If you read the media, you will often see that VCs are chasing unicorns and that it is all about unicorns nowadays. But in fact what VCs really need is a fund returner.
What’s a fund returner?
Before I answer that question, let me briefly explain one thing about how the VC machine works. VCs invest capital out of a close fund. The fund is 2% the VC’s own money (2% is market standard, but it can be higher or lower) and 98% the limited partners’ money (LPs). The VC’s job is to generate an above-average, risk-adjusted return for the LPs, which in general is considered to be 4x net cash-on-cash return. So for example, if an LP invest $10m in a VC fund, the VC needs to return at least $40m net to this LP to be considered a top tier performer. Why so much? Because venture capital is the riskiest asset class there is (“startups are risky and fail”) and investors need to be compensated for that extra risk. So now, let’s say that I’m a VC and just raised a $100m fund. To be considered as a good VC investor, I need to return $400m within the lifetime of the fund (usually 10 years). How do I do that? Well, this is when the fund returner matters.
A fund returner is one single deal which exit proceeds pay back the entire fund. VCs needs fund returner because they know that many portfolio companies will fail and the return will come from a few companies only. Therefore in order to increase their chances of success, one question VCs ask themselves prior to investing in your company is whether it can move the needle for them, i.e. can it be a fund returner? Because only a fund returner can help me reach my target of $400m. In my example, a fund returner would generate $100m in proceeds. Assuming I own 10% of your business (a rather fair % at exit for seed investors), simple maths would assume that an exit of $1B would be the minimum for me to even consider investing in your company. Assuming I can manage to increase my initial ownership to let’s say 20%, a $500m exit price would also make you a fund returner. But in a VC environment full of capital, the deal competition is high and valuations rise. Hence the difficulty for VCs to secure 20% or more ownership in this current environment. As a side note: many investors speak about generating a 10x on a deal - this metric is misleading since the fund performance depends on the portfolio construction, i.e. a 10x return based on a small amount invested will not move the needle on a fund level.
So are you a fund returner?
Before raising venture capital, make sure to understand this: professionally managed VC funds will need you to achieve a $b+ exit within their fund’s lifetime. So while a sub $100m exit is a big deal if you own most of your company, such exit size is irrelevant for VCs. Not every entrepreneur will for sure achieve a $b+ exit and that is why founders should keep their options open. Bootstrapping in the early days is the best way to keep high optionality while you gather more insights on the business’s actual potential as well as your personal goal. After that point, you can either raise VC (at much better price and terms btw) in order to speed up growth, or you can decide that selling is not an option and continue to grow a stable and profitable tech business.
Before you leave
Important note: this post is not anti-VC. It is an invitation to founders to reflect on the rights financing alternative for their business. If you are interested to learn more about self-funding strategies and venture capital financing, join us at our next Mereo event:
Where? Wayra Deutschland, Kaufingerstr. 15, 80331 Munich.
When? Friday, March 29th at 9am.
How to join? Shot me an email at mereo.community@gmail and briefly explain why you would like to join. Only 10 seats available.
Thank you for reading and please tell a few friends about Mereo if you feel like it.