???????? Hi friends!

Well, here we are, at the end of September looking down the barrel of a new year once again.

There are two narratives out there in venture land:

We’re back and life has never been so good.

It’s all shot to bits and it’ll take another couple of years to resolve itself.

I take a more pragmatic approach.

Neither life nor startups follow a linear path, so it pays to expect the unexpected.

Remember that things almost always resolve themselves over the long term.

For all the Londoners, I’ll be at the London Venture Capital Network’s drinks and networking event this Thursday at Dream Factory – I’ll be hot mic’d and cornering unsuspecting founders and VCs alike to get the skinny on what they’re up to!

Drop me a line if you’re going to be there ????????

In this weeks Off Balance, I’ll be chatting about:

???? VCs Now vs VCs Then
???? Finding a way to exit early investors
???? The Power Law: what does it mean and why should you care?

As a side note, I’d love to give a shoutout to EmergeOne portfolio client, Continuum Industries, that just locked in its $10m Series A led by Singular ????????

Read more below.

Also if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

Give me a follow on LinkedIn, Twitter (do I really have to start calling it ‘X’ soon?), Instagram and drop me a note 🙂

(If you are trying to connect with me on LinkedIn, maybe read this post I wrote and make sure to start your request with “Off Balance” and, more importantly, tell me why you’d like to connect ????????)

Don’t forget to like, rate and subscribe to Nothing Ventured on Apple, Spotify or YouTube, it really helps more people see what we’re doing!

Now let’s get into it.

Now vs Then

The meme below has been doing the rounds on social media this last week.

And once you get over the LOL imagery and take a minute to think, there is a story to be told…

For a start, over the last decade, we have been very involved in short term thinking, especially in venture land.

Too many deals were being done as a result of ‘hot rounds’, FOMO, party rounds and everything in between.

Much of the thinking was less about the fundamentals of the business, and more so around whether there was a ‘greater fool’ that would carry the bag down the track.

If you could invest early and then find someone to take the next round, you could show a paper return, increase your MOIC (multiple on invested capital), raise a larger fund and perpetuate the cycle.

Startups started buying into this hype, building fairly inconsequential software businesses (inconsequential from the perspective of the long term impact they could have on the world – let’s face it, a better to do list is hardly going to change the face of humanity).

And this could be done because of the abundance of capital out there willing to fund these businesses and then mark them up when the next investor came along.

Much of this short term thinking, along with a pretty loose attitude to cash, was perpetuated by the sort of literature that was being pushed out (and often pushed on) founders.

Books like ‘The Lean Startup’ and others like ‘Blitzscaling’ taught founders that they should move fast – the former pushing fast iteration and the latter almost vaunting profligacy in the pursuit of scale.

The problem with fast iteration is that whilst that might be ok for software products – especially ‘simple’ d2c or b2b products – it’s a lot harder for anything deeptech or in the hardware space.

You can’t build a new type of engine and fix the problems as and when they arise. The product is going to need to be almost fully baked by the time it even gets into a customer’s hands.

That takes time. And time requires money.

Sadly, too much money has been wasted not only on needless side projects or vanity features, but also on full blown businesses that had no need to exist.

It has been a very odd feeling over the last 8 years that I have been involved in the venture ecosystem, trying to reconcile this sort of attitude with my own training in finance and old school manufacturing where the most basic principle is sell a widget for more than it costs you to make it.

My shareholders would have hauled me over the coals if I just threw money at every problem, hoping they’d resolve themselves.

The reality is that scarcity breeds innovation, which is why the next epoch of the startup cycle has the potential to be transformational.

Or at least, that’s what I’m hoping.

How can did I add value?

Recently on one of the various founder groups I’m in, a couple of conversations sprang up around how to deal with early investors on the cap table.

This may be the case because you feel they aren’t adding a huge amount of value, or because you’ve got an incoming investor that maybe wants a larger chunk of equity which would dilute you more than you intended.

