Why Do VCs Care About Ownership?
I recently received a cold email with the following subject line:
Subject: Pre-Seed — Proven Founder — Round Almost Full — AI, Robotics
I opened the email purely out of curiosity, knowing full well that I had no intention of responding.
“Why not?” you ask. “Why wouldn’t you be interested in a repeat founder in a hot space with solid traction in their round?”
Because I know that I won’t be able to secure the ownership necessary to fit Panache’s fund model.
The scenario above happens quite frequently. In fact, it happens all the time,
“The round is almost entirely filled, and the opportunity to invest at this stage will not be open much longer.”
“Our raise is filling up, but we’re speaking to a few more investors.”
“Our funding round is almost full (~80%). The window to invest is closing.”
More often than not, introductions like these are just trying to project fake FOMO and the round isn’t really “almost full”. But sometimes it is.
Many first-time founders genuinely believe that approaching a VC with a scarce offering will increase their chances of closing them as an investor. In reality, the opposite is true — and most founders don’t even realize it. To understand what’s going on, you need to understand the role that ownership plays in generating returns for VCs.
Time for some VC math!
The Basics of VC Returns
In general, VCs aim for a 3x return over the course of about 10 years. For a $10M fund, this means a target of $40M in exit value (the amount of money that the fund receives as a result of IPOs and acquisitions). For a $100M fund, the goal is $400M. And so on.
Each fund has a thesis that underpins their approach to investing — the strategy that they intend to use to generate those returns. Some of the variables at play in a VC’s thesis are subjective, such as:
What sectors does the fund invest in?
What geographies does the fund focus on?
To what degree does the VC provide value-added services to their portfolio companies (accelerators, platforms, etc.)?
Under what conditions would the VC consider selling their position early?
Other variables directly impact the mathematics at play, including:
How many companies does the fund invest in?
How much money does the fund invest in each company?
Does the fund make follow-on investments (invest multiple times into the same company)?
There are a lot of variables at play in an investment thesis
These variables form the basis for what’s referred to as a fund model: the financial model that represents how a VC intends to achieve its target return. This blog post walks through a simplified version of the process used to come up with the inputs to a fund model for a hypothetical $100M VC fund.
You can think of a fund model as the concrete, mathematical encapsulation of a VC’s thesis. It includes the inputs (how many companies the fund plans to invest in, how much money the fund plans to invest into each company, etc.), projections about each portfolio company’s lifespan (how many companies will make it to each subsequent stage, all the way through to IPO), assumptions about exit scenarios and many other factors. One of the key variables included in every fund model is the percentage of each company that the VC believes it needs to own at exit (and, thus, at each stage leading up to exit) in order to generate its target returns.
Why is Ownership Percentage So Important to VCs?
Ownership percentage matters to VCs because of the explicit target return we discussed earlier. This is the most fundamental difference between VCs and angel investors.
Most angel investors aren’t too worried about ownership percentage because, unlike VCs, most angel investors don’t have specific return objectives. Whenever I’ve made angel investments, I wasn’t overly concerned about whether my investment had the potential to return 4x, 40x or 400x. My motivation was quite simply to invest in amazing founders who I thought were doing amazing things. At the end of the day, any positive return would generally be good for me (as part of a healthy, balanced portfolio 😉).
But VC funds are financial products that aim for a very specific target return (3x over 10 years). When you combine this objective with the power law nature of tech startups (that is, the notion that the majority will fail and a small percentage will drive most of a fund’s returns), the need to be explicit about ownership percentage starts to make sense.
Let’s dig into a hypothetical example to see what I mean:
A Simple Example
Imagine that I have a $10M fund and intend to invest $1M into each of 10 companies. For simplicity’s sake, let’s assume that I don’t intend to make any follow-on (pro rata) investments. In this overly-simplified fund model, assume that exactly 1 of those companies will reach a $1B exit valuation and the other 9 will fail outright.
In order to generate a 3x return ($40M in exit value), I need to own at least $40M / $1B = 4% of the successful company when it exits.
Let’s assume that the successful company raised 5 rounds of funding prior to exiting (Pre-Seed, Seed, Series A, Series B and Series C). Let’s further assume that each round of funding diluted my ownership in the company by exactly 25%. With these assumptions, we can work backwards to understand how much my fund needs to own after each stage of investment in order to generate my target return:
| Stage | Minimum Ownership |
|---|---|
| Exit (Series C) | 4% |
| Series B | 5.33% |
| Series A | 7.11% |
| Seed | 9.48% |
| Pre-Seed | 12.64% |
Looking at the above table, if I’m investing at the Seed stage, I need to secure at least 9.48% ownership in each company if I hope to return my fund with a single exit. Similarly, if I’m investing at the Pre-Seed stage, my post-round ownership must be at least 12.64%.
But there’s more…
The astute reader will immediately recognize that by combining the investment amount ($1M) with the ownership targets above, we can determine the maximum post-money valuation that I can invest at in order to secure my target ownership:
| Stage | Minimum Ownership | Maximum Valuation |
|---|---|---|
| Exit (Series C) | 4% | - |
| Series B | 5.33% | $18.76M |
| Series A | 7.11% | $14.06M |
| Seed | 9.48% | $10.55M |
| Pre-Seed | 12.64% | $7.91M |
Your Fund Size is Your Strategy
One of the most common expressions in venture capital is “your fund size is your strategy.” I have no idea who said it first, but Charles Hudson of Precursor Ventures has a great post about the concept here (in which he credits Mike Maples, Jr. of Floodgate for teaching him). Charles notes,
“Your fund size, for the most part, dictates your check size, ownership targets, and portfolio construction. A fund of a given size only has a few levers to pull to get to top-tier returns.”
