Arithmetic of Venture Capital

Arithmetic of Venture Capital

Here is an example computation of the expected return on investment that shows the benefit of a Bootstrap Capital strategy that increases the time frame and slows the growth rate in exchange for a higher probability of success.

Let

G = Target growth rate for each portfolio company

S = Probability of success for an individual company

Y = Number of years allowed before exit

For the conventional "rule of thumb" target of a factor of ten increase in five years, Y = 5 and G = 10 ** 1/5 - 1 = .585. Even before the dotcom bubble, less than twenty percent of venture backed companies succeeded, so take S = 0.2.

Then the expected value after five years is V = S * (1+G)**Y = 2.0. After subtracting a 20% carry, the annualized return on investment is only

R = (.8 * (V-1) + 1)**(1/Y) -1 = .125. That is, the expected ROI is 12.5%, which is only slightly better than the long term average return for the stock market averages.

For an Bootstrap Capital strategy, the figures might be

Y = 10

G = .40

S = 0.5

Then V = S * (1+G)**Y = 14.46 and the expected ROI after subtracting the carry is

R = (.8 * (V-1) + 1)**(1/Y) -1 = .280. That is, the expected ROI is 28%, more than twice as high as for the conventional strategy.

(Not only would the fund investors be happy with such a result, the fund managers would get a carry that is more than thirteen times as large as for the five year example. Of course, it takes ten years rather than five, so the annualized income from the carry is only 6.7 times as great.)