Silicon Valley Frontlines: Fred Wilson on Venture Capital Returns

As an entrepreneur its always good to know what kind of financial outcome or return your investors are looking for when the put their money in. The better you understand their motivations and dynamics the better you can line up the right investor and have all parties goals in alignment.

Fred Wilson, a partner at Union Square Ventures, gave a good view of this in a post on his "A VC" blog over the weekend. You can read the whole thing here.

At USV, which is an early stage or "seed" investor, Fred's rule of thumb "is "1/3, 1/3, 1/3" which means that we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments". He then goes on to explain how the returns on that last 1/3 need to average around 7.5x the money they put in to get the returns they and their investors expect on their portfolio. Ideally, they get one big home run - big enough to cover all the money invested in the portfolio - with the other winners generating the overall return. Of course, it depends on a bunch of other factors - size of investment (a 10x return on a $1m investment has a lot less impact than a 5x return on a $10m investment), etc.

Image via Wikipedia

So in a baseball analogy, you're considered pretty good if you can consistently hit .333 with the occasional home run, triples etc. within that average. Of course, its not cricket, which is a real bat and ball game and where you have to do some substantial scoring or bowling to win. But I digress ...

For an entrepreneur, the problem is that you don't have a portfolio approach you can take. This - your startup now - is it. You have to win. You have to hit the home run in your only at-bat. Being in the bottom 2/3 of the investor portfolio means you lose - your time, your effort and whatever sweat equity (founders stock) you put in. In fact, its a bit worse than that because you'll usually own common stock and the investors will own preferred stock - meaning they will get their money (and sometimes multiples of their money) back first before you see anything (except in an IPO where everyone converts to common at the IPO event).

Thats the way it is and, as always, he who has the gold makes the rules ...!