The solutions are similar, even if the implications are slightly different. So let’s take a look…

Share Buyback and Cancellation
If your business has sufficient capital, it might be able to buyback shares from your shareholders and then cancel them, thereby reducing the total number of shares outstanding.

This really only works if you have excess capital that you don’t need for growth – highly unlikely in an early stage business, and, you will need to get the appropriate consents in place as well as needing to convince the shareholders to sell.

On a positive note, it provides a return to those early investors as well as increasing all the remaining shareholders’ ownership.

Share Sale to a Third Party
If your business doesn’t have the cash, you might be able to find an investor that would like to purchase the shares from the existing shareholder. This means you don’t change the total number of shares outstanding, just who holds the ownership.

Again, you will need various consents for this to happen, and be warned that if an offer is made, you may need to make a similar offer to other existing shareholders.

There are potential tax implications for the seller and the buyer (in the UK at least) depending on the total value of the shares and the original purchase price. But these are the responsibility of the buyer and seller, not of the business.

This is one of the methods that might work if you have an investor looking to overfund a round. Say you have only £500k available but they want to invest £1m, you could offer the £500k as fresh equity with the balance being used to acquire existing shareholdings.

This is called a secondary share sale.

Debt / Equity Swap
Less utilised, but potentially achievable if you don’t have the capital available nor can find a third party buyer is to see if you can get the existing shareholders to essentially convert their equity into debt.

This has a few implications on the business…

It results in greater percentage ownership to remaining investors (because essentially the shares are being bought back and cancelled).

Debt holders typically have a number of rights that equity holders don’t – not least they will likely receive interest on the loan, or may demand that interest and capital are paid on a regular basis.

In these circumstances, knowing that the business has the cashflow to sustain repayment is critical.

If the business were to go under, debt holders are normally first cab off the rank in terms of getting repaid.

(Note: much of this will depend on your Articles of Association / Corporate Charter or equivalent, as well as any shareholder agreement and the rights associated with the specific shareholder and / or their specific share class. So this shouldn’t be taken as definitive advice and you should check with both your accountants and lawyers for the tax and legal implications of anything you might do. Things become additionally complicated if we’re talking about S/EIS shareholders).

The reality is that there are not a huge number of ways you can ‘get rid’ of early investors.

On the one hand, if the business is doing well then why would they want to sell off their chances of significant future upside? And, conversely, if the business isn’t doing great, how are you going to be able to offer to buy the shares at a valuation that doesn’t put them under water on their initial investment?

In fact, if they are S/EIS investors then they may prefer for the business to fold so they can recover some of their initial investment from HMRC.

Whatever you do, you should think long and hard about the implications, and always, always talk to a lawyer and someone that understands the tax implications for the business.

Remember it’s not your job to give tax advice to the shareholders – that’s their issue to deal with.

Off Balance

I know a lot of you have been waiting for this one. Let me tell you, it’s probably the least understood, most important and, equally, most talked about concepts in Venture Capital (at least if you’re on the investment side).

Power Law

We’re going to dig into a few things here including:

➡️ What do we mean by Power Law?
➡️ Power Law in the world of startups
➡️ What does this mean for VCs?
➡️ Strategies for navigating the Power Law
➡️ Critiques and limitations of the Power Law in VC

So what are we waiting for? Let’s get into it ????????????????????????

Power Law

What do we even mean by Power Law?

Power Law, related to the Pareto Principle also known as the 80:20 rule is often represented by the equation: y=axk

y is a function or, the result

x is the parameter you are going to change, aka the variable

k is the exponent or the factor by which scaling occurs

a is a constant

What this means is that small changes can lead to large outcomes – exponential outcomes – which can be quite difficult for the human mind to grasp because we are better at linear thinking (if x doubles, so does y).

For example, it’s intuitive that if one person needs 1 litre of water a day, then 2 people need 2 litres. This is linear thinking and would be equivalent to k being equal to 1.

