Venture capital is often described as a game of extremes, driven by a power law where the bulk of returns come from a small percentage of investments. As Bill Gurley famously put it, “Venture capital is not even a home run business. It’s a grand slam business.” This mindset underpins the “Return The Fund” (RTF) analysis—a quick yet crucial evaluation method used by VCs to gauge whether a single investment has the potential to repay an entire fund.
Here’s a breakdown of the RTF analysis and why it might explain why some VCs pass on seemingly strong startups.
The RTF Formula: Can One Exit Repay the Entire Fund?
The RTF analysis boils down to a simple equation:
Fund Size / % Owned at Exit = Minimum Viable Exit
This calculation helps VCs estimate the smallest exit size required for an investment to “return the fund.” Here’s an example:
- A $50M seed fund (Fund A) invests $1M into a startup at a $10M post-money valuation, acquiring 10% ownership.
- For this investment to return the fund, the startup must achieve a minimum exit valuation of $500M ($50M / 10%).
- Considering dilution over time (e.g., 20%), the real target climbs to $625M ($50M / 8%).
For larger funds, the stakes are even higher. A $250M fund (Fund B) investing $1M at the same valuation must believe the startup can exit at $2.5B to return the fund. If Fund B maintains 15% ownership through additional investment, the target drops to $1.66B. However, both figures remain far above the $500M threshold.
Why This Matters for Startups
For founders, understanding RTF analysis is critical. Investors’ return expectations influence their willingness to back a company. While a $500M exit might seem impressive, it falls short for larger funds seeking multibillion-dollar outcomes. As a result, startups with smaller exit potential—despite solid business models—may struggle to attract interest from big-name VCs.
For example, fewer than 10% of VC-backed exits in 2016 surpassed $500M, and only one U.S.-based tech company, Jet.com, exited above $2.5B. These stats illustrate how rare it is for startups to achieve the scale required to meet RTF thresholds for large funds.
The Broader Implications of RTF Analysis
While RTF analysis provides a quick gut check, it’s only one piece of the due diligence puzzle. It helps investors evaluate potential outcomes, ownership dynamics, and investment sizing, but outliers and unique circumstances often shape final decisions.
For founders, the key takeaway is to align your pitch with the fund’s size and philosophy. Smaller funds may welcome modest exit opportunities, while larger funds often push startups to swing for the fences. Understanding this dynamic can help you target the right investors for your vision.
Takeaways for Founders
- Know Your Exit Potential: Estimate whether your startup aligns with the return expectations of your target investors.
- Align with Fund Philosophy: Choose VCs whose fund size and strategy match your growth trajectory.
- Understand Ownership Dynamics: Consider how dilution and future funding rounds affect your investors’ RTF calculations.
By grasping the RTF framework, founders can better navigate the fundraising process and tailor their pitches to the expectations of prospective investors.
What’s your perspective? Should VCs focus more on grand slams or embrace smaller, consistent wins?
Continue reading this article to learn Why your startup idea isn’t big enough for some VCs.