Every company that a VC invests in needs to have the potential to return at least the fund. If you raise VC money, this calculation will determine the investor’s expectation and will establish at what point they would be happy for you to sell the company.
Let’s use an example to illustrate how this works.
Imagine a $ 300 million fund that wants to invest in twenty companies. VCs normally use a portion of their investments for their very first investment (called de novo capital), but the rest they keep as reserves (called follow-on capital) to maintain ownership in their companies in subsequent rounds.
Assuming it’s an equal divide, our imaginary fund can invest $ 7.5 million in each startup as new capital. Let’s say this fund leads a series A with $ 7.5 million in Startup X. The valuation is at $ 40 million, so the VC owns 18.75 percent of Startup X.
Our VC can keep their ownership by investing their reserved $ 7.5 million in the next round. But the company would still hit a lot of dilution by the time of exit. Let’s say the VC will be diluted 30 percent, so they own roughly 13 percent at exit.
For the ideal scenario that every investment is able to return 1x the fund, 13 percent of Startup X needs to be valued at $ 300 million (the size of the VC fund), which means that Startup X needs to exit for $ 2.3 billion.
This is why VCs care about the billion-dollar outcomes—not the hundred million-dollar ones.
Note that the fund size is a very important factor in this equation: it tends to greatly affect what the VC firm is looking for. For larger funds, the expected outcome increases proportionally.
Entrepreneurs should keep this math in mind when raising money from VCs, to know what type of outcome the VC firm is seeking.