Venture Capital Fund Returns: How a Pool of Businesses Generate Value
How can one portfolio company impact the returns of a venture capital fund?
What does a venture portfolio look like over time?
It can evolve quite a bit.
At what point can you tell if an investment will drive significant returns?
It can be six to seven years in some circumstances.
Series A focused venture capital funds are typically comprised of 20+ investments across a pool of capital. The performance of a fund is just the sum of the total returns of those investments minus management fees, carried interest, and expenses to run the fund.
How each individual company performs is rarely shared and typically only available to the Limited Partners of those funds as well as potential future investors.
In a conversation with an entrepreneur the other day, I mentioned that a fund’s early winners, ultimately may not succeed. It’s also common for companies that struggle early on to be the major drivers/ contributors to a fund’s returns.
His response made me realize that few founders and operators have a detailed understanding of how a fund’s performance is derived across a venture capital portfolio. Additionally, it became clear that it would be helpful to share the common paths for venture-backed businesses within a portfolio setting.
Here is an overview of how a fund makes investments over time, how those investments (can) perform, and how such investments drive the returns of the fund.
In order to help people understand a relatively complex topic, I have made the below model overly simple. The performance of the “mock” fund is illustrative of a 3X gross fund (not net of fees, expenses, and carried interest), which is top quartile in most annual vintages. (you can read more on that here, from a great piece by Rob Go)
A few key points to this model:
- Holding values are adjusted for follow-on financing and dilution.
- Each investment is modeled with the same investment amount for purposes of simplification.
Just as a refresher, venture capital firms typically raise money for new funds every 2.5 to 4 years. Firms typically raise new funds once they are sufficiently through what is called their “investment period,” which is the period in which the vast majority of their investments in new portfolio companies are made.
New investments are made within this time period, which results in their being a multi-year gap between the first investment and the last. One could feasibly have already had a company acquired before the last new investment is made. We recently had this situation arise with an investment of ours in Shipt, wherein the business was acquired by Target prior to us still having another six investments to make in that fund.
Here is an illustrative breakdown of the timing of a fund on an annual basis.
Keep in mind, every entrepreneurial journey is different and rarely (if ever) do businesses just skyrocket to the “moon.” Here is how that plays out in a venture capital fund portfolio.
As a way to display the increase in the value of a portfolio company, I have increased the multiple based on when the company has increased in value. The color shading represents its value as well. The darker the green, the greater the return. If red, it means that all of the invested capital has been lost.
If the number goes to zero, then the portfolio lost the investment. If the number is 10x, then it is a 10x investment. Just for purposes of clarity, if we invested $5M in the company that 10x’d, then it would now be worth $50M net of dilution.
I have modeled this across twelve years (most firms are active longer than this though):
If you zoom in, you can see that portfolio company #9 is the big winner of this fund, returning a 24X on the invested capital. I held years 10 through 12 static at 24X, which implies that this fund sold its position during year 10. As you can see below, this business increased in value twice within the first two years and then started to see major shifts in its total value in years 6 and 8.
Portfolio company #17 is one of the businesses that ended up not returning any capital. Most of our portfolio companies survive for 5–6 years, even when they may not be performing well. At year 10, this hypothetical firm “wrote-down” this investment to zero, which means it has no current value.
A few important takeaways here
- As mentioned above, every portfolio company has a different trajectory. Some rise early and fade later, whereas others take a bit of time to get going or have to pivot. You can see how this plays out below. Each line represents an individual portfolio company. The Y-axis is the multiple on each investment.
2. As can be seen below, portfolio company #9 was responsible for 1/3rd of the overall returns and returned the entire fund in and of itself. Companies #5 and #11 were both responsible for 13.79% of the returns each.
3. The total portfolio value ebbs and flows as it rises. Early winners start to falter and late bloomers hit their stride.
The Y-Axis is the multiple on the fund size, not the multiple on invested capital. If it were the latter, the multiple would be 1X at the beginning.
Companies tend to have seven different growth patterns during their lifecycle:
- It is typical for a few portfolio companies to generate the majority of the returns. Which ones drive the returns is not clear early on. It may be 5–7 years before there is true clarity on which companies will be the real drivers.
- The path to a profitable investment is not always the same, and in many circumstances it is not promising early on.
- Just because someone raises a lot of money and is valued highly, does not mean it will result in a successful outcome.
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Brendan Wales is a Partner at e.ventures (eventures.vc), a global venture capital firm with offices in San Francisco, Berlin, Sao Paulo, Tokyo, and Beijing. Since joining e.ventures in 2012, he has been a Seed or Series A investor in Segment, Shipt, HousecallPro, Fetch Rewards, Test.ai, and Shopmonkey.