How Venture Capitalists Measure Returns

8 links
From

editione1.1.4

Updated September 15, 2023
Raising Venture Capital

You’re reading an excerpt of The Holloway Guide to Raising Venture Capital, a book by Andy Sparks and over 55 other contributors. A current and comprehensive resource for entrepreneurs, with technical detail, practical knowledge, real-world scenarios, and pitfalls to avoid. Purchase the book to support the author and the ad-free Holloway reading experience. You get instant digital access, over 770 links and references, commentary and future updates, and a high-quality PDF download.

Depending on whether a company has exited, venture capitalists use two different metrics to measure returns: cash-on-cash return and IRR.

Definition A cash on cash return (or CoC) is the amount of money an investor receives after an exit takes place divided by the initial investment amount. Some refer to a CoC return as a realized return, emphasizing that the return is actual cash in a bank account.

Steve Anderson, investor at Baseline Ventures, invested $250K into Instagram. Assuming he did not make any follow-on investments into the company, his cash-on-cash return when Facebook bought Instagram would be $120M divided by $250K or a whopping 48,000%.* Cash on cash returns are also commonly expressed as a multiple, as in, “Anderson made 480X on investment,” where $250K multiplied by 480 is $120M.

Returns can also be expressed as a multiple of the fund the investment came from. For a $100M venture fund that has returned $300M, the multiple for the fund would be expressed as “a 3X return cash on cash.”

By nature of how a CoC return is calculated, a company must have exited—this is the simplest way to measure returns. But LPs want to measure the performance of a fund over time. If a company is still private (on average it takes a startup ten years to exit) and its stock is illiquid, investors have to use another method to estimate the value of their investment over time, called IRR.

Definition Internal rate of return (IRR) is the industry standard metric used by venture capitalists and LPs to measure the performance of the illiquid individual investments in a venture fund and the performance of a fund overall. IRR is a single metric that communicates how much money a fund returns across its lifetime by computing the annual return rates for each year of the fund.

There’s really no explaining IRR in a single paragraph definition. We recommend reading the following two pieces by Scott Hirleman and Jason D. Rowley to get your head around the concept:

In theory, IRR allows LPs and VCs to benchmark their performance against peer group funds.

In practice, the math of IRR is messy, with multiple methods of calculation. We recommend reading this breakdown of three methods of calculating IRR from the Corporate Finance Institute. If you want to dig deep into the math of IRR, check out this video. If you want to dig even deeper into why IRR can be messy and is calculated differently by different groups, this is the post for you.

Each year, Cambridge Associates publishes private investment benchmarks, including IRR benchmarks for the venture capital asset class. You’ll have to give them your name and contact information, but that’s how you’ll get the most up-to-date reports. As of Q2 2018, they report returns classified by stage ranging from ~12% all the way up to ~25%.

Carried Interest and Management Fees

While the power law of returns generates revenue for venture capital firms, individual venture capitalists at a venture firm make money in two ways: carried interest on realized returns and annual management.

Definition Carried interest (carry) is a performance fee, in the form of a portion of future profits from an investment, paid to general partners or fund managers in a venture capital firm. Carry is calculated as a percentage—typically between 20% and 30%*—of the return on investment after limited partners have been paid out 1X their investment. Carry is split (though not always equally) between partners. A common expression for carried interest payout is “2 and 20,” which means a fund charges a 2% management fee and a 20% carried interest fee.

controversy Carried interest is controversial. In tax law, carry is not considered part of an individual’s take-home pay and so is not affected by income tax. Instead, it’s taxed at a much lower rate as a long-term capital gain. Including carry, the average venture partner took home $634K in 2017.

You’re reading a preview of an online book. Buy it now for lifetime access to expert knowledge, including future updates.
If you found this post worthwhile, please share!