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The Math Behind Venture Capital: Understanding How VCs Think

Unpacking the Venture Capital Structure, Key Strategies, and the High-Stakes Math That Drives Their Decisions

Author

Anmol Goel
December 24, 2024 • Estimated Reading Time: 5min4 minutes

Hello Innovators,

Welcome to this edition of the GACS Newsletter! Venture capital (VC) often feels like a high-stakes gamble, but behind the scenes, it's driven by structured strategies and meticulous math. Whether you’re an entrepreneur seeking funding or just curious about the investment world, understanding how VCs think can provide valuable insights. Let’s break it down step by step.

The Players: Limited Partners (LPs) and General Partners (GPs)

  • Limited Partners (LPs): These are the investors—typically family offices or pension funds—that supply the capital. While VC investments are a small (2-5%) but risky portion of their portfolio, they offer the highest potential returns.

  • General Partners (GPs): The fund managers responsible for raising capital, making investment decisions, and overseeing the fund's operations. They earn fees and potential profit shares, making their role both challenging and rewarding.

The 2-20 Rule

The cornerstone of VC firm operations is the 2-20 rule:

  • Management Fee: GPs take a 2% annual fee from the total fund size for operational expenses.

  • Carry: If the returns exceed the LPs' expectations (typically 12% annually), GPs earn a 20% share of the profits.

For example, a $100M fund allocates $20M for operational fees across 10 years, leaving $80M for investments. To meet the LPs' expectations, the fund must generate around $310M over the fund’s lifespan.

Investment Scenarios and Returns

VCs typically follow the Pareto principle: 80% of their returns come from 20% of their investments. Let’s look at the math:

  • Scenario 1: All 10 investments exit at $50M each.
    Total returns = $125M → Falls short of $310M.

  • Scenario 2: 5 investments exit at $50M and 5 at $100M.
    Total returns = $187.5M → Still not enough.

  • Scenario 3: Add one high-performing “overachiever.”
    Total returns = $287.5M → Close, but not quite.

  • Scenario 4: A unicorn emerges.
    Total returns = $362.5M → Finally exceeds expectations!

The Reality

In most cases:

  • 5 startups fail outright.

  • 3 have small exits.

  • 1 has a medium exit.

  • 1 becomes a major success.

The final returns often hover around the break-even point for LP expectations. This illustrates the critical role of identifying and supporting potential unicorns.

The 5 Ts of Risk Mitigation

To reduce investment risks, VCs focus on these five key factors:

  1. Team: A cohesive and capable team with a track record of execution.

  2. TAM (Total Addressable Market): A large, scalable market opportunity.

  3. Technology: Innovative and scalable solutions.

  4. Traction: Strong growth and user adoption.

  5. Trenches: Defensible market positions, such as patents or unique advantages.

"Risk comes from not knowing what you're doing."
Warren Buffett

Venture capital is a calculated risk, balancing portfolio diversification, the search for high-growth companies, and the relentless pursuit of the next unicorn. By understanding the math and strategy behind VC thinking, entrepreneurs can position themselves better for investment success.

At GACS, we help startups navigate these complex dynamics to maximize their potential. Ready to refine your pitch or plan your funding journey?

We hope you found these tips helpful! For more insights and detailed guides, visit our GACS Blog, and stay tuned for more insights and tips from the startup world in our upcoming newsletters!

Best regards,

The GACS Team