Fake Gods
A lesson on what most VCs don't talk about
If you have been around the block a few times, a VC website’s “portfolio page” might have exit or IPO labels on them.
A super star unicorn exit does a lot to attract founders and LPs* alike but…. a warning to both, make sure you look under the hood.
Hidden behind the external “acquired or exit” markers, is something rarely discussed - namely, just because you have invested in a unicorn does not mean you are in for big returns.
One of VCs least sexy and discussed topics is how a fund distributes its follow on capital. This decision can make or break a fund. Lets take three very very simplified “follow on funding” scenarios:
Setting the Scene:
In all scenarios, a fund raises $100 million. They decided to invest $5 million at seed stage into ten companies owning an equity stake of 10% in each company in the first three years. The fund has the remaining amount ($50 million) to deploy into these portfolio companies. The timeline of the scenarios are as follows:
Year 1: 4 Start ups - A B C D
Year 2: 3 Start ups - E F G
Year 3: 3 Start ups - H I J
Scenario 1:
Start up B starts to do super well and goes out to raise their next rounds in Y2, Y3 and Y4, growing quickly and at chunky valuations. So the fund decides to invest $30 million across these three rounds to maintain their equity stake at 10%. By Y4, the company had raised $250 million in total. LPs* are happy and the fund hopes that Start up B will IPO soon.
In Year 4, Start up J starts doing exceptionally well, Generative AI has exploded, and growth funds are flocking to invest. With the $20 million remaining, the fund needs to decide how to distribute the remainder of their funds.
The team makes the decision to put all of the remaining $20 million into Start up J across its three subsequent rounds. Due to not quite having enough funds, the fund only maintains 7% equity (due to dilution**) at the time of exit.
BUT great news, both companies do well:
Start up B exits at €700 million valuation = returning $70 million to investors
Start up J exits at €1.5 billion valuation = returning $105 million to investors
However, all the other companies fail but through liquidation preferences*** €5 million is clawed back from each investment = $40million.
Therefore, the fund returns 2.15x ($215million)
Not too bad, but the fund still wishes it had reserved more to deploy into Start up J.
Scenario 2
The fund decided to double down on all investments equally (adding another $5million to each portfolio) but at the end of the fund’s lifespan eight companies exit at $50 million. The fund manages to retain an equity stake of 9% of each company.
Companies A and G however, perform well and end up exiting for $800 million each. However, due to this even distribution of follow-on funds, the fund’s equity stake in both has been significantly diluted over subsequent investment rounds meaning they now only own 4% of both companies.
Eight companies return: $4.5 million = $36 million
Companies A and G return: $32 million = $64 million
Therefore, this fund returns 1x ($100 million)
Scenario 3
Start up B starts to do super well and goes out to raise their next rounds in Y2, Y3 and Y4, growing quickly and have received very high valuations. So the fund decides to invest $30 million across these three rounds to maintain their equity stake at 10% (after dilution), the company in total has raised $250 million. LPs are happy and the fund hopes that Start up B will IPO soon.
In Year 4, Start up J starts doing exceptionally well, Generative AI has exploded, and Growth funds are flocking to invest. With the $20million remaining, the fund needs to decide how to distribute the remainder of their funds.
The team makes the decision to put the remaining $20million into Start up J’s subsequent rounds. Startup does six of these but the fund only participates in the next four before it runs out of reserve capital. However, Start up J is the hottest deal in town, valuations go up and up leading to a $5 billion valuation with over $900million being invested into the company in the private markets. Our fund’s $20million additional investment allows them to maintain only 4% ownership of the company. However, with the hope of a $10 billion+ IPO, it does not matter, 4% of $10 billion is $400 million.
However, as the IPO is about to be announced, Apple releases a tool 10x better than Start J’s…. the IPO collapses and Google turns up offering to buy the company’s Intellectual Property and client base for €600 million. Due to Liquidation Preferences*, and this fund being unable to participate in the last few rounds, they are left with nothing…
So in the end:
Start up B exits at $700 million valuation = $70 million
Start up J returns nothing
All the other companies fail but through liquidation preferences €5 million is clawed back from each investment = $40 million
Resulting in a feeble 1.1x multiple ($110 million) and pissed off investors.
Conclusion
These “basic” scenarios just give you a taste of the number of variations that can happen in a ten year fund cycle, and they do not even take into consideration things like “fund recycling” and “inflation”. It also highlights the fragility of VC game, that only with truly vast exits can you be sure to get the significant returns that LPs* are looking for. It makes you appreciate the fund managers and founders who do manage to successfully navigate these choppy and unknown waters.
One question, that I could spend decades on, is whether post-initial investment decision-making is pure luck or exceptional strategizing or a combination both?
So I word of advice - Founders and LPs alike when deciding to work with a VC, delve into a GPs**** follow on investment strategy past and present.
I am confident that it will reveal a lot of what is under the hood.
Terminology
*LP (or Limited Partners) are the people that invest in venture funds.
**Dilution occurs when the percentage of ownership for existing shareholders is reduced as a result of issuing additional shares of stock. Here’s a video explainer.
***Liquidation preference: The liquidation preference determines who gets paid first and how much they get paid when a company must be liquidated, such as the sale of the company. Investors or preferred shareholders are usually paid back first in order of timeline (latest to last), ahead of holders of common stock and debt.
****GPs (or General Partners) are the people responsible for distributing the funds.