How Exit Value, Ownership Stake, and Valuation Affect Fund Outcomes
A "Fun with VC Math" Explainer
About a month ago I released Track 8 of The Trajectory Africa, “Fun with VC Math”. The conversation I had with Eghosa Omoigui, Managing Partner of EchoVC, was a pithy exploration of what it actually takes to become a top-performing VC. Short version of a long story? It’s HARD. The slightly longer version? Venture capital assumes that within a portfolio of risky assets, i.e. startups, a small number of those assets will generate exponential returns. Portfolio construction is part of the larger fund design strategy a VC uses to secure those returns, based on assumptions about how many investments will be made, for what ticket size, how much additional capital will be invested, and what failure rates to expect, etc. Although portfolio construction is a multi-variate problem, some of the variables exert outsized influence on returns. To summarize:
Your portfolio winners really do have to produce exponential returns.
Your returns live or die by the size of your ownership stake.
Your returns live or die by the valuation (at entry) of the company you’re investing in, which determines the price you pay for your ownership stake.
Despite (or maybe because of) its hard edges, “Fun with VC Math” struck a chord, but it also raised questions about the mental math Eghosa deftly deployed to illustrate the above principles. So, for those of you who got the gist of the conversation but struggled to connect the numbers to the narrative, you’re in luck. I’m going to walk you through the five scenarios Eghosa introduced during our chat, along with the accompanying core insights.
Now, if you just need a break-down of some of the episode’s less obvious calculations (no context necessary), you can find that on EchoVC’s blog, courtesy of Eghosa and his team, as well as here and here, thanks to Stephen Muriithi, an aspiring VC and prolific commentator.
Right. So, let’s dive into the deep end, shall we?
Scenario 1: Outsized Returns Mean Outsized Returns
Rewind slightly to the healthy number of variables—ticket size, follow-on reserves, failure rates, etc.—that GPs have to bake into their fund design. Even before we dig into why some of these punch above their weight, we confront the uncomfortable reality that as a VC, the value of your portfolio has to appreciate SIGNIFICANTLY in order for your fund to perform well. More precisely, returning three times (3x) the size of your fund (excluding fees, etc.) to your LPs is considered good performance. To illustrate this principle, Eghosa posed the following question:
You’re raising a $50M fund. How much does it take to return that fund?
Step 1: Well, if you have a $50M fund, returning the fund is paying back $50M (1x) to your investors. Returning 3x the fund would mean you’ve returned $150M.
Step 2: Let’s say you own 10% of whatever amount of value your fund generates. How much value (x) does your fund have to generate for you to return $50M to your investors?
Step 3: 10% of x = $50M; .10x = $50M; x = $50M/.10
Step 4: x = $500M
So, if you’re a first-time fund manager raising a $50M fund, you need to generate about $500M of enterprise value to return the fund, and three times that amount ($1.5B) to deliver a 3x return to your LPs. At the risk of stating the obvious, this is a difficult accomplishment that few VCs are able to achieve.
Note: To keep things simple, this and all future scenarios conveniently exclude adjustments one might make to account for foreign exchange volatility, currency devaluation, inflation, etc.
Scenario 2: When Outsized Isn’t Outsized Enough (A PoV on Paystack’s Exit)
If you follow African VC trends, you probably recall Paystack’s landmark $200M acquisition by Stripe in 2020. That deal reverberated through African ecosystems as a harbinger of what’s happening now—record-breaking amounts of capital being raised by African startups. You might imagine that the Paystack transaction generated as much RAMO (regret about missing out) as it did adulation. But how would you feel if you were the GP of the $50M fund we discussed in Scenario 1? You know how hard it’ll be to return your fund, so you’re laser-focused on how much each investment contributes to that goal. With that in mind, how many $200M Paystack exits would it take to return your $50M fund?
Step 1: Let’s say you invested $1M in Paystack. If you’re an early-ish stage investor, that’s a reasonable enough assumption. Let’s also assume that your return is 14.4x (setting aside any considerations regarding dilution, etc.) This is also a decent assumption (perhaps even a cautious one) because as an early stage investor, you’re probably seeking 20x returns.
Step 2: Your return on the Paystack exit is $14.4M (14.4x * $1M = $14.4M)
Step 3: You have a $50M fund, so 3 Paystack exists (worth $14.4M each) would return $43.2M. We’ll round this up to $50M for the sake of simplicity, which means that 3 Paystack exits would return your fund.
Step 4: The problem, of course, is that you’d need to return 3x the fund to deliver top-tier performance. If 3 Paystacks return slightly less than 1x your fund, then 9 would return slightly less than 3x your fund, so 10 Paystacks would probably get you to 3x.
