Why VCs aren’t insanely rich (2015)

Disclaimer: I admire Jason Lemkin @jasonlk and his posts are amazing. I’ve learned some much and I’m humbled to write a follow up post on this topic.

I’ll start with a spoiler, or more precisely the bottom line: VC’s are that insanely rich, or at least most majority of them.

So Jason mentioned in his post that VC’s ends up with personal effective ownership of 32%-40% on a “one company equivalent” basis.

Here is a recap of the assumptions:

1. Total of 20% in 20 companies: VC that does A/B rounds and buys 20% ownership each time they invest

2. VC gets 4% of the gains: Firms (not partner, we’ll come back to it later) typically themselves keep 20% of the gains on 20% ownership.

3. Personal effective ownership in each = 32%: VC typically invests in 8 deals per VC. (8 deals x 4%)

Bottom line: effective ownership of 32% in portfolio of great companies= you’re insanely rich.

I beg to differ, as the second part of the equation is that in a typical fund the returns are from 20% of the Investments. In addition,the partners split the carry among the partnership, while the involved partner getting a bit more (a bit, not 100% of the VC gains on that investment)

Thus, effective ownership is 6.4%-8% of a successful company.

No matter what, in the end of the lifetime of the VC, the VC partner will personally own a 6.4%-8% equivalent of successful company. no risk, no hassle, and you still get hefty of management fees. In other words, every 4 years you’ll have a major liquidity event. So in a way it’s like being a serial entrepreneur.

It’s definitely good, but not great, not great in terms of justifying the title “insanely rich” (which will be the exceptions).

So, let’s drill into some numbers, shall we?
The 33%/33%/33% Rule or X2.5 ROI:

Most VCs will invest in flops anyhow. But let’s take an optimistic scenario of the VC’s that are in the “above the average” tier. Here is a super optimistic scenario (partner at top performing great fund VCs, a Mark Suster/ Fred Wilson/choose your other VC rockstar fund):

Assume you have a great fund that you have raised. 5 partners, about 100M (The average VC size is 149M, but for the sake of easy math let’s keep it simple 100M).Lets say it was very successful, and made 2.5x on the money. They will get 20% from the extra.

Now, let’s do the math based on Fred Wilson approach from Union square ventures: He states they aim to batting average of ⅓,⅓, ⅓ : “we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments (A.S- with 7.5x avg return).”

Example one:

Fund size: 100M

33% which reflects 33M x 0% ROI= 0

33% which reflects 33M x 60% ROI = 20M (some of the money will be back)

33% which reflects 33M x 700% ROI = 231M.

Total gains: 251M

Net gains: 151M (121M investors, 30M VCs)

Gains per partner (#5): 6M (0.6M-1.2M/yr*) — Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of extensions to allow for private companies still seeking liquidity.

Not bad.. But they need to be REALLY good. and most, again, aren’t. (Thank you Ofer‏ @oferwald for the feedback)

Example two:

Let’s try again with a 150M fund:

Fund size: 150M

33% which reflects 50M x 0% ROI= 0

33% which reflects 50M x 100% ROI = 25M

33% which reflects 50M x 750% ROI = 375M.

Total gains: 400M

Net gains: 250M (200M investors, 50M VCs)

Gains per partner (#5): 10M (1M-2M/yr).

So 20% of 250M is about it, 50M split by 5. 10M each then divide by the year of the fund life (5–10).Again, not bad at all…but not a fuck you money that makes VC’s insanely rich.

The 40%/40%/20% Rule:

Now, Let’s try the math with a 40%/40%/20% rule which is the above the average standard (That’s according to NVCA ‘National venture capital association’, not me).

since VC invest in high-risk enterprises. However, venture capitalists manage that risk through portfolio risk management. It is estimated that 40 percent of venture backed companies fail; 40 percent return moderate amounts of capital; and only 20 percent or less produce high returns. In a Typical Fund the Returns are From 20% of the Investments It is the small percentage of high return deals that are most responsible for the venture capital industry consistently performing above the public markets.

Let’s take our 100M fund. The VC invests in 10 companies (2m-7m per investment that include bridge loans, tag alone + practicing first refusal rights to maintain ownership share).

The breakdown by the type of investment might look like this:

Since we’re following a more “conservative/realistic” 40%/40%/20% rule the numbers will look like this:

-) 40% which reflects 40M x 0% ROI= 0
-) 40% which reflects 40M x 60% ROI = 24M
-) 20% which reflects 20M x 700% ROI = 140M.

Total gains: 164M (split: 115M investors, 29M VC).

Net gains: 64M (51.2M investors, 12.8M VCs)

Avg # partners: 5 . Avg yrs of fund: 5–10 yrs

Net gain per partner: 2.56M/ 0.25M-0.51M/yr

I was even intrigued by Magma, an Israeli VC that was on a recent streak of wins (Onavo and Waze, both sold to Facebook and Google respectively with over than x10 multiplier), as I was sure their batting rate is much higher. So I’ve looked how many exits they had. Total exits are 7/24 (29% success rate), and with some x10 investment, there are x3 investments- hence that aligns with the average x7 ROI on winning investments.

So same deal here.

I was once offered by an ex-VC partner to get a consulting package (it was a 10% finders fee + 5K/mo for 3 months consulting period). While the 10% makes totally sense (getting 10% out of the seed founding amount as finders fee), I couldn’t grasp why a respected ex-partner at a respected VC is going to do with 15K? Isn’t he carry boatloads of cash already? what a lousy 15K would help. That was the moment when the uber rich VC image that I had was completely shuttered.

If you’re a VC, you’ll make some great money, but not a FYM and you’re not the equivalent to Sean Parker you’ll be more like Don Harper. Who the hell is Don Harper ?? I don’t know.. that’s my point (and if Don Harper is reading this post and happen to be a VC- I apologize in advance. oh yeah and @jaltucher Altucher, I apologize for stealing your joke, I just like it so much I couldn’t help it).