Founder-Investor Alignment: The Impact of Fund Economics
Investor Alignment is Critical
I had a recent conversation with an early-stage founder trying to decide between multiple term sheets from institutional investors. Vocap was not involved in the process, but the founder sought my advice on sorting through the offers and making a final selection. After a quick stack ranking of:
The strengths/capabilities of the parties involved
The amount of capital offered relative to the company’s needs, and
The basic terms,
two of the offers moved to the top.
My next question surprised the founder a bit. I asked him if he knew what success looked like for the two prospective investors. After a puzzled look, I elaborated further; was he aware of the outcome these funds required for the investment to be deemed a strong success for their portfolio? Were they ‘underwriting’ their investments with expectations of $100M, $250M, $500M, or higher valuations at exit? This led to some explanation of the math behind most venture funds.
Portfolio Math
Typical early-stage venture funds spread their bets across 15-25 investments, anticipating a few very big wins will make up for the ones that don’t succeed. Historically, funds taking this classic ‘power law’ approach will have 1/3 of investments yield a strong positive return, 1/3 will return the original invested capital or a bit more, and 1/3 will fail to return invested capital. So for the fund to succeed, the few big wins must be large to make up for the other 2/3s of the portfolio.
Here is a simple example:
Assume an early-stage fund invests $100M in twenty companies with $5M invested into each company, and the fund collects $15M in fees over the life of the fund. That results in a fund size of $115M total. To keep it simple, assume on average the fund receives 20% ownership in each company and has no dilution from future rounds of funding. To remain competitive for future LP funding, early-stage funds typically need to return at least 3x the fund size or in this scenario $345M in total gross proceeds. This $115M fund would need over $1.7B in collective exit value across its portfolio to hit its 3x target for investors ($1.725B * 20% ownership = $345M gross proceeds). If the fund’s returns follow the typical 1/3, 1/3, 1/3 pattern, the top 1/3 of investments will need to cover the vast majority of the $1.7B in exit value. Now picture yourself as a founder and CEO receiving a $250M acquisition offer. It’s the kind of deal that could transform your life—perhaps even impact your grandchildren’s future. But in the scenario above, it will yield only $250M of the $1.7B in exit value needed by your investor. If they need your company to be one of their real big winners, they may be incentivized against taking the offer.
As funds scale in size, the math doesn’t get any easier. Still assuming 20% average ownership at exit, a $300M fund needs to generate $4.5B in exit value. A $1B fund needs to generate $15B in exit value. Although a $250M exit valuation is a great accomplishment, it won’t move the needle much for large funds.
Don’t Let the Tail Wag the Dog
As a CEO, you need to be careful the fund’s objectives don’t end up driving your company’s strategy and exit path. This could drive poor operating decisions or even worse cause you to pass up on a great exit because it’s a rounding error for one of your investors’ funds. This came to mind during a recent conversation with an independent board member of a company we evaluated during its Series A round. The company ended up raising significant early-stage capital from typical ‘power law’ institutional investors. These investors needed big outcomes to power their fund math, and this put a lot of pressure on the CEO to scale quickly. Their Series A was followed by an even larger Series B, increasing the pressure for an outsized return. The company had reasonable growth, but burned through a significant amount of capital in the process, leading to a lot of dilution for the founders, seed investors, and management team along the way. The company might eventually attract acquirers, but the dilution from trying to shoot the moon will have turned a very good outcome into a disappointing one for all involved.
Key Questions to Ask
Ensuring you have alignment with investors on the target outcome upfront can save a lot of pain and frustration going forward. There is nothing wrong with striving for big outcomes, as this is the cornerstone of venture and growth investing. However, value creation should be driven by the company and its market opportunity, not by its investors’ fund economics. To ensure you have aligned objectives, we recommend asking investors a few key questions upfront:
How big is your fund?
How many investments will you be making in this fund?
For your fund, what’s a successful exit range for this investment?
If the company received an offer to sell that is below your target exit range, what is your fund’s decision-making process for supporting or opposing such an offer?
Has your firm ever blocked the sale of a company?
If you get any unclear answers to the last few questions, you can run the math yourself based on the first two questions and have a pretty good sense of the type of outcome they need.