’re giving yourself another 8-10 companies you can invest in overall.

1. Chris DeVore

Great point, Niki — both models are radically simplified, so they don’t take into account the timing of investments / follow-ons at all. Most of the time you can spot a “no follow” deal before the follow-on opportunity comes around, so instead of reserving 1:1 you can reserve less, assuming you’ll only use the reserve when merited. Whether that’s 20 cents on the dollar, or 33 cents, or some other number, a seed fund that *does* do follow-ons can reserve less and make more initial commitments than the simplified 1:1 allocation suggests.

2. acorginc

Thank you for taking the time to explain this.

So I have one of these 9 figure projects (maybe 10) but need to find the funding. Any suggestions on how I can stand out amongst the other companies you see?

1. Chris DeVore

The best way (IMO) to prove you’re not just a crackpot with delusions of grandeur is to start building — assemble an amazing team, ship product, line up partners and customers, get the best analysts / academics / experienced founders in the space to sign on as advisors or angel investors, etc. In software (which is all I really know about) very few of these tasks require significant capital — and if the team is skilled enough you can accomplish a lot before you take a nickel from anyone outside the founding team.

1. acorginc

Hi Chris

I do agree with you but in my case, I do need some funding to purchase address data and infrastructure. For my local search engine to attract and maintain users, the data must be as complete as possible.

I am in a “chicken or egg” type of situation here. It doesn’t help that I my location is not startup friendly and I am out of cash personally.

The product is market ready and ready to scale. It seems counter intuitive to take on team members in exchange for equity at this stage. I do understand the importance of a team but up until now they were not required.

I do have multiple revenue streams built on value innovation that does not principally rely on advertising.

Any other thoughts??

3. Jessica Darko

This spreadsheet shows some very key aspects of the industry.

First off, the VCs are ripping off their capital providers by charging an up front %20 fee on the funds invested, without regard to how well they do. (%2 over 10 years)   This is a terrible idea, and it explains why VCs are so focused on billion dollar exists- they are investing OPM that they make a profit on either way.

Secondly, if they really do need to bat for the fenses in order to make the model viable, this does not explain why the terms are so onerous and one sided.  “Standard terms” like charging the startup for their legal fees (an unlimited check writing privilege there) and preferences that give them a multiple return before the rest of the investors (namely the founders) have a chance to participate, as well as forcing all founder shares to vest (which is literally taking away stock that is already paid for by another investor and forces founders to kowtow to the VC firm lest they be kicked out of their own company and lose their shares.  Creating a pool of vestable shares for everyone is something that could happen any time, but making Founders vest shares they already own is cheating.)

The bottom line is, VCs force terms that are simply unfair and dishonest.

Either the valuation of the company is legitimate before the investment, or it isn’t.   If it isn’t, then don’t do an investment at that valuation.

If it is, then stealing the equity of pre-existing investors (including founders) is cheating.

1. pointsnfigures

You assume a few things.  The VC has to eat and clothe themselves.  They need some sort of a fee to provide daily living expenses.  You also assume that all the VC does is write a check.  A good VC will be an active investor and manage their investment to create opportunities for it in a variety of ways.  Pricing the initial round is all about risk/reward.  For the VC, they are weighing the risk/reward of one deal against all others they are invested in, evaluating, or the ones they know will come in the future.

4. David Aronchick

I love the simplicity of this model – I wish more entrepreneurs understood this when they went around posting that “they only need \$250k to get it off the ground”. That’s fine that they do, but understand what the outcome must be in order for your funders to have success.

5. lunarmobiscuit

Great post Chris.  And good feedback Brad.  However, I wonder how the psychology of the Series A changes if the seed investor doesn’t invest in that round.  In the “traditional” funding of days past, when existing investors don’t follow-on, its a yellow-flag to the new investors.

It would certainly help if the seed fund had a stated policy of no follow-ons, but any such changes from the “norms” adds to the complexity of the fund raising, from both the perspective of the entrepreneur and the new investor.

Secondly, for both Chris and Brad, what percentage of your seed investments are priced deals, vs. convertible debt?  Are we talking about no follow-on in Series A, or is Series A assumed via a convertible seed, and the follow-on in question is in the Series B?  The spreadsheet names an average price and thus doesn’t imply an answer.

1. Chris DeVore

Thanks for the note + questions Luni. Re: follow-ons, while traditional venture firms (i.e., those with \$100MM+ funds) are designed to follow on, most Seed Funds (i.e., 10-50MM) aren’t designed / capitalized to maintain lead funder roles past the Seed round, so the “signaling” issues associated with not following on are less of an issue. And re: pricing, the cap in capped convertible notes acts as a reasonable proxy for pricing — the cap represents the effective price the investor will be paying at the time of the first priced round, no matter what the negotiated pre-money valuation is at that time — so the model applies equally well whether the Seed round is done as convertible debt with a price cap or priced equity.

1. bfeld

Chris summarized it well.

When I made angel investments, I almost always made them as priced equity rounds. If I do a convertible note, I always insist on a cap.

6. Omri Mor

Very valuable information Chris! Really enjoyed reading that, and getting to hear the flipside