Table of contents
Venture capital is, as is well known, essential to fuel the development of new businesses: startups, scaleups, is the main source of funding, along with private investors such as business angels. Almost every day here at Startupbusiness we publish news of startups that have raised capital, and that’s good, and we often follow the evolution of these companies as they develop their markets and raise subsequent rounds. What is also important, however, is to understand what are the dynamics that make venture capital, whose job is to get the most out of their investments, which are aimed at developing innovations with potential great economic, financial, social, environmental impact, but are also aimed at making returns as significant as possible to ensure that the so-called LPs (limited partners), i.e. those who put their money into the Funds that are managed by GPs (general partners), are not only happy with the returns on their investments but are so happy to the point of wanting to continue investing those returns in order to continue to feed the flow of money needed to support startups and scaleups. In this article written by Luca Campaiola, we analyze the basic formulas and dynamics that are needed to understand if a VC Fund is doing well and therefore generates performance that satisfies LPs and, consequently, also GPs, the startups that receive such investments and, by extension, make their active contribution to the growth of the entire ecosystem.
Introduction
Venture capital (VC) is a crucial source of funding for innovative startups. Assessing the performance of VC funds requires an understanding of specific metrics and their importance. In addition, the social benefits of VC include the creation of new businesses by founders who have come out of previous startups and the importance of fast capital recirculation. This document integrates the key points of the “Global VC Ecosystem Rankings” report and analyzes Italy’s position.
Venture Capital Metrics
- Distributions to Paid-In Capital (DPI)
- Definition: Measures the amount of capital distributed to investors relative to the total paid-up capital.
- Formula: DPI = Distributions / Paid-in Capital
- Importance: This indicates how much capital has actually been returned to investors, providing a measure of the fund’s liquidity.
- Residual Value to Paid-In Capital (RVPI)
- Definition: Measures the residual value of investments relative to paid-up capital.
- Formula: RVPI = Residual Value / Paid-in Capital
- Importance: indicates the potential for unrealized value, which is useful for assessing the future value of the portfolio.
- Total Value to Paid-In Capital (TVPI)
- Definition: Represents the total value (distributions plus residual value) of the portfolio relative to the paid-up capital.
- Formula: TVPI = (Distributions + Residual Value) / Paid-in Capital
- Importance: Provides an overall view of the fund’s performance, combining both realized and potential returns.
- Internal Rate of Return (IRR)
- Definition: The annualized rate of return that makes the net present value of the fund’s cash flows equal to zero.
- Importance: Evaluate the time return of investments, taking into account the time value of money.
- Multiple on Invested Capital (MOIC)
- Definition: Measures the total return generated by an investment relative to the capital invested.
- Formula: MOIC = (Distributions + Residual Value) / Paid-in Capital
- Importance: Provides a measure of the fund’s overall return without considering the time factor.
Importance of using both PPE and MOIC and IRR
Using both DPI, MOIC, and IRR is crucial for a comprehensive valuation of a VC fund:
- MOIC: measures the multiplication of invested capital, which is useful for understanding the total return generated by an investment. However, it does not take into account the time it takes to generate those returns. A high MOIC could be the result of a long period of investment.
- IRR: measures the annualized return on an investment, taking into account the time value of money. A high IRR indicates that returns were generated quickly. However, a high IRR with a low MOIC could indicate that the total returns were not very significant in absolute terms.
Methods for valuing investments not yet realised
Unrealized investments in the portfolio are valued using different methods to estimate their present value:
- Market valuation: Use comparable market data, such as recent valuations of similar companies or funding rounds.
- Valuation by multiples: Applies market multiples (such as price-to-sales or price-to-EBITDA) to the company’s financial metrics.
- DCF (Discounted Cash Flow): Estimates the net present value of discounted future cash flows at the required rate of return.
- Last Round Valuation: One of the most widely used methods, it uses the valuation of the last funding round, especially if there is significant investment from new institutional investors in the round, possibly adjusted for significant changes in performance or the market.
Importance of Performance for Vintage
- What is Vintage Year?
- Definition: The year a VC fund raises capital and starts investing.
