When evaluating early-stage funds, the value of the most common performance metrics (e.g. TVPI, MOIC, IRR) is low in the first years of the life cycle of a fund.  

Given that for most emerging managers the track record is either inexistent or too early to assess, if we used only these metrics to assess new opportunities, we would have a very limited view.  

For this reason, we think about which other quantitative aspects we can add in our assessment.  

If we did not do this, we would certainly miss the overall picture as well as great investment opportunities.  

Explanation of the Paradox

Among the metrics that we look at in a track record, we think that there are two that have a quite interesting relationship: 

• The Seed to Series A Graduation rate 

• The Write Off Rate 

In some public resources, we found out that both seem to be positively correlated with performance (i.e. TVPI). If this was completely true, we would expect the relationship between performance, graduation rate and write off rate to be as shown in the chart below:  

Apparently, this positive correlation for both variables does not make sense, as: 

• On one side, the more the portfolio raises follow on rounds, the better the performance 

• On the other side, the performance also improves when more companies fail 

How is this possible? 

The case for the Seed to Series A Graduation Rate

This metric is calculated as the ratio between the number of Seed investments that raise a subsequent Series A round and the number of total Seed investments. 

Basically, the concept is that when a company converts to Series A, then the value of the investment increases. Consequently, the more companies convert to Series A, the higher the value of the entire fund should be. This is why managers focus on this metric in their pitches as well as in their portfolio activity (i.e. helping their companies to raise a new round).  

But is the Seed to Series A graduation rate actually a good proxy of performance or is it just a myth? A complete assessment of this question would require a statistical analysis (which is not the purpose of this article), but here we just want to challenge this thinking and share some of our insights.  

Our internal discussion was driven by two central arguments, each supporting a different side of the paradox.   

The supporting argument we found was actually based on some interesting data from Dealroom. 

This chart shows the median conversion rates from Seed to Series A by investor quartiles.  

According to this report, the better an investor is, the higher the median conversion rate will be.  

Indeed, the top quartile funds shown in the slide are well established brands in the European ecosystem and some of them (Seedcamp, Kima) even published their performance, which is objectively very strong. Even Creandum, one of the most prolific investors in Europe, shared an article stating its Seed to Series A graduation rate.   

Based on this, the graduation rate appears to be a good proxy for performance.  

The Case for the Write-Off Rate

On the other side, when discussing internally about graduation rates, we stumbled upon a completely different metric: the write-off rate.  

This metric is calculated as the ratio between the number of write-offs (i.e. companies that are closed / shut down) and the number of total investments.  

Also in this case, managers pitch this number quite often as they believe that the lower the write off-rate is, the higher will be the performance. The curious reality of venture capital is actually quite different from what many managers assume: As Andrew Chen (a16z) explains in this outstanding article, “good” 2-3x fund and a fantastic >5x fund lose money about the same % of the time”. Looking at the data from the article and shown below,  >5x funds have a higher write off rate than >3x-5x funds and >2x-3x funds.  

Why is this strange? Because it seems that the more startups in a portfolio fail, the better that portfolio will perform. How can this make sense? 

Benedict Evans provides an answer here mentioning “the 'Babe Ruth effect' - you take more risks to get the best returns (..) Venture funds invest in a particular type of startup, one that is much more likely to go to zero, but which has the potential, if it does succeed, to produce something very big”

Basically, funds with a lower write-off rate do not perform outstandingly because they do not take enough risk, as “a fund gets better returns by having more really big hits, not by having fewer failures”. The more risk you take, the more startups in your portfolio will fail, but the more the winner will outperform.  

The Resolution of the Paradox

To summarize, when discussing the quality of the Seed to Series A conversion rate as a proxy of performance, we had two opposite arguments:  

• On one side, some high performing European Seed funds have a very strong Seed to Series A conversion rate 

• On the other side, top performing funds have a high write-off rate, which is basically the opposite of the graduation rate 

It seems that performance is correlated with both the share of startups in a portfolio that raise a new round as well as with the share of startups that fail.  

Our take is that, as curious as it sounds, this is not a paradox as the two arguments are not necessarily mutually exclusive.  

Good funds could have both high conversion rates as well as high write-off rates.  

To check this, we had a look at some insights from our portfolio.  

We collected data from 7 mature funds from the 2015 vintage, ranked them based on Net TVPI from 1-7 (top-bottom) and gathered information on their graduation and write-off rates.  

The chart below shows the data we collected: 

Curiously, the two curves are completely different from what we would expect, but, we still can extract some relevant insights: 

• On the graduation rate, there is no clear correlation with performance, but there are signs that top performing funds could show a higher graduation rate 

• The write-off rate is more interesting as its pattern is not linear: 

• The top performing fund has the same write-off rate as the bottom one, which is also the same as the average  

• However, for the funds which are between the average and either the top or the bottom, the write off rate is the same and higher than average 

• Based on this, it is difficult to predict the performance based on the write-off rate 

Basically, the main point is that the correlation between TVPI, graduation and rate and write-off rate is not that clear. What could be the reasons? 

Our take is that other factors also impact significantly the TVPI as well as its relationship with the two metrics, and therefore the correlations described above can not be considered in absolute terms. Some of these factors are: 

• Fund size 

• Reserve strategy 

• Ownership stakes 

• Portfolio concentration  

• Exact stage of initial investment (e.g. Pre-Seed vs Series A) 

• Value concentration in one, few or more companies 

• Absolute value of the main drivers 

• Deployment pace 

• Sector focus (e.g. deeptech/hardware vs consumer software) 

• Value add approach (hands on vs hands off) 

Conclusion

In conclusion, we can say that the write-off rate is difficult to interpret, but a very, very strong graduation rate actually signals high performance.  

Clearly, such insights would need further investigation with a broader data set, but we think it is useful for the VC community to foster a discussion around the topic and share some perspectives from the LP side.  

We would be glad to continue the conversation and hear anyone interested in sharing thoughts or comments. 

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Let us imagine a situation, if you may — You are ambitious, visionary, and like to live life on the edge. You decide to quit your high-paying cushy corporate job to build a start-up that is going to change the world and become the next unicorn, may be even a decacorn. You build a successful tech product and raise several rounds of funding. However, a few years later you realize that your start-up even with a superior product and a decent customer base is no longer growing as it was before. One of your investors introduced you to a firm that would buy your company for some tens of millions. It’s not what you expected, but you agree to sell, nonetheless. Dust settles, your key employees, you, and your co-founder find that the equity stake that you all hold is essentially worthless. Investors, on the other hand, did much better, recouped their money, and even pocketed a positive return.

Shocked!? Well, such situations, can and do happen to some founders.

Through this article, I will try to demystify the returns to different stakeholders when a startup exits and through that, I will touch upon some key term sheet clauses.

I will be using a relatively simple and hypothetical problem statement to explain various aspects that lead to exit modeling. The final output will allow you to simulate different exit scenarios and understand how much financial returns different stakeholders will make.

You can download the problem statement and the solution by clicking here.

This article is not a tutorial to build a financial model from scratch, but I have attached the completed and unlocked version excel model for you to learn from. The objective of the article is to introduce key term sheet clauses that impacts startup exits.

I. Preferred vs. Common Shares

When institutional VC investors invest in a startup, they demand Preferred shares. Founders and key employees do not get Preferred shares, they get Common shares. Angels, incubators, accelerators, and likes may or may not demand preferred shares.

Preferred shares holders, unlike Common shares holders, receive preferential treatment. They have special rights. These rights are negotiable and are included in the term sheet. The most common and important right is the liquidation preference. Liquidation preferences mitigate the risk investors take by ensuring they get paid first over common shareholders. The term sheet fine prints determine how much, if any, remains for you, key employees, and other common shareholders.

In the problem statement shared above, the founders, key employees, angels, and the incubator own common shares. The later investments by the angels, VC1, VC2, and VC3 are allocated with preferred shares.

