Why do venture capitalists invest in lots of companies even though 90% of them go bankrupt?
Well, 90% of most venture-backed startups that don’t go bankrupt. They at least try to pick the best ones they can. That helps — a bit.
But many still do. The “loss ratio” at early-stage VC firms is often around 40% by logo, and 20%-30% by dollars. In other words, 4/10 may go bankrupt or at least lose money … but since the winners tend to get more than the losers, in the end, maybe “only” 20%-30% of the fund is lost in losers.
The thing is, that’s build into the model. Because if you do VC investing right, the winners far outpace the losers.
Let’s take say a
- $50m fund
- that does 25 $2m investments
- each for 10% of a company
(to keep it overly simple).
Now let’s assume of those 25 investments:
- One investment IPOs at a $2 billion valuation. That equals $200m to the fund, or 4x the entire $50m fund.
- Another is acquired for $500m. That equals $50m, or 1x the entire fund.
- 8 others are acquired for $250m in total. That’s $25m back or 0.5x the entire fund.
- All the rest are losers or make no money. So say $15m in losses from other 15 in total.
Ok now we have a fairly high loss ratio, BUT, it doesn’t matter. The $15m lost pales in comparison to the total 5.5x of the fund, or $275m in gains.
At least, it doesn’t matter as long as you are careful not to put too much more money into the losers. That’s key. You can see the portfolio above can easily absorb any “first check” losses. But if a lot more had been put into losers? That’s much more painful. So the stakes go up as VCs write checks #2, #3, etc. into startups.
But generally speaking, Power Laws mean the losers don’t really matter in VC, so long as you have enough winners. Sometimes even just 1 or 2 winners.
A related post here: