An Insite to what the VC's do with your money if you are so lucky

Venture Fund Economics
When I write about venture fund returns, there are always comments and questions that lead me to believe that the economics of a venture fund are not well understood. And since most of the readers and commenters on this blog are people who work in the startup ecosystem, I think its important that the economics are better understood. So I am planning on some posts on this topic in the coming weeks.
The first thing I'd like to tackle is how returns are calculated and why the reported returns are often higher than people might think.
Unlike hedge funds or other investments you might be familiar with, venture funds do not call all of the committed capital upfront. If you commit $1mm to a venture fund, you will receive capital calls about once a quarter for anywhere from 3% of your commitment to 10% of your commitment. That is because it takes time for a venture firm to put the money to work and they'd rather leave it in your bank account than have in in their bank account.
And because venture investments are generally made in a number of rounds staged out over a three to six year period, even when the venture firm finds an investment, the amount they invest in the company upfront is a percentage of what they will eventually put to work.
So the money flows into venture funds slowly.
The money also flows out slowly. When a company is sold, the proceeds are distributed. There are some situations when the money is not distributed, but they are not that common and it's not useful to dwell on them right now. Venture investments require long hold periods, typically five to seven years. So it's common for a venture fund to have to wait five or six years to make its first distribution. Most venture funds have a ten year life and are often extended a few more years to get all the distributions out.
The low end of acceptable performance for a venture fund is to return two times invested capital to its limited partners (investors). If you put all the money in day one and waited ten years to get 2x back, that wouldn't be a particularly interesting rate of return. It's 8% to be exact, not the kind of return an investor would think is acceptable for a ten year illiquid investment.
But if you map out the cash flows that I described in this post, they look something like this:

So, if you invest $1mm into a ten year fund and get back $2mm, you will likely be earning something closer to 13% than 8% just because the $1mm wasn't tied up in the fund for the entire ten years.
I'd like to make a couple points about this to be clear. First, as I said before, I think getting 2x invested capital back is the absolute low end of acceptable performance in a venture fund and I sure hope and expect we can do better for our investors. But I needed to use a simple number and so I went with 2x.
Second, these cash flows are conservative in my mind. Our 2004 fund has called about 65% of committed capital about four years into its history. This model shows 75% called after four years. So, money can often be called even more slowly than I showed. And waiting for years 8, 9, and 10 to get your distributions is also very conservative. Our 2004 fund returned about 40% of committed capital in its first three years which is likely to happen when you get some companies sold early on in their development. And we are seeing more of that kind of thing these days.
If you model capital being called over a slower pace and distributions coming back earlier, you could theoretically get to annual returns of over 40% for a fund that only delivers 2x on committed capital.
Of course, annual rates of return are not the only measure that investors look for in a fund. They want to get the highest absolute returns they can get. And 2x is just not that exciting. I think 3x or better is what it takes to deliver top tier performance in the venture capital business and that's what we shoot for.

from Fred Wilson's Blog

http://avc.blogs.com/a_vc/2008/08/venture-fund-ec.html


Regards

Gordon