The Economics of Fund Ownership: Ignoring Ownership and Enabling LP Co-Investment

Venture capital has long been associated with the “Go big or go home” mentality. While most investments flop, the few that make it generate enough money to cover all the losses and more. 

As a result, VC hoards as much ownership over their winners as they can, doubling and tripling down when possible because those few home runs make or break the economics of the entire fund. 

Most Venture Capital Funds Live and Die by The Power Law

With about a 90% startup failure rate, it follows that venture return doesn’t follow a normal distribution—and that’s likely a conservative estimate. 

The remaining 10% (or less) must generate enough return to cover the losses from failed companies and generate 3 – 5x multiples. Anything less doesn’t make them work the risk profile of the asset class. 

Figure 1. Return distribution for early and late-stage venture capital funds

This especially rings true for early-stage ventures, given their relatively lower survival rate. Most venture fund returns follow an 80/20 rule: 80% of the return comes from 20% of the investments. In many cases, a single winner will often return the entire fund.

VCs Have No Choice But to Search for a Unicorn

Consider the following use case to demonstrate how venture economics work in the real world:

Assume you run a $100 million fund. To generate a respectable 3x return, you’ll need to return $300 million. You charge a 2/20 fee, which means that over 10 years, 20% of your capital goes into your pocket, leaving 80% or $80 million as your investable capital. 

Because you charge 20% profit, you need to generate 5x gross return on the $80 million (i.e., $400 million gross proceeds). After your 20% carry ($400 million x 20% = $80 million), that return will give you $320 million in net proceeds to your limited partners (LPs; the investors in your fund), or 3.2x net return. 

You have $80 million to deploy, and the goal is to make $400 million. One way to do this is to invest $2 million into 40 companies at an $8 million pre-money valuation, which means you will own 20% of each company. But your ownership will get diluted over multiple subsequent rounds, so you will likely end up with ~10% ownership by the time the company exits. 

Mathematically, this means that your winner needs to be a unicorn: a mystical $1 billion company that will bring you a $100 million return at only 10% ownership. 

For Most VCs, Ownership is Everything

Perhaps you’re wondering, “Why not invest $1 million into 40 companies, wait to see which one is the winner, and then invest the remaining dollars into those winners?” 

This is the primary strategy of a Seed Fund. Diversify into a variety of companies early and then concentrate follow-on investments into breakout companies. Ownership is built over time rather than all at once. 

But this strategy assumes you have the information advantage once you invest. And this is not always the case. 

If you don’t have people and time to gain information and build a relationship, you likely won’t have them at all. 

No Time and No People Means No Information and No Relationships

Investing in a company does not mean you will naturally know a winner when they raise the next round. Without taking the time to follow up, it’s unlikely you will just intuitively know whether the company is really a winner. After all, founders are great storytellers, and understanding the ups and downs each company faces is the only way to begin to understand whether or not that founder’s story is fact or fiction.

In other words, this approach requires you to be an active investor. You sit on the board or take the board observer seat. You brainstorm the strategy, help founders hire their engineers and VP of Sales. You sit through fundraising prep and answer calls for prospective investors. 

It doesn’t sound that bad…until you remember, you’ll be doing this for 40 companies.

An early-stage venture fund that can buy 20% ownership with $1 million operates at a Seed stage. For a Seed stage fund, 40 companies per portfolio is on the low end. A typical seed fund has 50+ companies, though we have seen as many as 200 companies in a fund. 

A Strategy At Odds with LPs

This deployment strategy is at odds with LPs looking to co-invest alongside the fund. 

Many LPs–especially those in early-stage funds—invest in the fund because they look to co-invest alongside the fund. 

Therefore, a deployment strategy based on building and protecting ownership over time among a few portfolio companies is at odds with the interest of the LPs. The fund effectively competes with the LP since it needs to deploy the fund’s capital into the winner, leaving little room for co-investment opportunities. 

More importantly, the fund may not have spent sufficient time and resources to determine whether a company is a winner in the first place. If they have 50 (or 200) companies in a portfolio, that would be impossible. 

Most funds also have legacy portfolios they still oversee even though they already deployed all the capital. The actual number of companies is probably closer to 150 – 500, especially as they become successful and raise subsequent funds. 

The Creative Ventures Solution: Be Right and Have a High Hit Rate

Venture math—and its deployment strategy—is the way it is because most startups fail. So instead of dancing around this fact, we tackle this problem head-on:

By being right and having a high hit rate.

Most startups fail because of a lack of product-market fit. They fail to find customers to buy their product with a repeatable business model, so they eventually run out of money and die. 

The simple and most direct way is to ensure product-market fit before we invest. This is not to be confused with the easiest way, however. At Creative, we do this using our proprietary method-driven approach. 

Since talking about method-driven investment and predicting product-market fit are topics worth exploring on their own, we have written two extensive blogs on them. What is Method Driven VC?and Deep Tech Awakening and How to Predict its Success: Part II” both go further into detail, and I recommend checking them out if you are curious how we do this.

In any case, our results speak for themselves. So far, our company survival rate has been north of 90%. 

Being Right Often Means Less Stress Over Ownership

Being a method-driven VC, we’re not playing Russian Roulette. We’re counting cards in the game of 21. 

Our returns become more distributed. We do not need to protect our ownership or plow our money into a few companies that we do not have much information about (even if the signals tell us that they must be great companies or suggest we have to overpay because they are “hot”). 

Concentrating on our portfolio and staying active is crucial to helping our LPs co-invest. 

Once we can safely ignore the need for ownership, we can focus on what matters as venture capitalists. We can create value for our founders and generate outsized returns for our LPs through fund and co-investment opportunities. 

We are free to have a smaller and more concentrated portfolio of 20-25 companies, half a typical fund size in our stage. Our smaller portfolio means we can add value to our founders by serving as an active investor as their board of directors, helping the companies hire and fundraise, and even assisting in business development and expansion to new markets and regions. 

Having a small portfolio and playing an active role gives us the ability to deeply understand the challenges our companies’ may face and why they might succeed or fail. It helps us avoid making follow-on investments when the risk-return is not worth it. We’re also able to take advantage of more lucrative opportunities as a result.

One of our companies, Exo Imaging, has recently raised a $220 million Series C. At one point, they struggled to raise a Series B. The company raised a bridge round to put itself in a position of higher negotiating power. We participated because we knew what was happening on the other side of the table from the lead investor and that it was a matter of paperwork before they could commit to leading the round.

Intel Capital came in to lead Exo’s Series B, and we had an attractive discount by taking advantage of this information arbitrage. 

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