Trace CohenEstimated Reading Time: 3 minutes
Shots on goal!
After my newsletter a few weeks ago about family offices saving Emerging Mangers, I received numerous emails asking how fund dynamics actually work. There are two schools of thought in the VC world with early smaller funds; have a concentrated portfolio of 10-15 and own a larger % or as we like to say take more shots on goal and invest in 30-40.
I personally think it’s more risky to do a concentrated portfolio - I usually see this in very sector focused funds with the GP who has that specific deep expertise. Most fund 1 emerging managers I know want to invest in more startups to show they have access, refine their thesis, potentially increase their chances of success and spread the risk. Either way, you still need an outsized return to be successful.
This example assumes a $20M fund investing in 40 startups, with one VERY successful investment to achieve a 3x DPI net of fees. Also remember that because of fees etc, the fund really only invests about 80% of the capital as well, which is something I’ll discuss in a later post about recycling, following-on and other ways to deploy closer to 100%.
Fund Size: $20,000,000
Number of Startups: 40
Investment per Startup: $500,000
Post-Money Valuation of Successful Startup Initial investment: $10,000,000
Initial Ownership Percentage: 5%
Dilution Through Additional Rounds
The startup then goes on to raise 4 more up-rounds, each resulting in 20% dilution. A few assumptions; no pro-rata/additional investment and re-upping option pools etc - it’s all baked in.
After 1st Round: 5.00% * (1 - 0.20) = 4.00%
After 2nd Round: 4.00% * (1 - 0.20) = 3.20%
After 3rd Round: 3.20% * (1 - 0.20) = 2.56%
After 4th Round: 2.56% * (1 - 0.20) = 2.048%
Required Exit Value Calculation
To achieve a 3x DPI net of fees, the fund needs to generate $64M in liquidity:
Fund Size: $20,000,000
Total Returns Needed: $64,000,000
Management Fees: 2% annually over a 10-year period
Annual Fee: 2% * $20,000,000 = $400,000
Total Management Fees: $400,000 * 10 = $4,000,000
Net Return Needed (after fees): $60,000,000 + $4,000,000 = $64,000,000
Net Returns Calculation
The exit value required for the startup to achieve this return given the final ownership percentage:
Final Ownership Percentage: 2.048%
Required Exit Value: $64,000,0000 / 2.048% ≈ $3,125,000,000
Chart: Fund Performance Analysis
Metric Value
Initial Ownership
5%
Final Ownership after Dilution
2.048%
Required Exit Value
$3,125,000,000
Gross Return
$64,000,000
Management Fees
$4,000,000
Net Returns to LPs
$60,000,000
DPI
3.0
So basically because you’ve been diluted by 60% over the years, you need to achieve a 128x return on your initial $500k investment in order to be successful. You need to invest in a startup at a $10M valuation and have it exit at a $3B valuation. There are maybe a dozen of these a year at best - not so much in the last 3 years though, which is causing lots of issues.
3x DPI is kind of the gold standard in what most funds are aiming to achieve over their 10yr life. LPs into funds need to understand that during this time their investment will be basically 100% illiquid as the investments grow. Early stage investing and building a real business takes a long time - you need to build a product, find product market fit hire a team, grow 100%+ yoy eventually and also hope the industry doesn’t fall out from under you or a new competitors takes away your customers.
https://news.crunchbase.com/seed/market-dilemmas-slow-h1-2024/
As you can unfortunately see in this chart, deal volume continues to decline, which means less shots on goal are happening and the chances of outsized returns I believe will decrease as well. This is why I’m bullish that we’re almost at the bottom and that Q1 2025 will begin the uptick and/or stability in our market once again as there are lots of smaller funds going to market right now (lots of my friends) that will create a solid foundation.
Also really hoping for some IPOs and M&A around this time as well to inject some much needed liquidity into the markets and take some pressure off of VCs so they can focus on investing again 🙂
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What strategy do you prefer - concentrated or shots on goal?
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