Searching for Outliers: Evaluating VC firms

🌈 Abstract

The article discusses the author's journey from a stable Big Tech Software Engineering job to the world of Venture Capital (VC). It explores the significant financial advantages of working at a top-tier VC firm compared to an average firm, and examines why top VC firms significantly outperform the rest. The article also provides guidance on how to identify a top VC firm by analyzing key metrics such as Internal Rate of Return (IRR), Multiple on Invested Capital (MOIC), Distribution to Paid-in Capital (DPI), fund size, and the background and reputation of the team.

🙋 Q&A

[01] Why do Top VC's significantly outperform the rest?

• VC fund performance follows a power law distribution, where the top firms produce the majority of returns for Limited Partners (LPs).
• This is because the markets that startups are attempting to take over are winner-take-all markets, with only one next Nvidia, Microsoft, Apple, Google, or Amazon.
• The best startups typically only partner with a handful of the best VCs for funding, brand recognition, support, and connections.
• LPs (of which there are fewer than VCs) know that the best VCs have the best returns because they have the best startups, so the best LPs only partner with the best VCs.
• This cycle perpetuates and further exacerbates the uneven distribution of returns.

[02] How can one identify a Top VC firm?

• Look at key metrics such as:
  • Internal Rate of Return (IRR): Expected to be around 20% or higher
  • Multiple on Invested Capital (MOIC): How much the fund is projected to be worth divided by the initial size of the fund
  • Distribution to Paid-in Capital (DPI): Of the money paid in, how much has been paid out to the GPs & LPs
• Consider the firm's fund size, which is typically large and oversubscribed for top-tier VCs.
• Evaluate the team's background - have they been successful founders or operators? Do they have a diverse and impressive background?
• Assess the firm's network and expertise that they can provide to portfolio companies.
• Look at the firm's LPs - large institutional investors like university endowments are a good sign.
• Examine the firm's portfolio companies and their performance - are they likely to be winning their market?
• Reach out to people who have worked with the partners or other prominent team members to get a sense of their reputation and how they operate.