Frozen-rails-2014

The Maths Behind Venture Capital

I want to be fully honest about this, but I'm really thrilled to be sharing information like this so openly about the venture capital business with the help of Nexit Ventures about the mathematics behind the venture capital business. While it's pretty straight forwards on a basic level, it's great to get these figures actually with comments from an actual investor. In this post, we'll look at the fundamental financials and why venture capitalists are looking for certain growth figures in the way they invest.

I talked about all this with Artturi Tarjanne of Nexit Ventures and all the related to this are his.

So most people know the reality that venture capitalists go through hundreds of potential startups each year in the search of those few really good ones to invest in. Furthermore from the ones that they are serious about, they only invest in a mere few. This isn't arrogance, but a business that is built on world class wonders - something that expects at least 10 fold returns per company invested.

We'll run this through an example. We'll have a 75 million venture capital fund. The cost of running this kind of a fund is about 15 million euros. This include the management teams work, the founding of the fund, management of it and so on. Due to this, the amount that is left to be invested is about 60 million euros.

Let's say the VC invests this money (60 million euros) into 12 companies. This means on average the investment is about 5 million euros.

Before we go into detail on this, its good to go through the rules of thumb regarding expected success rates. Even the best investors, according to Artturi Tarjanne, believe that one third of the companies will go bankrupt (or be sold at a loss), one third of the companies will return your investment on some level and finally, the last third will return a clear return on investment with a multiple of 2 or more.

If we put figures into this calculation, the first third will return you basically nothing. The second group of companies to return your investment will return you about 20 million (4 companies x 5 million euros each). The last group should return you at least 40 million (4 companies x at least 10 million each).

So how much should the best third return so the venture capitalists could be content with their performance?

Typically, a venture capitalist first returns the original capital (75 million euros in this case) with an interest, a hurdle rate, around 8% per annum. Beyond this the profit can be shared between the LPs and the venture capital firm in an agreed way, but for the sake of argument - let's say for our calculation this would be 80% for the LPs and 20% for the investor.

To be able to make any kind of profit (for the venture capitalists), the fund itself should aim for at least 100 million euros in return on investment. This is for the duration of 4 to 5 years.

Therefore, the best third should perform extremely well - earning at least 80 million euros for the fund so that the 100 million euros would be reachable (if we take into account the average third returns of 20 million euros and the worse third returns of 0 million euros). Therefore, each of the four investments should yield at least 20 million euros (four times invested capital) in return to reach the goal of 80 million euros.

All this is calculated with an 8% return on investment for the LPs, something that is more or less the basis for doing business in this industry. This is far from being competitive and if you're not competitive - it's very unlikely you'll be able to raise a new fund of investments.

Therefore the goal is to reach a 10 fold return on at least one investment. This is pretty much the driving factor in the venture capital business - investors want high returns, to be able to make a profit for themselves as well.

Going through this with thought helps entrepreneurs better understand the mindset of investors and thus prepare for the pitch hopefully. Investors are, and should be on the same side of the table - they too want a return on their investment.

Image by elefevre7.

-----
This post is part of a series of posts supported by
Nexit Ventures.

Nexit Ventures is a mobile venture capital firm focused on wireless technologies and services. Leveraging its extensive network in the global mobile marketplace, Nexit invests primarily in Nordic and US-based earlystage companies with products and services for a global market. For Nordic mobile companies, Nexit provides a bridge to Silicon Valley markets and exit opportunities.

Like this article? Share it!

blog comments powered by Disqus