But what happens in exponential functions?

Let’s look at the area of a circle (the result, y).

We know that we calculate the area as being equal to pi (the constant, a) multiplied by the radius of the circle (the variable, x) squared (i.e. k = 2).

Looking at a range of results where we double the radius, a each time we see the following:

What we’re seeing is a relationship where a relative change in one quantity results in a proportional relative change in another.

Put simply, it means that a small number of events or entities can have a disproportionately large impact.

In this case, increasing the radius of a circle 16 times leads to a 256 times increase in the area of the circle.

Applying this to VC: the Power Law implies that a very small number of investments will provide the majority of the returns.

This is unlike things that follow a pattern of normal distribution where results cluster around the mean.

Instead, in a Power Law distribution, while many startups might go to zero or produce minimal returns, a few outliers can generate immense profits.

This compensates for the losses and indeed pushes the portfolio to generate supernormal returns, paying back the invested capital of the entire fund and even more (from which VCs earn their carry – the percentage of the profits that they are due).

Peter Thiel is widely accredited, in his book Zero to One, for having recognised the fact that VC is subject to Power Law, stating as follows:

Power Law in the World of Startups

Startups operate in a high-risk, high-reward environment. The majority of them fail within the first few years – some manage to survive, others don’t have the sort of returns that VCs look for, whilst a few go on to redefine entire industries.

This distribution of outcomes is not normal but, as discussed, follows the Power Law.

There are plenty of reasons we see this distribution, but essentially what you are looking for is that certain something which triggers that exponential growth.

Examples may be market dynamics, technological breakthroughs, network effects, or first-mover advantage.

Network effects is a really important one that we often see in marketplaces and social media. As more users join, the platform becomes more valuable for all users.

I mean, would X or LinkedIn be valuable if there were only a dozen users on there? Or would Uber be useful if there were a million drivers but only 20 customers?

I’ll cover network effects in a separate issue, but it’s worth checking out this pod with Sameer Singh and his writings here where he goes deep into different aspects of network effects and their impact on how you should think about your venture.

The point is that whatever the trigger for your business to start exhibiting exponential growth, it is ultimately this that makes it attractive for venture capital investors – not only because of the large outcomes, but also because of the timing of those outcomes.

Take a business that grows linearly, starting at $1m and adding $1m per year of revenue. The business would take 99 years to get to $100m.

Now take a business that grows by 2.5x every year, it gets to $100m within 6 years – well within the normal time horizon for a VC fund to harvest returns from their portfolio.

What does this mean for VCs?

Clearly, this means that if a VC is looking for its portfolio to distribute per the Power Law, it means that they must identify and invest in potential outliers – this is why every investment that a VC makes must have the potential to return their fund.

And given how few of these types of businesses actually do end up returning such a substantial amount of capital, missing out on one can have massive implications on the overall performance of the fund.

This therefore means that VCs must look at much riskier deals than one might normally consider in a balanced portfolio, but critically must also be able to identify and mitigate as much of that risk as possible.

They know that most of their portfolio will likely go to zero, but the one or two that really go big will more than compensate for those that don’t.

However, this doesn’t mean that VCs invest blindly. Rigorous due diligence, market analysis, and founder vetting are crucial to increase the odds of picking winners.

Strategies for Navigating the Power Law

Given the Power Law dynamics, VCs employ several strategies to optimise their portfolios:

Diversification: By allocating into a diverse set of startups across sectors and stages, VCs can mitigate the risk of any single failure. This is a simplification as there is also merit in taking a more concentrated approach – we covered portfolio construction in a previous issue and it’s worth checking that out if you haven’t already.

Deep Market Research: Understanding market trends, technological advancements, and consumer behaviours can help VCs identify startups with outlier potential. This is why you often see specialist VC firms which only invest in one vertical or one stage as opposed to taking a more generalist approach.

