What Winning Looks Like in VC

In today’s interview, we quickly discussed the key metrics by which venture fund managers are measured. I’d like to use this week’s tip to review what these metrics are, who values each and why some can be manipulated while others can’t.

The metrics we will review include: DPI, TVPI, IRR, Follow-on and Bulge Bracket Follow-on. And, in the case of the first three, I will use definitions from Silicon Valley Bank.

  • DPI: The ratio of cumulative distributions to limited partners divided by the amount of capital contributed by the limited partners. The nice thing about this metric is that it compares actual dollars distributed to LPs against the dollars that they invested. It is a true cash-on-cash multiple. The drawback is that it’s typically not usable, until later in a fund’s life. It’s rare for a new fund to have exits and cash distributions very early, so the metric doesn’t paint a clear picture early on. From my discussions, it appears that a 3-5x DPI puts you on the big board.
  • TVPI: The sum of cumulative distributions to limited partners and the net asset value of their investment, divided by the capital contributed by the limited partners. So this metrics accounts for both cash distributions to LPs and the net asset value of existing investments that have not yet exited. In theory, it sounds great but the problem here is that paper valuations, in venture, are pretty unreliable. Some may go to zero, others to the moon and yet others may languish in the private markets for many years… delaying an exit and cash distribution. It’s also worth mentioning that neither of these first two metrics accounts for the time it takes to return capital, which leads us to our next metric…
  • IRR: The annualized effective return rate which can be earned on the contributed (invested) capital, i.e. the yield on the investment. This determines the time-adjusted yearly rate of return. Many great firms are in the 20’s. Many not so great are in the low single digits. On paper, this would seem like the best metric for assessing winners. However, it’s an easy metric to manipulate. GPs can do a number of things to inflate their IRR. Namely, they can borrow money from a bank, at low interest, invest that capital in a startup, then call the capital from the fund much later. This effectively reduces the time between when the capital was invested and when distributions are made. I’ve even heard of cases, with early exits, where the capital isn’t officially invested until after distributions are already made. This causes some firms to show doctored IRRs that are very high, particularly early in a fund’s life.
  • Follow-on: This is simply a percentage that represents the number of companies that have received follow-on funding vs. the total number of companies invested in. This metric can be used to assess Series A follow-on ratio, Series B, etc… depending on how mature investments are.
  • Bulge Bracket Follow-on: This is a key metric that I hear about more often lately. Great institutional investors don’t care about follow-on alone; they want to see the percentage of follow-on by the best performing A and B investors. If you’re a GP, how many of your investments receive funding from Sequoia, Accel, Bessemer, KPCB, etc. When assessing funds very early in their lifecycle, this can be a helpful signal that shows both quality of investment, relationships with top firms and outcome potential.

In discussions with a wide range of LPs, including HNW, UHNW, family offices, fund of funds, sovereign wealth, foundations, pensions, and endowments… My big takeaway is that there is no silver bullet. Each type of LP and each individual LP looks at different metrics. Trey likely has his own priority and even cited the merits of DPI as it can’t be easily manipulated. Many HNW retail investors also tend to prefer cash-on-cash multiples over IRRs or follow-on. Regardless, each GP must measure them all and be measured by each. Those that optimize for one, at the expense of others, may not be raising a fund 2.