Fundamentals of Venture Capital

Fundamentals of Venture Capital May 2020
Manish Singhal
Founding Partner, pi Ventures @manish_saarthi

2
https://dilbert.com/search_results?terms=Venture+Capitalist

Agenda
VC as a business
Power Law
What does it take to run a fund
Structure
Design & Strategy
Execution

Statutory Warning!
This presentation may be injurious to your VC ambitions!!

What is the core business of Venture Capital?

Raise Money
Invest Money
Return Money

piVentures2020AllRightsReserved
Do VCs really make Money?
https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/

What is a good return to aim for?

IRRs
http://www.industryventures.com/the-venture-capital-risk-and-return-matrix/

Good Return?
Most LPs would expect around 12% p.a. return as other
instruments would probably be lower but safer
Assuming a 10 year fund, 12% IRR return would be ~3.1x
Q: Can you have a 3x fund with 20% IRR?

Flat Model Capital Call Model Early Returns
1 Jan 2020 -100 -20 -10
1 Jan 2021 -20 -20
1 Jan 2022 -20 -20
1 Jan 2023 -20 -20
1 Jan 2024 -20 -20
1 Jan 2025 -10
1 Jan 2026 30
1 Jan 2027 120
1 Jan 2028
1 Jan 2029
1 Jan 2030 300 300 150
Total Return 300 300 300
IRR 11.60% 14.45% 20.59%
3x with 20% IRR

VC IRRs (less than 250M USD)
Source: PitchBook

Fund Return Multiples (TVPI)
Source: PitchBook

Overall, if you make 3x-5x, you are in good
company!

Scenario
Fund Size: 100M USD
10 Investments. Flat allocation - 10M per investment
Desired Return is 3x. 300M USD exit value
Assume 25% ownership at the time of exits

Scenario 1
They all do “average” and exit at $50 million
Ten companies, they all exit at $50 million.
The VC would return $12.5 million on each.
Outcome: 10 * $12.5 million =
$125 million

Half do average like before, and half do better
Five sold at $50 million, so $12.5 million
return on each.
The other five did much better and pulled off
$100 million exits.
Return: (5 * $12.5 million) + (5 * $25
million) =
$187.5 million return
Scenario 2

Majority do “average;” we’ll throw in
an overachiever
The 10th company, instead of selling for $100M
as before, now does $500M.
So our original five still sell at $50M, four sell at
$100 million and our new one at $500M.
Returns:
(5 * $12.5M) + (4 * $25M) + (1 * $125M) =
$287.5 million
Scenario 3

We need one big fat unicorn exit!
We would need one large exit to see good
profits.
Something like this would work: nine startups
sell for $50 million each and one goes for $1
billion:
(9 * $12.5 million) + (1 * $250 million) =
$362.5 million
Scenario 4

The Realistic Scenario
Five startups fail and do $0, three exit at
$25 million, one exits at $200 million and
our superstar does $1 billion.
Return:
(5 * $0) + (3 * $6 million) + (1 * $50
million) + (1 * $250 million) =
$318 million
Scenario 5

Fund Exit Values
(Assuming 3x Returns)
Equity Ownership, Total Exit Value (B USD)
Fund Size
(M USD) 5% 10% 15% 20% 25%
20 1.20 0.60 0.40 0.30 0.24
30 1.80 0.90 0.60 0.45 0.36
50 3.00 1.50 1.00 0.75 0.60
75 4.50 2.25 1.50 1.13 0.90
100 6.00 3.00 2.00 1.50 1.20
250 15.00 7.50 5.00 3.75 3.00
500 30.00 15.00 10.00 7.50 6.00

Fund Exit Values
(Assuming 3x Returns)
Fund Size
(M USD) 5% 10% 15% 20% 25%
20 1.20 0.60 0.40 0.30 0.24
30 1.80 0.90 0.60 0.45 0.36
50 3.00 1.50 1.00 0.75 0.60
75 4.50 2.25 1.50 1.13 0.90
100 6.00 3.00 2.00 1.50 1.20
250 15.00 7.50 5.00 3.75 3.00
500 30.00 15.00 10.00 7.50 6.00
Circle of Practicality

Startups Success Odds
https://www.sethlevine.com/archives/2018/04/whats-the-optimal-portfolio-strategy-for-a-venture-fund.html

Few Deals make the Returns!
https://www.ben-evans.com/benedictevans/2016/4/28/winning-and-losing
For funds with an overall return of 3-5x, which is what VC funds aim for, the overall return was 4.6x but the return of
he deals that did better than 10x was actually 26.7x. For >5x funds, it was 64.3x.
https://www.ben-evans.com/benedictevans/2016/4/28/winning-and-losing

Few Funds make up the return for LPs

Power Power Law rules the VC industry!
https://visible.vc/blog/understanding-the-power-law-curve-of-vc/
https://blog.ourcrowd.com/a-moonshot-bet-on-moonshots/

Return Persistence
Top Quartile funds tend to remain there
https://blogs.cfainstitute.org/investor/2020/02/17/venture-capital-worth-venturing-into/

Do you still want to become a VC?

