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June 17, 2005
MYTH: 10x "Best Case" Return is Compelling to Investors
REALITY: 10x “Worst Case” Return is Compelling to Investors
- $500m Venture Fund Size
- $10m Average Investment Size
- Series B Average Investment Stage
- 50 Deals Total
Do the math!
- 100x at 5 years delivers an incremental 15% IRR to the fund
- 10x at 5 years delivers an incremental 1.5% IRR to the fund
- 100X at 10 years delivers an incremetal 7% IRR to the fund
- 10X at 10 years delivers an incremetal 0.7% IRR to the fund
In other words
- To get a 15% IRR at 5 years, at least 1 deal out of 50 needs to return 100x
- To get a 15% IRR at 5 years, at least 10 deals out of 50 need to return 10x
- To get a 30% IRR at 5 years, at least 2 deals out of 50 need to return 100x
- To get a 30% IRR at 5 years, at least 20 deals out of 50 need to return 10x
Venture Capitalist’s Game Plan
As with any heavy hitter in baseball, every swing of the bat must be to the bleachers. Only 100x and above are home runs — 10x base hits just don’t count.
Entrepreneur’s Game Plan
For a business plan to be compelling to smart investors, it needs to convince them that a 100x return is not only possible but probable.
In other words, if you need to raise —
- $10m — you need to show how you will get the enterprise value to be $3b to $5b at year 5 without additional financing
- $2m — you need to show how you will get the enterprise value to be $500m to $1b at year 5 without additional financing
- $200k — you need to show how you will get the enterprise value to be $50m to $100m at year 5 without additional financing
The Entrepreneur’s Real Job —-
… is to create enough shareholder wealth for investors so that losses incurred in “less fortunate” enterprises can be absorbed while still achieving premium investment returns — thus insuring an ongoing source of venture capital for future generations of entrepreneurs.
In other words, each successful entrepreneur must pay for their share of the unsuccessful entrepreneurs to ensure a healthy future supply of capital for every entrepreneur (successful and not).
Your math assumes that only 1 company out of 50 returns any capital to investors. To that extent, you are correct that a 100x return is required to generate a 15% IRR over five years.
But you ought to look at the hypothetical $500m venture fund as making 50 investments, some of which return no capital, some return a modest amount, and some are homeruns.
If of 50 investments, 16 return no capital, 16 return exactly the invested capital, 15 return 3x and 2 return 10x, then you only need one deal to be a 20x for the total portfolio to produce a 15% IRR.
The distribution of hits and misses can be argued over, but the general idea is that venture capitalists aren't relying on one deal to make the whole portfolio.
Granted, a 20x multiple on your best deal (and 3x on a slew of others) is nothing to sneeze at -- but it is a lot easier to achieve than 100x, and gets you the same results when considered as part of a total portfolio.
Posted by: Jim Basili at June 20, 2005 01:44 PM
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