Even if you know the market and company well, your answer will be way off. Try to extrapolate cash flows out 10 years for a pre-revenue startup. However, it’s harder for younger companies. This is helpful in private equity, where companies are already often generating predictable cash flows.
So your returns start low, go negative, and then go up–in theory.Ĭhanging tack, trying to measure value using NPV requires forecasting several years’ cash flows. Meanwhile, the next unicorn the fund is invested in won’t return any money to investors for a long time. Realized returns would total -50 percent ($25 million returned from $50 million invested). Five exit in the next year, two of which eventually yield nothing, and the other three return $5 million, $8 million, and $12 million. Most startups that fail often fail fast, so a fund’s early realized returns are often negative.įor example, say Fund ABC invests $10 million in 10 startups. Measuring returns based on realized dollars returned to date will usually lead to a lower measured return until the final close of the fund (when the fund exits its last investment) compared to other methods. However, internal rate of return (IRR), if measured correctly, is the best way to evaluate venture returns. Rowley contends that net present value (NPV) is the best way to measure venture returns. That’s especially true for the first three to five years of a fund, a time window of key importance, as firms often raise new funds every one to four years therefore, potential limited partners (LPs) often base investment decisions on that previous fund’s more nascent results. In practice, it’s far harder to use effectively than you might expect.Īs Jason Rowley wrote yesterday in “ Everything You’ve Ever Wanted To Know About VC Returns (But Were Afraid to Ask),” most measures of venture capital returns are squishy. Tl dr: IRR is theoretically the best way to measure the performance of a venture capital firm.
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