VC - Mirages
Make a lot of money!
I can “help” entrepreneurs
I don’t like operations
All I have to do it listen to some pitches, write cheques
and give some arm chair advice!

“Long Term” reasons to become a VC
True passion for being part of creating the future
Working with the best of the entrepreneurs
True passion of understanding trends / behaviours / needs
Constant learning and unlearning - every single day!
“If you can’t invent the future, the next best thing is to fund it.”
John Doerr, Kleiner Perkins

What does it take to run a Fund

Typical Fund Structure
Limited Partner (LPs)
Startups
Fund
Management Co
General Partners (GPs)
ContributionsDistributions
Exits Investments
Fee & Carry
Contribution
(small)

Other Entities
Sponsor
Jurisdiction based rules
For AIF funds (India), every fund needs a Sponsor who
has to commit 2.5% of fund size or 5CR (whichever is
lower)
Key Decision - Internal or External Sponsor
LP Advisory Committee (LPAC)
Subset of LPs form LPAC
Governance and guidance to the IM
Investment Committee

Typical Time Lines
Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10Y0
Fund Raising
Fund Raising
Commitment
Period
Follow Ons
3-5 Years
2 years post Commitment Period
Next Fund Raise
First Close
Final Close
No More Fresh Investments post
Commitment Period

VC Treadmill
Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10Y0
Fund Raising
Fund Raising
Commitment
Period
Follow Ons
4 Years
2 years post Commitment Period
Next Fund Raise
First Close
Final Close
No More Fresh Investments post
Commitment Period
Raise
Deploy
Raise
Deploy
Return

Investment Team in a “Startup” Fund
Analyst / Associates / VPs Principal Managing Director Partner General Partner
Deal Sourcing
Analysis
Developing Thesis
Leading Deals
Deal Negotiations
Managing Boards
Brand Presence
Fund Raising
Building Teams
Independence/ Depth /
Quality
Decision Making
Leadership
Demonstrated
Track Record

Non-Investment Roles
Finance / Compliances
Dedicated Product Roles
Dedicated Business Roles
Marketing Roles
Admin Staﬀ

Carry Allocation
Equivalent of ESOP Allocations for Startups
General practise is to keep this for Investment Team
(Above Principal / VP / Senior Associates) and Advisors
In my book, everyone should be part of Carry; after all it
is a team sport
Vesting Curves are typically back loaded with a cliﬀ

Prevalent Numbers
https://vcpreneur.com/vc-funds-101-understanding-venture-fund-structures-team-compensation-fund-metrics-and-reporting-152b02e8504a

Fund Strategy
Thesis
Stage
Capital Allocation
Portfolio Construction
Target Ownership

Thesis
Thesis design is most critical in these times
Narrow vs Broad
Specialized vs Generalist
Gives focus and positioning

Stage Choice
0 1 2 3 4 5 6 7 8 9
Valuation
Seed
Round
Angel
Round
Series A
Series B
Series C
Product Market Fit Business Model Fit
Bridge
Round*

Stage Choice
0 1 2 3 4 5 6 7 8 9
Valuation
Seed
Round
Angel
Round
Series A
Series B
Series C
Bridge
Round*
Early Stage
Founder Focussed
Product Market ﬁt risk
Team Risk
Good ownerships
Requires more hands-on
work

Stage Choice
0 1 2 3 4 5 6 7 8 9
Valuation
Seed
Round
Angel
Round
Series A
Series B
Series C
Bridge
Round*
Mid Stage
Team Focussed
Growth Risk
Needs bigger corpus funds (>
100M USD)
Hands-off governance

Stage Choice
0 1 2 3 4 5 6 7 8 9
Valuation
Seed
Round
Angel
Round
Series A
Series B
Series C
Bridge
Round*
Late Stage
Market Share focussed
Market Capture/ Exit Risk
Needs much larger corpus
funds (> 250M USD)
Private Equity like governance

What is the optimal number of companies?
Balance between too few shots and spreading too thin
Case Study
30m USD Investible Corpus, Early Stage Deep tech fund
1st Cheque is 1M USD on an average
Additional 1M is invested in subsequent follow-on
rounds

X number of companies
Half of them raise only ﬁrst cheque (1M)
Half of Half raise one more 1m (2M in total)
Half of Half raise one more 1m (3M in total)
First Cheques = X * 1M USD
1st Follow On = (X/2) * 1M USD
2nd Follow On = ((X/2)/2) * 1M USD
So, X+X/2+X/4 = 30M
X = ~17 companies

Portfolio Construction - Key Considerations
Min 10-12 investments
Balance between going deep vs spreading thin
Number of Partners / MDs

Capital Allocation
20%
40%
60%
80%
100%
20% 40% 60% 80% 100%
First Cheques
Follow Ons
Spread too thin
You have to be a
really good picker!
Good Balance
between breadth
and depth

Follow On Funding Data
https://www.cbinsights.com/research/venture-capital-funnel-2/

