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Fundamentals of Venture Capital

This is session 1 of the pi fellows 2020 programme covering the fundamentals of Venture Capital

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Fundamentals of Venture Capital

  1. 1. Fundamentals of Venture Capital May 2020 Manish Singhal Founding Partner, pi Ventures @manish_saarthi
  2. 2. 2 https://dilbert.com/search_results?terms=Venture+Capitalist
  3. 3. Agenda VC as a business Power Law What does it take to run a fund Structure Design & Strategy Execution
  4. 4. Statutory Warning! This presentation may be injurious to your VC ambitions!!
  5. 5. What is the core business of Venture Capital?
  6. 6. Raise Money Invest Money Return Money
  7. 7. piVentures2020AllRightsReserved Do VCs really make Money? https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/
  8. 8. What is a good return to aim for?
  9. 9. IRRs http://www.industryventures.com/the-venture-capital-risk-and-return-matrix/
  10. 10. Good Return? Most LPs would expect around 12% p.a. return as other instruments would probably be lower but safer Assuming a 10 year fund, 12% IRR return would be ~3.1x Q: Can you have a 3x fund with 20% IRR?
  11. 11. Flat Model Capital Call Model Early Returns 1 Jan 2020 -100 -20 -10 1 Jan 2021 -20 -20 1 Jan 2022 -20 -20 1 Jan 2023 -20 -20 1 Jan 2024 -20 -20 1 Jan 2025 -10 1 Jan 2026 30 1 Jan 2027 120 1 Jan 2028 1 Jan 2029 1 Jan 2030 300 300 150 Total Return 300 300 300 IRR 11.60% 14.45% 20.59% 3x with 20% IRR
  12. 12. VC IRRs (less than 250M USD) Source: PitchBook
  13. 13. Fund Return Multiples (TVPI) Source: PitchBook
  14. 14. Overall, if you make 3x-5x, you are in good company!
  15. 15. Road to 3x
  16. 16. Scenario Fund Size: 100M USD 10 Investments. Flat allocation - 10M per investment Desired Return is 3x. 300M USD exit value Assume 25% ownership at the time of exits
  17. 17. Scenario 1 https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/ They all do “average” and exit at $50 million Ten companies, they all exit at $50 million. The VC would return $12.5 million on each. Outcome: 10 * $12.5 million = $125 million https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/
  18. 18. https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/ Half do average like before, and half do better Five sold at $50 million, so $12.5 million return on each. The other five did much better and pulled off $100 million exits. Return: (5 * $12.5 million) + (5 * $25 million) = $187.5 million return Scenario 2 https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/
  19. 19. https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/ Majority do “average;” we’ll throw in an overachiever The 10th company, instead of selling for $100M as before, now does $500M. So our original five still sell at $50M, four sell at $100 million and our new one at $500M. Returns: (5 * $12.5M) + (4 * $25M) + (1 * $125M) = $287.5 million Scenario 3 https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/
  20. 20. https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/ We need one big fat unicorn exit! We would need one large exit to see good profits. Something like this would work: nine startups sell for $50 million each and one goes for $1 billion: (9 * $12.5 million) + (1 * $250 million) = $362.5 million Scenario 4 https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/
  21. 21. https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/ The Realistic Scenario Five startups fail and do $0, three exit at $25 million, one exits at $200 million and our superstar does $1 billion. Return: (5 * $0) + (3 * $6 million) + (1 * $50 million) + (1 * $250 million) = $318 million Scenario 5 https://techcrunch.com/2017/06/01/the-meeting-that-showed-me-the-truth-about-vcs/
  22. 22. Fund Exit Values (Assuming 3x Returns) Equity Ownership, Total Exit Value (B USD) Fund Size (M USD) 5% 10% 15% 20% 25% 20 1.20 0.60 0.40 0.30 0.24 30 1.80 0.90 0.60 0.45 0.36 50 3.00 1.50 1.00 0.75 0.60 75 4.50 2.25 1.50 1.13 0.90 100 6.00 3.00 2.00 1.50 1.20 250 15.00 7.50 5.00 3.75 3.00 500 30.00 15.00 10.00 7.50 6.00
  23. 23. Fund Exit Values (Assuming 3x Returns) Equity Ownership, Total Exit Value (B USD) Fund Size (M USD) 5% 10% 15% 20% 25% 20 1.20 0.60 0.40 0.30 0.24 30 1.80 0.90 0.60 0.45 0.36 50 3.00 1.50 1.00 0.75 0.60 75 4.50 2.25 1.50 1.13 0.90 100 6.00 3.00 2.00 1.50 1.20 250 15.00 7.50 5.00 3.75 3.00 500 30.00 15.00 10.00 7.50 6.00 Circle of Practicality
  24. 24. Power of Power Law!
