DPI: The Only Metric that Matters in Venture
DPI: The Only Metric that Matters in Venture
The Internal Rate of Return (IRR) for an investment that triples (3x) over 15 years is around 7.60%. Despite this relatively moderate return, it's considered a model of success, representing the top decile that venture managers aim for. Hitting this benchmark not only validates their performance but also helps them build credibility with investors and justify raising future funds.
However, the data reveals that only 12.5% of funds manage to generate returns greater than a 3x Distributions to Paid-In (DPI) ratio, even after 15 years. (1) Even more rare, just 2.5% of funds manage to return three times their invested capital across more than two separate funds, underscoring the challenge of consistently delivering high performance.
With the 30-year Treasury yield at 4.2% and Certificates of Deposit (CDs) offering 5.25%, there should be a significant premium for locking up funds for a decade or more. This is because the opportunity cost and the risk of illiquidity must be compensated with higher returns.
In venture capital, if you’re not consistently achieving returns of 12% or more across multiple funds, the risk associated with this asset class may not be justified. Given the availability of safer investments with reasonable returns, the premium for venture capital should reflect its higher risk and longer investment horizons.
You also have to exclude funds that most people can't access. Many large institutional funds make it nearly impossible for individual accredited investors to invest, especially when they’re accepting $100 million from pensions. These funds typically have little interest in accommodating someone looking to invest $250k or seeking regular updates and partner meetings.
In that scenario, the likelihood of investors achieving a return that justifies the risk is nearly zero, especially when investing in an underperforming fund where all the companies could potentially fail. The chance of a reliable payoff becomes virtually nonexistent.
The solution for this is to insist on a venture firm that invests hot at the pre-seed, Seed, or Series A, but directly from an accelerator or from the earliest life cycle. If you’re investing at a $2M valuation, common in European and US Midwest markets, and they do a “seed” round for $18M with traditional VCs or via crowdfunding or syndicate networks, your investment just did a 9x.
The conventional wisdom advises against selling any secondary shares until after a Series B round or later. However, with 30% of Series A companies valued above $40 million, your early investment could have yielded a 20x return, potentially generating enough capital to achieve a 1.0 DPI and return your principal. This would leave you with a portfolio of promising investments that still have years to generate additional returns.
I would definitely recommend taking some money off the table; failing to do so, even for a portion of your investment, could be seen as a breach of fiduciary responsibility. That $40 million investment could quickly diminish, given that 30-50% of companies typically fail between Series A and Series B. Even in more mature companies, you face a 25-35% failure rate between Series B and C, and a 15-25% failure rate from Series C to D. Can you imagine riding a company from inception to a Series C, where only 20% achieve valuations over $200 million, only to watch your 100x return evaporate?
I advise investors looking into emerging managers to focus exclusively on those who are targeting companies at the Friends and Family round. This stage is often the most reliable opportunity to achieve the necessary multiples for a defensive and outperforming venture fund. While individual investors may be drawn to the specifics of syndicate deals, I recommend investing in AngelList or SPV deals only if you have a personal connection, a strong emotional appeal, or additional fringe benefits.
Equity crowdfunding poses even greater risks; I observed a basic web application platform raising over $250 million with less than $9 million in revenue, attracting unsophisticated investors who invested millions simply because they liked the platform. In contrast, Uber raised $1.25 million at a $4 million valuation in 2011, and such favorable valuations are increasingly rare to find.
I believe the ideal approach is what we implement at Palo Alto Partners: investing 10% at a $1M valuation and 8% at a $5M valuation. This strategy allows us to maintain 18% with minimal dilution in subsequent financing rounds. Additionally, we take great care to introduce each portfolio company to three potential clients, connect them with a financial institution that is eager to lend to venture-based businesses, and do everything we can to ensure they have a few uninterrupted years to build their agile startups. This preparation sets them up for success when they approach larger VC firms in the Bay Area or aim for a lucrative exit.
If you’re passionate about doing a deep dive into VC economics, my buddy David Zhou’s Cup of Zhou is the definite resource.
Venture capital is still grappling with issues related to signal uniformity, the tendency of partners to invest in founders who resemble them, and existing power imbalances. However, I believe that when executed correctly from the beginning, venture capital can be a powerful accelerant for entrepreneurship.