II. Liquidation Waterfall and Seniority

With multiple financing rounds into a start-up, a new clause enters the term sheet called “Seniority”. Seniority determines the preference order in which investors get their money back at the exit. Seniority ranking is usually allotted to share classes and not individual investors.

For instance, in the problem statement shared, Series B shares have the highest seniority for getting paid, Series A is next in seniority, Seed after that, and Common shareholders have the lowest seniority.

In most cases, the later investors get higher preferences. So, Series B holders are paid back first before Series A, and so on.

Therefore, the returns at exit flow in as a waterfall or rather rapids (if you are one of those people who use to top in geography classes in high school). Such an arrangement is shown below (note it simply shows preference initially without any complicated clauses like participation, which we will discuss next).

III. Liquidation Preferences and Participation

As stated above, institutional investors demand preferred shares with liquidation preferences. It means that preferred shareholders are guaranteed proceeds over the common shareholders. The amount of return guaranteed is stated in the term sheet (after negotiation) as a multiple of amount invested in the start-up. Basis the negotiation done, it can go as high as it can be, but usually restricted to 1x of the amount invested. This clause was initially created to safeguard investors in case of the start-up was exited for a value less than expected. A 1x liquidation preference ensures investors in the start-up recover at least the initial investments.

Such liquidation preferences could either be non-participating or participating.

Non- Participating Liquidation preference:

If certain investors have preferred shares with non-participating preference, then they have a choice to convert to common shares, if payout from common shares is more than that obtained from liquidation preference. Let’s understand this through a simple example:

VC investor, Marc made a seed investment of € 2M for 40% stake in a start-up, X.

Assumption: there is no other investor in X apart from Marc who has preferred shares with non-participating preference.

In the table above, we observe that Marc as a preferred shareholder with non-participating preference is:

1. Entitled to exit proceeds first over founders of X (holder of common shares).
2. Has a choice to use liquidation preference (1x or 2x) or convert to common shares, determined by the highest amount of payout received through either of the processes.
3. We observed that Marc receives equal to or more than his % shareholding (which 40% in this case) upon exit depending on the terms agreed upon the exit value.

Participating Liquidation preference:

In contrast, participating liquidation preference, also commonly known as double-dipping, allows investors to receive payouts in the remaining proceeds on a pro-rata basis in addition to the liquidation preference.

Using the same example above, Marc will get 40% of the remaining proceeds in addition to the payout through liquidation preference.

Participating preferred holders never convert to common shares as they are adding their participation on top of the liquidation preference, something which common shareholders do not get. Such a clause is not at all founder friendly.

In the problem statement shared, Series B shareholders have participating preferred shares and also have a special right to obtain accrued dividends at the exit. Series A and Seed shareholders have non-participating preferred shares.

To protect the founders from participating preferred shareholders, a clause called Participation Cap was introduced. They are also stated as a multiple of invested amount and provides a conversion threshold for participating preferred shareholders. For instance, a 2x cap indicates that the investor can only receive up to 2 times the invested amount and would have to convert to common shares to receive a higher payout.

Let’s use the same example as above in which Marc has a liquidation preference of 1x.

Many other clauses form the part of a term sheet. In case you are interested and want me to author a follow-on article covering certain other clauses, please send me your suggestions to as@bfp.vc or put them below in the comment section. Moreover, if you are an emerging VC fund with fund size less than $200M and investing in early-stage rounds (pre-seed, seed, late seed and Series A) and want to know more about our work and investments, please feel free to drop in an email and I will connect with you.

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About Abhisekh Shah
Abhisekh is part of the investment team at Blue Future Partners, a venture capital fund of funds investing globally in early-stage VC firms and in growth stage start-ups. He is an engineer by training and holds an MBA, specialized in Finance, from HEC Paris. Prior to joining Blue Future Partners, Abhisekh had six years of work experience, which is mainly entrepreneurial. He worked for a multi-national pharmaceutical company in their Industrial Automation division and then went on start his own startup in the luxury clothing rental space. Following that, he joined another startup (that provided SaaS based solution and advisory services to large corporate to manage their ESG objectives) in their core team to grow and build the startup, scaling it from single digit team to triple digits team across multiple offices and catered to 200+ corporate clients (including Fortune 500 companies). They raised funding from the likes of Nexus Venture Partners, Saif Partners, and Omidiyar Network.
LinkedIn – Twitter.

