We got a few questions from the 'Fun with VC Math: Designing Funds in Africa' podcast. We are sharing the responses below. 

Thanks to all those that took the time to listen to the podcast. I realize it can get a bit complex so apologies in advance. I have tried to simplify it as best as possible. Comments and questions welcome.

1) Why does it take $500M to 1X a $50M fund and $1.35-1.4B to 3x a $50M fund?

2) Why does it take 10 Paystacks to return a $50M fund?  

3) In the example when you introduce 50% failure rates, why is the average entry price $10M?

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Answers:

1) These numbers represent aggregate enterprise value created. If you assume you own 10% of a startup at exit, then $500m of enterprise value created returns $50m.

So it's not solely a scenario where a company in the portfolio exits at $500m, but what percentage you own at the exit. By the time you reflect dilution, it gets harder to own 10% at exit.

2) It doesn’t. It takes 10 of those exits to put the fund manager in position to potentially generate a 3x return on a $50m fund.

With Paystack, assume the exit multiple was 14.4x and assume you invested $1m into it. That is a $14.4m return sans dilution. You'd need to do that 10 times to return ~3x the fund. 

 This is not impossible (more likely improbable) but assumptions about the entry price and the dilution that occurred during the path to exit mean that the Paystack example is unusual. If I recall correctly, it raised just a Seed (~$2m in SAFE notes at different caps ranging from $5m to $10m) and an $8m Series A ($20m pre, $28m post, give or take) prior to its ~$200m exit so the dilution was not too material to the early shareholders.

Note that Paystack was acquired by an existing shareholder so the net payout to other shareholders was closer to $171m.

What is important to keep in mind is that many venture-backed companies may raise 3 or 4 times and it is in this cycle where your starting ownership goes to die. I have seen quite a few Series Es and Fs. Series Gs and Hs exist. The metaphor is like a font size: you start at Arial Bold 72 and end with Arial Narrow 8. You can still read your line on the cap table but your outcome looks (and feels) quite different. 

3) The failure rates tie in to 2 above. 

A ten-year $50m Africa fund with a 2.5% fee and expenses may leave you ~$36m to actually invest (after netting out management fees, fund and investing expenses) but, for ease of understanding, let's use $35m of investable capital to illustrate. 

Note that the illustration is solely of money on invested capital (MOIC) and doesn’t address internal rates of return (IRR) thresholds, which on a risk-adjusted basis, should be closer to 30%.

Let's say your strategy is to invest $1m checks, and assume you reserve $10m to defend your pro rata in certain deals. Pro rata is your right to invest at the next round of financing to preserve your ownership stake. FWIW, a 20% reserve ratio ($10m ÷ 50m) is on the low side and it's more common to see 30-50% of the fund set aside for reserves. That said, I know of funds that are designed to not have pro rata but those are usually much smaller.

So you make 25 investments (25 * $1m = $25m), and your avg postmoney entry valuation is $10m so you buy 10% in 25 companies.

Then you apply your reserves to defend your pro rata at the Series A (which are usually $15m+ rounds but may drift lower as a result of the current contagion in the public markets) so your follow-on check size is say, $1.5m. That means you can do ~6 follow-ons to protect your initial 10% holding.

So if all 6 companies exit after that point so they don't raise again (almost statistically impossible), then you hold 10% of the aggregate exit value. You would have invested $2.5m ($1m initial check plus a $1.5m follow on) into each of the 6.

Assuming they are all Paystack type exits at $200m (sure, everyone thinks they will be unicorns but actual exit data belies that) then your gross return from the 6 companies is $120m (10% * $200m [enterprise value per company] * 6 companies). 

But remember we started off by investing in 25 companies. 

If ~50% of them fail to return 1x or better, (remember that batting .300 (3 in 10) in major league baseball likely gets you in the MLB Hall of Fame) then we are looking at ~13 companies to drive the fund returns. 

Of these 13, 6 based on our example (pro rata defense) will return $120m. Maybe the remaining 7, representing $7m of investments ($1m * 7 companies) return 3x (unlikely but let's say so just for shits and giggles).

Then the aggregate fund return is $120m + $21m = $141m.

On first read, that's a smashing success for a $50m fund and delivers the 20% carry (profit share) to the manager.

Some quick calcs to illustrate the return multiples.

$141m: dollars returned.

$35m: dollars invested by the GP (LP committed dollars less fees and expenses).

$50m: dollars invested by LPs.

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$141m/$35m = 4.02x $-at-work gross; 

$141m/$50m = 2.82x trued up gross;

$141m - $50m = [$91m] * 80% [$72.8m] + $50m = [$122.8m] ÷ $50m = 2.45x net to LPs. 

The LPs have to get the money they invested right off the top. That’s why their $50m is deducted first from the $141m total. The 20% profit share applies to the balance.

This example of course assumes no recycling i.e. the GP taking interim returns from early exits and reinvesting so that (s)he can get to invest the full $50m and not the $35m after fees. Doing so generally improves the odds for the fund as more dollars are working via startups and not just underwriting fees and expenses.

2.45x is still a great VC fund net return (that should put you in the top decile globally iirc) but don't get too excited as Thoma Bravo and Vista Equity (multi-$B PE funds) have exceeded this threshold, and with lower risk profiles too.

But to have six Paystack exits (and seven 3xrs) is quite the dream. I'd sleep in for that.

Which then leads us to the power law. That is, one company sets up to return the whole fund (or more). But for that to happen in a $50m fund, you have to have at least one $1b exit and own 5% of the company at exit (and after dilution). With the fundraising froth and (increased) round sizes, many companies would have raised 4-5 times before they become unicorns. That's at least 3-4 dilutive rounds.

Which brings us full circle to why the entry price always matters. Buying 10% for $1m makes it harder to own 5% at a billion dollar exit. Buy 20% and then you have a shot. 

But the entry prices are now so high (e.g. valuations for pre-seeds in the high single digits and seeds in the high teens or more) and the competition to invest is so excitably frothy (with price-insensitive investors committing hundreds of thousands of dollars after the first meeting), that $50m funds may actually need up to three unicorn exits to have a shot at returning 1x.

Rough play.

This business is like many others. It may seem easy from the outside looking in but it's really much harder than it appears and takes a long while to be successful. I am grateful to have found a career that I love and would do for free but make no mistake, it requires a ton of hard work, conviction, adaptability, and luck.

Go make it happen.

-Eghosa