Active Portfolio Management: Whilst not hands on in management, like say private equity firms are, VCs, rather than being wholly passive investors, may still take active roles in their portfolio companies. They will often take board seats to shape strategy, offer mentorship, introduce potential high calibre employees, networking opportunities, and other value adds. All of this is with a view to giving their investee companies the best chance at success.

Indeed, they may even actively work to find a buyer for the business if the company does not look like it is going to succeed. In this case, it might be better to receive some value back from the investment rather than seeing it go to zero.

Critiques and Limitations of the Power Law in VC

One of the major critiques to the Power Law is that it leads to – no, it drives – an all or nothing // move fast and break things // growth at all costs attitude to venture building.

Because companies know that they need to have significant outcomes, they may do things that they would ordinarily not consider (selling at a loss, hiring more staff than they need to cover inefficiencies).

What this can lead to is, ultimately, otherwise sustainable businesses being killed off as they are not able to sustain the growth that the Power Law demands.

Some also argue that not all VC returns are power-law distributed. They believe that with the right strategies, VCs can achieve consistent returns across their portfolios.

The other major problem is that there is also the risk of confirmation bias.

If VCs become too fixated on the Power Law, they might overlook startups that don’t fit the typical “unicorn” mould but could still provide solid returns. Though some would argue that solid returns are not what the business of venture capital is all about.

I hope the above breakdown was useful, but at the end of the day, real-world examples offer the best illustrations of the Power Law in VC.

Companies like Airbnb, Dropbox, and WhatsApp were once early-stage startups that many may have been overlooked or dismissed.

But, the VCs who recognised their potential and invested early reaped exponential returns when these companies achieved massive success.

A great example of this is Uber’s early investors. Famously, Benchmark Capital invested $11m into Uber’s Series A and received a 591x return on their investment – $6.5bn – when they exited their position.

But it’s always worth noting, for every unicorn, there are countless startups that didn’t make it. This just underscores the high-risk nature of VC and the Power Law dynamics at play.

I hope you found this useful, as always, I’d love to get your feedback and understand the sort of topics you’d love to hear about.

Just hit reply to this mail or drop me a line at [email protected] and let me know ????

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

???? And if you think someone else might love this, please forward it on to them,

???? Finally, if you’re a fan of the Nothing Ventured podcast, please don’t forget to like, rate and subscribe wherever you get your pods – it really helps us spread the word.

That’s it from me so until next time…

Stay liquid 🙂

Aarish

???????? Hi friends!

The older I get, the more I open myself to moments of planned serendipity.

Yes, I know that is a contradiction in terms. But hear me out.

When I go to events, I usually get overwhelmed by the sheer number of people there are. Having conversations in rooms where it’s so loud you can hardly hear yourself think isn’t really my cup of tea.

So I flipped the script at last week’s London VC Network event that EmergeOne sponsored.

I ran a podcast studio – in amongst the flowing free drinks – and ended up having ten super high quality conversations with VCs, founders and operators.

It was valuable one-on-one time to get to know each of them and form an actual connection with the added bonus of getting some super cool ‘podcast on the move’ content.

And I had never met most of the folk I ended up interviewing.

So you can rely on serendipity… or you can simply engineer your own.

In this weeks Off Balance, I’ll be chatting about:

???? How the Metaverse just got interesting
???? Early stage predators
???? VC Fund metrics worth understanding

Also if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

Give me a follow on LinkedIn, Twitter (do I really have to start calling it ‘X’ soon?), Instagram and drop me a note 🙂

(If you are trying to connect with me on LinkedIn, maybe read this post I wrote and make sure to start your request with “Off Balance” and, more importantly, tell me why you’d like to connect ????????)

Don’t forget to like, rate and subscribe to Nothing Ventured on Apple, Spotify or YouTube, it really helps more people see what we’re doing!

Now let’s get into it.