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Provided below are snippets of the solution to the problem statement mentioned above. A detailed solution is there in the excel sheet that can be downloaded through the link provided at the beginning of this article.

Cap Table before later stage investments were made:

Cap Table after all the investments are made until exit:

Final Proceeds charts:

While keeping an eye on the early stage VC stalwarts, we also closely track the fringes of the industry.

Here, we are seeing a new cohort of managers eagerly wading into this void, armed with contrarian investment philosophies and strategies looking fairly different, if not entirely at odds, with your household names of early VC.

Here, we are seeing a new cohort of managers eagerly wading into this void, armed with contrarian investment philosophies and strategies looking fairly different, if not entirely at odds, with your household names of early VC.

Our research takes a first principles approach to discuss the rise of challenger VCs and how they may fulfil the risk return profiles sought by LPs. Specifically, we ask ourselves:

· What are challenger VCs?
· How do the economics work for challenger VCs?
· How do we due diligence challenger VCs?
· How should LPs compare challenger VCs vs traditional VCs?
· What does the future hold for early stage VC?

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Spotting challenger VCs

We note that challenger VCs usually differentiate from traditional VCs in two ways.

LPs can expect sooner distributions from challenger VCs, instead of decade-long lock-ups prevalent in early stage VC whilst delivering the typical return multiple as expected.

(How this is done is best illustrated through a sample portfolio construction walkthrough, which we cover in detail below.)

Challenger VCs are also attracting a new class of successful founders running capital efficient businesses whose upside LPs have yet to be able to access. Armed with sustainably high growth, if not already profitable businesses, founders prefer less restrictive forms of funding given the increasingly well publicised drawbacks of venture.

Whether the slogan of ‘greater founder optionality’ can gather a stable of high growth companies that bears out the challenger VC thesis is yet to be seen. However, our deep dive into the challenger VC fund economics shows signs of promise.

The Economics of Challenger VCs

Generally, from the perspective of challenger VCs, proceeds can be obtained from a combination of two components:

1. Equity (sale or IPO)

2. Revenue (or Profit) sharing (which we call the Liquidity Component)

Proceeds consisting purely of the first is no different from traditional VC. Proceeds consisting purely or partially of the second is what distinguishes challenger VCs.

After investing, the fund will receive over a certain period of time (usually few years) a share of the Revenues (or the Profits) up to a limit (a cap), which is usually around 2–4x.

For instance, if the fund invests US100k with a 4x cap, the company will repay its Revenues (or Profits) to the fund over time until a cumulative amount of US400k is reached.

The precise design mechanism of the economics depends on the specific fund model. One aspect we noticed in our research is that there is no standard framework and each firm has its own.

For instance, the Equity component is integral to some models, but missing in others. For certain challenger VCs, the Liquidity component is generated from Revenues, while others from Profit sharing.

The different types of models in the market are summarized in the chart below together with their main strength and weakness:

The Due Diligence for Challenger VCs

Each model poses different questions and it is quite difficult to generalize, but, taking the hybrid models as an example, we believe there are several crucial aspects to understand when diligencing the economics of RBF funds.

1. Are the returns coming mostly from the Equity or Liquidity component? Does the Liquidity component return at least entirely the capital, and in what time frame?

The composition of the total expected return is a key aspect of how challenger VCs succeed. In hybrid models, these two return components serve different functions:

·  The Liquidity component serves as a mechanism of risk reduction by providing early liquidity. Basically, the more total returns are dependent on repayments, the less the downside risk.

·  The Equity component provides the model with upside potential or additional residual value after the Revenue Share.

