Why should Entrepreneurs Care About VC’s Performance Metrics?
VCs operate like any other business: They set strategy and tactics in order to achieve goals. These goals are influenced by the industry and shaped by fund partners and limited partners who invest in the fund, macro- and micro-economic factors, and financial market conditions. They use metrics to analyze current performance and end results.
In general, VCs are not forthcoming about their performance. One of the main reasons for this reticence are the NDAs put in place by certain types of LPs (e.g., private schools and pension funds). Under these arrangements, returns are not publicly disclosed. Of course, some LPs are required to disclose their returns (e.g., public schools), and the resulting tension between non-disclosure and disclosure results in VC caution about sharing fund performance.
NDAs, however, do not apply to closed-out funds. This condition provides a basis for a VC partner to share fund performance with an inquiring entrepreneur. The drawback to this solution, though, is that the VC partner leading your investment at a fund may have had limited—or even no—role in determining the performance of the closed-out funds.
This leads to a different approach to understanding VC performance metrics based on three rules of thumb:
Recommendation #1: Inquire about performance metrics when you have at least two term sheets.
Any return—in the absence of comparable, “peer” returns—is difficult to assess.
Peer comparison is one of the most widely-used and accepted methods of analyzing equities, and works equally well with VC funds. In this case, comparing standardized performance metrics between VCs in a given round provides excellent peer comparison analysis.
There are six VC or fund performance metrics that founders and startup CEOs should know should they come up in course of discussions, including:
Net present value (NPV)
Internal rate of return (IRR)
"Cash-on-Cash" returns
Distributions to Paid In capital (DPI)
Total Value to Paid In (TVPI)
Investment to Exit Ratio (IER).
You can go to the CFI or Corporate Finance Institute, Glossary of Private Equity and Venture Capital Terms or Investopedia for definitions of these metrics.
But there are some significant challenges toward understanding and using these metrics. For example, in the first three years of a fund, IRR may be quite low. After three years, IRR improves because, typically, one to two startups “fail fast” or early big bets fail. These factors negatively impact a fund’s realized returns in the early years, and are often not indicative of long-term performance.
Also, absolute returns are sometimes hard to compare. For example, funds with a 2019 vintage enjoyed spectacular returns, while funds with a 1999 vintage had disastrous returns.
Recommendation #2: Don’t ask about broad fund performance metrics, ask instead about the partner’s “last three hits and last three misses”.
After at least two term sheets, you are positioned to ask the VC partner leading your round about her or his “last three hits and last three misses.” This question is an effective way to assess an individual partner’s oversight of companies from initial investment all the way through exit. Your partner will reveal what she or he discovered along the way, and you may learn something about partner and fund dynamics—always helpful information.
Recommendation #3: Ask these five (5) questions about the VC partner and their fund:
“Where are you in your fund’s life cycle?” Early in the cycle means more funds available and late in the cycle means less.
Not every VC fund has a sector focus, but for those that do the question is: “How does my company fit with your sector and stage focus?” Concentrate your pitches and burgeoning relationships on funds that invest in rounds in your sector, at your stage, and in the size range that conforms with your capital requirements.
“How do you work with portfolio companies?” Related questions include: “Does your partner make operational recommendations?” “Are sales and marketing a strength?” “Does your partner attend board meetings and contribute to financings? Introduce potential customers, supportive services and other VC? Participate in the hiring process of executives.”
Early discussions with your VC partner will ideally indicate that their fund invests in firms which may be competitive. If not, ask: “Do you have any directly competitive investments in your portfolio?” Look for a proactive statement of competition, but avoid surprise by doing research before you step foot into their offices or take a Zoom meeting.
Key question: “How long did your last investment take from first meeting to cash in the bank?”
All of these discussions and questions boil down to your use of the information you’ve gathered to examine how committed and knowledgeable these potential partners are, how are they hedging their bets, what are their firm dynamics, and what will they do for you and your company?
Misalignment is another concern. Obviously, VC sit on one side of the table and Founders and CEOs sit on the other. VCs have to raise and spend money in order to fuel their model. These performance metrics indicate whether they must raise more capital, potentially leading to excessively high valuations and over-funding, conditions that are not advantageous for startups.
The best-performing funds are ones that resist raising excessive funds and jacking-up the valuations of companies in their portfolios. Experience shows that raising big funds requires doing bigger deals, and places undue pressure on the effective post-money outcomes on each investment. In the end, mark-ups don’t make as much sense as owning more of a good company. Correspondingly, knowledgeable founders and startup CEOs are mindful of the intrinsic value of their company and don’t accept astronomical valuations simply to help VCs tantalize LPs and deploy capital.
Understanding and effectively putting these rules of thumb to work will help you make the most of any partnership with a VC, most importantly by assisting you in the choice of the right partner at the right time in your company’s life cycle. As important as using metrics to evaluate fit and performance is its corollary: using the right metrics to ensure the optimum conditions for rational growth and valuation.
I want to thank David Flaschen for his pre-release review of this blog post.