Crossing the Rubicon

If you only consume two pieces of content this week, it should be this:

Read the rest of this newsletter ???? 

Watch Lex Fridman’s interview with Mark Zuckerberg ???? 

And in that particular order.

I’ve no doubt that many of you will have seen the cartoony style Metaverse adverts Zuck and the Meta team made a year or so ago. You may have even rolled your eyes and laughed at its absurdness like I did.

This interview, however, is anything but absurd.

Lex and Mark have a conversation in the Metaverse as photorealistic avatars.

But, as you will see from the video, photorealistic feels like a bit of an understatement.

All I can say is that, we will continue to see technology such as this and AI improve almost exponentially with mind blowing speed (anyone see that ChatGPT can now write code by looking at a sketch you upload?) whilst at the same time costs continue to move to zero… we are going to see some pretty incredible stuff that most of us probably haven’t even imagined.

Here’s my conversation with Mark Zuckerberg, his 3rd time on the podcast, but this time we talked in the Metaverse as photorealistic avatars. This was one of the most incredible experiences of my life. It really felt like we were talking in-person, but we were miles apart ???? It’s… twitter.com/i/web/status/1…

— Lex Fridman (@lexfridman)
Sep 28, 2023

How can did I add value?

Recently one of my team reached out to me for a steer on a situation they had come across.

Here are the facts:

➡️ Founder had engaged an agency to build their product.
➡️ Agency had invested £150,000 into the business.
➡️ For the £150,000 investment, they had bought ~16% equity.
➡️ Which would value the business in the region of £950,000.
➡️ The agency had then taken £300,000 to build the tech.
➡️ i.e. an additional £150,000 over their investment.
➡️ The founder also had a non executive director (NED) on board.
➡️ The NED was associated with the agency that built the tech.

This sort of thing REALLY gets on my last nerve.

Here’s why:

✔️ Market salary for decent full stack dev (below CTO) – £80k p.a.
✔️ Market salary for decent front end dev – £60k p.a.
✔️ Market salary for decent product person – £70k p.a.
✔️ These numbers could be reduced if equity on offer.
✔️ If they’d hired a co-founder / CTO on salary + equity it would have cost less.
✔️ £100k salary reduced to £80k with say £20k in equity x 2 years.
✔️ Based on £950k valuation, this would have been 4.2%.
✔️ So they have spent more money and sold more equity than necessary.
✔️ Future investors coming in would have massive issues with the cap table.
✔️ This much equity to an external agency? Massive ????.
✔️ Not to mention, £300k for a product build? Sounds very high.
✔️ And who owns the IP? And who’s going to maintain the product?
✔️ Oh, and let’s not forget the ‘NED’.
✔️ They have essentially had their cake and ate it.
✔️ And whilst I don’t know this, I bet you they had advisory equity too.

Moral of the story?

At the earliest stages of your business there are A LOT of sharks out there looking to prey on unsuspecting founders.

It is worth finding and taking the advice of a few people who are:

a) completely impartial

b) experienced in early stage businesses

c) preferably founders themselves, because they are the most likely people to give you proper guidance – warts and all.

And of course, read this newsletter – I have a habit of being open to the point of it costing me business because I refuse to take money from folk that can’t afford it or don’t need it.

Off Balance

Having trouble separating your DPI from your IRR?

Got your MOIC in a twist?

Well, I’ve got you covered.

Now you may be asking yourself why I’m expending all this time helping you to understand how VCs work.

I mean, if you’re a VC you know this (hopefully) and if you’re a startup founder, you care out the metrics that startups care about.

But whilst a lot of time is spent by various writers on one or the other, you need to understand both to be able to really be able to navigate the whole ecosystem.

Plus I just love geeking out on this sort of stuff, so you’re just going to have to put up with me ???? 

Let’s get into it – VC Metrics Explained.

