Venture Fund Economics: When One Deal Returns The Fund

Comments (Archived):

1. This line of thinking also allows you to take more chances on innovative or non-traditional ideas. Always swinging for the fences tends to keep people sticking to “safe” proven ideas.

   1. Exactly. When we invested in Etsy, we really had no idea of the size of theopportunity. It revealed itself to us over time.

      1. By the way, my wife would like to thank you for Etsy! She is an artist, and buys and sells on there all the time.

         1. Don’t thank me! Thank the team who built it

      2. Actually, we thought it might have been a little small at the time. 🙂 We looked at comps like Michael’s stores, which weren’t actually doing so hot.

         1. Is it possible to invest in something that does not have a comparable, that may be breaking new ground in terms of creating new markets? In biotech this might fit into the category of experimental research which addresses small populations, is badly needed by the culture, but may not be easily sold to investors. Do [venture capital] funds, set aside a percentage of proceeds for this kind of funding? I don’t mean just taking on “riskier investments”.It could involve merging what may have been non-profit interests within the framework of a hybrid funding strategy using Limited Partnerships. A couple of good resources for these include the article, “A How-to for Joint Ventures” by Marion R. Fremont-Smith, from the Hauser Center for Nonprofit Organizations at Harvard, and the book, “Program-Related Investments”, by Christie I. Baxter, at MIT.I guess my interest here is in finding ways to support development and research that may not have a defined precedent. As it seems like what is considered a risky investment, is often just something that does not have all the components of a known “home run” for those covering the industry, (i.e. the film industry, or software industry represented in posts here).But what I am referring to, is investing in areas where there may be no components of a known.The non-profit sector used to fund these areas, but this really has not worked well in our economy over the past 15-20 years. Non-profits become overly politicized and with the chronic underfunding, there is no room for energy; the good ones fail quickly. The bad ones become havens for cronyism and eventually just crank out support for work that fits their defined template of “acceptable”, leaving out any room for creativity or real risk taking.We need a new type of funding mechanism to support blurry areas; those ideas that we don’t have categories for, but that will create new markets.There has to be some solution, where a funding mechanism could support innovation outside of established precedents. There needs to be some kind of incubator for innovation _across disciplines_…that allows the best ideas to rise to the top and establish new markets.

            1. I don’t think non profits are the answer. The lack of a profit motive is not a good thing in my viewI think the vc industry does a good job of going pretty far out on the risk curve in energy tech, biotech, and possibly materials techIn IT, I believe we are in a different phase of the technology diffusion curve and that’s why vcs focus on more here and now opportunitiesBut we do take a few flyers. Bug Labs would be one of them for example. I think all vc firms should do some of that

2. Do you think that the desire for that nice, symmetrical outcome — making back the entire fund on one investment — leads to those really wild deals at the end of the business cycle? My guess is that someone raising a billion-dollar fund is also tempted to look for businesses that could singlehandedly turn a $50 million investment into a billion-dollar return — but it’s a lot harder to make the same percentage returns on a higher capital base. The only choice they have is to go for the really revolutionary, really nutty ideas.In fact, I suspect that every benchmark besides “find the best deal for your money” will eventually lead to bad decisions.

3. Fred, given the virtual disappearance of the IPO exit alternative, at least for a while, how does this impact the home-run probability? Do you feel that strategics are as comfortable as the public markets to provide VCs with a HR type exit value?

   1. A home run is relative. On a 100mm fund, a 500mm exit can do it for youAnd I don’t think you need IPOs for a 500mm exitYou just need patience, a solid business, and a great management team

4. Very interesting, Fred. Another example, to my mind, of Pareto’s insights at work. We focus on the 20/80 “rule,” but in many cases it’s even more extreme, e.g. 5% of inputs yield 70% of outputs.This whole series is very interesting — good insights for this outsider.

