Why should you care about VC math as a startup founder? Well, because you should know who you’re getting into business with and their incentives which explain a lot of their actions… Alright, let’s dive real deep into the VC world. Grab your scuba gear, because we’re going all the way down!
First things first: what exactly is a VC fund?
Think of it as a pool of money, but instead of being filled with water and screaming kids, it’s filled with cash and ambitious dreams.
This pool of money comes from Limited Partners (LPs). These are the folks with deep pockets – we’re talking pension funds, endowments, family offices, and sometimes even successful entrepreneurs looking to give back to the startup ecosystem. They’re called “limited” because their liability is limited to the amount they invest. They usually invest 1-10% of their total capital assets into venture capital and the rest into other asset classes (public markets, real estate, arts and antiques, debt, you name it).
On the other side, we have the General Partners (GPs). These are the actual venture capitalists, the ones you’ll be pitching to. They’re the ones making investment decisions and (hopefully) turning that pool of money into an ocean of returns.
Now, how do these GPs make money?
Two ways:
- Management Fees: This is typically 2% of the fund size per year. It’s meant to keep the lights on and pay salaries. So if a fund is $100 million, the GPs get $2 million per year to run the show. However, the 2% decreases to only 1% after year 4 when the active investment period is over.
- Carry: Short for “carried interest,” this is where the real money is made. It’s usually 20% of the profits of the fund. So if that $100 million fund turns into $500 million, the GPs pocket 20% of that $400 million profit = $80M. Not too shabby!
But here’s the catch – VC funds typically have a 10-year lifespan. The first 3-5 years are for making new investments, and the rest is for follow-on investments and (hopefully) exits. This means GPs need to raise a new fund every 2-4 years if they want to keep those management fees flowing.
The VC Scorecard
To raise a new fund, GPs need to show LPs that they’re worth betting on. They do this through two key metrics:
- IRR (Internal Rate of Return): This is the annualized return of the fund. A top-quartile VC fund aims for an IRR of 20% or higher.
- DPI (Distributions to Paid-In Capital): This measures how much cash the fund has actually returned to LPs compared to what was invested. A DPI of 3x or higher after 10 years is considered strong performance.
- TVPI (Total Value to Paid-In Capital): This is the big-picture metric, combining the realized returns (DPI) with the estimated value of the fund’s current holdings. It gives LPs an idea of the fund’s total performance before the end of its lifecycle, both realized and unrealized. A TVPI of 3x or higher is generally considered good, but the higher, the better!
These metrics are like the report card for VCs. Good grades here mean happy LPs, and happy LPs mean more money for future funds.
How do they get a 3x portfolio return?
Not by investing in 30 startups that all return 3x unfortunately, because of something called the power law.
The power law is basically VC-speak for “go big or go home.” It means that in a typical VC portfolio, a tiny handful of investments will return the entire fund (and then some). We’re talking unicorns, people!
Here’s how it breaks down:
- Most investments (like, 70-80%) will fail or return less than the original investment. Ouch.
- A bunch (10-20%) will return 1-5x. Not bad, but not earth-shattering.
- A select few (maybe 5-10 %) will return 5-20x. Now we’re talking!
- And then there’s the holy grail: 1-2% that return 50x or more. These are the ones VCs dream about.
So what does this mean for you, dear founder? Well, it means VCs are looking for startups with massive potential. They’re not interested in “nice little businesses.” They want companies that could dominate entire markets.
The larger the fund, the larger the outcome needs to be.
This is why you’ll often hear VCs ask about your TAM (Total Addressable Market). If your TAM isn’t in the billions, most VCs will pass faster than you can say “pitch deck.”
But here’s the kicker: even if you have a huge market, that’s not enough. VCs also need to believe that your team can execute to capture a significant share of your massive TAM. This is why everyone in venture capital is talking about the importance of the team.
Furthermore, your startup needs to have some secret sauce, some unfair advantage that’ll let you leave the competition in the dust.
Now, I know what you’re thinking: “My startup is amazing! We’re going to revolutionize [insert industry here]!” And hey, you might be right! But if you can’t convince a VC that you have 100x potential, you might need to look elsewhere for funding.
So, which startups are VC-fundable?
Here’s a quick checklist:
- Huge market potential (we’re talking billions)
- Scalable business model (software is the darling here)
- Strong team with relevant experience
- Clear unique and innovative advantage
- Early traction that hints at explosive growth
If you’re ticking all these boxes, congrats! You’re speaking VC language.
Because when you take VC money, you’re not just getting cash – you’re getting a whole lot of expectations bundled with it.
After the investment, VCs need those massive returns dictated by the power law to make their math work. This means they’ll be pushing you for fast growth – and I mean fast. We’re talking “make Usain Bolt look like he’s running in slow motion” kind of fast.
They’ll also want you to raise another round within 18-24 months. Why? Because they need to show their LPs that their investments are appreciating in value. Your new investment round at a higher valuation lets them mark up their investment in their spreadsheets, making their performance look better on paper.
This can be great if you’re building a hypergrowth company and everything goes according to plan. But it can also mean immense pressure, potential dilution if you can’t meet those growth targets, and sometimes making decisions that prioritize growth over profitability or other important factors.
There is also an advantage to the power law. If your company doesn’t work out and fails, the VC has no reason to hate you. It just means you’re one of the 90% of the portfolio not performing. If you showed that you did good work but were unlucky this time, the VC can be convinced to back you again.
Ask yourself
So before you jump into the VC pool, ask yourself: Is this the right path for my startup? Am I ready for the high-octane, high-stakes world of VC-backed growth? Can my business realistically achieve the kind of returns VCs need?
If the answer is yes, go for it!
Taking VC funding is like strapping a rocket to your back. It can propel you to incredible heights, but it can also blow up spectacularly if you’re not prepared. Make sure you’re ready for the ride before you light that fuse!
At the end of the day, VC funding isn’t the only path to startup success. But if you do decide to dive in, at least now you know what’s swimming beneath the surface. So go forth, pitch with confidence, and may the startup gods be ever in your favor!
