I wrote both a Twitter thread (I know it’s X now, but habits die hard) and a LinkedIn post recently on student and recent graduate funds. A good friend and I have been seeing a number of small sub-$10M funds run by college students and/or recent grads. And even more since the afore-mentioned social posts came out. In a way, it was my flag in the sand moment inviting additional conversations on the topic.
The TL;DR version of the post, although the post itself is at most a two-minute read, is that these student funds are interesting. Most will die. But a small, small few will deliver insane returns. As such, as LPs, the underwriting for these funds, where sourcing is extremely predictable (i.e. invest in their peers), needs for these funds to be 10X funds, as opposed to 5X net for the typical seed fund or 3X for the typical Series A fund. Also, we know going in that most, if not all, of these funds won’t be enduring. Most likely one and done.
And so what does the underwriting look like?
I actually elaborated on this in response to a comment that asked what percent of unicorns were founded by students, but thought it made sense to expand here in this blogpost as well.
Venture, at the end of the day, is a game driven by the power law. I’m not the first to say that. And I won’t be the last. In other words, in VC, we are applauded not by our batting average (like buyouts or hedge funds), but by the magnitude of our home runs. We can miss on the vast majority, but as long as we strike one Uber or Coupang or Google or Facebook and it returns multiple times of our portfolio, then… we did it.
To quote a Midas list investor (who’ll go nameless for now, until I have his permission to share his name), who at the time was presenting on stage, “The only reason you are listening to me today is because I’m on the Midas list. And the only reason I’m on the Midas list is because of this one investment I made [redacted] years ago.”
Obviously, there was definitely some modesty there. In fact, he’s hit a number of exits in the years since. Nevertheless, when said in broad strokes, his point stands.
So to the comment that started it all. By numbers, a rather small number of unicorns were founded by active students. I don’t know the exact number (writing this on vacation, and I don’t have Pitchbook access on this small device), but I’m willing to bet that only a small percentage of unicorns are founded by students. And even less when you consider realized unicorn exits. Excluding the crazy markups of 2020-2022. It’s why the average age of a startup founder is 42 at the inception of the company.
That said, “Among the top 0.1% of startups based on growth in their first five years, [an HBR study finds] that the founders started their companies, on average, when they were 45 years old.” In fact, in the same study, they found “[r]elative to founders with no relevant experience, those with at least three years of prior work experience in the same narrow industry as their startup were 85% more likely to launch a highly successful startup.” In a separate Endeavor study, it’s also why there’s only a small sliver of founders with no work experience prior to the founding of their unicorn company.
All that to say, from Alexandr Wang to Jeff Bezos to Mark Zuckerberg to Patrick and John Collison, all were in their early twenties (or earlier) when they started their companies. Each, in their own right, an outlier.
To build a hypothetical portfolio — forgive my generalizations, but doing so for nice, even numbers…
Say one allocates a $10M fund of funds portfolio. It’ll write 10 $1M checks into $5M funds. In other words, for a 20% stake at the fund level. In a bad economy, where $200M is the median ARR to go public, and if we assume a 10x multiple on exit, a $2B unicorn exit in that $5M VC fund returns ~$2.2M in the fund of funds portfolio. 0.6% equity valued at $12M. A 2.4X on the $5M fund alone. And a little over $2.2M back to the LP, as the GP takes 20% carry. This assumes $100K checks, 2% ownership on entry and 70% dilution by the time of exit. Naturally, no reserves. needing about 10-11 unicorns to 2x. A lot to expect for a portfolio of student funds. 10 unicorns out of 400 is quite hard even for most seasoned investors.
And so one must believe that these student funds can find true outliers. And before anyone else. Additionally have enough downstream capital relationships to facilitate intros to funds who will lead current and future rounds. Which luckily for them, a lot of GPs of multi-stage funds are individual LPs in these funds. Playing a pure access approach.
And so, if there’s a $10B exit in one of the VC portfolios, under the same fund strategy assumptions as earlier, a single $10B company exit returns the whole fund of funds portfolio. Every other exit will just be cherries on top. So out of a 400 underlying startup portfolio, only one decacorn exit is needed. Instead of multiple unicorns.
Separately, and worth noting, although I’ll be honest, I haven’t had a single conversation with a young GP where any were as deliberate with their sell strategy as this, there are multiple exit paths today outside of M&A and IPO, most notably secondaries (portfolio and fund) (something that the one and only Hunter Walk wrote recently in a blogpost far more eloquently than I could have put it). And so even in a crazy AI hype right now, there are paths to liquidity in these multi billion valuations at the Series B and C, if not earlier. In the increasing availability of such options, my only hope is that these young fund managers have the wherewithal to be disciplined sellers. Perhaps, an additional reason these young VCs should have LPACs.
A blogpost for another day.
Photo by 🇸🇮 Janko Ferlič on Unsplash
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The views expressed on this blogpost are for informational purposes only. None of the views expressed herein constitute legal, investment, business, or tax advice. Any allusions or references to funds or companies are for illustrative purposes only, and should not be relied upon as investment recommendations. Consult a professional investment advisor prior to making any investment decisions.