  25. 25. Startups Success Odds https://www.sethlevine.com/archives/2018/04/whats-the-optimal-portfolio-strategy-for-a-venture-fund.html
  26. 26. Few Deals make the Returns! https://www.ben-evans.com/benedictevans/2016/4/28/winning-and-losing For funds with an overall return of 3-5x, which is what VC funds aim for, the overall return was 4.6x but the return of he deals that did better than 10x was actually 26.7x. For >5x funds, it was 64.3x. https://www.ben-evans.com/benedictevans/2016/4/28/winning-and-losing
  27. 27. Few Funds make up the return for LPs
  28. 28. Power Power Law rules the VC industry! https://visible.vc/blog/understanding-the-power-law-curve-of-vc/ https://blog.ourcrowd.com/a-moonshot-bet-on-moonshots/
  29. 29. Return Persistence Top Quartile funds tend to remain there https://blogs.cfainstitute.org/investor/2020/02/17/venture-capital-worth-venturing-into/
  30. 30. Do you still want to become a VC?
  31. 31. VC - Mirages Make a lot of money! I can “help” entrepreneurs I don’t like operations All I have to do it listen to some pitches, write cheques and give some arm chair advice!
  32. 32. 
 “Long Term” reasons to become a VC True passion for being part of creating the future Working with the best of the entrepreneurs True passion of understanding trends / behaviours / needs Constant learning and unlearning - every single day! “If you can’t invent the future, the next best thing is to fund it.” John Doerr, Kleiner Perkins
  33. 33. What does it take to run a Fund
  34. 34. piVentures2020AllRightsReserved Typical Fund Structure Limited Partner (LPs) Startups Fund Management Co General Partners (GPs) ContributionsDistributions Exits Investments Fee & Carry Contribution (small)
  35. 35. piVentures2020AllRightsReserved Other Entities Sponsor Jurisdiction based rules For AIF funds (India), every fund needs a Sponsor who has to commit 2.5% of fund size or 5CR (whichever is lower) Key Decision - Internal or External Sponsor LP Advisory Committee (LPAC) Subset of LPs form LPAC Governance and guidance to the IM Investment Committee
  36. 36. Typical Time Lines Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10Y0 Fund Raising Fund Raising Commitment Period Follow Ons 3-5 Years 2 years post Commitment Period Next Fund Raise First Close Final Close No More Fresh Investments post Commitment Period
  37. 37. VC Treadmill Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10Y0 Fund Raising Fund Raising Commitment Period Follow Ons 4 Years 2 years post Commitment Period Next Fund Raise First Close Final Close No More Fresh Investments post Commitment Period Raise Deploy Raise Deploy Return
  38. 38. Investment Team in a “Startup” Fund Analyst / Associates / VPs Principal Managing Director Partner General Partner Deal Sourcing Analysis Developing Thesis Leading Deals Deal Negotiations Managing Boards Brand Presence Fund Raising Building Teams Independence/ Depth / Quality Decision Making Leadership Demonstrated Track Record
  39. 39. Non-Investment Roles Finance / Compliances Dedicated Product Roles Dedicated Business Roles Marketing Roles Admin Staff
  40. 40. Carry Allocation Equivalent of ESOP Allocations for Startups General practise is to keep this for Investment Team (Above Principal / VP / Senior Associates) and Advisors In my book, everyone should be part of Carry; after all it is a team sport Vesting Curves are typically back loaded with a cliff
  41. 41. Prevalent Numbers https://vcpreneur.com/vc-funds-101-understanding-venture-fund-structures-team-compensation-fund-metrics-and-reporting-152b02e8504a
