dv766095Lately there has been a lot of discussion about the broken VC model. Some blame the dry IPO market, LPs taking big hits on overvalued investment and running for safer asset classes and a heightened interest in liquidity. It’s no wonder than, that only 19% of Israeli venture capital funds plan to make new investments in 2009 according to the Deloitte Brightman Almagor Zohar Israel VC Indicator Survey results for Quarter 3, 2009 (see document below).

next six_israel vc

Israel VC Indicator Survey

It all comes down to a simple principle – in order for the VC model to work, the fund needs to compensate its investors for the high risk they are taking, therefore, an investment needs to yield not only an abnormal return (compared to the market and other alternative investments) but it also needs to cover for all those investments that didn’t yield anything at all (see TC’s deadpool for many examples).

I had a chance to meet Fred Wilson of Union Square Ventures in London a few weeks ago. He calls it the Venture Capital Math Problem:

The venture industry has been raising between $20bn and $30bn per year for the past few years. Here’s recent data from the NVCA’s web site.

VC Fundraising

Let’s be generous and say that the average is $25bn per year (it’s actually more). The math problem is to figure out how much in proceeds every year need to be generated to deliver a reasonable return to the investors.

Here’s how I go about solving it. My math is not perfect and I’d like to hear from all of you how you’d solve it in the comments.

First, the money needs to generate 2.5x net of fees and carry to the investors to deliver a decent return. Fees and carry bump that number to 3x gross returns. So $25bn needs to turn into $75bn per year in proceeds to the venture funds.

Then you need to figure out how much of the companies the VCs normally own. The number bandied about by most VCs is 20%. That means that each VC investor owns, on average 20% of each portfolio company. We’ll use that number but to be honest I think it’s lower, like 15% which makes the math even tougher.

Using the 20% number, that $75bn per year must come from exits producing $375bn in total value.

But it is also true that many of these exits have multiple VC investors in them, sometimes three or four. So you really need to look at the percent ownership by VC funds in the average deal at the time of exit. That number is likely to be over 50% and maybe as high as 60%. If we use 50%, then to get $75bn per year in distributions, we need to get $150bn per year in exits.

Here’s where my math starts to get a little fuzzy and where I’d love some other approaches…

Now put yourself in the shoes of the VC. When you come to pitch him your business idea for a social media application with an ad-supported business model, will you be one of the companies that will get him these results? Can ultra-light start ups even live up to this expectations? Are you  the CEO that they are looking for, one that is willing to go all the way and remain patient until the big payday?

Think about all that and then decide if the VC funding route is the right one for your start up. You may want to save yourself the heartbreak when your board doesn’t approve a ‘small’ exit of $20-$50 million and call an angel instead.

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Eze Vidra

Head of Google for Entrepreneurs Europe and Campus London at Google
Eze is the Head of Google for Entrepreneurs Europe and Campus London. In 2005, he started VC Cafe to shine a spotlight on startups and Venture Capital in Israel, and in 2012, Eze founded Techbikers, a non-for-profit that supports education through cycling challenges for techies.
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