Venture Fund Economics: When One Deal Returns The Fund
If you looked closely at the model and the assumptions in my last post on this topic, you'll note that I assume an early stage venture fund will lose money on 1/3 of its investments, breakeven to make a little bit on 1/3 of its investments, and will make good money (5-10x) on only 1/3 of its investments.
What that means is that 1/3 of your investments will produce all of the proceeds as the breakeven to make a little bit deals simple go to cover the losers. But that is a hypothetical model. It's actually even more stark than that.
Every really good venture fund I have been involved in or have witnessed has had one or more investments that paid off so large that one deal single handedly returned the entire fund.
Let's take the hypothetical $100mm venture fund that I modeled out in the previous post. The average investment in that fund is $5.3mm. If the fund invested that much in one company over a number of years and owns 20% of the business and the business is sold for $500mm, then the fund's 20% is worth $100mm. It's a 20x multiple on the investment. Not a common occurrence, but it happens in this business.
When that $100mm is distributed, one deal has returned the entire fund. That is huge because then the other winners will typically collectively return from one times the fund's value to three times the fund's value. After carried interest fees, that gets you to the 1.5x to 3x NET to LPs I talked about in my first post on this topic.
When I look at a venture portfolio that is fully constructed, but not yet fully invested (like our 2004 fund is right now), I like to look for the deals that can return the fund. I think we have six or seven. That doesn't mean that those six or seven are the best deals in our portfolio right now. A few of them could be complete busts. But we have six or seven deals that sitting here today I can honestly construct a scenario where they will return the entire fund when they are sold. I hope that one or two will actually do it.
Because if we can get that kind of hit, it will make the rest a lot easier. As many have pointed out in the comments to the first two posts on this topic, venture investing is a hard way to make money. We need some big wins to make the model work.
Some will read this and suggest that our business is all about swinging for the fences. But I don't think so. There are hitters in baseball, the best hitters in fact, that hit balls out of the park when they are just trying to make good contact. That's how you have to do it in the venture business. You try to make 20 great investments and you work with them closely in hopes that four years in you have six or seven that have home run potential, and after ten years, you maybe hit one or two out of the park. If you try to hit every one out of the park day one, you'll strike out way too much and the fund won't work out very well.