Understanding VC fund mechanics: Why VCs make the investment decisions they do

The venture capital industry is often described as broken. But why do people say that? To truly understand the challenges in the VC world, we need to take a closer look at how a VC fund operates, the math behind their investments, and what it means for startups trying to raise capital.

The basics of VC fund structure

A typical VC fund has a fixed lifespan, usually around 10 years. During this time, the fund’s goal is to invest in high-growth startups and generate substantial returns for its investors - also known as limited partners (LPs). But the way these returns are structured has major implications for startups.

Let’s take a simplified example:

1. A VC manages a €100 million fund

2. They aim to deliver a 3X to 5X return to their investors over 10 years

3. To achieve this, they invest in 20-30 startups

However, the reality of startup success rates means that only a handful of these companies will succeed, and only one or two will be true "fund returners."

The importance of a fund returner

VCs don’t just look for successful companies, they need companies that can return the entire fund on their own. This means that out of 20-30 investments, a single company must generate returns large enough to make up for the majority of the fund’s losses.

But how do VCs determine what makes a "fund returner"?

A typical early-stage VC will own around 5-10% of a startup’s equity at the time of exit. That means, for a €100 million fund, a startup must exit at a valuation of 10-20 times the fund’s size for the VC’s stake to be worth €100 million.

1. If a VC owns 10% of a startup, that company needs to reach a €1 billion valuation to return the fund (10X multiple)

2. If the VC owns just 5%, the startup needs to exit at €2 billion (20X multiple)

This explains why VCs focus on companies that have the potential for massive growth rather than steady, sustainable businesses. The math simply doesn’t work for them otherwise.

What this means for startups

If you are a founder pitching to a €100 million fund, you need to understand that they are looking for companies with the potential for at least a €1 billion+ exit. If your business model suggests a more modest exit- say, €150-200 million - it may still be a successful business, but it won’t be compelling for a large VC fund.

For example, if you’re raising at a €15 million valuation, a reasonable exit might be around €150-200 million. While that’s a great outcome for founders, it’s unlikely to significantly impact a large VC fund’s returns. This is why VCs often pass on deals that seem like "good businesses" but don’t have "fund returner" potential.

Conclusion: Raising the right capital for your business

Understanding VC fund mechanics is crucial for founders. It explains why VCs are selective, why they chase billion-dollar outcomes, and why some startups struggle to secure funding despite having strong fundamentals. If your business doesn’t align with the return expectations of a large VC fund, consider alternative funding sources- such as smaller funds, angel investors, or bootstrapping - that may be better suited to your growth trajectory.

By aligning your fundraising strategy with investor expectations, you can increase your chances of securing the right capital to scale your startup successfully.