VC Economics: Why You Shouldn't Be Surprised if You Don't Get Funded by a VC

Several big funds that used to invest in seed companies have stopped. In the wake of this investment gaps tons of micro VC funds have popped up. Funds ranging from $10MM-$100MM are growing all over the US. But why is this trend happening? Why did Andreesen Horowitz close their seed fund and now only focuses on Series A and higher investments? Why are several $500MM-$1BN funds also adding growth equity departments?

The reason is that small investments don't make economic sense for large funds. Let's keep the assumptions and math super simple.

Assumptions: (1) A fund must return 3X its value in order to make a 20% ROI. (2) We have a $100MM fund with a 10 year life. (3) I know what I'm talking about.

Simple Math - A $100MM fund must return $300MM. We are excluding management fees and carry to keep things simple.

In our imaginary $100MM fund called JHill Ventures, we have to return $300MM in order to have a "successful" fund. Let's assume that our seed stage 20% stake has been diluted to 5%. Again, we are using simple math. So how many unicorns ($1BN Companies) would we need to be "successful"?

The answer is 6! If we own 5% of a $1BN company then we make $50MM. In order to get to $300MM, we would need 6 unicorns. Again this is a very simplified model, but it shows the difficulty of producing a "successful" fund. If there are 100 VC/micro VC funds in NYC and 300 additional funds in SF, how many of these funds will end up with one highly valued unicorn (Uber) or several smaller unicorns (Instagram)? Not many. 

The above analysis demonstrates why VCs can ONLY invest in companies that will return billion dollar valuations. If they don't, these VCs won't be able to raise additional funds in the future. We only examined JHill ventures' $100MM fund. Imagine what funds that have $500MM-$1BN must return in order to be successful. The VC business is a hard business.