VC Metrics Explained

Internal Rate of Return (IRR)

Calculation: IRR is the rate at which the net present value of all cash flows (both inflow and outflow) from a particular investment becomes zero. It’s essentially the rate of growth a project is expected to generate.

OK, lot of words there I know. Let’s unpack.

Present Value (PV) and net present value by extension is a concept that is used in a lot of financial analysis to help users of financial information allow for the ‘time value’ of money (the fact that money today is normally worth more to you today than it is to you tomorrow.

To get to a present value of some future amount of cash, you discount that future amount back using a discount rate (often called a hurdle rate, because it’s the minimum rate that you would want the investment or project to beat because you can get it elsewhere with less risk). So:

PV = FV (1 / (1+r)^n

PV is Present Value

FV is Future Value

r is the discount rate

n is the number periods to discount back from

When you have a series of cashflows over a series of time, you would discount them all back and sum them to get to a Net Present Value.

We would normally say that an investment is viable if the NPV is greater than zero (i.e it’s worth something in today’s money).

OK but wait, what’s this got to do with IRR?

Well IRR is essentially the discount rate where the NPV would be equal to zero.

In today’s spreadsheet driven environment, it’s easy to do this using a formula. But back in the day I remember having to work it out using trial and error – i.e. you would play around with different rates going between positive and negative NPVs until you got as close as you could to zero to get the IRR.

Example:

Let’s use a simple (albeit unlikely) scenario:

$100m fund but only does 2 capital calls – 50% in year 0 and 50% in year 2.

Deploy evenly over 5 years.

Money returned between 6th and 11th year.

I have shown the PVs and NPVs at at hurdle rate of 5% as well as 10%. You can see that they sit either side of an NPV of 0 (though the distance between the NPV and zero is closer at 10% than 5%).

I’ve then, through a process of trial and error, gotten an IRR of 8.83% (NPV of 7 – i.e. as close to 0 as I was going to get). And have then used the spreadsheet calculation to work out the actual IRR, which as you can see is 8.831%

Now, the largest inflow happened in the 10th year ($100m) in this example.

Let’s see what happens if I change the timing and have it happen in the 8th year instead, keeping everything else the same.

Even though the total cash returned remained the same at $180m, the IRR has increased to over 9.6%.

And this is the beauty of IRR – it gives you a way of evaluating a return whilst taking into account the time value of money.

Implications: A higher IRR would indicate a potentially more successful fund and portfolio of investments.

It is a measure of the profitability of the fund over its lifetime and takes into account the different periods during which investments are made and returns harvested.

Limitations: The biggest problem with IRR is that it doesn’t consider the scale of the investment. Two funds might have exactly the same IRR but vastly different net cash inflows – this is is easily illustrated by looking at a the same numbers but reduced to a tenth.

Now we have the same IRR, but instead of $180m returned, $18m is returned. Both are good results from an IRR perspective, but obviously one is far less capital than the other.

Or, indeed, if under the original scenario, less cash is returned, but it is returned sooner, once again you will arrive at the same IRR, but you have substantially lower overall ‘profit.’

Multiple on Invested Capital (MOIC)

Calculation: Multiple on invested capital, better known as MOIC is a way of evaluating the performance of a venture fund. It’s used as a fairly easy-to-understand shorthand, providing a snapshot of fund performance at any single point in time.

MOIC = (Current Value of Investment + Distributions) / Invested Capital.

Implications: MOIC essentially indicates how many times an investment has increased in value.

It’s normally expressed as Yx:

Y is the multiple

x stands for times

If you had an original fund value of $50m pre investment and currently the total value of all realised and unrealised assets in the portfolio is sat at $100m, you would have achieved a MOIC of 2x. This means the investment has doubled.

Limitations: There are a few issues with using MOIC to gauge fund performance, even if it is a very simple way to understand how well a fund is doing at a specific point in time.

The first issue is that MOIC doesn’t take into account the time value of money.

