Rules Of Thumbs

A good rule of thumb for an appropriate start-up burn rate is about $100,000 per month.  For example, a web-based startup should be able to operate for one year if they raise a $1 million dollar angel round.  This will equate to approximately 3 founders at the time of the equity raise, to hiring 7 people for a total of 10 people at the end of 1 year.  The cash will be burned on the salaries and operating expenses of the startup and should provide enough runway to eliminate some of the initial market and technical risks so that the startup can raise a venture round at a favorable valuation.

For a myriad of complex legal reasons, Limited Partners require General Partners to contribute their own capital into their venture capital fund.  While this amount can vary, the vast majority of the time GPs need to contribute 1% of the committed capital with LPs contributing the remaining 99%.   Thus the 99/1 rule. 

The depth of an venture capitalist or private equity investor’s “J curve” is typically 3 years.   In good times (such as 1999) it can be as short as 1 year.   In bad times (such as 2002) it can be as long as 5 years…or infinite. A “J curve” is the graphical representation of the value of a portfolio of illiquid investments over time.  For example, in the first years of a venture capital firm’s new fund, they are deploying capital at cost and collecting management fees.  Therefore, until they have a reason to write up the value of their investments (follow-on funding at higher valuations) or a liquidity event, the value of their fund is lower than the capital contributed.   So, the depth or length of the “j curve” is the length of time that a funds value is less than the capital contributed.

As a general rule, firms will only raise an inside investmetn round if they cannot raise an outside round.  An inside round means that the entreprenuer only raises capital from the investors in the previous round.  This situation raises a serious conflict of interest around the valuation of the round since there is not any objective 3rd party to set the new valuation. 

Fund of Funds typically receive a 1% management fee and 5% carry (or carried interest).   Since funds of funds are much more scalable than a direct investment fund, they can charge a lower management fee and carry and make up the difference by quickly deploying the committed capital and raising another fund.  This allows them to quickly amass a large amount of capital under management and thus earn significant management fees.

The General Partnership (GP) of a venture capital fund typically receive to types of fees for their investment services:

• A 20% carried interest.  This means they receive 20% of all of the capital gains on the funds they invest.  Typically they must repay all of the contributed capital or they may be forced to pay this carried interest back to the Limited Partners (LP), this is known as a “claw-back”
• A 2.5% management fee.  This fee is charged on all COMMITTED capital, regardless of whether or not it has been invested yet.

In recent years (following the bubble of the late 90’s) it has taken new ventures an average of 6.5 years to reach a profitable exit via a liquidity event (acquisition or IPO)

Private equity funds (including venture captial funds) are typically structured to be “self-liquidating”.  This means that they dissolve at a pre-determined time, which is typically 10-12 years after its founding.  However, if the fund is not fully invested and/or liquidated by the pre-determined time, the Limited Partners generally grant an extension to the General Partners.

On average start-up new ventures will require $68 million in financing to reach cash flow positive.  This capital is typically raised over 4 rounds.  Once the new venture reaches cash flow positive, in theory, it should be self-sufficient thus not requiring any further investment. 

• When incorporating a new venture, a good rule of thumb is to authorize (or issue) 10 million shares @ 1/10 of cent. 50% of these shares should be issued to the founders (with a vesting schedule). 10% should be set aside for future employees. The remaining 40% will go to future investors.

• Also, ALWAYS elect to “pay” taxes on any shares immediately, even if they will vest over time. This way you will not have to pay any income tax on the difference of the value of the shares at time of receipt and their market value at that time.