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.