Deals

Why VCs aren’t insanely rich

Man standing with cash raining
Image Credit: Shutterstock

Arie Shpanya is the CEO of WisePricer

I’ll start with a spoiler, or more precisely the bottom line: VC’s are not that insanely rich, or at least the vast majority of them.

Jason Lemkin, a managing director at Storm Ventures, recently mentioned in his post on Quora that venture capitalists end up with personal effective ownership of 32-40 percent of a “company” on a “one company equivalent” basis.

Here is a recap of the assumptions:

  1. VCs invest 20 percent in 20 companies
    A VC that does A/B rounds and buys 20 percent ownership each time they invest.
  2. The VC gets 4 percent of the gains
    Firms (not partners, we’ll come back to it later) typically themselves keep 20 percent of the gains on 20 percent ownership.
  3. Personal effective ownership in each is 32 percent
    VC firms typically invest in eight deals per VC (8 deals times 4 percent)

The bottom line is effective ownership of 32 percent in a portfolio of great companies, which then means that you’re insanely rich.

I beg to differ, as the second part of the equation is that in a typical fund the returns are from 20 percent of the investments. In addition, the partners split the carry among the partnership, with the involved partner getting a bit more (a bit, not 100 percent of the VC gains on that investment).

Thus, effective ownership is actually just 6.4-8 percent of a successful company.

No matter what, at the end of the lifetime of the VC, the VC partner will personally own a 6.4-8 percent equivalent of the successful company. No risk, no hassle, and you still get a hefty sum of management fees. In other words, every 4 years you’ll have a major liquidity event. So in a way it’s like being a serial entrepreneur.

It’s definitely good, but not great. Not great enough in terms of justifying the title “insanely rich” (which will be the exception).

So, let’s drill into some numbers, shall we?

The  33%/33%/33% Rule or X2.5 ROI

Most VCs will invest in flops anyhow. But let’s take an optimistic scenario of the VCs that are in the “above average” tier. Here is a super optimistic scenario (partner at top performing great fund VCs, a Mark Suster/ Fred Wilson/choose your other VC rock-star fund):

Assume you have a great fund that you have raised. Five partners, about 100M (the average VC size is 149 million, but for the sake of easy math let’s keep it simple). Let’s say it was very successful, and made 2.5x on the money. They will get 20 percent from the extra.

Now, let’s do the math based on Fred Wilson’s approach from Union square ventures: He states that they aim for a batting average of ⅓,⅓, ⅓  : “we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments (A.S- with 7.5x avg return).”

Example one:
Fund size: 100M
33 percent which reflects 33 million  x 0 percent ROI= 0
33 percent which reflects 33 million x 60 percent ROI = $20 million (some of the money will be returned)
33 percent which reflects 33 million x 700 percent ROI = $231 million

Total gains: $251 million
Net gains: $151 million ($121 to investors, $30 million to VCs)
Gains per partner (five partners): $6 million (0.6M-1.2M/yr*)

Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of extensions to allow for private companies still seeking liquidity. Not bad … but they need to be REALLY good. And most, again, aren’t. (Thank you Ofer‏ for the feedback on this.)

Example two:
Let’s try again with a $150 million fund:

Fund size: $150 million
33 percent which reflects $50 million  x 0% ROI= 0
33 percent which reflects $50 million x 100% ROI = $25 million
33 percent which reflects $50 million x 750% ROI = $375 million

Total gains: $400 million
Net gains: $250 million ($200 million for investors, 50 million for VCs)
Gains per partner (five partners): $10 million ($1-2 million/year).

So 20 percent of $250 million is about it: $50 million split by five partners. That’s $10 million each, which you need to then divide by the years of the fund life (typically five to ten). Again, not bad at all…but not the kind of fuck you money that makes VCs insanely rich.

The 40%/40%/20% Rule:

Now, lets try the math with a 40 percent/40 percent/20 percent rule which is the above average standard (according to National Venture Capital Association, not me).

VCs invest in high-risk enterprises. However, venture capitalists manage that risk through portfolio risk management. It is estimated that 40 percent of venture backed companies fail; 40 percent return moderate amounts of capital; and only 20 percent or less produce high returns. In a typical fund the returns are from 20 percent of the investments. It is the small percentage of high return deals that are most responsible for the venture capital industry consistently performing above the public markets.

Let’s take our $100 million fund. The VC invests in 10 companies ($2-7 million per investment that includes bridge loans, tag alongs, and practicing first refusal rights to maintain ownership share).

The breakdown by the type of investment might look like this:

Since we’re following a more “conservative/realistic” 40 percent/40 percent/20v rule the numbers will look like this:

40 percent which reflects $40 million  x 0 percent ROI = 0
40 percent which reflects $40 million x 60 percent ROI = $24 million
20 percent which reflects $20 million x 700 percent ROI = $140 million

Total gains: $164 million (split: $115 million investors, $29 million VCs)
Net gains: $64 million ($51.2 million for investors, $12.8 million for VCs)
Average number of partners: 5 . Average year of fund: 5-10
Net gain per partner: $2.56 million or $0.25M-0.51 million per year

I was intrigued by Magma, an Israeli VC that was on a recent streak of wins (Onavo and Waze, both sold to Facebook and Google respectively with over 10X multiplier), as I was sure their batting rate is much higher. So I’ve looked at how many exits they had. Total exits are 7/24 (29 percent success rate), and with some 10X investment, there are 3X investments, which aligns with the average 7X ROI on winning investments.

So same deal here.

I was once offered a consulting package by an ex-VC partner (it was a 10 percent finders fee plus $5K/month for a 3-month consulting period). While the 10 percent makes total sense (getting 10 percent out of the seed funding amount as a finders fee), I couldn’t grasp what a respected ex-partner at a respected VC is going to do with $15K? Isn’t he carrying boatloads of cash already? What would a lousy $15K do?

That was the moment when the uber rich VC image that I had was completely shattered.

If you’re a VC, you’ll make some great money, but not FYM and you’re not the equivalent to Sean Parker. You’ll be more like Don Harper. Who the hell is Don Harper?? I don’t know… that’s my point (and if Don Harper is reading this post and happens to be a VC, I apologize in advance.

Oh yeah: James Altucher, I apologize for stealing your joke. I just like it so much I couldn’t help it.