5. this is a business built on far more trust than i was aware of … you are trusted from both sides, fund investors, and recipients … amazing

6. You mention that “It’s actually even more stark than that,” that is, it’s not exactly 1/3, 1/3, 1/3, that one investment can carry the fund.Is it also more stark than that for typical VC firms (maybe not Union Square which seems to be doing particularly well)? In other words, do you think that a typical VC firm can expect for 2/3 of its investments to do break even or better? 2/3 seems like a high proportion to me.

   1. Yes I think most funds can do that. But outsized returns come from home runs (the subject of this post) and by allocating most of the capital to the winners (hard to do in practice)

7. “…will return the entire fund when they are sold” did you intentionally only mention acquisitions as a viable exit? Or are there also realistic scenarios for USV companies to go public?Great string of posts…

   1. One way or another you have to sell the stock and send back cash. I know that many funds distribute marketable stock but I wasn’t thinking that wayI think public offerings are an appropriate exit for only the very best companiesFred

8. Great posts. Thanks, Fred…I keep applying this to the Hollywood model, which I operate in, and it’s not so different. Lots of at-bats, lots of sinkholes, some outright bombs, one or two strong runners, and then a hit that showers everything with money.Peter Guber tells the story of his first meeting with his Sony bosses in Tokyo, after they installed him at what was then Columbia/Tri-Star, and he told them his business plan: make about 14 movies a year — 6 will do okay, maybe break even; 2 or 3 will do a bit better, and have franchise possibilities; 2 will be hits; 1 will be a monster hit; and at least 3 will be total losses, total bombs. They listened respectfully, then one of the older guys asked (through an interpreter), “May I ask Guber-san why he bothers to make the bombs?”I guess the real question is, what can you learn from the failures that might help move the successes along? In Hollywood, honestly, not much. There’s a temptation to learn too much, if anything. Each failure suggests its own new rules, most of which aren’t useful: No more westerns! No dark comedies! And that holds until someone makes a hit western, or dark comedy, and then the rules are rewritten again.Personnel, I guess, is one area where you can learn a lot from a failure. There are people I’ve worked with on failed shows that I can’t wait to work with again; actors and writers who are fantastic — a failed show or movie really has a million reasons for going down. And there are people I’d never work with again, even though we worked on a successful project together.I can think of times when I consciously went to “swing for the fence” and pitched a project that really was a little out there, and times when I made a more strategic decision and pitched an 8:30 show to a network that needed a 8:30 show. In a fear-based business (which Hollywood most definitely is) the trick is to convince the studio or network that’s putting up the money that your project is a straight-down-the-middle double. And then when they greenlight the project, you start swinging for the fence!I’m guessing that’s where the venture model and the Hollywood model part company….

   1. “Why do you insist on making the bombs?”LOL. That’s so greatHere’s where early stage VC and Hollywood might be different. We get to start with a 250k wager, then see a flop that can last a year, then put up a 1mm additional bet, then see another flop that lasts another year, at that point we can go all in, or ask to see another flopIts risk mitigation with outs along the way that include selling the company earlyCan Holywood play the game that way?

      1. Rob Long is a funny as shit Podcaster for KCRW in Santa Monica. His Podcast is called ‘Martini Shot’. He’s just too bashful to say he’s a 4 minute internet mogul himself. “Next week we’ll…”

         1. I knew he was someone special

         2. (I can’t edit my own post)I have a follow up question for Rob’s point though. Can you break down results along the lines of either ‘Internal failures’ or ‘external forces’ that lead to results? It seems to me that the number 1 lead of lack of return is that the external market changes i.e. a signficant competitor enters. Up front people want to know what your sustainable competitive advantage is, which is fine. But looking back on your own returns, is that a main cause of the lack of returns and is that beyond managements control?

         3. Wow. I’m blushing. Thanks! I love the term “4 Minute Internet Mogul,” though. I’m going to steal that. (Typical Hollywood writer….)