Looking at the above table, we can see this concept in action. With a $10M fund writing $1M checks, there are only a couple of investment strategies that make sense. It’s completely realistic for a Pre-Seed fund to invest in $1M into great startups at a ~$8M valuation. It’s possible to find strong Seed startups at a $10.5M valuation (but they’re more likely to be diamonds in the rough and/or located outside of the major tech ecosystems). A top-notch Series A company at a $14M valuation?
Thus, the strategy for my hypothetical fund directly flows from its size: I can either do Pre-Seed investing (mostly as the lead investor) or Seed investing (mostly as a follow-on investor in second tier markets). Regardless of which strategy I pursue, my ownership targets are not arbitrary.
(There are, of course, other theses one could use to invest $10M, but I’ll leave that as an exercise for the reader.)
How Flexible are VC Ownership Targets?
We’ve covered why ownership targets are so important to VCs, but sometimes it can be hard to for founders to figure out what those targets actually are.
While many VCs will transparently share their ownership targets with founders, others are cagey (particularly when they’re trying to use ownership target as a negotiating lever). Even more confusing is the fact that some VCs claim to not have ownership targets. What’s the deal?
There are a few mitigating factors at play, which can muddy the waters.
Multistage Funds
Multistage funds (funds that invest in multiple stages) typically only enforce their ownership targets at the stage that they consider their “primary” focus. For example, a fund that invests in Seed and Series A will likely only place a hard limit on ownership for Series A investments as they have the opportunity to increase their ownership in companies that they invest in at the Seed round. This opens up a variety of additional strategies, including:
Investing a small (possibly inconsequential) amount into a Seed round in order to have an “option” on the Series A (VC scouts and scout checks are a direct manifestation of this strategy)
Investing at the Seed stage with the intention of doubling down (exceeding the target ownership) in particularly strong companies
It’s worth noting that this dynamic is the source of “signalling” and why taking a small investment from a multistage fund is so problematic if they don’t subsequently invest — if a fund is known to focus on target ownership in a particular round and they opt not to pursue that level of ownership in a company that they previously invested in, it leads to the (very reasonable) presumption that there must be something wrong with the company.
When dealing with multistage funds, it’s important to go a level deeper when asking about ownership targets,
“Can you walk me through the specific ownership targets you have at each stage that you invest in?”
“What is your specific ownership target at Seed? What is the target at Series A?”
Exit Modeling
Another significant factor in how VCs treat ownership targets is how they model various exit scenarios. Does the firm believe that only 1 company will have a significant exit or more than 1? Do they believe that any of the companies that are not “breakout winners” will still generate enough of a return to statistically impact the overall fund return? And so on.
Exit modeling is one of the main drivers in how strict (or not) a VC is when it comes to their target ownership percentage.
And guess what? Fund size is a big driver of this,
“The size of your fund also dictates the scale of outcomes that can actually move the needle for your fund, and that shapes the lens through which you evaluate the terminal scale of startups that come across your desk. The larger your fund, the larger absolute scale of outcomes you need and the more of those outcomes you need to achieve to make your math work.”
Smaller funds, notes Charles Hudson, have a lot more flexibility in the types of investments they can make by virtue of the fact that smaller outcomes move the needle for them. But it still depends on how they model the likely future.
In our earlier example, we used a very simplistic model which stated that one company would succeed and all others would fail outright. In such a case, the VC must enforce hard limits on the minimum ownership in each and every company. Failing to achieve it’s ownership target in even a single company could cause the fund to not reach its target return (should that one company be the one that reaches a $1B exit).
But most fund models are more sophisticated and include a variety of scenarios, including some number of smaller exits, secondary opportunities (sales of a company’s shares prior to a final exit) and terminal exits that aren’t always the same size (e.g. one company’s “best case scenario” might be $1B, while another’s could be $5B). How these scenarios come together and which scenario(s) a potential investor feels most realistically map to your company ultimately determine how flexible (or inflexible) their minimum ownership requirement is.
Asking a potential investor a more weighty question about their ownership targets can not only illuminate their thinking, but it shows the investor that you have a strong understanding of how their decision process works:
“Can you walk me through how your fund model leads to this ownership target?”
“What assumptions about my company are baked into your fund model that lead to this ownership target?”
“What are you assuming has to occur after an investment in order for this ownership target to lead to your return objective?”
“What is your return objective for my company?”
Which brings us back to our initial cold email.
When a founder says “round almost full,” what many VCs hear is “we won’t be able to achieve our ownership target”. Some investors will still take the time to meet with the founder as a first step towards a potential investment in their next round, but more often than not, it’s simply not worth it. So what should you do?
If your round is legitimately almost full, try to focus on investors that you know write checks that are size-appropriate (most investors make it easy to figure out from their website what their range of investments is).
On the other hand, if you have soft-circled a significant amount of investment yet are still hoping to land a VC, consider adjusting your outreach in a way that allays ownership fears while still projecting strong interest:
Subject: Pre-Seed — Proven Founder — $800K in angel interest — AI, Robotics