?? How VCs Decide on Their Average Funding Amount ?

Venture capital (VC) firms are vital players in the startup ecosystem, providing essential funding to early-stage companies. Determining the average check size for investments is a critical aspect of fund management. This calculation influences a fund's ability to support portfolio companies adequately and achieve desired returns.

In this article, we'll explore how VCs determine their average check size using a hypothetical $100M fund targeting 20 investments, with detailed explanations for each step.

Fund Size Calculation (A)

The first step in determining the average check size is understanding the total fund size. This is the amount of capital that the VC firm has raised from its limited partners (LPs). The fund size sets the stage for all subsequent calculations and decisions. For our example, we'll assume a VC fund with a total capital commitment of $100M.

Fund Size: $100M

Explanation

The fund size is the cornerstone of any VC firm's investment strategy. It represents the total pool of capital available for investments, management fees, and other expenses. The size of the fund often reflects the firm's strategy, risk appetite, and the types of companies it aims to invest in. For instance, larger funds might target later-stage companies or have the flexibility to write bigger checks, while smaller funds might focus on early-stage startups with smaller capital requirements.

Management Fees (B)

VC firms charge management fees to cover their operational costs, such as salaries, office expenses, and administrative costs. These fees are typically a percentage of the total fund size, charged annually over the life of the fund. In our hypothetical scenario, we'll assume a management fee of 2%.

Management Fees Calculation:

• Annual management fee: 2% of $100M = $2M/year
• Over the typical 10-year life of the fund: $2M/year * 10 years = $20M

Therefore, the adjusted fund size after accounting for management fees is:

Adjusted Fund Size (A - B): $100M - $20M = $80M

Explanation

Management fees are crucial for the operational sustainability of a VC firm. These fees ensure that the firm can attract and retain talent, conduct due diligence, and manage its portfolio effectively. The industry standard for management fees is usually around 2% per year, although this can vary. Over a typical 10-year fund life, these fees can add up significantly, reducing the total capital available for investments. Understanding the impact of management fees is essential for accurate fund planning and allocation.

Initial and Follow-On Investments

VC firms allocate a portion of their fund for initial investments in new portfolio companies and another portion for follow-on investments to support these companies in subsequent funding rounds. For our example, we'll assume that 50% of the fund is reserved for follow-on investments.

Follow-On Investment: 50% of $100M = $50M

The remaining amount is available for initial investments:

Remaining Net Amount for Initial Investment: $80M - $50M = $30M

Explanation

The allocation between initial and follow-on investments is a strategic decision that balances the need to diversify the portfolio with the need to support successful companies through their growth stages. Reserving a significant portion of the fund for follow-ons allows the VC to double down on its winners, increasing the potential for high returns. However, this also means that the initial investment pool is smaller, requiring careful selection and due diligence to ensure the initial investments have high potential.

Average Check Size for Initial Investment

With the remaining net amount for initial investments, we can now calculate the average check size per company. Since the fund targets 20 investments, we divide the available capital by the number of companies.

Average Check Size: $30M / 20 = $1.5M

Explanation

The average check size for initial investments determines how much capital the VC firm can commit to each new portfolio company. This check size needs to be large enough to provide the startup with sufficient runway to achieve its next set of milestones, but small enough to allow the VC to build a diversified portfolio. The balance between these two considerations is crucial for managing risk and maximizing the potential for high returns.

Strategic Follow-On Investment

VC firms often adopt a strategy for follow-on investments where they invest additional capital in their most promising portfolio companies. A common approach is to invest $2 in follow-on for every $1 in the initial investment. However, the actual follow-on investment may be constrained by the available funds.

Strategic Follow-On Investment Calculation:

• Total Follow-On Investment: 20 companies $1.5M 2 = $60M
• Adjusted Follow-On Investment (limited by available funds): $50M

Since the available follow-on funds are $50M, the actual follow-on investment per company must be adjusted accordingly.

Explanation

Strategic follow-on investments are a way for VCs to support their most promising portfolio companies through additional funding rounds. By investing more capital in successful companies, VCs can increase their ownership stake and potential returns. The $2 follow-on for every $1 initial investment is a common heuristic, reflecting the need to provide substantial support to winners. However, the actual follow-on capacity is limited by the fund's allocation, necessitating adjustments to ensure the strategy aligns with available capital.

Adjusted Average Check Size with Strategic Follow-On

To determine the adjusted average check size, we consider the total follow-on investment and the number of companies.

Adjusted Average Check Size: $50M / (20 * 2) = $1.25M

Explanation

The adjusted average check size accounts for the strategic follow-on investments within the constraints of the fund's allocation. This calculation provides a realistic view of the average investment amount per company, balancing the initial and follow-on funding needs. It ensures that the VC firm can adequately support its portfolio companies while managing the fund's capital efficiently.

In Short

Determining the average check size is a crucial exercise for VCs to ensure they can adequately support their portfolio companies and maximize their investment returns. In our hypothetical scenario, we started with a $100M fund and accounted for management fees, initial investments, and follow-on strategies to arrive at an adjusted average check size of $1.25M per company.

A Couple of Other Takeaways

1. Flexibility in Follow-On Allocation: The follow-on allocation can be adjusted based on the performance of the portfolio. For instance, not all 20 companies may receive follow-on funding, allowing for larger investments in the most promising companies.
2. Fee Structure Adjustments: Management fees typically step down after the initial investment period, usually around year five, which can free up more capital for investments in the latter half of the fund's life.

Understanding these dynamics helps VCs manage their funds more effectively and make strategic decisions that can lead to successful outcomes for both the investors and the portfolio companies.

Examples from the Real World

1. Sequoia Capital: Known for their large funds, Sequoia often manages multi-billion dollar funds with a focus on both initial and follow-on investments. Their strategy includes reserving substantial capital for follow-ons to support their portfolio companies through various stages of growth.
2. Andreessen Horowitz (a16z): a16z manages large funds and follows a similar strategy of significant follow-on investments. They are known for their "all-weather" portfolio approach, which ensures they have enough capital to support their companies in both good and bad market conditions.
3. Benchmark Capital: With a more concentrated portfolio approach, Benchmark typically invests in fewer companies per fund, which allows them to allocate larger check sizes for both initial and follow-on investments. This strategy helps them focus on high-impact investments.

These examples highlight how different VC firms apply these principles to manage their funds effectively and achieve their investment goals. By understanding and calculating the average check size, VCs can ensure they have the right balance between initial and follow-on investments to support their portfolio companies and drive successful outcomes.