Understanding Venture Capital Math: A Comprehensive Guide for Startup Founders

Have you ever wondered how venture capitalists make decisions about which startups to invest in? Or perhaps you’re curious about how they calculate their returns? Want to frame your pitch better so investors can relate more?. If so, you’re in the right place.

This blog condenses our learnings as founders that have raised millions and have been raising capital for more than 7 years. We will break down the complex world of venture capital math and help you understand the key principles and metrics that drive investment decisions.

Why Understanding Venture Capital Math Matters

When you are creating your deck for your funding round and preparing what you want to talk about when you meet with investors, there are a million things that you can pitch. However, raising capital from investors is extremely difficult, according to Forbes, only 1% of startups raise capital from Venture Capitals. So it is very important that you choose the right things to focus on when you talk about your startup. Understanding the logic and principles that guide how these funds operate will help you building rapport when pitching them and make the whole situation less “stiff”.

Key Concepts in Venture Capital Math

We are going to talk about the following basic concepts around Venture Capital math:

  • Power Law: Why they invest
  • Fund size and Check Size: How they invest
  • Performance metric: The Exit Multiple and IR
  • Basic concepts in VC deals:
    • Pre-Money and Post Money Valuation
    • Ownership Percentage
    • Dilution

Power Law: Why they invest

The VC math that venture capitals have in mind when they hear founders pitching is run by The Power Law, a law that explains many events around us, both in business and in nature, follow an exponential growth pattern, or “power law”: The bigger they get, the faster they grow.

In the case of startups, the numbers are that 5% of startups generate 95% of all exit returns. That’s what’s called “The Power Law”, and it’s the law embedded in every successful fundraise and why real VCs always aim at investing in home runs.

The Power Law indicates that in a typical scenario, out of 100 startups a standard investor backs, only 2-4 will bring returns that multiply the entire fund.

The outcome of the remaining 97 investments essentially becomes way less relevant than the overwhelming impact of The Power Law. This success happens with successful artists and music labels, with movies in Hollywood or the video games investments.

Knowing this, your mission as a founder, your mission is to craft a narrative that convinces investors that your company is poised to be one of those rare success stories that can return their entire fund many times over.

This evokes two thoughts:

  1. Focus on the size of outcome, if successful, rather than the probability of success. Let the investor determine your probability of success. They will assess this based on your team, the space, and external factors that are hard to change.
  2. The thing that drives someone to believe that an investment of $1M is going to turn into more than $100M (100x) can’t be the facts. Therefore, emotions play a big role. Startups are projects that, by definition, don’t have all the information to determine their success. When someone doesn’t have all the information, emotions drive many decisions. Facts in your story only matter insomuch as they generate an emotion that leads to an investment decision. (needless to say you should never come with made-up “facts”…!). Top early-stage investors understand that your ability to evoke emotions amplifies your impact. It helps in your fundraising, but also in bringing talent, unifying your team, convincing clients, landing partnerships, and many factors that will determine your probability of success.

Always keep in mind what are the variables and weights that VCs assess when investing, and understanding the Power Law is a great tool for you as a founder to be able to successfully raise capital and how emotions play such a big role when investors decide to invest. Remember; numbers, projections and an investment thesis follow a good story. Not the other way around.

Fund Size: How they invest

Now that we have talked about the Venture Capital math behind “why” Venture Capitals invest, now we are going to talk about “how” they invest. This section will help you understand how they calculate ticket sizes, follow-ons, their performance metrics and their fee structure with their LPs (Limited Partners).

Let’s use a $100M fund example where the founder has decided to target 20 investments.

1. Management Fees:

Funds have on average 2% of yearly management fee ($2M a year). According to Pitchbook, the average lifetime that VCs agree with their Limited Partners is 10 years (therefore, $20M in management fees). That means:

  • $20M in management fees.
  • $80M to invest.