Of course, Paystack was a fantastic outcome for African tech ecosystem(s) generally, and for many of its early investors specifically. Nonetheless, as enviable as it was, you would’ve needed a larger exit to drive top-tier performance for your $50M fund. Perhaps even more importantly, it would be incredibly difficult to replicate that landmark exit multiple times.
Scenario 3: Outsized Still Isn’t Outsized Enough (Even with No Failures)
Clearly, we’re using a lot of simplifying assumptions to navigate complexity. In fact, the heuristic Eghosa used to distill the drivers of competitive outcomes suggests that the key is to invest in the “right company, with the right-sized check, at the right stage.” Again, if you’re an early stage investor, you’re probably aiming for each investment to appreciate by 20x or more. But as we’ll see below, there’s a BIG difference in the outcomes for your fund at each end of the spectrum, even if you assume a 100% success rate in your portfolio. Let’s take a look.
Step 1: Once again, you have a $50M fund. This time, you’re writing $500K checks, and aiming for a 20x return on each investment.
Step 2: As a first time fund manager, it’s easy to assume that if you’ve raised a $50M fund, you’ll have all $50M to deploy. This isn’t the case for a variety of reasons, but in this scenario, we’ll focus on fees (to cover operational expenses) and capital to reinvest. The fees you charge your investors, usually equal to 2% of the value of your fund, can be used to cover operational expenses such as salaries. Let’s assume that you’ll reserve $10M to cover operational expenses, which leaves $40M to invest.
Step 3: From that $40M, you also want to set aside money to re-invest in companies that are doing really well to preserve a meaningful ownership stake. (We’ll discuss how important this is later). You decide to reserve 30% of your $40M fund for follow-on investments.
30% x $40M = .30 x $40M = $12M; $40M - $12M = $28M
This means that you only have $28M to invest, which means that every dollar of that smaller amount of money has to work much harder.Step 4: Let’s also assume that you invest $500K into 50 companies, for a total investment of $25M ($500K x 50 companies = $25M). Each company generates a 20x return, and you own 10% of the value of the whole portfolio. So, one company generates a $10M return ($500K * 20x) while 50 generate a $500M return. Given that you own 10%, that $500M return earns you $50M (10% x $500M = $50M), or 1x your fund. This means that 20x returns are too low to earn carry, which is the profit sharing you earn after you’re returned the fund.
Step 5: If a 20x return multiple is too low, let’s try 50x. So, if a 20x return yields $500M, what does a 50x return yield?
50x = (some number) * 20x; some number = 50x/20x;
some number = 2.5;
$500M (the return yielded by a 20x multiple) * 2.5 = $1.25B (the return yielded by a 50x multiple)
Yay! You’re finally close to returning 3x your fund and reaching top tier fund performance. But guess what? All of the above assumes that none of your companies fail. Given that you’re an early stage investor taking a lot of risk, zero failure seems like a wildly unrealistic expectation. This means, (you guessed it), it’s time to build in failure rates.
Scenario 4: Introducing Failure Rates (Because Startups Fail…Often)
What’s useful about the preceding examples is that they illustrate how hard it is to succeed in VC, even without any “grounding” assumptions.
However, it’s important to walk through one example that represents reality a bit more closely. Let’s have a look.
Step 1: We’ll stick with the $50M fund, which we’ll assume has a 10-year life span. You’ll take 2.5% of the total amount in fees. You’ll also write $1M checks and reserve $10M (or 20% of your fund) for follow-on investments to preserve your ownership stake. $10M/$50M = 20%.
Note: Preserving your ownership means defending your pro rata, or your right to invest in the next round of financing and maintain your initial level of ownership in the company. It’s worth highlighting that a 20% reserve ratio is on the low side; it's more common to see 30-50% of the fund set aside for reserves.
Step 2: Let’s figure out how much capital you’ll have available to deploy.
.025 x $50M = $1.25M; $1.25M x 10 years = $12.5M;
$50M - $12.5M = $38.5M
We’ll round down to $35M to make the math easier, so you’ll have $35M of investable capital.
Note: This example focuses on the multiple on invested capital (MOIC) and doesn’t address internal rates of return (IRR) thresholds, which should be closer to 30% on a risk-adjusted basis.Step 3: Now you’re ready to invest. This time we’re using the ticket size from the Paystack scenario, $1M. You’ll make 25 $1M investments, where the average post-money valuation is $10M when you enter the deal. Since you invested $1M, you bought 10% ($1M/$10M) in each of the 25 companies.
Step 4: You want to retain your 10% ownership stake in all 25 companies due to their stellar performance, so you use your $10M reserves to write follow-on checks. Let’s assume the average Series A round is worth $15M, and you decide to write a follow-on check size of $1.5M. (This number isn’t based on a calculation; we’re just choosing to use $1.5M for this example.) With $10M in reserves, how many follow-on investments can you make?
$10M / $1.5M = 6.7 We’ll round this down to 6 investments.