  42. 42. Fund Strategy Thesis Stage Capital Allocation Portfolio Construction Target Ownership Investment Committee
  43. 43. Thesis Thesis design is most critical in these times Narrow vs Broad Specialized vs Generalist Gives focus and positioning
  44. 44. Stage Choice 0 1 2 3 4 5 6 7 8 9 Valuation Seed Round Angel Round Series A Series B Series C Product Market Fit Business Model Fit Bridge Round*
  45. 45. Stage Choice 0 1 2 3 4 5 6 7 8 9 Valuation Seed Round Angel Round Series A Series B Series C Product Market Fit Business Model Fit Bridge Round* Early Stage Founder Focussed Product Market fit risk Team Risk Good ownerships Requires more hands-on work
  46. 46. Stage Choice 0 1 2 3 4 5 6 7 8 9 Valuation Seed Round Angel Round Series A Series B Series C Product Market Fit Business Model Fit Bridge Round* Mid Stage Team Focussed Growth Risk Needs bigger corpus funds (> 100M USD) Hands-off governance
  47. 47. Stage Choice 0 1 2 3 4 5 6 7 8 9 Valuation Seed Round Angel Round Series A Series B Series C Product Market Fit Business Model Fit Bridge Round* Late Stage Market Share focussed Market Capture/ Exit Risk Needs much larger corpus funds (> 250M USD) Private Equity like governance
  48. 48. Portfolio Construction What is the optimal number of companies? Balance between too few shots and spreading too thin Case Study 30m USD Investible Corpus, Early Stage Deep tech fund 1st Cheque is 1M USD on an average Additional 1M is invested in subsequent follow-on rounds
  49. 49. Portfolio Construction X number of companies Half of them raise only first cheque (1M) Half of Half raise one more 1m (2M in total) Half of Half raise one more 1m (3M in total) First Cheques = X * 1M USD 1st Follow On = (X/2) * 1M USD 2nd Follow On = ((X/2)/2) * 1M USD So, X+X/2+X/4 = 30M X = ~17 companies
  50. 50. Portfolio Construction - Key Considerations Min 10-12 investments Balance between going deep vs spreading thin Number of Partners / MDs
  51. 51. Capital Allocation 20% 40% 60% 80% 100% 20% 40% 60% 80% 100% First Cheques Follow Ons Spread too thin You have to be a really good picker! Good Balance between breadth and depth
  52. 52. Follow On Funding Data https://www.cbinsights.com/research/venture-capital-funnel-2/
  53. 53. FC: FO Ratios for an early stage VC Round Number of SUs Round Size (M USD) Prorata Amount (20% ownership) Seed Investor Investment Total (M USD) FC: FO Seed 1,119 0.67 0.67 750 750 39% 2nd Round 534 4.27 0.85 456 1,193 61%3rd Round 335 11.00 2.20 737 3.72Total Investment by Seed VC Round Number of SUs Round Size (M USD) Prorata Amount (20% ownership) Seed Investor Investment Total (M USD) FC: FO Seed 1,119 0.67 0.67 750 750 44% 2nd Round 534 4.27 0.85 456 959 56%3rd Round 335 11.00 1.50 503 3.02Total Investment by Seed VC
  54. 54. Capital Allocation FC - FO 40-60 FC - FO 50-50 FC - FO 60-40 Ideal Forces discipline on finding right deals at the right time Maybe hard to implement Unsure Will make the follow-on decisions harder Can run out of capital to back winners Practical Indicative that first cheques were more expensive than planned Tightness around follow-on cheques
  55. 55. Target Ownership Equity Ownership, Total Exit Value (B USD) Fund Size (M USD) 5% 10% 15% 20% 25% 20 1.20 0.60 0.40 0.30 0.24 30 1.80 0.90 0.60 0.45 0.36 50 3.00 1.50 1.00 0.75 0.60 75 4.50 2.25 1.50 1.13 0.90 100 6.00 3.00 2.00 1.50 1.20 250 15.00 7.50 5.00 3.75 3.00 500 30.00 15.00 10.00 7.50 6.00 3x Return. Fund Exit Values
  56. 56. Napkin Method to understand ownership needed for 3x return Investment 30M USD Total Exit Value 1B USD
