Exits and returns

When founders and investors disagree about scale or speed of growth, it often comes down to what VCs expect in returns (and need to deliver to their LPs), and how they chase them. In this section, we’ll explain how VCs generate returns through exits. To learn how VCs measure returns before and after a company’s stock has become liquid, visit Appendix B.

Definition In finance, a return is the profit an investor receives from an investment. Returns can be expressed as absolute sums (“the fund returned $30M to investors”), multiples of the original investment (“the investment returned 3X”), or as percentages (“the fund boasts a 300% return”).

Limited partners expect venture capital firms to generate net IRR (internal rate of return) in the neighborhood of 20% annually—no small task when you’re talking about tens or hundreds of millions or even billions of dollars. Venture capital funds aspire to generate 3X net IRR. Most firms end up in the 2X category, 5X is the breakpoint for a top-tier fund, and 10X is exceptional (and rarely repeats in the next fund).

So how do venture capital firms generate these kinds of numbers? Through liquidity events.

Definition Liquidity events (or liquidation events), also known as exits, convert equity held in a company into cash or freely tradable public company stock. Liquidity events are called exits because the conversion of ownership stock into cash is an “exit strategy” for owners. Liquidity events include when a company is acquired by another company, begins trading its stock on the public markets in an IPO, or if the company discontinues or shuts down, resulting in a sale of “substantially all”* of the assets of a company.

There are three types of liquidity events, all of which are essential to the venture capital business model:

Definition A merger or acquisition event (M&A event or M&A) takes place when two companies combine their assets into a single new company or one of the existing companies. The legal distinction between mergers and other types of acquisitions depends on the way the transaction is structured. An M&A event allows a company’s shareholders to cash out some or all of their shares in exchange for cash or equity in the acquiring company.

confusion Many people use the terms merger and acquisition interchangeably because the details that distinguish them can be complex and technical. However, they are distinct legal concepts and financial transactions. Acquisition is the more expansive term, encompassing asset acquisitions, stock acquisitions, and mergers. Mergers are a form of acquisition in which one company is legally collapsed into another.

Definition An initial public offering (IPO) is the first sale of a company’s stock to the public where the sale is registered with the SEC, specifies an initial trading price for the stock, and is generally financed by one or more investment banks.* An IPO is not the only way for a company to first sell its stock publicly, but it is the most common.*

After an IPO or other form of public offering, a company is referred to as a public company, as it is traded on open exchanges where anyone can use a broker to purchase shares of that company. Before a public offering, a company is referred to as a private company, as the company controls who is and isn’t able to purchase shares of the company.

Definition A secondary sale (or secondary) is when a shareholder in a private company sells some or all of their stock to a third party outside the context of an M&A event. Secondaries are common at late-stage startups as investors seek liquidity but do not want to wait for an M&A or IPO. The term secondary can also be used to refer to a secondary offering, which is an additional issuance of stock to the public, via either an existing large shareholder selling their shares or the creation of new stock for issuance after an IPO has taken place.

Why VCs seek outliers

Silicon Valley is a system for running experiments. It’s the nature of experiments that some fail—the key is for the ones that work to really really work.Benedict Evans, investor, Andreessen Horowitz*

Venture capitalists take risks on a lot of untested companies because the venture capital business model depends on the extravagant success of a small number of those companies. Most of a firm’s investments are expected to “fail”—that is, not return money to the investors—because the success of a single company can make up for the risks that don’t pay out. Companies that make up that small number are called outliers.

LPs are looking to get net 3X their original investment back from a venture capital fund, so outliers must generate enough capital to return 1X+ the original sum of the entire fund of each of their investors. Due to their ability to produce a return equal to or greater than the sum of a whole fund, investors also call these outliers fund returners.

There’s one description out there of the venture capital business model that a lot of people take as gospel:

…[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.Fred Wilson’s “⅓ rule”*

However, in 2014, Seth Levine of Foundry Group shared data from Correlation Ventures that told a different story:

…a full 65% of financings fail to return 1X capital. And perhaps more interestingly, only 4% produce a return of 10X or more and only 10% produce a return of 5X or more.Seth Levine*

Returning a fund once, let alone five or ten times, is no easy task, and the challenge of doing so only increases with a fund’s size. For example, Steve Anderson’s Baseline Ventures raised a combined $70M for its first three funds. Anderson invested $250K into Instagram and owned 12% when Facebook bought the company for $1B, valuing Anderson’s shares at $120M, enough to return nearly 2X the value of his first three funds.* However, had Anderson’s fund been a $250M fund, the $120M from Instagram wouldn’t even get the fund to break even on their LPs’ investments.

Much of the math around venture capital fund returns comes down to ownership percentage. With 10% ownership, a $250M fund needs a company to exit for $2.5B to return the fund once, but with a 20% stake, the fund needs the company to exit for half of that. When venture capitalists talk about ownership targets, they’re talking about reducing the hurdles to getting a meaningful return out of an acquisition or IPO.

important Given the variance in fund sizes, it’s not necessary for every company to generate a $1B or greater exit for their investors. But most of the bigger funds do need these $1B+ exits to make their business model work.

The National Venture Capital Association’s 2018 Yearbook, one of the most comprehensive annual reports on the venture capital asset class, reported that there are 1,047 venture capital firms in existence.* But according to CB Insights, there are only ~363 companies with valuations over $1B* (the so-called unicorns).

The highly uneven distribution of venture capital returns, where most returns come from a tiny number of companies, is a power law. According to the NVCA Yearbook, more than 8,300 companies raised venture capital in 2018, and only ~1900 are capable of returning funds for more than 1,000 venture firms. The power law that governs returns in venture capital gets a lot of attention, and this is a simple explanation of the complicated math and economics involved. (If you’re interested in going deep on power laws, we highly recommend you read Jerry Neumann’s “Power Laws in Venture.”)

So if venture capital as a business depends so much on outliers, investors must be geniuses at finding hugely successful companies, right? Not so much. One criticism of venture capital is that the number of investments a VC makes means that they don’t have to be experts on picking winners at all—odds are, one of those risks will pay off, but investors don’t know who it’s going to be. But certainly, some venture capital firms are better at picking and getting access to fund-returning companies than others.

In 2017, PitchBook reported that Fidelity invested in 34 of these unicorns, while Sequoia Capital and Andreessen Horowitz each invested in 30.* The same data suggested that only 18 venture firms have portfolios with 15 or more unicorn investments. While the firms’ ownership percentages are not public, these data indicate that venture capital returns are not only skewed regarding how few companies can generate returns, but they’re also skewed to benefit only a small number of firms.

Assessing a fund based on the number of unicorns in a portfolio is misleading, however. What really matters is at what stage the fund invested and how much ownership they received for that investment. If, like Fidelity, a fund invests at the late stages, their return will be much lower than if the fund invested when the company was only worth single-digit millions.

Knowing how venture capitalists make money investing in risky businesses will help founders understand how their companies are viewed by VCs, what they’re looking for in the long term, and what motivates them in negotiations. Ultimately, understanding how the business of venture capital works is important for founders when they’re considering whether or not raising venture capital is the right decision.

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