Forget the Noise: OC Founders Need Just Two VC Moves

An article we liked from Thought Leader Rex Woodbury of Daybreak Ventures:

Fund Math for Dummies

For Most Venture Funds, the Math Aint Mathing

The Only Two Things That Matter: Ownership and Outliers

Venture capital seems complicated, but it really boils down to two things: (1) good ownership in (2) great companies. Ownership + outliers. That’s about it. Everything else will funnel into one of those two variables.

Let’s look at sample portfolio construction for a Pre-Seed firm. This is oversimplified math, but it should demonstrate the two key variables.

Say we invest $1M each into 30 companies. Because of fees, we’ll need a slightly-larger fund—say, $35M for simplicity. We average 10% ownership at entry ($10M post-money valuation) and get diluted 50% to 5% ownership at exit.

Here’s one set of outcomes that gets us to a ~6x multiple:

22 / 30 companies return $0, while 8 / 30 produce a range of good to great outcomes.

We’re ignoring a lot here: reserves, recycling, gross returns vs. net returns. More on some of those topics in a bit. But the math gets the point across: a handful of companies drive the lion’s share of the returns. Half the proceeds generated here come from a single company, Company 19. Remove Company 19 and you’re down from a 6.3x fund to a 3.4x fund.

A good rule of thumb in early-stage venture:

About 1/3 of companies will be zeroes.
About 1/3 of companies will return their capital, or produce modest returns.
About 1/3 of companies will be outliers, with a couple driving 90%+ of the returns.

This rule of thumb, though directionally helpful, still underestimates the power law. Data from StepStone and Primary shows that we should expect a ~50% loss ratio (with “great” funds actually having higher loss ratios than “good” funds), while over 90%+ of returns come from 10x investments.

To illustrate the power law further, consider what would happen if 29 of 30 companies return $0, but one company becomes worth $5B:

Here we have a 7x fund, turning $35M into $250M+. LPs earn $172M; the GP earns $43M. All because of one company.

Sapphire Ventures put out good data on the top-performing funds in their portfolio. Of funds that are 5x or greater, the best company in the fund averaged 90x; the second-best company averaged 25x; and the average mark for the remaining was a 1x (!). Clearly, this is an industry built on outliers.

This is helpful for VCs to understand, of course: every investment should be a potential fund returner. We aren’t in the business of second base hits. But this is also helpful for founders to understand. A $100M exit might be life-changing for a founder, but it won’t...