Economics of an Early Stage Venture Fund

For tech startups out raising money, which is many of them, it’s important to understand the economics of an early stage venture fund or super angel. The model is very different from a retail investor approach where a mutual fund might focus on a specific segment of the market, e.g. large Fortune 500 companies that pay regular dividends. Early stage investing is a high risk, high reward proposition with unusual dynamics.

Here’s how the economics of a $30 million early stage venture fund might work:

  • Receive commitments for $30 million from limited partners — usually endowments, family offices, pensions, and other sophisticated entities
  • 20% of the commitments are paid in immediately while the remaining 80% of the monies are requested as needed (capital calls)
  • Fund goal of returning three times cash on cash over the life of the fund (e.g. take $30M and turn it into $90M)
  • Timeline is to make all the initial investments in the first five years and invest the majority of the money while saving 1/4th to 1/3rd for follow-on or pro-rata participation in future financings with a goal of exiting all the investments in 10 years (usually there is an option to extend the fund an extra year a couple times for a max of 12 years)
  • Take $20M of the $30M for the initial investments, that might result in the following:
    – Five $1M investments
    – Five $3M investments
    – Remaining $10M saved to participate in the future rounds of those 10 initial investments
  • Financially, the majority of the profits would come from one of the 10 investments (e.g. hit a homerun) while a couple would return a modest amount and the majority would not return a profit
  • Compensation for the fund partners of 2% of the fund’s value annually plus 20% of the profits (carried interest)
  • Example economics for this fund with one general partner:
    – $600,000/year operating budget for the first five years then a smaller budget for the remaining years
    – $300,000/year salary and $300,000/year for expenses like legal, accounting, travel, office space, assistant, analyst, etc
    – Profits at the end of 10 years assuming returned 3x cash on cash: $90M minus $30M initial capital for a total gain of $60M. Now, take 20% of $60M and you get $12M less management fees taken out (e.g. $3M+ of management fees in five years) for a final profit for the one general partner of $9M.
  • Limited partners would receive $88M for their original $30M investment (assuming goals were met — the majority of venture funds over the past decade did not meet their goals, or make any money for their investors)

The economics of an early stage venture fund show that it is much more difficult than many perceive for VCs to make great money. There’s a nice salary for a good lifestyle but to do really well, it’s much harder than it looks.

What else? What are your thoughts on the economics of an early stage venture fund?

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