#75 VC Power Law & RTF Math (w/ Template)

Hi Everyone! 👋 Welcome to the new members of @TheFundCFO crew! We recently released our New VC Fund Playbook + Model Downloads @ Streamlined.Fund! Re-linking our top 2023 posts: #67 Top VC CFO Posts & References of April, #65: WTF is Going On in VC (+ New Fund Model Data) & #60 Emerging VC Fund Tech Stacks!

Every Tuesday/Thursday, we bring you actionable tools, real-world experiences, and insider insights for #VC CFOs/Finance Pros and fund managers, #LP investors, and general industry enthusiasts/people who want to learn :).

“How you climb a mountain is more important than reaching the top.” -Yvon Chouinard

How Venture Capital Really Works: Returns Are Driven by Power Law

For years, we’ve been saying that every VC fund manager needs a fund model (portfolio construction and reserves). Why? A fund model provides a plan for investing, is often required by investors, and can drive outsized returns (and help avoid value-destroying mistakes)!

While our fund models typically get super-detailed with various scenarios in play, we always find it helpful to simplify VC fund math (credit Fred Wilson in 2008) to something like the following:

• 1/3 of your investments lose money

• 1/3 of your investments breakeven

• 1/3 of your investments make money, with “~6% of investments generating ~60% of total returns” (credit Chris Dixon on the power law, citing Horsley Bridge industry data)

This point can’t be overstated! In a VC fund portfolio with 30 investments, this means that ~2 companies will drive ~60% of the total returns.

You need to hit home runs to deliver superior performance to your investors!

VC Losses Are Real, But Dwarfed by Outperformance

James Health (VC Principal at Multi-Family Office in London) share insights (linked here) on this recently from the SuperVenture conference:

• 🤯 The VC power law, backed up by 15+ years of data

• 📖 The power law suggests a small number of investments will have an outsized impact on the total returns. It is very real

• 🚀 VC is an outlier asset class. Forget loss ratios. If a vintage (or fund) doesn't have its outliers, it's not going to outperform

A couple of takeaways:

• 💰 The only group outperforming cost is investments returning 5.0x or more. Anything less technically isn't worth doing

• ❌ Nearly 50% of investments made won't return the capital initially invested

• 🚀 80% of the returns are made in just 18% of the investments. If the average VC portfolio is 25 companies, you are looking at your returns on one hand

• 🔎 Realised returns of LP investments in Europe between 2006 - 2022, presented by Adams Street Partners this week at SuperVenture.

How Can This Deal RTF? The Investing Math (Yes or No)

Every venture fund manager I know wants to deliver superior performance. Before investing in any deal, a VC fund investor should ask: “How can this deal RTF? Or 2x, 3x RTF? What do I need to believe about the future for that to happen?”

There’s always a story around things like an amazing founding team and an exciting market to capture. What about the math to RTF?

It’s possible to lose sight of RTF math as a VC fund investor moves quickly to close an investment. In response to this challenge, we’re sharing a simple RTF Calculator for VC fund investors to use when thinking about a new investment opportunity.

In the example below, a $50m fund making a $2m investment will require a $1b outcome to RTF (assuming a $20m valuation and 50% dilution). These assumptions can vary by fund strategy and sector focus so modify as you see fit!

Additional Resources

“Performance Data and the ‘Babe Ruth’ Effect in Venture Capital” by Chris Dixon

“Picking winners is a myth, but the PowerLaw is not” by Clint Korver

“Venture Fund Economics: When One Deal Returns The Fund” by Fred Wilson

Fun Picture of the Day: Barton Springs in Austin, TX (Courtesy of Visit Austin)

That’s all for today folks! Thanks for your support and spreading the word! Share this on Twitter or LinkedIn to help grow “the crew!”

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