We saw this with IRR, especially the fact that cash in hand earlier will lead to a higher return in today’s money.

Equally, you could have a 10x fund, but what if it took 20 years to get to 10x?

If you were a Limited Partner (LP or investor in the fund) you might not be that happy that your money has been tied up for so long before getting a return from it.

The second (and in my opinion bigger) problem is the fact that it uses unrealised gains as part of the calculation.

Why does this matter?

Well one only needs to look at what’s been happening over the last few years in private markets to understand why.

We have seen lots of businesses raise at hugely inflated valuations that have now had to raise at much lower valuations.

This is a problem in venture capital and other private market asset classes (e.g. property) where there is a regular flow of liquidity and buying and selling of shares that can help you ascertain true value of an particular business as you can in public markets.

This means that MOIC is driven by so called paper valuations (i.e. based on last round size) as opposed to an analytical approach that is substantiated by the market and can mask problems in how those valuations are derived.

It should also be apparent that it drives the wrong sort of behaviour as early investors are always incentivised to push up valuation and encourage ever larger rounds even where the business doesn not warrant it.

Distribution to Paid-in (DPI)

Calculation: Distribution to Paid-in or DPI is what I would look at most closely if I were trying to evaluate fund performance – especially funds that had been fully deployed or were reaching the end of their life cylce.

Why?

Well, as I am fond of saying, cash is both reality as well as king.

DPI essentially looks at the cash returned to investors versus the amount of cash they’ve already put in. In fact, it’s often called the cash on cash return.

It’s the purest representation of the actual return on LPs’ investment into a fund and is calculated as follows:

DPI = Cumulative Distributions / Paid-in Capital.

Implications: Like MOIC, this is a simple and easy to understand way for LPs to understand how their investment into any given fund has performed.

Like the old saying goes, a bird in the hand is worth two in the bush – or cash in my pocket is more valuable to me than cash in yours!

Limitations: Similar to MOIC, there are a couple of limitations, the first one, just like MOIC, is that DPI does not take into account the time value of money.

If, as an LP, my cash is returned only after a couple of decades then that isn’t great – though at the very least, if my DPI remains pretty low for several years after the fund has been fully deployed then it’s a pretty good signal that I need to have a conversation with the fund managers.

The second problem and one that runs contrary to what I have said earlier, is that it doesn’t consider unrealised gains or potential future distributions. So even if some of the investments made have had legitimate lifts in their valuations, this is not reflected in DPI.

Total Value to Paid-in (TVPI)

Calculation: Total value to paid-in is very similar to MOIC, with one fairly large difference.

The denominator.

So whilst MOIC divides by investment value, TVPI uses paid-in capital as the denominator.

Essentially, MOIC is looking at the return on money actually invested into portfolio companies whilst TVPI looks at the return based on the total money an LP has put into the fund.

The reason these two numbers are different is that in a General Partner (GP) / Limited Partner (LP) agreement, the GPs will draw fees based on the total fund value (normally 2% of the total fund over each year of the fund lifetime) – so a 10 year fund of $100m would result in $2m of fees per year for 10 years – i.e. $20m.

That means (in theory) that only $80m is available to GPs to put into fresh investments even if the LPs have paid in $100m.

TVPI = (Residual Value + Cumulative Distributions) / Paid-in Capital.

Implications: This arguably gives a truer representation of the return on an LPs investment into a VC fund (than say MOIC) as it is the return on their cash invested.

But, as always, there are limitations.

Limitations: We again have the same arguments arising with TVPI as we did with MOIC.

Firstly the fact that it does not allow for the time value of money and secondly it relies on paper valuations which can be manipulated in private markets.

One way around this issue of valuations would be to mark the investments to market on a regular basis and outside of a funding round.

This can be done by taking into account recent funding rounds of competitors as well as public market valuations to see what valuation might be achieved based on today’s multiples.

