Why Growth Is King
VC relies on very, very fast growing companies.
The logic of why comes down to simple maths. Let’s assume a fund has a 2/3rds write-off rate - that is, two of three investments go to zero. Let’s also assume the fund is aiming for a 5x multiple of invested capital (MOIC) on the fund overall - solid but not ludicrous returns for their own investors (their so-called “Limited Partners”).
We can solve for the return required on the 1/3rd of companies that aren’t write-offs (your “Hits”) like this:
(67% x 0) + (33% x X) = 5 therefore X = 5 / 33% = 15
Or more generically we can say:
Required Hit MOIC = Target Fund MOIC / Hit Rate
So in this scenario need your winners to deliver 15x MOIC.
Now consider you are a Seed stage investor backing a company with £500k ARR (and assume it’s actual ARR!). Let’s say that company is raising £3m. Typical dilution at Seed is 20%, so the implied post-money valuation is £3m / 20% = £15m, and the pre-money valuation is £12m, equal to 24x ARR.
To get 15x your money (assuming no further dilution for now), you need the company to be worth £15m x 15 = £225m on exit. You also know that companies of that scale tend to grow more slowly and your ARR multiple on exit is likely to be sub 10x - let’s say 8x to be conservative. Therefore you need that business to be generating £225m / 8 = £28m ARR at exit - more than 50x its current ARR. Assume a few extra funding rounds cumulatively diluting you by 50% before exit and you can double all the numbers above…
So to recap, to hit 15x MOIC on a Hit you need that company to grow 50-100x from where it is today due to two factors: (i) the so-called “negative multiple arbitrage” of buying in at 24x ARR and exiting at 8x ARR; and (ii) cumulative lifetime dilution.
That’s why growth is so important for VC. Not at all costs, no, but it has to be there. It’s necessary if not sufficient. It’s not because we’re greedy or shortsighted - it’s just how the maths work.