The dependency of the model on equity proceeds is fundamental to understand because challenger VCs are targeting companies with a different risk profile than traditional VC.

The more the model is dependent on equity, the more the fund is similar to a traditional VC, and the more its risk profile will be similar to a normal VC fund.

2. Can you elaborate on key assumptions behind return expectations of the Liquidity Component alone? What are key assumptions behind revenue or profit repayments?

This aspect is especially relevant for Profit sharing models.

Let’s take an example: a challenger VC invests $250k in a company that has to return 2.5x such amount with a profit share of 20% in 4 years.

This means that the company has to give back to the investor a total amount of $625k ($250×2.5x), which means $156k per year ($625/4).

It follows that the company has to produce yearly profits of $780k ($156/20%). If the company has a 10% profit margin, then the yearly revenues necessary for the model to work are $7.8m ($780/10%).

A company that needs $250k of financing today (equivalent of a pre-Seed round at pre-Revenue stage) needs to grow in 4 years to $8m in Revenues. This is fairly ambitious and impractical (almost comparable to a Series B — Series C profile), especially when challenger VCs should be targeting less risky and therefore less high startups. Hence a word of caution:

Always assess the underlying financial targets that portfolio companies are expected to hit. Sometimes, it exposes unrealistic growth expectations that are antithetical to fundamental ways challenger VCs seek to differentiate in the first place.

3. How about from the Equity component alone? How does this compare with traditional VC benchmarks?

Comparison with traditional VC benchmarks is interesting if a challenger VC depends heavily on the Equity component to make up its total returns.

Generally, we find that challenger VCs aim to construct portfolios that do not follow power law distributions, which expand the universe of potential investments and lowers the overall risk profile.

4. What are other key portfolio construction assumptions underlying your strategy?

This is where challenger VC and traditional VC due diligence converges. Deployment pace, entry valuations, and return expectations, among others, are important to consider.

As an exercise for our readers, we created a very simple model on Google Sheets that readers can download to test assumptions by inserting inputs in the yellow cells.

The model is just a simplified example, does not cover important aspects of the economics of RBF funds and it is not suitable for assessment, evaluation, or analysis, but only for learning purposes.

Comparing Challenger VCs with Traditional VCs

Challenger VCs offer a lower risk product for potential LPs to enter early stage VC, due to three main elements:

1. Faster Liquidity. From an LP perspective, an investment in traditional VC funds poses great problems of long term liquidity planning. Challenger VCs receive cash from their portfolio, which can be distributed early. Moreover, earlier liquidity also implies a better performance at IRR level, if compared to a traditional VC reaching the same money multiple but with later liquidity.

2. Diversification from power law. Traditional VCs usually need to invest in the top 1% of the companies to achieve meaningful returns. Given that only 1% of the VCs manage to do that, VC returns partly follow power law as well (only few VCs are successful, most are not). This leads to a high variance in VC performance (higher than other asset classes), which is of course a risk. In contrast, challenger VCs do not necessarily target rocket ships and hence return variance should be theoretically be lower than traditional VC.

3. Exposure to the camels and zebras of early stage VC. The focus on “sustainable”, capital efficient, and downturn resilient playbooks makes the underlying assets of challenger VCs less risky, which consequently provides a new angle of downside protection for LPs.

The biggest question is this: Is it the right time to invest in challenger VCs? Or is it still too early?

Here are three hurdles for potential LPs to begin their manager selection journey:

1. Lack of track record. In practice, challenger VCs still number few and far between, and no successful track record has been widely publicised to put traditional VCs on notice. It is still a relatively unproven concept with no key leaders to back.

2. Deal sourcing and access. Without a track record to point to, will challenger VCs actually be able to secure allocation in the unconventional profile of cashflow positive, EBITDA positive, or otherwise perfectly self sustaining startups?

3. Manager value add. Suppose challenger VCs do secure a spot. While eschewing the path to become a unicorn creates more options, challenger VCs still have their work cut out for them to groom their portfolios and grow from 100k in Revenues to 500k or 1m without resorting to blitzscaling and other capital-inefficient means.