Of course, this would lead to issues of inconsistency as it isn’t always easy to get to a market valuation today and it would be imprudent to mark up the valuation if the market is tending towards a bubble.

Residual Value to Paid-in (RVPI)

Calculation: Residual value to Paid-In, or RVPI, is a useful metric for investors to understand what the outstanding value of their investment in a fund is worth.

It tells them how much unrealised capital there is left to potentially distribute if all the investments could be realised for cash today.

Over a fund lifetime, RVPI moves to zero, either because investments have exited and funds distributed or because the value of the investment has been written off as the business has been wound up.

It is calculated as:

RVPI = Residual Value / Paid-in Capital.

Implications: It is a simple way for LPs to understand how much value is yet to be returned by the fund and can be used with other metrics to evaluate overall fund performance.

Limitations: Again RVPI ignores the time value of money and is reliant on paper valuations to calculate which, as already discussed, can be highly objective.

And finally… 

There are a few other things that an LP might look at to understand fund dynamics, which I’ll cover briefly here:

Vintage Year: This is the year in which the first influx of investment capital is delivered to a project or investment and is used to categorise investments by the year they were made. This helps if you are trying to compare performance across different periods. Of course, it in no way provides insights into the performance of the investment itself.

Capital Called: This is the amount of committed capital that has been requested by the fund (let’s say you have a $100m fund, the total $100m isn’t requested up front, but via a series of capital calls). The total capital called indicates how much of the committed capital has been put to use, either by way of investment or by ways of fees. Again, it doesn’t provide any insights into the performance or returns of the fund or, indeed, the called capital.

Capital Distributed: This is the amount of proceeds from the fund that has been returned to the investors (i.e. where a portfolio company has exited or wound up and cash has been returned first to the fund and then back to the LPs). Obviously this gives an absolute number that indicates the returns generated from the investments. But it doesn’t tell you how the investment has performed relative to the initial amount invested, nor does it account for the remaining value of ongoing investments.

Bringing it all together

Let’s consider a fund with the following dynamics:

The total fund size is $100m of which $70m has been paid in to the fund via a series of capital calls.

$55m of the $70m has already been invested and the current portfolio (excluding distributions) is valued at $90m.

On top of this, $15m has been harvested from a couple of early exits.

Can you work out the MOIC, DPI, TVPI and RVPI?

How did you go?

Hopefully it was pretty clear and the maths shouldn’t have been too complicated.

The only real red herring is the actual fund size which is not relevant in any of the calculations we’ve looked at.

Here is a breakdown of what you should have gotten back – notice the variation in results across all of these which is why it’s important to look at them together, not in total isolation.

And there you have it, a deep dive into VC fund metrics and why they’re important from the perspective of an LP.

From the perspective of a startup, if you are able to do this sort of research, then it will give you an important understanding of how the fund performs.

If you see funds with poor MOIC it possibly means that they’re not that great at picking high growth potential ventures, and if they have a low DPI (whilst being quite advanced in their fund) it could mean that they’re not great a creating exit opportunities for their LPs.

You may only be concerned about getting an investment today, which is valid, but you have to think about whether this fund will be around to follow on in future rounds or, indeed, whether it will be able to convince other VCs to invest in those future rounds and provide the markups that it (and, let’s face it, you) need.

It always pays to be aware of these things when you’re evaluating which fund you want to work with because as one of my previous guests on the podcast – Marcus Love – said, the average VC / founder relationship lasts longer than the average UK marriage. ???? 

I hope you found this useful, as always, I’d love to get your feedback and understand the sort of topics you would love to hear about.

Just hit reply to this mail or drop me a line at [email protected] and let me know ????

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

???? And if you think someone else might love this, please forward it on to them,

???? Finally, if you’re a fan of the Nothing Ventured podcast, please don’t forget to like, rate and subscribe wherever you get your pods – it really helps us spread the word.

That’s it from me so until next time…

Stay liquid 🙂

Aarish