As founders starting the process to raise VC money, it’s important to understand VC math at a high level. Understanding this math will help founders appreciate VC’s diligence process and set founders up for proper alignment & negotiation.
A VC is a partnership between the General Partners (GPs – whom founders interact with) and one or more Limited Partners (LPs – individuals and entities) who contribute capital to the VC fund.
A typical VC fund has a 10 year horizon and is structured with a 2% yearly management fee and 20% profit sharing (called carry).
Let’s assume that an example VC has successfully raised a $20M fund (just focus on the intuition – reality will be fund specific and will deviate from this example).
This implies that $4M of the fund (2% of $20M over 10 years) will be allocated to management fee leaving $16M available for investments.
Assume that the VC deploys $4M each across 4 startups and further assume that 3 of those startups fail. This means that the $4M invested in one of the startups that did well must eventually return $20M for the fund to break-even. Ideally, this startup needs to return more than $20M so the GPs get their share of the carry profit.
Now, assume that the $4M investment gets the VC 15% of the startup. This implies that the exit price needs to be at least $134M for the fund to break-even.
|Life of Fund (Years)||10|
|Management Fee Per Year||2%|
|Total Management Fee (over life of fund)||$4M|
|Funds Available for Investment||$16M|
|Carry (GPs Profit Sharing)||20%|
|Number of Portfolio Companies||4|
|Investment Per Portfolio Company||$4M|
|Ownership at time of Investment||15%|
|Number of Startups that Fail||3 out of 4|
|Number of Successful Exits||1 out of 4|
|Expected Price of Successful Exit to Return Fund Size||$134M (15% = $20M)|
And that is just the start.
There are several additional aspects to consider that may require VC to expect much higher exit from the startup.
a) The VC may only get say 10% equity in the company.
b) The startup may end up raising more capital or increasing their option pool that dilutes the VC ownership.
c) The startup may have NOTEs or other loans that have higher seniority.
d) The startup may give out economic rights to future investors that reduce VC’s share of the exit proceeds.
e) M&A events have operational costs that come out of the top line.
f) GPs must deliver oversized returns to LPs to successfully raise follow on funds.
g) The real money GPs make is the carry (20% of the fund profit in this example).
To protect the VC interest and for the VC math to work, founders can expect the term sheet to include anti-dilution clauses, variations to liquidation preferences, and pro-rata rights. Founders can anticipate similar terms from every investor including the future ones.
So, as founders, just as you think through your market, business model, capital needed and such in preparation for your VC meetings, you will also want to develop a clear strategy for your equity.
Think through from a VC perspective – how much equity you plan to give, how much capital you plan to raise in the future, how many options you plan to give out over the lifetime of your company, how would VC terms impact their returns, and most importantly how all of this will impact your equity.
TWO12 can help founders with their equity and fund raise strategy. FInd out how by signing up for a free trial at https://sigma.two12.co/sign-up.