The Venture Capital Mindset
May 2007 (School for Startups)
Why do VC firms require their funds to invest in companies that provide such a rate of return of around – typically 10 times the original investment in 5 years? Let’s take an imaginary venture capital fund as an example. The VC fund has a portfolio of companies in which it is invested. This allows them to diversify and reduce risk because their capital is spread over a number of different opportunities, in various sectors.
VCs and investors in their funds have come to accept that a certain proportion of their investments will fail, a certain proportion will just about break even and a certain proportion will hopefully become stars:
‘Stars’ Successful 1/3
‘Zombies’/’Walking Dead’ Breakeven 1/3
‘Dogs’ Failures 1/3
A VC expects that about two-thirds of their investments will not achieve “star” status. As a result, the one third that are stars have to generate very large returns in order to give the portfolio overall a respectable return. In effect, the stars have to subsidise the zombies and dogs.
This explains why VC funds and their investors demand such a high rate of return. A 60% IRR means that the overall portfolio will generate around 20% returns for those who invested in the VC fund.
If one third are successful, this translates to 4 companies returning £200 m (£5 m x 10 x 4). The fund would have invested £60 m. This gives a return on investment of £200/£60 = 3.33 times, which, over 7 years is an IRR of just under 20%.
How This Relates To Your Business
VCs don’t know which firms will be successful or not, so they require the high IRR of 60% across the board; you need to be able to offer extraordinary growth even to be considered. Before approaching any VC for funding you should ask yourself can your team pull it off? Can you market segment support such growth? Is your innovation going to move markets? You need to be able to credibly answer these questions if you will have any chance of successfully raising VC funding.