Venture capital investments are risky and failure is more common than success. Learn about what kind of returns VCs need, and how long it might take to achieve them.
Venture capital (VC) has been growing in prominence over the past few years. Unlike other investors in private markets, VC invest in startups, which make their investments risky and illiquid for long periods. So, along with their growing popularity, VCs have also gained a reputation in the startup world as investors with big risk appetites.
According to Crunchbase data, around US$294.8 billion of VC money was invested globally in 2019, while around $1.5 trillion of VC money was invested between 2010 and 2019.
However, VC firms or investors are not the ones that bear the risk of investment. In reality, it is the limited partners (LPs) of the VC funds whose money is at risk. Generally, VC firms create a fund that seeks investment from LPs like funds of funds, university endowments, public pensions, sovereign wealth funds, corporate investors, high net worth individuals, family offices and others. After LPs buy into the fund, their money is used to invest in a portfolio of startups. They are the ones who lose their money if the investment fails to provide returns.
VCs, on the other hand, are well-compensated with management fees and a share of the profits when a startup in the portfolio exits through IPO or is acquired or merged with another entity. The management fees are usually a percentage of an LP’s total investment in a fund.
The VC fund’s general partners are responsible for finding the right startups to back. This is the most difficult task, since there are thousands of startups to choose from. The ultimate goal of VCs is to deliver returns higher than other investment options like the stock market or real estate. It is the promise of oversized returns that draws LPs into taking the risk of investing in startups.
But 90% of new startups fail. Investors conduct due diligence, vet the teams, and test the ideas, but at the end of the day, investing in a startup is still a gamble. This is especially true when investors are backing companies at their early stages when they have not established a record or revenue. So it comes as no surprise that most VCs are unprofitable.
In fact, VC returns are heavily skewed. According to data from Correlation Ventures, 65% of VC investment rounds fail to return their capital and only 4% rounds return over 10 times the capital invested.
How much returns do VCs have to get to be profitable?
In order for VC investments to make economic sense, they have to provide higher returns than the stock market average. Between 2010 and 2020, S&P 500 made an average annual return of 13.6%. So, VCs need to ensure a return of at least 15% yearly in order to make the investments worth the risk.
VCs generally invest in 25 to 40 startups, irrespective of the fund size. Now, since most startups and investments fail, a VC can logically expect to get its capital back when it has at least one high-performing startup in its portfolio.
Let’s understand this with an example. Let’s say a VC firm with a fund size of $100 million invests in 25 startups. For the sake of this example, let’s assume that the fund invests in each startup equally, i.e., $4 million. Let’s assume that one of the 25 startups is a high-performer that will return between 10 and 20 times its investment.
Now, 13 of the startups fail and return no money. 10 of them exit with small returns of about $6 million. 1 manages to provide medium returns of $50 million. And one true outlier exits as a unicorn at $1 billion. If the VC firm owns 25% of the high-achieving startup, it would get a return of $250 million. The fund’s total returns would be $360 million.
The Pareto principle applies here: 80% of the fund’s returns come from 20% of the startups in its portfolio. Since the VC fund size was $100 million, in this example, the VC firm was profitable.
However, more often than not, VC funds do not have an outlier in their portfolio, and therefore fail to return capital to their investors. Identifying a startup that has the potential to exit as a unicorn is not an easy feat and requires experience, knowledge, and sometimes a bit of luck.
How long do VCs have to wait for returns?
VC funds generally invest actively for three to four years and are locked in for about 7–10 years. Studies have shown however, that it takes about 12-14 years to fully liquidate returns. This is because not all startups with huge exit potential can do it within 10 years.
It is important to note that the longer the duration of the investment, the more returns the LPs want. There is no fixed percentage of returns that VCs target. While some look to gain 3X returns in 10 years, others consider 20% annual returns or 6X returns in 10 years as ‘respectable.’
But it is important to remember that during the entire duration of the investment, LPs are stuck with illiquid assets. So, when they want to liquidate their stakes in a VC fund at any point, they have to sell it for a discount.
Although VCs have come to be associated with glamor, they operate in an uncertain world where failure is more common than success. VCs themselves earn enough from carried interest (share of profit from exits) and yearly management fees. But they are answerable to LPs, which puts them under pressure – pressure that is often passed on to the founding teams of the startups they have backed – to perform.
Header image by Ibrahim Rifath on Unsplash