The mechanics of (single) venture capital funds and how we use them for our fund of funds
How to find a sweetspot in Venture Capital funds
The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined.
- Peter Thiel-
Being a direct investor or business angel has has become more and more popular.
On the other hand, there are statistics regarding the chances of success of a direct investor.
The best of the best venture capital funds made several hundred investments. On average, they achieved 95% of the returns with 20% of the investments.
But even the winners are not equally distributed. Here, too, 20% of the winners account for approx. 80% of the total success.
Peter Thiel sums it up:
“We don’t live in a normal world; we live under a power law. … In venture capital, where investors try to profit from exponential growth in early-stage companies, a few companies attain exponentially greater value than all others. … We do not live in a normal world, we live under the power of law. In venture capital, where investors try to profit from the exponential growth of young companies, a few companies achieve an exponentially higher value than all others.”
What does this mean in practice?
It is unlikely that a direct investor with less than 10 start-ups in the portfolio will make a total profit (if you are a passive investor and do not play an active role in the start-up). With 20 startups, at least 10 could become a total loss.
1 out of 20 start-ups will make a large part of the total profit. Whether this results in a total profit for the portfolio depends on whether there is a 10x and some 2–3x or not.
A study from 2015 looked at the “Unicorn maker”. The best 14 VC had 93 Unicorns in their portfolio. This represents 2.6% of the investments made. Approximately 0.07% of VC-financed start-ups reach Unicorn status. However, it is 40 times more likely to become a Unicorn if one of the top VC is on board than without.
This study shows the hopelessness of direct (passive) investors when investments are made without a qualified investment team.
Most VC funds invest in approximately 15 to 20 start-ups per fund during the investment period. Each investment must have the chance of a 10x right from the start. Most VC funds do not start building their portfolios until after 1st closing. At the final closing there are often already up to 10 startups in the portfolio.
Up to 18 months are in between 1st and final closing, therefore it is not an optimal solution from our point of view to invest right at the start.
Why we don’t like invest at 1st closing?
With the first capital call, which amounts to approx. 20% of the subscribed fund volume, the first investments are made. This means that these start-ups are provided with capital for the next 12 to 18 months. Write-ups are unlikely. As an initial investor, the fund investment cannot provide us with any positive performance contributions in this phase. Due to the costs, the NAVs of the funds (TVPI between 0.80x and 0.90x) will drop.
For our due diligence it is better to be able to track initial investments. Since a VC cannot actually afford a bad investment, the first 5 to 10 investments already show us a tendency as to whether the fund can achieve our performance expectations or is already lagging behind. At the same time, the chances for the next (higher-priced) financing round are also increasing in order to generate higher valuations.
Since the chance of follow-up financing from seed to Series A is only just under 21%, we see this as a key metric in the valuation of the fund.
If during the period from 1st closing to final closing of the first 5 seed investments already 2 start-ups are targeting a Series A, we rate a fund in this Metric positively.
Why is this smart?
1. The next 5 investments offer a certain buffer, since the 20% quota of seed on Series A has already been reached.
2. The probability of getting from Series A to Series B is 50%.
Typically, our fund of funds is therefore a final closing investor, because we are
- entering the fund shortly before the first up-rounds
- not investing in a “Black Box”.
However, we are also aware that a single VC fund cannot start without a 1st closing. Therefore we accompany 1st closings with small tickets, if not otherwise possible. Our focus is not on switching to secondaries.
Mato Krahl | MK Venture Capital