2. Follow-on strategy:

A follow-on is the capital that VCs will deploy in the companies that are doing best from the 20 investments they have performed. For this, they normally allocate between 40% (called ”what’s left” strategy) and 60% (”Percentage of the Fund” strategy) for follow-ons, this means they would invest 2$ in follow-ons for every dollar invested.

So on average, they set aside 50% for follow-on investments = $50M Amount for initial invesments = $80M – $50M = $30m

3. Initial average check size:

Average check size = Amount for initial investments / Number of Companies = $30M / 20 Companies = $1.5M

4. Wrap-up:

From a $100M Fund, this is the structure of the fund:

$20M Management Fees + ($1.5M x 20 Companies) + $50M Follow-ons

There are even more aspects behind the VC math of the structure of a Venture Capital fund, but it’s a great understanding if you are a startup founder raising capital.

Performance metric: The Exit Multiple and IRR

When evaluating the performance of a startup investment, venture capitalists rely on two key metrics: the Exit Multiple and the Internal Rate of Return (IRR).

The Exit Multiple

The Exit Multiple is a straightforward measure of investment performance. It is calculated by dividing the total capital received from an exit by the initial investment. For example, if a venture capitalist invests $1 million in a startup and later exits the investment with $10 million, the Exit Multiple is 10x. This metric helps investors quickly gauge the magnitude of returns from their investments.

Internal Rate of Return (IRR)

The IRR is a more complex and nuanced performance metric that considers the time value of money. It is the annualized effective compounded return rate that makes the net present value (NPV) of all cash flows (both inflows and outflows) from an investment equal to zero. In simpler terms, IRR reflects the annual growth rate of an investment, taking into account the timing of cash flows.

For venture capital investments, IRR is particularly important because it adjusts for the duration over which returns are realized. A higher IRR indicates a more efficient use of capital, where returns are generated more quickly. Venture capitalists often target a gross IRR of around 30% for early-stage investments and around 20% for later-stage investments. These targets account for the high-risk nature of early-stage ventures and the relatively lower risk of later-stage companies.

Understanding the Relationship Between Exit Multiple and IRR

While both the Exit Multiple and IRR are crucial for assessing investment performance, they provide different perspectives. The Exit Multiple focuses on the total return relative to the initial investment, whereas IRR accounts for the rate at which these returns are achieved over time.

For example, an investment that returns 10x the initial capital over 10 years will have a lower IRR compared to an investment that returns the same 10x over 5 years. This is because the latter achieves the same multiple in a shorter period, thus generating a higher annualized return. In this table created by Industry Ventures, you can see what a great multiple and a great IRR are for investors of each stage:

Basic concepts in VC deals:

When starting negotiations with investors and Venture Capitals, the most simple math in VC you need to know are the following:

Pre-Money and Post-Money Valuation

One of the first things you need to understand in venture capital math is the concept of pre-money and post-money valuation. The pre-money valuation is how much your company is worth before receiving investment. The post-money valuation is the pre-money valuation plus the investment.

If your company is worth $8M, and you close a $2M funding round, just after the transaction, your company will be worth $10M ($8M + $2M of cash invested)

Ownership Percentage

Venture capitalists buy a percentage of your company when they invest. The percentage they own is calculated by dividing the amount they invest by the post-money valuation.

Dilution

Dilution is what happens when more shares are issued to new investors, reducing the percentage of the company that existing shareholders own. Understanding dilution is crucial because it can significantly impact your ownership stake in your company.

Conclusion

By understanding the Venture Capital math that investors calculate when investing in companies and framing your pitch in a way that your startup can achieve them, you can align your pitch with the expectations and goals of venture capitalists.

Remember, focus on the size of the outcome rather than the probability of success. This means speaking about the Total Addressable Market, your secret insight inside the industry, how special your team is, and any other aspects that can help you craft a narrative around a massive and executable return.

This not only makes your proposition more attractive, but also establishes you as a knowledgeable and strategic founder who understands the dynamics of venture capital investing.