Here is a hypothetical example of what a typical VC portfolio could look like and why they need to invest only when they can see a potential for a 10 – 20 times return on their investment. The numbers are overly simplified (see notes) to demonstrate the point of why the Big Profits have to be such a high multiple of the initial investment.
In this example we’ll take a fund of R200 million, which needs to make 20% over 5 years. It makes 20 investments with an average investment of R 10 million.
We also assume that out of every 10 investments that an average VC makes, they’ll have 2 where they loose all their money and fail outright; 3 where they will foresee the company failing and shut it down recovering 50% of cash from selling assets; 4 that will become profitable and make some cash but will never really make it huge; and 1 that will make large multiples on the investment. This seems to be a very rough trend for your average VC but is also simplified for these purposes.
|Total||Total loss||50% loss||50% gain||Big Profit||Definition|
|10||2||3||4||1||Investors average /10|
|20||4||6||8||2X||# of investments by fund|
|200||-40||-30||80||2X||Millions invested (X is unknown)|
To calculate X:
(fund) + (interest) + (tot loss) + (50% loss) = (50% gain) + (Big Profit) [gains must equal loss plus investment and fund]
.: 200 + 40 + 40 + 30 = 80 + 2X [ in R millions ]
.: X = R 115 million
.: The fund has to have at least 2 companies sell for over R115 million (over 10 times the investment) for them to make their 20% interest in 5 years.
– this is an overly simplified example. The following points are some reasons why the final value is a little low…
– The 20% is very low for compound interest over 5 years
– R200 mil is on the small side for South African VC funds.
– 20 investments is on the high side
– Management fees (normally about 15%) are not accounted for
This is the Appendix of my Funding Secrets Series.