LPs would like VC firms to return three times (3x) their capital or more in the span of ten years. The media has sometimes mocked highly funded venture-backed companies that fail, or companies that fundraise at a high valuation without revenues. These critiques are right nine out of ten times. But that failure is baked into the VC model.
When a VC is wrong, they lose 1x their money. When they are right, they can make 20x their money. Downside is limited, but upside is not, which is why VCs are fine with companies that can lose 100 percent of their money at the very low possibility of making 10x the investment.
VC is an exponential game, and startup exit outcomes typically follow an exponential curve rather than a normal distribution. If even the best VC firm invests in ten companies in a fund, the firm will typically see three or four of them lose most of their money, and three or four merely return their money.
The success of each fund entirely rests on the top one to three companies in the fund. There’s often even a large gap between the returns from the No. 1 company and those from the runner-up.
Fred Wilson, co-founder of Union Square Ventures, uses a heuristic of thirds: “one deal returns the fund, another 3 to 4 deals return it again, and the rest return it a third time to get to the 3x gross that a fund must hit to deliver good returns to the LPs.” And Wilson’s heuristic probably applies to the more elite VC funds.
Research done by Correlation Ventures found that about half of all the capital invested into venture-funded companies exiting over the last decade lost money, while less than 4 percent generated a 10x or greater multiple.