- Importance: Funds with the same vintage can be compared more accurately since they operate under similar market conditions.
- Performance Comparison by Vintage
- Reason: Comparing funds of the same vintage allows investors to assess relative performance by removing the influence of changing market conditions.
Details:
- Market conditions: Each vintage reflects the specific economic, political, and market conditions prevailing at that time. This environment can significantly affect investment opportunities and achievable returns.
- Benchmarking: Funds of the same vintage can be used as a benchmark to assess a fund’s performance against its peers. This is crucial in determining whether a fund has outperformed or underperformed competitors in similar circumstances. Since it is often difficult to find accurate benchmark data, a good, but not exhaustive, reference to evaluate the performance of a VC fund is to use the average annual performance over a period of 5 to 10 years of Nasdaq or S&P, adjusted for risk (illiquid VC).
- Investment strategies: Investment strategies can vary over time depending on market trends and technological innovations. Comparing funds of the same vintage helps to understand how these strategies worked in a similar context.
- Phases of the business cycle: The different phases of the business cycle (expansion, recession) can have a drastic impact on investment performance. Funds of the same vintage have faced the same economic phases, making the comparison fairer. Considering the overall duration of a VC fund (typically 8-10 years), investments in VC funds with vintage in times of recession are able to achieve higher average performance than those with vintage in years of expansion.
Social benefits of venture capital
- Setting up new businesses and improving exit statistics
- Statistics: According to Accel’s “Flywheel of Talent” report, 1,451 new startups were created by former employees of 248 European unicorns. This shows the importance of venture capital in promoting the creation of new businesses.
- Example: Fintech companies such as Revolut, Klarna, N26, and Wise have helped create more than 120 new tech companies.
- Importance of Fast Capital Recirculation
- Secondary market: With a listed market that is not efficient for early-stage exits, it is important to develop the possibility of a secondary market for such stages in order to allow Business Angels (BAs), Family & Friends (F&F) and early stage investors to reinvest their profits in new startups.
Advantages:
- Support for new businesses: the recirculation of capital facilitates the creation of new startups.
- Liquidity: Offers an exit option to initial investors, improving their liquidity and incentivizing further investment in new startups.
Average expected performance by investment stages
| Stadium | Expected Return (IRR) | Average Duration | Risk (Failure Rate) | Success Rate (Exit/Next Round) |
| Seed | 30% – 50% | 5-7 years | 70% – 90% | 10% – 30% |
| Serie A | 25% – 35% | 4-6 years | 50% – 70% | 30% – 50% |
| Serie B | 20% – 30% | 3-5 years | 40% – 60% | 40% – 60% |
| C Series | 15% – 25% | 3-5 years | 30% – 50% | 50% – 70% |
| Growth | 15% – 20% | 2-4 years | 20% – 40% | 60% – 80% |
| Pre-IPO | 10% – 15% | 1-3 years | 10% – 20% | 80% – 90% |
The following information is based on data from sources such as PitchBook, CB Insights, NVCA, and Cambridge Associates. This data demonstrates how risk decreases as the investment stage progresses, while expected returns reduce accordingly, offering guidance for balancing risks and returns in startup investing.
NASDAQ and S&P 500 Annualized Percentage Return
Here are the annualized returns for the NASDAQ and S&P 500:
- From 2011 to today
- NASDAQ: 13.55%
- S&P 500: 10.57%
- In the last 10 years
- NASDAQ: 14.59%
- S&P 500: 10.98%
- In the last 5 years
- NASDAQ: 13.11%
- S&P 500: 10.86%
Risk premium for venture capital investments
The risk premium represents the additional return required by investors to compensate for the higher risk compared to safer investments, such as those in public equity markets. In the case of venture capital funds, the risk premium is generally higher due to the high-risk and illiquid nature of the investments.
Risk Premium Considerations
- Suggested risk premium: A risk premium for venture capital investments is commonly estimated to be between 5% and 10% above stock market returns.
