Why A 4-5x Return On an Investment Isn’t “Good Enough” For Most VCs

Q: Will VCs who invested in my startup be happy to exit with a 4-5x return after 4.5 years?

It’s hard to say.

On average, VCs are looking for the entire portfolio to do about 2.5x “gross” (before fees). They want to do much better, of course. But 2.5x is usually enough to raise another fund, make some money, and fight another day.

So why isn’t 4x-5x good enough on any individual investment?

Two reasons:

  • It’s not enough of the fund. If you put all the fund into 1 investment, then a 4x-5x return would be plenty. But if the investment was say 3% of the fund (a typical amount), then that would only return 12%-15% of the fund. That won’t come close to even getting you to 1x, let alone 2.5x. This math is nonobvious. It’s worth taking a pause and understanding how it works:

This 5x investment above, while impressive in relative terms, only gets you so far in absolute terms in helping the VC fund just make the money back it has invested in total in all its portfolio ($100m).

  • You also have to make up for the failures. This isn’t as big a deal as the prior point once you understand the math, but still, most VC funds will have loss ratios by dollars as high as 40%. So you also have to do “better” to make up for the deals your VCs lose money on.

Combine the two, and it really does take a unicorn typically to “return the fund”, or make 1x the amount the fund has invested. And 1x of the fund isn’t enough.  As a corollary, even just 1 Unicorn in a typical venture fund might well not be “enough”.

So at least for an early-stage fund, the VCs are hoping a couple of the investments do well more than 10x, ideally 50x+ the initial check.

Having said all that, will the VCs be happy with 4x-5x? Yes — if that’s about as well as they think you are going to do. VCs know only a few of their investments will knock it out of the part. If you aren’t one of those, then 4x-5x is still a great outcome.

A bit more here:

Why VCs Need Unicorns Just to Survive

View original question on quora

Published on December 23, 2019

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