The Venture Capitalists Bill of Rights (VCBR) Article 1: The right to make large returns December 3, 2009Posted by Lawrence Lenihan in Uncategorized.
OK, don’t tell anyone that I told you, but VC’s are supposed to make a lot of money for their investors. I mean a whole lot. Like 10x or 20x or 100x! Why do we need such high multiples? Because not all of our companies succeed! We have a high risk of failure and we make way more than 100% of our profits on a small percentage (less than 50%) of the companies in which we invest. The math is pretty simple for us, but my friend and former colleague, Will Price, wrote an excellent piece on this in his blog a while back. (check it out here: http://willprice.blogspot.com/2007/09/portfolio-math.html).
So, we are in an “X” business, that is, multiples on our investment. Our investors need us to generate an annualized return net of management fees and carried interest of more than 20%. These return hurdles are so high because we are in the risk-adjusted return business. The risk is high and, therefore, so should be the return. Since Internal Rates of Returns (IRRs) are time-based outcomes (e.g. for two investments held for different durations, the multiple of the longer duration investment would need to be higher than the shorter duration for equal IRRs), we need at least a couple of 10X exits and some other minor successes to hit these hurdles. We crunched some data last year at FirstMark that showed that more than 60% of successful exits were below $200MM in value. Given only a fraction of all investments are “successful” you start to understand the parameters that we are under to drive returns. If we pay too much, we simply won’t hit our hurdles. If we don’t hit our hurdles, we won’t be in business.