Why are VCs so greedy?

Posted by Pierre de la Fortune on May 23, 2015 @ 12:01 a.m.

Written by Paul McLellan

Why are venture capitalists so greedy? Why do they want a 20-30X return on their money? Why doesnt investing $5M and selling the company for $15M a couple of years later make them happy? After all, when Ive bought a stock and sold it for three times what I paid, Im pretty pleased with myself.

To understand the reasons, you need to know a little about how venture capital funds work. There are two lots of people involved, the general partners, who are the people who work for the venture capital company; and then there are limited partners (LPs), the people (insurance companies, pension funds, whatever) that put up the money to be invested. The general partners may pay themselves 2% of the value of the fund per year a management fee, plus 20% of any profits.

One critical factor is that the fund has a lifetime, maybe 10 years. A fund would like return at least 20% per year. After all, the stock market has returned nearly 10% since 1900, including a great depression and the current downturn, and with a lot less risk. VCs should do at least twice as well as that.

The money isnt actually all put into the fund by the LPs on day one, and taken out on the tenth anniversary. As the VCs find companies to invest in, they make capital calls on the LPs to get the money. If and when there are successful exits, meaning that portfolio companies are sold or go public, then money is returned to the LPs. To keep the math simple, though, lets calculate returns as if all the money were invested early, and all the payouts arrive late.

There is one thing about VC investments that is different from you making an investment in the stock market but that is not often explicitly talked about: the venture fund (normally) only gets to invest the money once. This is a big difference from other types of investors, and is one of the reasons that you are happy if your stock triples in a couple of years and you sell it, and a VC is not. You can do something else with the money for the next 8 years and make more money. The VC typically cannot, it is returned to the LPs.

So lets do a bit of math. Lets say there is a $100M fund with a lifetime of 10 years. To keep things really simple, lets ignore the management fees and the carry, the percentage of profits that the VCs retain to buy their Ferraris. A return of 20% per year means that the $100M fund needs to return about $600M in total (thats simply 20% per year compounded for 10 years).

But not all investments will turn out to be wise. VCs, by definition, are investing in risky companies and at most 15-20% will make money, and often fewer (fund 20, pray for 2). So the $20M that turns out to be invested in great companies needs to generate $600M, meaning a 30X multiple.

Thats why VCs are so greedy. They have to get a 30X return on the good investments to make their numbers. Getting a 3X return in 2 years doesnt do much to help them, even though it might be great for the founders, early investors and employees. If they have a company that is doing well enough to get an acquisition offer yielding a 3X return in 2 years, they will prefer to keep on being independent, and hope the company continues to do well and can generate a 30X return (or more) during the remanining lifetime of the fund. They are all like Barry Bonds was: home-run or strikeout. Getting on first base is just not that interesting.

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