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  • #13 - Venture Capital Fund Modelling: Masterclass & Advice From Managing Partner at Compound.

#13 - Venture Capital Fund Modelling: Masterclass & Advice From Managing Partner at Compound.

Average Check Calculation & Focus on Emerging Markets By Managing Partner at Compound.

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VC Crafters
July 24, 2024

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đź‘‹ Hey there! Welcome to Wednesday's edition of this week's Break Into VC Newsletter. We've got a packed issue focusing on everything you need to break into venture capital.

  • Deep Dive On Venture Capital Fund Modelling: Masterclass I

  • Today’s Tips From VC Professional On Younger VCs and a Focus on Emerging Markets By Managing Partner at Compound.

  • 15+ Venture Capital Job Opportunities.

  • Upcoming Global Online and In Person Events List

  • Must Read Articles on Startups, Tech & Venture Capital - VC Investment Thesis

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DEEP DIVE

Venture Capital Fund Modelling: Masterclass I

In the next 3-4 newsletters, I'll be diving deep into VC fund modeling. Get ready to crunch some numbers, and keep a pen or pencil handy for some simple math (think 4th/5th grade level).

If you haven't read our previous article on 'How VC Funds Work,' I recommend checking it out before diving into this series. In this I'll explain how VC firms calculate the average check size for startups.

Suppose, the fund, XYS has a fund size of $100 M and targeting to invest in around 20 companies.

So, you might think

the average check size = $100M / 20 = $5 M: Average check size would be $5M and you might be thinking that it’s easy, but the calculation and approach are wrong.

Because here we haven’t considered the Operating expenses or the fees charged by the VC fund.

Generally, the management fees which are taken by most of the funds are around 2% of the fund size annually and considered the fund period of 10 years.

So, management fees = 2% * $100 M = $2M / year.

This will be charged by vc fund to manage their expenses. So, as the fund period is for 10 years, the fees for the 10 years will be = $20 M for 10 years.

So, let’s deduce the fees from the fund size and look into the average cheque size:

Therefore, the average check size = ($100M - $20M) / 20Comapnies = $4 M. Now the average check size to invest in a company is around $4M. Isn’t it easy, but this approach is also wrong as we didn’t consider the follow-on and investment amount that decide by the VC fund.

If you are not aware of what’s the initial investment amount and follow-on investment in a VC fund? Let me explain these in simple words:

“Every VC fund has its own fund period, in which it will utilize all funds to invest in startups and also come up with some return for their investors. As the Venture Crew fund has a fund period of 10 years, they will divide the fund into the two-part - first: the initial investment amount which will invest in the 20 startups in 4-5 years of period and seconds: follow investment which will be invested in the same startup they had invested based on the past performance as it will help to increase the stake in successful companies.”

So, every fund decides the investment amount and the follow on investment amount depends on the total fund size and agreement with the limited partners.

Let’s assume, the fund “Break Into VC” decided to invest 50% of the fund size in the follow-on.

So, the amount reserved for the follow-on investment = 50% * 100 M = $50M. And Remaining net amount = $100M - $50M(follow-on investment) - $20M (fees for 10 years) = $30M;

$30M will be invested in the companies as the initial investment amount in 20 companies within a span of 4-5 years.

So, the average check size = $30M / 20 = $1.5M (This is the accurate calculation for VC Opened Fund’s average check size).

Also, different investors can think about the follow-on investment amount in various strategic way, as the follow-on investment amount help the venture capital to filter out the losers and invest only in winners.

The other way to think about the follow-on investment amount - VC want to invest $2 for each $1 initial investment. Then the average check size is less than $1.5M. How? -

As VC want to invest $2 in follow-on investment for each $1 investment in the Initial investment. As 2:1 => (20 1.52) = $60M but we have $50M.

Hence average cheque size = $50M / (20 *2) = $1.25M.

That’s it. Hope this helps you to understand - how venture capital comes up with the average check size. Let me summarize this -

Fund size ($100M)

(A) → Subtract all management fees for the 10-year fund period

(B) → Divide the new fund amount into the initial investment amount and follow on the investment amount which depends on the fund to fund → Subtract the follow-on investment amount from the (B) fund amount

(C) → Divide the C fund size to the number of companies you want to invest.

I hope this article helped you understand some basic VC concepts. If you have any questions or suggestions for topics for our next newsletter, please add them in the comments.

TODAY’S TIPS FROM VC PROFESSIONAL

On Younger VCs and a Focus on Emerging Markets By Managing Partner at Compound.

Michael Dempsey, managing partner at Compound has a advice for younger VCs -

“A pattern I’ve observed when interviewing younger candidates in the venture is a desire and focus on understanding emerging markets as an investment theme/area of edge.

While I get why that may be intellectually interesting and seem like a good idea, it feels like a minimally creative way to build an edge against average investors (which does not = good returns in VC) and a non-durable way to do so unless you’re going to physically move and build a firm in an emerging ecosystem (which likely requires far more capital to execute well than some appreciate).

And I understand why this dynamic could happen.

  1. Being a generalist is more fun, but being a young VC generalist is not a good way to get hired.

  2. Emerging ecosystems are less echo-chamber so it feels like you have a unique insight because everyone will listen vs. heavily debate you.

  3. We all want to believe startups are democratizing across the world far more than they are.

  4. The untapped market feels huge versus the mature but penetrated one

  5. If you are from a part of the world, it may narratively make you feel like you have an edge…sorry, you probably don’t if you’ve spent the last 10–20 years here and your parents aren’t someone very high up in the ecosystem.

New geographies take way more activation energy than people realize to consistently drive venture scale returns and odd international dynamics sometimes create even less of a meritocracy and introduce hard-to-underwrite risks vs other startups in top-tier markets (i.e. fundraising ecosystems not mature, governments get in the way, talent just not there, etc.)

I think at growth there is a good strategy of understanding things that need rocket fuel and selling large quantities of that fuel ahead of when others are willing to underwrite that risk of scaling (aka very post-PMF), but at early stages, I’d advise to heavily focus on categorical/technological edge or (imo worse but possible) network-driven edge versus pushing on the frontier of goes.

The new geo flywheel is very hard to spin fast enough such that it compounds.”

VC JOB OPPORTUNITIES

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Today’s Theme - VC Investment Thesis

“One of the most important things for a VC is their investment thesis. Defined as "the strategy by which a Venture Capital professional (or fund) makes money for the fund investors", your thesis will be a guideline / set of principles that will drive your decisions as an investor.” But how do they write thesis, here’re resources:

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