The venture capital equation
The math that undergirds the startup game
If you want to play the game of startups, you have to understand the math that undergirds much of the game. That is understanding the premises in which the venture capital industry (here we're focusing on seed to series A funds) operate.
Every early stage VC wants to be a top-quartile performer. Empirically, top-quartile performers have had at least one company in their vintages that has returned the size of the fund in proceeds. That means that on selling its stake in the company, the fund gets back, from this one sale, as much as it raised from investors.
So if the fund has raised $300m from investors, it has to get back $300m from the sale of its top company or companies (each). And if the fund ends up owning, at the moment of the sale, 15% of the company, the equity value of the company has to be $300m / 15% = $2b. Two billion dollars is the valuation a $300m fund is looking for at exit.
Of course, that math depends heavily on (i) stake at sale (post-dilution) and (ii) fund size. And stake at sale depends on iii. stake pre-dilution.
For a Series A investment, funds model something from 25% to 50% dilution, meaning they buy, for example, a 20% stake in the company and end up, at exit, owning just 10-15%, because other, later-stage investors will have bought in and diluted their ownership stake. (This ignores subsequent investments, e.g. pro-ratas, which make the math a bit more complicated but that do not fundamentally nor directionally change the VC equation). With more competition amongst VCs for top startups, it is not that common for a fund to buy a 20% stake in a startup anymore. So at-sale stakes can easily run below 10% if no subsequent investments are made.
The other key variable is fund size. VCs are incentivized to grow their assets under management, because they make a management fee (something around 2%) on these assets. That means the average VC fund has been growing in size. Et ceteris paribus, a $100m fund means a fund-returner valued at $670m, whereas a $500m fund means a fund-returner valued at $3.3bn. Benchmark Capital has been really disciplined and kept its funds at around $450m raised. Andreessen Horowitz has a $600m fund only focused on American Dynamism, and $42b in assets under management. $500m at a 10% stake means a $5b valuation at exit.
The underlying point I'm trying to make is that your startup has to at least have the potential to be a fund returner, and that certainly means at the very least, for a small fund, unicorn valuation. If not, the math just doesn't add up for the VC, and you won't be able to raise the money needed to play the game.
So next time you're thinking about your startup, or pitching VCs (the preparing for which is a great way to think about your startup in a structured way), ask yourself whether what you have is a fund returner.
Thanks to the YC Brazil community for feedback on this.