VC Math 101: Stages, Strategies, and Exit Distributions

9 min read3 days ago

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Strategy and the math behind it in VC can feel overwhelming, especially when terms like “burn rate,” “runway,” and “valuation” start flying around. As a founder, aspiring entrepreneur, or junior investor, having a firm grasp of VC fund math is crucial to understanding what VCs look for and how they make decisions. Consider this your VC math 101 crash course.

The Stages of VC Investing

VCs may focus on one or two stages of funding, or choose a mutli-stage strategy. Each fund will have specific milestones at various stages of investment.

Pre-Seed: At this stage, startups are often pre-revenue and are focused on validating the market and achieving problem-solution fit. The goal here is to prove that the startup’s product solves a significant problem, and initial investments are used for development and testing.
Series Seed: With some traction, seed-stage companies aim to develop their product-market fit (PMF) and Go-To-Market (GTM) strategies. At this point, companies are still figuring out their business model. Valuations remain relatively low, as these startups typically have less than $1M in annual recurring revenue (ARR). Investors focus on metrics like burn rate, gross merchandise volume (GMV), and runway to assess how long the company can sustain itself before requiring additional funding.
Series A: By Series A, the company should have a validated business model and some revenue predictability. Companies at this stage will often range from $1M to $3M ARR. Investors will be scrutinizing the company’s ability to scale, with a focus on burn multiple, sales conversions, and gross margins.
Series B+: From Series B onward, the focus shifts heavily towards growth and achieving breakeven cash flow. Metrics like EBITDA, revenue growth, and customer lifetime value (LTV) become central. Investors are looking for more mature businesses that can demonstrate sustainable growth and profitability.

The Types of VC Fund Strategies

VCs employ different strategies based on their target returns, ownership goals, and risk appetite. Below is an overview of the three common strategies.

Concentrated: These funds typically invest in fewer companies (under 20) but aim for significant ownership stakes of 10% or more, frequently leading or co-leading investment rounds. The idea is to maximize returns by betting on fewer but potentially higher-impact investments.
Diversified: With a portfolio of 20–45 companies, these funds aim for more modest ownership stakes (5–10%) while spreading risk across a wider range of startups. These funds will sometimes lead or co-lead investment rounds.
Broad: These funds may invest in 45 or more companies, often writing smaller checks and holding less than 5% ownership. The idea here is to spread risk even further by investing in a higher number of companies. These funds will rarely, if ever, lead or co-lead rounds.

The Anatomy of a VC Fund Structure

At its core, a typical fund is structured with three main entities: the management company, the general partnership entity, and the limited partnership entity.

Management Company: General Partners (GPs) establish a management company, typically an LLC, that handles operational overhead. GPs receive management fees paid to the management company, usually around 2% annually, for providing services to the fund and managing the portfolio. These fees are typically higher in the early years of the fund and step down over time. Additionally, GPs are also entitled to carried interest, generally 20% of the fund’s profits, but only if they hit certain hurdles (more on that later). The arrangement of a 2% management fee and 20% carry is commonly referred to as a “2–20 Structure” in VC.
General Partnership Entity: In addition to the management company, GPs create a general partnership entity, typically an LLC, which is responsible for making investments on behalf of the limited partnership.
Limited Partnership Entity: Capital from LPs is pooled to form the LP entity, which serves as the source for investments.

The Math Behind VC Fund Management

Let’s break down basic fund terminology, and look at how it functions in practice.

Investable Capital: The money you have left to deploy after subtracting your management fees and expenses from your fund size. Fund level expenses include fund formation, legal, fund admin, and Annual General Meeting costs, among other things. Managers typically set aside anywhere from 2%-5% for these expenses.
Follow-On Capital: The money you set aside that allows you to maintain your ownership target in subsequent rounds. This reserving of capital is referred to as the reserve ratio.
Initial Capital: The money you have left to write checks after determining how much money to set aside for follow-on investments.
Initial Check: This is the average initial check size that you will write to portfolio companies depending on your fund strategy.
Post Money Valuation: The estimated worth of a company after outside financing.
Ownership Target: How much of the company you own when there is an exit event, the amount of which determines proceeds and returns to the fund.

Okay, so how does it actually work? Let’s look at an example of a $100M fund.

Assume this $100M fund has a 10 year term, and has a typical 2–20 structure. Management fees of 2% over ten years would amount to $20M, and other fund expenses at 2% over ten years would amount to $2M. This leaves $78M in investable capital.

Let’s then say the fund has a 35% reserve ratio for follow-on capital, leaving you with $43M in capital to deploy. In this scenario, you have a concentrated strategy and will only invest in 10 companies, so you have $4.3M to write initial checks.

