Because for VCs, a low but real probability of a huge outcome is better than a high probability of a medium outcome.
Imagine two scenarios:
- Good CEO, good start-up, doing $1m ARR, growing 100% Year-over-Year. At this scale, the company won’t fail. The CEO wants to sell for $80m-$100m. This puts the company in the top 1% of venture-backed start-ups, those that sell for this much. You can invest at a $10m valuation. You get to buy 20% for $2m.
- Great CEO, unclear start-up, doing $0.1m ARR, not growing yet. It’s very early. But a handful of customers say it’s insanely great. Decacorn or bust. The company is hot somehow so you can only invest at $30m post. You can buy 15% for $4.5m.
- Your fund is $150m in size.
In the first scenario, you have a decent chance of an 8x-10x return (which is great) on ~$2m … and making $16m-$20m.
In the second scenario, you have a small chance of making money, and the deal is twice as expensive with 1/10th the revenue. But. At least there is a chance of a $1b+ exit. You have to invest ~$4.5m here to get less ownership. But if somehow the second company IPOs at $2b … you make $300m.
The first scenario is the more rational bet, probably, the right bet to make with your own money. But it only returns 10–13% of the fund. You aren’t even close to making money on that $150m fund yet.
The second scenario is a bit nuts for your own money. The price is way too high, and you will probably lose it all. But. The $150m VC fund returns 200% of the fund just with this one investment.
And also — the second scenario is the same amount of work as the first one. It’s very hard to make small outcomes up in volume.