|#522 MWAVC| — VC Math isn’t Mathing ➕➖➗
Hi,
Welcome to MWAVC, a newsletter about finance, investing, venture capital and all that jazz. My name is Ato (more about me here and here) and I try to write every single day. Most of it is stuff I find interesting that I’d like to share and hear your thoughts on. If you’d like to sign up, you can do so here. Or just read on.
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Busy couple of months. Forgive me. That’s all I have to say. Moving on!
Saw this thread from Eghosa at Echo VC and I thought, “finally, something to get me back to posting on a regular schedule” so here we are. Enjoy understanding why VC isn’t easy and the bigger VC fund raises may be just be for the 2% mgt fees 😏. But hey, I respect everyone’s hustle.
Also, for my angel investor friends out there, understand that unless you have pro-rata rights, you really have no business staying in the company when they’re raising a 50m$ Series A. May sounds nice to say “I have money in xxx” but think about dilution and make sure you’re not simply pushed out into oblivion.
I got a few questions from my ‘Fun with VC Math: Designing Funds in Africa’ podcast (https://bit.ly/3MgCueu) and sharing the responses.
I know it can get a bit complex so apologies in advance.
Comments and edits welcome.
1) Why does it take $500M to 1X a $50M fund and $1.35-1.4B to 3x a $50M fund? It seems as if there’s at least one scenario in a 10-company portfolio where 2 companies return 12x or $500M, but that seems unlikely. There are probably embedded assumptions I’m missing.
2) Why does it take 10 Paystacks to return a $50M fund? I tried to do the literal math and failed, so I’m clearly missing something.
3) In the example when you introduce 50% failure rates, why is the average entry price $10M?
Answers:
1) Portfolio construction is the short answer. If you assume you own 10%, then $500m of enterprise value created returns $50m.
So it’s not solely a scenario where a company in the portfolio exits at $500m, but what percentage you own at the exit. By the time you assume dilution, it gets harder to own 10% at exit.
2. With Paystack, assume the exit multiple was 14.4x and assume you invested $1m into it. That is a $14.4m return sans dilution. You’d need to do that 10 times to return ~3x the fund.
Not impossible but the assumptions about the entry price and the dilution that occur during the path to exit mean that the Paystack example is unusual. It raised just a Seed and a Series A prior to its $200m exit so the dilution was not material. Many companies may raise 3 or 4 times and that is where your starting ownership goes to die. I have seen quite a few Series Es and Fs. Gs and Hs exist.
3. And the failure rates tie in to 2 above.
A ten-year $50m fund with a 2% fee may leave you ~$35m to actually invest. Let’s say your strategy is to invest $1m checks, and assume you reserve $10m to defend your pro rata in certain deals.
So you make 25 investments ($25m), and your avg postmoney entry valuation is $10m so you buy 10%.
Then you apply your reserves to defend your pro rata at the A (usually $15m+ rounds) so your check size is say $1.5m. That means you can do ~6 follow-ons to protect your 10% holding.
So if all 6 exit after that point so they don’t raise again (almost statistically impossible), then you hold 10% of the aggregate exit value. You would have invested $2.5m ($1m initial check plus a $1.5m follow on) into each of the 6.
Assuming they are all Paystack type exits at $200m (sure everyone thinks they will be unicorns but actual exit data belies that) then your gross return from the 6 companies is $120m (10%/$20m per company * 6 companies).
But remember we started off by investing in 25 companies.
If 50% fail to return 1x or better, (remember that batting .300 in major league baseball likely gets you in the hall of fame) then we are looking at ~13 companies to drive the fund returns.
Of these 13, 6 based on our example will return $120m. Maybe the remaining 7, representing $7m of investments return 3x (unlikely but let’s say so just for shits and giggles). Then the aggregate fund return is $120m + $21m = $141m.
On first read, that’s a smashing success for a $50m fund ($141m/$35m = 4.02x $-at-work gross, $141m/$50m = 2.82x trued up gross, 2.45x net).
2.45x is still a great VC fund net return (that should put you in the top decile globally iirc) but don’t get too excited as Thoma Bravo and Vista Equity (multi-$B PE funds) exceed this threshold.
This example of course assumes no recycling which is the GP taking interim returns from early exits and reinvesting so that (s)he can get to invest the full $50m and not $35m after fees. Doing so improves the odds for the fund as more dollars are working and not just underwriting fees and expenses.
But to have 6 Paystack exits is quite the dream. I’d sleep in for that.
Which then leads you to the power law. That is, one company sets up to return the whole fund. But for that to happen in a $50m fund, you have to have at least one $1b exit and own 5% of the company after dilution. With the fundraising froth and (increased) round sizes, many companies would have raised 4-5 times before they become unicorns. That’s at least 3-4 dilutive rounds.
Which brings us full circle to why the entry price always matters. Buying 10% for $1m makes it harder to own 5% at a billion dollar exit. Buy 20% and then you have a shot.
But the entry prices are now so high and the competition to invest is so excitably frothy, that $50m funds may actually need up to three unicorns to have a shot at returning 1x.
Rough play.
Sign up to my cousin Yasbo’s newsletter, ChopLife Express btw AND listen to her podcast, Savings or Current. She’s already been dropping some serious gems, including this one on time management and this one on how the economy works.
Also, Afrobility Podcast is exactly what you need to be listening to for the deep-dives into Africa’s most note-worthy companies.
Recommended Substacks: Afridigest by Emeka; African Entrepreneurship Series by Jeph; Getthebrief by Loye and Fola.
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