- Expected return for VC funds: Considering the annualized returns of the equity markets, investors in VC funds could expect the following returns:
- From 2011 to date:
- NASDAQ: 13.55% + %-10% = 18.55% – 23.55%
- S&P 500: 10.57% + %-10% = 15.57% – 20.57%
- In the last 10 years:
- NASDAQ: 14.59% + %-10% = 19.59% – 24.59%
- S&P 500: 10.98% + %-10% = 15.98% – 20.98%
- In the last 5 years:
- NASDAQ: 13.11% + %-10% = 18.11% – 23.11%
- S&P 500: 10.86% + %-10% = 15.86% – 20.86%
Analysis of Italy’s position in the global context
Parameters for assessing the maturity of a VC ecosystem
The PitchBook report identifies the following key metrics for assessing the maturity of a venture capital (VC) ecosystem:
- Dimension:
- Total Deal Value (VC) Investments: The amount of capital invested in startups in a specific area.
- Number of VC deals (Deal Count): Volume of investment deals in a region.
- Total Exit VC Value (Exit Value): Value generated by startups through exits.
- Number of VC Exits (Exit Count): The number of exit operations completed.
- Total Value of VC Funds (Fund Value): Capital raised by VC funds.
- Number of VC Funds (Fund Count): Number of closed-end funds in a region.
- Maturity:
- Number of mega VC exits (Mega Exit Count): number of exits greater than one billion dollars (or euros).
- Number of unicorns (Unicorn Count): startups with valuations of more than one billion dollars (or euros).
- Late-stage to Early-stage Ratio: Indicates the maturity of companies.
- Nontraditional Investor Participation: Involvement of institutional investors.
- Exit Value to Deal Ratio: efficiency in generating value from exits.
- Number of First Financing Round Counts: An indicator of the growth of startups.
- Late-stage Median Pre-money Valuation: A reflection on the maturity of companies.
- Late-stage Median Deal Value: The average size of late-stage deals.
- Growth:
- Growth rate of the value of VC investments over one, three and five years (1-year, 3-year, 5-year Deal Value Growth Rate).
- Growth rate of the number of VC deals over one, three and five years (1-year, 3-year, 5-year Deal Count Growth Rate).
- Growth rate of the value of VC exits over one, three and five years (1-year, 3-year, 5-year Exit Value Growth Rate).
- Growth rate of the number of VC exits over one, three and five years (1-year, 3-year, 5-year Exit Count Growth Rate).
- Growth rate of the value of VC funds over one, three and five years (1-year, 3-year, 5-year Fund Value Growth Rate).
- Growth rate of the number of VC funds over one, three and five years (1-year, 3-year, 5-year Fund Count Growth Rate).
Position of Italy
Maturity of the VC Ecosystem in Italy:
Milan:
- Included in the top 20 cities with the highest VC growth with a growth score of 69.3.
- Metrics such as the value of investments, number of deals, value and number of exits, and value and number of funds are lower than in cities such as San Francisco, New York, and Berlin.
Parameters to be monitored:
- Size of investments and exits: significantly smaller than in major global cities.
- Number of unicorns and mega exits: Low number of unicorns and mega exits compared to leading cities.
- Non-Traditional Investor Participation: Limited presence of institutional investors compared to major VC hubs.
Conclusion:
Italy, and Milan in particular, shows signs of growth in the VC landscape, but remains a frontier market compared to the main global ecosystems in terms of size and maturity of investments. The concentration of assets is lower and the participation of institutional investors is limited, necessitating further development to reach the maturity of more advanced ecosystems.
Sources and Further Reading
- Pitchbook Analyst Note: Global VC Ecosystem Rankings– PitchBook
- Accel: Flywheel of Talent Report– Accel Report
- Digital Agenda: How to make unicorns in Italy and why it is important – Digital Agenda
- Visible.vc: VC Fund Performance Metrics 101– Visible.vc
- Diligent Equity: Venture Capital Metrics Cheat Sheet– Diligent Equity
- Leland: Comprehensive Guide to VC Portfolio Strategy– Leland
Other useful links for further reading:
- Why Startups Fail in the First Year and Survival Tips
- PitchBook Global VC Ecosystem Rankings
- PitchBook Q4 2023 Analyst Note
(Photo by Scott Graham on Unsplash)
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