To their confusion and exasperation, entrepreneurs often hear from VC's that the VC is passing on their deal because the VC doesn't see how it can be a "home run". Understanding how VC's think about "home runs" is important for entrepreneurs (and their advisors who help them with fundraising) in choosing which VC's to pitch.
Historically, the VC business has been a "hits" business. For most VC funds over a 10 - 15 year period, more than 90% of the returns come from fewer than 10% of the investments (this is, actually, probably conservative). Investments in the other 90% either go out of business or deliver meaningless-to-modest returns. This highlights the perils, quirkiness and luck-ridden nature of early-stage investing. It also, to some degree, explains why many VC firms that traditionally focused on early-stage deals are morphing into later-stage, growth equity funds (more on this in a future post).
So, what is a "home run"? Two factors determine the answer, one obvious, one more subtle.
First, the absolute size of the return is an obvious component: No matter what, the bigger the return, the more likely it will constitute a "home run".
The second attribute, however, is less well known: the ratio of the absolute dollar size of the return to the size of the fund.
Why is this? Shouldn't a $1 million investment that yields a $25 million return be good, bad or indifferent regardless of the size of the fund from which the investment was made? It's the same amount of money, and the return is a lot higher than the amount invested.
A major component of the answer is that VC's are principally graded by their LP's on what's called "times return", not so much on an IRR basis (though both matter). Briefly, "times return" means for every dollar invested by an LP, how many dollars does that LP get back from the VC -- over the life of the fund, not in any particular year. There are a number of reasons for this that I'll deal with in future posts, but the relevance here is that "times return" is very important for VC's and their LP's. More "times return" is better. One can also see that generating a good "times return" is easier on a smaller fund than a larger one.
Historically (lots of variation in this as you'd expect from a business as volatile as early-stage VC), VC firms that achieved 3X "times return" (on a "net" basis, which I'll explain in a future post) were in the top quartile of VC funds and had no trouble raising their next fund.
The "home run" nature of the early-stage VC business, combined with the importance of "times return" to the VC business model, means that entrepreneurs should focus their fundraising approaches on those VC's whose funds are appropriate to the amount of money needed and the possible size of outcome that an entrepreneur can reasonably (and credibly) portray to the VC. Approaching a $500 million fund (average for VC's in today's world) for a $1 million dollar investment is likely a waste of time. For a fund of that size, even if the $1 million investment returns 25X (a very good "times return" in VC-land), the resulting $25 million return (given the hits nature of the business) won't move the needle.
For a $25 million return in a $500 million fund (even on a $1 million investment), half of one's partners might remember to mention it to you on their way to the coffee machine (it not being worth a special trip down the hall to your office), the second half wouldn't think it noteworthy enough to mention at all, and the third half would say to themselves: "why did he spend so much time on such a crappy little deal?"). For a $25 million return on a $40 million fund, your partner(s) send you and your family to Hawaii on an all expenses paid week-long trip.
Size of fund is not, of course, the only attribute of a VC that an entrepreneur should consider in his fundraising approach (there are a number of others), but it is a very important one. More on others in subsequent posts.