Here is the venture capital model, oversimplified.
Congratulations, you have raised £10,000,000 and now you have to invest it into businesses. Worth noting at this stage: this is not the partners' money. The GP (general partner) is the manager of the fund. The LP (limited partner) is the provider of the funds.
There are 4 GPs for every LP, so the first thing to be mindful of is that it is a competitive industry. They have to promise certain things, and this is the "mandate". High up that list will be the return. This is a financial instrument and that is fine by me. I'm not anti people making money.
In this model we assume the VC uses a fund manager, so they will be charged (or pass on to the founder) a management fee of 2% per annum. They also have to run a business, promote the fund and pay talented staff, so it's quite the hefty operation.
Let's go invest: which strategy do you pick?
The first real question is whether you invest in 10 companies at £1m or 100 companies at £100k. The second option is practically impossible on this budget with a £10m fund, so again, you can't really blame them.
- Ten steady exits. 10 companies, £1m each at a £5m post-money valuation. All exit after 10 years for £15m. Portfolio return: 12% IRR. Outcome: very difficult to raise fund 2. Likely to get a second chance, but it's brutal. Slightly outperformed a major US stock index.
- A mixed portfolio. 10 companies, £1m each at a £5m post-money valuation. After 10 years, 5 fail, 4 make a 3x £15m exit and 1 makes a 50x £250m exit. Portfolio IRR: 20%.
- One big winner. 10 companies, £1m each at a £5m post-money valuation. After 10 years, 9 fail and 1 makes an amazing exit of £500m. Overall portfolio IRR: 26%.
The problem for pre-seed founders
Here is the problem. For the LP and GP to win and keep winning, 9 businesses have to lose. That's messed up, if you ask me. I'm sure they want all 10 to succeed; however, they invest in companies that can return a minimum of 70%, and this is where it starts getting dangerous.
I am an advocate for VC further down the line. From Series A onwards the track record is outstanding. The problem we face is that this model cannot work at scale for pre-seed businesses. It creates a gap. Big kudos to any VC who goes after volume with small tickets. It isn't easy.
I'm just trying to share some of what I can see, to help others understand a game without rules.