VC Math 101: Decoding Venture Capital Math for Aspiring Entrepreneurs

Introduction: Why Understanding VC Math Matters

For aspiring entrepreneurs, raising venture capital is often one of the most difficult and unfamiliar endeavors of their journey. Many founders focus on securing that coveted first check, but few understand the financial mechanics that drive venture capital decisions. We see this lack of understanding creating huge frustrations and misalignments. For a more positive experience and a better chance of success, it's crucial to demystify how venture capital (VC) math works; especially because VCs evaluate potential investments through a unique lens unlike any other industry.

In this article, we'll cover the key financial concepts that startup founders need to know, from the power law that governs VC returns to how the size of a fund impacts investment decisions. Understanding these principles will help you better navigate the fundraising process and ensure you know what it takes to become an attractive investment for VCs.

But first, a helpful reminder about how a VC firm works. Venture capital firms borrow money from wealthy individuals and institutions (called limited partners (LPs)) with the agreement they will return them more money in the future. The VCs then lend this money to startups with the same agreement, that they expect a return on this money in the future. There are no handouts in this industry, just a lot of contractual obligations.

The first VC principle to understand is Power Law

The power law is a financial concept of distribution where a small number of holdings generate the majority of the returns. In a typical VC portfolio, only about 10% of the portfolio generates approximately 95% of the returns, making up for the losses or low returns of the remaining companies. The power law dictates that successful startups are extreme outliers, achieving exponentially higher returns than others. This distribution shapes a VC's investment strategy, compelling them to seek out and support companies that have the potential to deliver upwards of 100x returns.

An example of how this typically works: For every 10 investments a VC fund makes, usually 1 will do very well, ~3 will have a small return or breakeven and the rest will return $0. This is just the reality early-stage VCs are faced with despite every investment seeming good at the time of investment.

So for example, a VC fund makes 10 investments, each of $1 million, $10M in total. If 7 of these startups fail and return $0, and 2 return $2 million, the remaining 1 would need to return at least $25 million (25x multiple) for the fund to have a modest return to investors.

Does your startup have "Return the Fund Potential"?

Because of power law, a core goal for any VC is to back startups that have the potential to "return the fund"—that is, a single investment should be capable of generating a return equal to the entire value of the fund.

For a $100 million fund, a single investment needs to deliver $100 million in profit (excluding the initial investment, fees, and carried interest) to achieve this. If a VC owns 10% of a company, that company must exit for $1 billion for the VC to return its funds from a single deal.

Now you see why there's all this fuss about unicorns and why valuation is extremely important.

The key takeaway here is to understand why VCs care so much about growth and scale. Founders need to understand that VCs aren't just looking for companies that will be profitable; they want ventures that can dominate markets and scale rapidly. If your business model and comfort zone only support moderate growth, it might be better suited for alternative financing sources; which there is nothing wrong with and is often an easier path.

To further understand how this plays out in the real world, you need to look at how power law and return the fund apply at the fund level because while the distribution looks largely the same, the numbers look very different based on fund size.

How Fund Size Determines Exit Size

The size of a VC fund significantly impacts the type of investments a VC will consider and the required exit size. Larger funds must focus on investments that can produce large-scale exits, while smaller funds can afford to back smaller, niche opportunities.

Simply put, the larger the fund, the larger the exit needed to deliver a meaningful return, as larger funds have more capital to deploy and thus need proportionally larger exits to generate the same level of performance for their investors.

Consider a $500 million fund aiming for a 3x return. To achieve $1.5 billion in returns, the fund needs some huge exits to achieve this. Typically a fund of this size will own anywhere from 10%-25% of a company, so at 10% ownership, they'll need $15B in exits; at 25% ownership, they'll need $6B in exits.

In contrast, a $20 million fund looking to achieve $60M in returns can invest in companies that can exit in the $200M-$400M range assuming 5%-10% ownership.

Being practical about how big you think you can make your company will save you a lot of time and effort if you are going for VC money. Matching exit value to the size of the funds you are pitching to can be a crucial step in this process and shows you’ve come prepared.

Knowing your market size thoroughly, which we will cover in subsequent articles, makes all the difference when having these conversations with VCs.

And we see very few founders actually doing this!

Everything we've discussed up to this point has been very back-of-the-envelope math to hopefully make things simple and easy to understand. You can take away these simple calculations and apply them very easily to know if that fund could be a good fit for you based on size.

In the real world, VC math does get much more complicated when you start to factor in things like dilution from multiple rounds of funding, management fees, carried interest, exit timelines, initial checks vs follow-up, and liquidation preferences; all of which we will cover in subsequent posts.

Stay tuned for VC Math 201 coming soon.

Further Exploration

For those interested in diving deeper into the math and strategy behind venture capital, consider exploring resources such as:

• Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Brad Feld and Jason Mendelson

• Secrets of Sand Hill Road: Venture Capital and How to Get It by Scott Kupor