The stakes are high in startup financing

Why should you be interested in VC math as a startup founder? Well, because you should know who you’re doing business with and what the motivations are that explain many of their actions… Alright, let’s dive really deep into the world of VC. Grab your snorkeling gear because we’re going down to the bottom!

First of all: what exactly is a VC fund?

Think of it as a pot of money, but instead of it being filled with water and screaming children, it’s filled with cash and big dreams.

This pot of money comes from Limited partners (LP). These are people with deep pockets – we are talking about pension funds, foundations, family offices, and sometimes even successful entrepreneurs who want to give something back to the startup ecosystem. They are called “limited” because their liability is limited to the amount they invest. They typically invest 1-10% of their total capital assets in venture capital and the rest in other asset classes (public markets, real estate, art and antiques, debt, you name it).

On the other hand, we have general partners (GPs). These are the real venture capitalists you will be reaching out to. They are the ones who make the investment decisions and (hopefully) turn that pot of money into an ocean of profits.

How do these GPs make money?

Two ways:

1. Management fees: This is typically 2% of the fund size per year. It’s about keeping the lights on and paying wages. So if the fund is $100 million, primary care physicians get $2 million a year to run the program. However, 2% drops to just 1% after year 4, when the active investment period ends.
2. To wear: Short for “carryed interest” – this is where you make real money. It is usually 20% of the fund’s profits. So if a $100 million fund turns into $500 million, GPs will get 20% of that $400 million profit = $80 million. Not too shabby!

But here’s the catch – VC funds typically have a lifespan of 10 years. The first 3-5 years are for new investments and the rest for subsequent investments and (hopefully) exits. This means that GPs must raise a new fund every 2-4 years if they want to keep their management fees afloat.

VC Scorecard

To attract a new fund, GPs must show LPs that they are worth investing in. They do this using two key metrics:

1. IRR (internal rate of return): This is the fund’s annual return. A top quartile VC fund aims for an IRR of 20% or higher.
2. DPI (distributions to paid-in capital): It measures how much cash the fund actually returned to the LP compared to the amount invested. A DPI of 3x or more after 10 years is considered good performance.
3. TVPI (Total paid-in capital): This is a broad-picture metric that combines realized returns (DPI) with an estimate of the fund’s current holdings. It gives investors an idea of ​​the fund’s overall performance before the end of its life, both realized and unrealized. A TVPI of 3x or higher is generally considered good, but the higher the better!

These metrics are like a report card for a VC. Good ratings here mean happy LPs, and happy LPs mean more money for future funds.

How to get a 3x return on your portfolio?

Not by investing in 30 startups that unfortunately pay off 3x because of something called the law of power.

Power Law is abbreviated as VC, meaning “go big or go home.” This means that in a typical VC portfolio, a small handful of investments will return the entire fund (and then some). People, we’re talking about unicorns!

Here’s how it breaks down:

• Most investments (e.g. 70-80%) will fail or return less than the original investment. Ouch.
• A bunch (10-20%) will return 1-5x. Not bad, but not earth-shattering.
• A few (maybe 5-10%) will return 5-20x. Now we’re talking!
• And then there is the holy grail: 1-2% that returns 50x or more. These are the ones VCs dream of.

What does this mean for you, dear founder? This means that VCs are looking for startups with huge potential. They are not interested in “nice little companies.” They want companies that can dominate entire markets.

The bigger the fund, the bigger the result needs to be.

That’s why you often hear VCs asking about your TAM (Total Addressable Market). Unless your TAM is in the billions, most VCs will pass faster than you can say “pitch.”

But here’s the kicker: even if you have a huge market, it’s not enough. VCs also need to believe that your team can capture a significant portion of your massive TAM. That’s why everyone in venture capital talks about the importance of a team.

Moreover, your startup must have some secret, some unfair advantage that will allow you to leave the competition behind.

I know what you’re thinking: “My startup is amazing! We will revolutionize (insert industry here)!” And hey, you might be right! However, if you can’t convince VCs that you have 100x potential, you may need to look elsewhere for funding.

So what startups can be financed from VC funds?

Here is a short checklist:

1. Huge market potential (we’re talking about billions)
2. Scalable business model (software is the favorite here)
3. A strong team with relevant experience
4. A clear, unique and innovative advantage
5. Early grip this indicates a sharp increase

If you check all of these boxes, congratulations! You speak VC language.

Because you’re taking VC money, you’re not just getting cash – there are a lot of expectations attached to it.

Once invested, VCs need massive power-law returns to make their calculations work. This means they’ll be pushing you to grow fast – and I mean fast. We’re talking about “making Usain Bolt look like he’s running in slow motion,” pretty fast.

They will also want you to raise another round within 18-24 months. Why? Because they need to show their investors that their investments are gaining value. Your new investment round with a higher valuation will allow them to mark up their investment on spreadsheets, making their results look better on paper.

This can be a great solution if you are building a rapidly growing company and everything is going according to plan. But it can also mean enormous pressure, diluting potential if growth targets are not met, and sometimes making decisions that prioritize growth over profitability or other important factors.

Energy law also has an advantage. If your company doesn’t perform and fails, the VC has no reason to hate you. This simply means that you are part of the 90% of the portfolio that is underperforming. If you have shown that you did a good job but were unlucky this time, the VC may be convinced to back you again.

Ask yourself

So before you jump into the VC pool, ask yourself: Is this the right path for my startup? Am I ready for the high-octane, high-stakes world of VC-backed growth? Can my company realistically achieve the returns required by VC funds?

If the answer is yes, take action!

Accepting VC funding is like strapping a rocket to your back. It can take you to incredible heights, but it can also explode spectacularly if you’re not prepared. Before you light the fuse, make sure you’re ready to ride!

Ultimately, VC funding is not the only path to startup success. But if you decide to dive in, at least now you know what lies beneath the surface. So go ahead, throw boldly and may the startup gods always be in your favor!