Broad Strokes : Why Early-Stage VCs want Startups growing 4x every year

→ VCs as most people know invest in startups

→ Generate returns by taking exits from their portfolio of companies → at a higher multiple

→ They essentially raise money from LPs (Limited Partners), whom they have to return capital to

To show this in a better fashion :

Fund life / Typical period for which they can hold their investment in any company is ~8-10 years, post the same they need to exit and give returns to the LPs

LPs mostly are :

1. Financial Institutions (E.g. Pension Funds)
2. HNIs (High Networth Individuals) or their Family Offices
3. Fund of Funds (e.g. Sovereign wealth funds etc.)

For anyone to invest in a VC fund is a risky bet, they can alternately invest in other public market assets which can easily give them an IRR (Internal Rate of Return) of ~ 10 - 12%

Lets say a VC raises 100 Mn for 10 years, which means the minimum return should yield for VC to be considered a remunerative asset for LPs becomes :

100 Mn x [ ( 1 + 12% )^10 ] ~ 310 Mn, which is 3.1 times MoIC (Multiple on Invested Capital)

At an IRR of ~ 12%

For such a risky asset, which :

• nearly 70% of the time fails give such return or
• only ~30% give favourable returns (as in diagram)

The risk and return need to be adjusted : (rational assumptions)

70% of the time / funds give 1.2x avg. return in 10 years which is ~ 2% IRR

Which means the remaining 30% of the time, money has to work much harder to get atleast to a viable 12% IRR to take the risk for an LP to invest money into the fund.

To get 3.1x return needed : [Calculations based on Probability]

70% of Money has given 1.2x return = 0.84 times of total value of the fund raised ($ 100 Mn)

Now the remaining 30% has to generate = 3.1x - 0.84x = 2.26x of the total value of the fund

Meaning an MoIC / return of (2.26x / 30%) = ~ 7.53x in 10years Which translates to minimum of ~ 23% IRR for risk to be adjusted

How it translates on the Startup side :

→ Assuming on avg. 30 investments from a fund (highly diversified fund)

→ A cap. of 15% investment can be done in a single company (*Return assumptions are very optimistic)

Now to achieve minimum 7.53 MoIC means

1.24 + 0.225X > 7.53

X > 28 ( MoIC on the winners ) Which translates to IRR being greater than ~40% for the winning bets / startups of the fund.

On Avg. ~5 rounds of investments happen in any Unicorn ( proxy for winners - source)

Which means nearly 4-5 rounds before the Fund takes exit (10 years fund-life) on average 2.5 years to raise next rounds (avg. as early-stage round happen quickly and later stage rounds take much more time)

Which means each consecutive round valuation jump on average should be greater than :

(1 + 40% IRR) ^ (2.5 years) = 2.32 times for minimum viable returns

Hence early stage VCs look for winners who are growing at least 3-4 times every year as a winning bet.

Which translates to a minimum of ~ 10-15% growth on a Month on Month basis.