  57. 57. Napkin Method to understand ownership needed for 3x return Investment 30M USD Total Exit Value 1B USD Exit Needed - 100M Ownership here:10%
  58. 58. Napkin Method to understand ownership needed for 3x return Investment 30M USD Total Exit Value 1B USD Exit Needed - 100M Ownership here:? Assuming 50% dilution along the way Ownership at the time of investment: 20%
  59. 59. Entry Ownership for a typical Early Stage Fund 0 1 2 3 4 5 6 7 8 9 Valuation Seed Round Angel Round Series A Series B Series C Product Market Fit Business Model Fit Bridge Round* 20-25% 15-20% 10-15%
  60. 60. Path to Ownership Stage Round Size Post Money Valuation Pro-Rata Amount Fund Participation Ownership Seed 1 4 1 25% Series A 5 20 1.25 1.25 25% Series B 15 60 3.75 0.75 20% Case A Stage Round Size Post Money Valuation Pro-Rata Amount Fund Participation Ownership Seed 1 4 0.5 12.5% Series A 5 20 0.625 1 14% Series B 15 60 1.875 1.5 13% CaseB Ownership @ Exit Value Multiple Case A 13% 12.5 4.2 Case B 7% 6.6 2.2 Exit Value Comparison for a 100M exit assuming 50% dilution
  61. 61. Path to Ownership Go big early Go cautious early Good ownership Rights are easier to get with bigger investment early-on Risks of write offs is bigger Ownership is hard to catch up for seed funds May have a compromise on rights Hedge the Risks
  62. 62. Investment Committee Typically comprises of Partners & External members Key Decisions Internal vs External Consensus vs Conviction Establishing Culture of Intellectual Honesty Nimbleness & Responsive
  63. 63. Running a Fund Raising Money Building a team and a great culture Getting access to the best deals Portfolio Work Making Decisions Thesis Evolution
  64. 64. Raising Money Most difficult process in the lifecycle 10x more difficult than raising money as an entrepreneur First time funds face a bigger challenge Having a USP helps Strong team Strong Thesis Strong Track record Tests your sales skills to the max
  65. 65. Building a Team & Culture Funds typically have a small teams Structure Roles Independent thinking yet have common goals Individual as well as a team sport Disagree but commit
  66. 66. Portfolio Work Good probability of a break out Great team. Solid PMF. Good Capitalisation 10-15% Struggling Team Issues. Poor PMF. Poor Runways10-15% Finding their path out Good team. Iffy PMF. Okish Capitalization 70-80% Critical Question: Where should you spend your time? %s shown are typical portfolio construct
  67. 67. Portfolio Work Good probability of a break out Great team. Solid PMF. Good Capitalisation 10-15% Struggling Team Issues. Poor PMF. Poor Runways10-15% Finding their path out Good team. Iffy PMF. Okish Capitalization 70-80% Time Spent Low High High Why? Makes the fund return. Normally founders of this category are scalable Makes / Breaks reputations. 1x - 3x outcomes can make a difference of 3x vs 5x returns Finding home takes time and effort. Problem solving is repetitive https://avc.com/2017/12/the-second-quartile/%s shown are typical portfolio construct
  68. 68. Making Decisions You are constantly making decisions with less information Intellectual Honesty Emotional Awareness Knowing your biases Process vs Gut Is the key to develop an intuitive understanding of People, Business, Technology, Finance?
  69. 69. What does a PMF for a VC fund look like? Submit your reflections on a slide or two
  70. 70. Thank You! *Thanks to Prof Shivaram from IIT Mumbai for the phrase J AI HIND*

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