At this stage, you’ve invested $2.5M ($1M initial check plus a $1.5M follow-on check) into each of these 6 companies.Step 5: Now, it’s time for exits! If all 6 companies exit after your series A investment and they don’t raise additional capital (highly improbable), then you still own 10% of all 25 companies, or 10% of the aggregate exit value. Let’s assume that each company had a $200M exit like Paystack’s. If that’s the case, what is your gross return?
10% ownership x $200M exit (for 1 company) x 6 companies = $120MStep 6: But wait, what about failure? During our chat, Eghosa likened the probability of success as a VC to that of a top-tier baseball player. Hall of Fame hitters only connected with the ball 3 times out of 10. Meanwhile, the typical example used to illustrate VC odds assumes that 1 or 2 investments out of a 10 company portfolio might be an exponential winner. But let’s say you’re an exceptional picker, and only 50% of your deals fail, i.e. they don’t return 1x or better. Since you started with investments in 25 companies, a 50% failure rate leaves you with ~13 companies to drive your fund returns.
Step 7: Of these 13, the 6 we discussed in Step 5 will return $120M. How much will the remaining 7 return? Let’s make the unlikely assumption that the remaining 7 companies return 3x. You invested $1M in each of those 7 companies. So, if the total amount invested in those 7 companies is $7M ($1M x 7 companies) and they collectively return 3x, the group of 7 will have returned $21M.
Step 8: And now, for the finale! What is your aggregate fund return in this example?
The first 6 Paystack return companies earned you $120M, and the last 7 brought in $21M. $120M + $21M = $141M, which is nearly 3x your $50M fund.
Congratulations! You’re well on your way to great performance. Well, you are until you start to differentiate between gross and net returns. To see how that plays out, check out EchoVC’s “Fun with VC Math” epilogue.
Scenario 5: Ownership and Valuation Above All Else
As we round the bend on this tour of “Fun with VC Math” mini cases, you’ll notice that we’ve spent A LOT of time on takeaway #1, the importance of outsized returns. However, as we’ll see with this final scenario, without a significant percentage of ownership and an enabling valuation, your extravaganza of exponential returns will fall flat. Let’s find out why.
Step 1: You’ve really embodied the ethos of exponential returns, and have developed a disciplined approach to evaluating companies. It’s a regular Thursday and you’ve had your umpteenth coffee or Zoom of the day. But in your next to last call, you meet Moolah Mountain, a promising Ghanaian fintech startup that checks all of your preliminary due diligence boxes. The founders are world class, they’re operating in a lucrative but poorly understood market, the assets in their sector are under-priced, the company’s unit economics look strong, you’re clear about the type of risk they’re eliminating, and you understand the milestones associated with potential follow-on rounds of funding. In other words, Moolah Mountain looks like a great investment, but you need to figure out much to invest now for what percentage of ownership to secure an excellent exit in the future.
Step 2: Moolah Mountain is generating $35-$40M in annual revenue, on target to hit $50M in Year 5. You think a $300M exit would be a solid, achievable outcome for the company. (No, this one isn’t a unicorn but most M&A exits are worth less than $150M). Historical sector data suggest that companies are typically acquired at an 8x revenue multiple, which means that Moolah is right on target for a $300M+ exit.
Step 3: Because you enjoy pain and difficulty, you’re still an early (seed) stage investor writing $1M checks from a $50M fund and buy 10% ownership in each company you investment in. Also, because you invest at the seed stage, there are at least three funding rounds after yours (Series A, Series B, and Series C). Unlike in the other examples, for the sake of simplicity, we’ll assume that you don’t re-invest in winners. We’ll also assume that over the course of subsequent funding rounds, your ownership stake drops to 5%.
Step 4: When Moolah Mountain exits at $300M, your fund will earn $15M.
5% x $300M = $15M
We’ve established that a $300M return would be a desirable one. But for a $1M check (representing 5% ownership) to be a fund returner, the exit would need to be at least $1B because 5% of 1B = $50M, or 1x the fund.Step 5: But what happens if you pay $5M for 20% ownership?
If your ownership drops by half, as it did in step 3, you’ll go from 20% to 10%. However, with 10% ownership, you’ll earn $30M from a $300M exit (10% x $300M). And $30M is 60% of the way to returning your $50M fund ($30M/$50M = 60%).
Step 6: Of course, if Moolah Mountain turned out to be a unicorn and exited at $1B, you’d earn $100M with 10% ownership (10% x $1B), which means a 2x return for your fund.
So, yes, outcomes can really be made or broken by the price at entry (valuation) and the percentage of ownership at exit. And, if you’ve made it this far, dear reader, hopefully you’re feeling more enlightened than you are depressed. But as the saying goes, the things worth doing are usually the hardest. For those of you who are traveling this road, perhaps this piece makes the path ahead a bit clearer.