A venture capitalist gives his one-third rule:
1/3 of the deals really work out the way you thought they would and produce great gains. These gains are often in the 5-10x range. The entrepreneurs generally do very well on these deals.1/3 of the deals end up going mostly sideways. They turn into businesses, but not businesses that can produce significant gains. The gains on these deals are in the range of 1-2x and the venture capitalists get most to all of the money generated in these deals.
1/3 of the deals turn out badly. They are shut down or sold for less than the money invested. In these deals the venture capitalists get all the money even though it isn’t much.
So if you take the 1/3 rule and add to it the typical structure of a venture capital deal, you’ll quickly see that the venture capitalist is not really negotiating a value at all. We are negotiating how much of the upside we are going to [get] in the 1/3 of our deals that actually produce real gains. Our deal structure provides most of the downside protection that protects our capital.
I think it is much better to think of a venture capital deal as a loan plus an option. The loan will be repaid on 2/3 of our investments and partially repaid on some of the rest. The option comes into play in a big way on something like 1/3 of our investments and probably no more than half of all of our investments.