Future of Challenger VCs

The early stage VC space will be interesting to monitor with the arrival of challenger VCs. It will likely become bigger and more dynamic in the future.

We expect the number of challenger VCs to increase from now on. We also expect increasing competition due to a set of new incumbents with similar models and offerings, ranging from banks to startups.

Over time, successful transactions and knowledge spillover may also lead to a greater standardization of the models towards similar economic mechanisms and investment frameworks.

Don’t be surprised to find even traditional VCs getting in on the act. Investing in challenger VCs, carving out allocations for startups that used to only interest challenger VCs, or launching new vehicles with a challenger VC model under their established brand are all within the realm of possibility.

To potential LPs, the big question is whether to enter the market early to secure an allocation in the top funds or to wait until more information is available and the market matures as brands establish themselves.

Meanwhile, start grilling existing managers how they plan to solve for faster LP liquidity and greater founder optionality. At the first sign of dithering, make them read this article!

At BFP we are currently investigating fund recycling and the perspective of GPs on this topic.

We analysed data from approximately 60 US funds with a vintage from 2010 to 2015 to examine how many of them have managed to reinvest some of their fees and to what extent.

“There is really not much downside on recycling” (Michael Jackson)

The three main takeaways are:

1. Only 49% of the funds managed to reinvest any of their fees and thus increased the chance of higher gains.

2. Of this 49%, 68% recycle less than 15%, which is an amount lower than the fees

3. Beyond this, during our research we also found out that in Europe recycling is a much less common practice

For the funds that recycle, the chart below displays the amount of capital recycled as a share of the total fund size.

The Advantage of Recycling

“Recycling is giving good investors more shots to make money” (Michael Jackson)

The main reason why GPs should recycle is that recycling improves the performance of a fund. Without it, a Manager needs a significantly stronger capital efficiency in order to achieve the same results.

Let´s take an example. A fund has a size of $100M, 2% management fees and a target Net TVPI of 4x:

• Without Recycling: If the manager does not recycle, the invested capital would be     $80M ($100 * 2% * 10years). In order to return a 4x Net TVPI from a $100m fund, the manager has to return to its LPs $400m. Given that the manager will receive a carried interest equal to 20% of the gain of the fund, then he/she will have to generate a total value of 475 = 100 + 300 / 80%. Therefore, to return 4x Net, a Manager needs to achieve a Multiple of Invested Capital of 5.93x = 475 / 80.

• With Recycling: If the manager recycles the fees [1], the invested capital would be $100M, which means that to generate the same value (475) and the same return (4x Net), he/she will have to achieve a Multiple of Invested Capital of 4.75x, which is significantly lower than the 5.93x without recycling.

The challenge of executing

However, if recycling improves performance, why do only 49% of the Managers reinvest capital, and why so conservatively? The problem is that recycling in practice is not so simple. There are basically two ways to do it:

• Reinvesting proceeds from early exits

• Delaying management fees and pay the GPs with proceeds later on in the cycle

On an execution level, the following problems arise:

• Proceeds from early exits can not be forecasted in advance

• In case of reinvesting management fees, the GP might lack capital to fund operations, which becomes especially challenging for first time funds

• With recycling, LPs receive distributions at a later point in time, meaning that GPs would show lower DPIs when raising their new fund

Recycling in Europe

In order to obtain further information about recycling, BFP had the chance to discuss the topic with Michael Jackson [2], who recently published an interesting post about fund recycling.  

“Recycling is more common in the US compared to Europe. VC firms in North America often have agreements with their LPs allowing them to recycle up to 115-120% of the fund. 

Certain LPs in Europe all too frequently seem more concerned with minimising their downside exposure than in maximising their upside, but as an LP you should believe in the GPs you invest in, particularly in an asset class like venture.

Another issue is that some European LPs don’t necessarily prioritise returns – it could be question of tax benefits for example. In addition, venture in Europe has historically been seen as an economic development tool rather than as an asset class”.