FC: FO Ratios for an early stage VC
Round Number of SUs
Round Size
(M USD)
Prorata Amount
(20% ownership)
Seed Investor
Investment
Total
(M USD) FC: FO
Seed 1,119 0.67 0.67 750 750 39%
2nd Round 534 4.27 0.85 456
1,193 61%3rd Round 335 11.00 2.20 737
3.72Total Investment by Seed VC
Round Number of SUs
Round Size
(M USD)
Prorata Amount
(20% ownership)
Seed Investor
Investment
Total
(M USD) FC: FO
Seed 1,119 0.67 0.67 750 750 44%
2nd Round 534 4.27 0.85 456
959 56%3rd Round 335 11.00 1.50 503
3.02Total Investment by Seed VC

Capital Allocation
FC - FO
40-60
FC - FO
50-50
FC - FO
60-40
Ideal
Forces discipline on
ﬁnding right deals at the
right time
Maybe hard to
implement
Unsure
Will make the follow-on
decisions harder
Can run out of capital to
back winners
Practical
Indicative that ﬁrst
cheques were more
expensive than planned
Tightness around
follow-on cheques

Target Ownership
Fund Size
(M USD) 5% 10% 15% 20% 25%
20 1.20 0.60 0.40 0.30 0.24
30 1.80 0.90 0.60 0.45 0.36
50 3.00 1.50 1.00 0.75 0.60
75 4.50 2.25 1.50 1.13 0.90
100 6.00 3.00 2.00 1.50 1.20
250 15.00 7.50 5.00 3.75 3.00
500 30.00 15.00 10.00 7.50 6.00
3x Return. Fund Exit Values

Napkin Method to understand ownership needed for
3x return
Investment
30M USD
Total Exit Value
1B USD

3x return
Investment
30M USD
Total Exit Value
1B USD
Exit Needed - 100M
Ownership here:10%

3x return
Investment
30M USD
Total Exit Value
1B USD
Exit Needed - 100M
Ownership here:?
Assuming 50% dilution along the way
Ownership at the time of investment: 20%

Entry Ownership for a typical Early Stage Fund
0 1 2 3 4 5 6 7 8 9
Valuation
Seed
Round
Angel
Round
Series A
Series B
Series C
Bridge
Round*
20-25% 15-20% 10-15%

Path to Ownership
Stage Round Size
Post Money
Valuation
Pro-Rata
Amount
Fund
Participation Ownership
Seed 1 4 1 25%
Series A 5 20 1.25 1.25 25%
Series B 15 60 3.75 0.75 20%
Case A
Stage Round Size
Post Money
Valuation
Pro-Rata
Amount
Fund
Participation Ownership
Seed 1 4 0.5 12.5%
Series A 5 20 0.625 1 14%
Series B 15 60 1.875 1.5 13%
CaseB
Ownership @
Exit Value Multiple
Case A 13% 12.5 4.2
Case B 7% 6.6 2.2
Exit Value Comparison for a 100M exit assuming 50% dilution

Path to Ownership
Go big early Go cautious early
Good ownership
Rights are easier to get
with bigger investment
early-on
Risks of write oﬀs is
bigger
Ownership is hard to
catch up for seed funds
May have a compromise
on rights
Hedge the Risks

Typically comprises of Partners & External members
Key Decisions
Internal vs External
Consensus vs Conviction
Establishing Culture of Intellectual Honesty
Nimbleness & Responsive

Running a Fund
Raising Money
Building a team and a great culture
Getting access to the best deals
Portfolio Work
Making Decisions
Thesis Evolution

Raising Money
Most diﬃcult process in the lifecycle
10x more diﬃcult than raising money as an entrepreneur
First time funds face a bigger challenge
Having a USP helps
Strong team
Strong Thesis
Strong Track record
Tests your sales skills to the max

Building a Team & Culture
Funds typically have a small teams
Structure
Roles
Independent thinking yet have common goals
Individual as well as a team sport
Disagree but commit

Portfolio Work
Good probability of a break out
Great team. Solid PMF. Good
Capitalisation
10-15%
Struggling
Team Issues. Poor PMF. Poor Runways10-15%
Finding their path out
Good team. Iﬀy PMF. Okish
Capitalization
70-80%
Critical Question:
Where should you spend
your time?
%s shown are typical
portfolio construct

Portfolio Work
Good probability of a break out
Great team. Solid PMF. Good
Capitalisation
10-15%
Struggling
Team Issues. Poor PMF. Poor Runways10-15%
Finding their path out
Good team. Iffy PMF. Okish
Capitalization
70-80%
Time Spent
Low
High
High
Why?
Makes the fund return.
Normally founders of
this category are
scalable
Makes / Breaks reputations.
1x - 3x outcomes can make a
difference of 3x vs 5x returns
Finding home takes time and
effort. Problem solving is
repetitive
https://avc.com/2017/12/the-second-quartile/%s shown are typical
portfolio construct

Making Decisions
You are constantly making decisions with less information
Intellectual Honesty
Emotional Awareness
Knowing your biases
Process vs Gut
Is the key to develop an intuitive understanding of
People, Business, Technology, Finance?

What does a PMF for a VC fund look like?
Submit your reﬂections on a slide or two

Thank You!
*Thanks to Prof Shivaram from IIT Mumbai for the phrase
J AI HIND*

Fundamentals of Venture Capital

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