Assuming an average entry valuation of $20M for all initial investments, you would be targeting 21.5% initial ownership. In venture, managers rely on a small percentage of companies to drive the majority of returns for funds. Many companies in a portfolio will fail, but the outliers (the ones that succeed massively) can return the entire fund — and more. This is called Power Law. Let’s talk about how a company gets to a $1B valuation.

Why Market Size Matters

Market size is essentially the total revenue potential in a given market, based on the number of customers and historical sales trends. It represents the upper limit of your company’s revenue potential and is a key metric that investors use to gauge the potential ROI.

For a company to reach a billion-dollar valuation, it must capture a significant portion of its Serviceable Obtainable Market (SOM). If a company can capture 5% of a SOM worth $4B, that would give the company $200M in revenue. With a 5x revenue multiple, this would result in a $1B valuation.

VCs are targeting to return 3–5X to their LPs, and LPs expect to receive a 12% annual return over ten years. Market size analysis is critical because it helps VCs determine if a company has the potential to deliver outlier returns.

For a deeper dive on this subject, and to learn about all things TAM, SAM, and SOM, check out our comprehensive writeup here.

How Everyone Gets Paid When There is an Exit: American vs. European Waterfalls

The way proceeds from an exit are distributed to investors and fund managers is governed by a distribution waterfall. This determines the order in which LPs and GPs get paid. European waterfalls tend to be more investor-friendly and are more frequently used in VC structures.

European Waterfall

The European waterfall structure ensures that LPs are fully repaid their initial capital before GPs receive any carried interest. This structure aligns the interests of the investors and fund managers by ensuring that LPs receive their preferred return, also known as the “hurdle rate,” before GPs participate in profits.

In a European waterfall:

Return of Capital: LPs get 100% of their initial investment back.
Preferred Return: LPs receive a preferred return (often 6–8%) on the capital invested.
GP Catch-Up: After LPs receive their initial capital and the preferred return, GPs are allocated up to 100% of distributions until their carried interest (typically 20%) is caught up to reflect their share of the profits.
Remaining Distribution: After the GP catch-up, any remaining profits are split, with 80% going to LPs and 20% to GPs as carried interest.

This structure ensures that LPs recover their investment before GPs begin earning substantial profits, making it a safer option for investors.

American Waterfall

The American waterfall allows GPs to begin receiving carried interest earlier, on a deal-by-deal basis. In this structure, GPs can earn carried interest from the profits of individual investments, even if the overall fund has not yet returned the LPs’ full investment.

In an American waterfall:

Return of Capital for Each Deal: LPs receive their invested capital from each deal that exits, but only on a per-deal basis, not the entire fund.
Carried Interest on Profitable Deals: GPs can receive their carried interest from successful deals before all LP capital has been returned from less successful or failing investments.
Remaining Distribution: Similar to the European waterfall, profits are eventually split with 80% going to LPs and 20% to GPs, but the timing of GP payouts differs significantly.

The American waterfall can benefit GPs, especially if some investments perform well while others take longer to exit. However, it exposes LPs to greater risk, as they might not fully recover their initial investment before GPs begin earning carried interest.

Other Fund Math & Terminology to Know

Pre-money Valuation = Post-money Valuation — Round Size
Post-money Valuation = Pre-money Valuation + Round Size
Equity Purchased = Round Size / Valuation
Return the Fund Valuation = Fund Size / Exit Ownership
Dilution: Reduction in ownership of equity shares (Function of round size, valuation, option pool)
MOIC: Multiple On Invested Capital- Measures value / investment (Gross/Net of Fees + Expenses)
TVPI: Total Value Paid In- Measures value / called capital (Gross/Net of Fees + Expenses)
IRR: Internal Rate of Return- Measures how fast you return capital

VC fund math is complex, but it ultimately serves to align the interests of all stakeholders, ensuring that capital is deployed strategically and returns are maximized. By breaking down concepts like market sizing, ownership targets, and how exit proceeds are distributed, founders can better understand what investors are looking for, while investors can confidently evaluate the potential of their portfolios.

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Disclaimer: Before making an investment decision of any kind, potential investors are advised to consult with their tax, legal, ERISA and financial advisors. Artemis Fund and its affiliated entities are not currently registered as investment advisers with the United States Securities and Exchange Commission or with any other U.S. Federal or state regulatory authority but will do so in the future to the extent such registration becomes necessary in compliance with applicable laws in the United States. Artemis Fund provides no guarantee with regard to the content and completeness of this material and does not accept any liability for losses which might arise from making use of this information. The opinions expressed in this material are those of Artemis Fund as of the date of this summary, unless otherwise specified, and are subject to change at any time without notice.