A startup projecting a 3x return doesn’t help VCs make their numbers

After reviewing the pitch deck of a startup, I’ll ask the founder about their exit strategy.

Hopefully, they’ll describe a well-thought-out plan to reach an acquisition or IPO within a reasonable time frame. But I press for details — what kind of return should early investors expect if everything goes according to plan?

After a bit of hemming and hawing, the founder says something like, “We’re confident you’ll get a 2x–3x return on your investment.”

I chuckle, lower my eyes, and put on my frowny face. “Sorry, guys,” I say, “that’s not going to work.”

The founders are incredulous — I’d turn down a doubling or tripling of my money???

If they could guarantee a doubling of my money in 3 years, hell, yes, I’d take that any day. But startups aren’t offering any guarantees (at least not any guarantees worth believing.)

The failure rate of seed-stage startups is around 90%. In other words, only 1 out of 10 succeed. If I go to the race track, no way am I betting on a 10–1 shot that pays out 2–1 if it wins.

When I explain that venture investors are looking for returns of 100x, their mouths hang open. “That’s outrageous!” they cough. “Why are you so greedy?” (To be fair, nobody has actually said that to my face. But I can see what they’re thinking.)

Venture capitalists have an undeserved reputation as greedy bastards preying on poor startups. Angels have just as undeserved reputation as angelic creatures hovering over LinkedIn with a pot of gold for deserving startups. Both images are completely wrong. Angels and VCs are investors looking to make money by investing in the high-risk, illiquid stock of early-stage startups.

What returns venture investors need and why

Let’s examine the typical portfolio of a small fund investing in early-stage startups. We’ll assume the fund has $2 million to invest in a portfolio of 20 companies. To keep the math simple, we’ll assume $100K is invested in each startup and ignore complications like follow-on rounds.

As a good rule of thumb, venture investors assume 90% of startups will fail. Data shows a huge range of numbers depending on how the dataset of startups, the stage, and how failure is defined.

If we confine ourselves to the pre-seed/seed rounds that precede Series A and define failure not just as a complete shutdown but returning the original investment or less, the 90% failure rate feels about right. Whether the number is 80% or 95% won’t make a significant difference for this portfolio analysis.

Of our 20 investments, here are our returns:

  • 12 shut down (60% shutdown rate)
  • 2 firesales returning 50% of original investment each
  • 4 return the original investment
  • 1 5x return
  • 1 big IPO

This matches our expected 90% failure rate, with 18 of the 20 companies in the portfolio returning no more than the original investment.

We have 2 winners: one that generates a nice 5x return and the other with a big IPO. The 5x return makes up for less than half of the 12 shutdowns. Without the big IPO, of the 19 companies, we’ve only gotten back $1M of our initial $2M invested. Not good. But we’ve got the 1 big winner. How big does it need to be to make our portfolio successful?

With a 10x return on the IPO, we get back the full $2M we started with to break even. But the goal of investors in tying up capital for 10 years is not to break even.

We need to do better than that.

Risk versus reward

Basic economic theory says reward should commiserate with risk. Early-stage investing is as risky as it comes. It’s certainly a higher risk than a portfolio of public stocks. They might go down, there might even be a failure or two, but most won’t go to zero, and we can cash in the stocks at any time if we need the cash or decide to invest in real estate instead.

The average S&P returns over the past 10 years have been around 14%. Venture capital funds average around 20%.

Angel investors, getting into deals at an earlier stage than VCs, should be looking for an even higher return, but let’s stick with the 20% number for venture capital.

According to this Tech Coast Angels portfolio report, starting from the seed round, big exits average about 8 years to materialize.

To make 20% per year over 8 years means the $2M investment needs to grow to $8.6M. The other investments have returned $1M, so our big winner needs to return $7.6M alone.

On a $100K investment, that’s a return of 76x.

The performance of the other 19 investments hardly matters.

If there are 10 shut downs instead of 12, if there are three 2x returns instead of two, if the 5x return is 6x instead, none of these move the needle. They get us a bit closer to breaking even, but not for getting an adequate return. The 1 big winner out of the portfolio of 20 has to carry the entire fund.

If we run a 10-year fund instead of rolling investments, the one winner needs to return 114x the initial investment to carry a 20% return for 10 years.

Even worse, nobody aims to be average if they’re competing with other venture funds for new investors. To break into the top quartile with a 25% return, our one winner needs a 176x return.

So what return are investors shooting for? Somewhere between 77x and 177x. Let’s call it 100x.

If we invest in a startup in the pre-seed/seed stage with a $10M valuation, ignoring dilution from later rounds, the company needs to reach a valuation of $1B at exit for me to get an adequate return.

In other words, investors are only hunting for unicorns.

For a VC investing in Series A at a $40M valuation, to reach their goal of becoming a top-performing fund, they need to capture a decacorn.

Every venture investor is looking exclusively for the one company that will become a unicorn or better. We have 20 shots on goal to find it. That’s how venture capital works.

And that’s why you’ll have difficulty getting venture investors excited about investing in your plan that, if all goes well, will reach a 2x–3x exit.