      2. Well, theoretically, of course, the major studios could figure out a way to do business like this. But it’s awfully hard to change a culture, especially one that is still making a lot of people rich. It’s sort of like the Ottoman Empire in 1850: a glorious history, lots of treasure, creeping decay.Incremental investing of the kind you describe is hard to do when you have a closed-ended product. It’s hard to invest in a movie in stages, because you really have no idea until you’ve seen the finished picture if it’s any good or not. The truth is — and this is why people in this business seem so anxious and crazy all the time — is that a great script and a great cast and a great director really don’t add up to a great movie, necessarily. Hits are lightning in a bottle. Hits are the worst possible thing: that thing that can’t be reverse engineered.So the studios do the smart thing: they try to spread the risk around, and raise capital from hedge funds and private equity funds, with hilariously lop-sided terms, to fund their conservative, highly hedged and promoted big releases, betting that even if they have to share the profits of, say, Iron Man, they’ve subsidized the development of a huge franchise that’s going to last, maybe, 10 years (or more, look at “The Dark Knight”) .The problem for them is, they used to be the only game in town. Studios and media companies used to make all the movies, produce all the TV shows. Now they’ve moved sideways a bit along the chain, and they’ve bought distribution outfits like MySpace and TV networks and Last.fm. But they’ve shut down their development efforts, so the script and project pipeline is shorter and a lot tighter. My prediction is that they’re going to essentially outsource the “new idea” business to the web, to people with funny blogs and short YouTube films, things like that. The media companies that used to be such great incubators of scripts and stories are finding it hard to afford that side of the business.Which is great news, actually, if you’re a young person who wants to break into Hollywood. And exciting if you’re someone like me, who’s been in it for a while and doesn’t have a crushing mortgage. But if you’re in the middle somewhere, these are tough times. Textbook times, actually: an old business getting squeezed by disruptive, cheaper innovations…

         1. This is a great comment and deserves to be a post. Where is that reblog button daniel? I need it!!!!,

            1. My understanding about the movie business is that it has become very accurately predictable in its economics based on (a) first day’s box office receipts, and (b) size of project (i.e., small, mid-sized, huge), with varying success probabilities that can be assigned with great precision. For this reason (and also driven by the multiple and growing number of distribution outlets), the financing opportunity for hedge funds and the like is actually not as high-risk as one might imagine… That is, if we’re talking about a portfolio of titles. But I think the risk is considerably different (and greater) for a VC portfolio… which may explain why the terms offered by hedge funds to film studios constitute fairly low-cost capital. Now, if we could only come up with a statistical formula to make the VC business just as predictable… Interestingly, the new YouNoodle service professes to do just that, but I have some doubts. Fred, have you seen that one, and what are your thoughts?

            2. Finally, a post where I could actually provide insight based upon experience and I’m beaten to it by two rather eloquent gentlemen. Though I would have to say I prefer to hear Rob Long, as opposed to reading him…there’s a knowing, pragmatic realism to his pieces. That said, both Rob and dskaletsky are correct in their assessment in the film industry.That said, studios do have the option to shut films down at different stages, even to the point of minimizing distribution to the fewest number of theaters that enable a film to be placed through pre-existing post-theatrical distribution deals. They can keep a film on the shelf for years, only to release, if at all, in the home entertainment window to capitalize on current publicity of one of the actors in the film. They can spend millions on screenwriters on a script only to abandon the project when the studio regime changes or a key piece of talent becomes unavailable or disinterested. And they can and have sold off interests in projects while they were in development and production.One last piece, in the 80s, there was a fund that attempted to raise capital by claiming it would employ real options theory to the development and financing selection process of films.Way to create discussion Fred.

            3. Way to have discussion guys. This was quite illuminating!

         2. Actually the Hollywood studios can and do operate very much like VCs. They can and do make incremental investments in a project. In the film business, it is said that a film is made three times:1. When the script is written2. When the film is shot (produced)3. And again in the editing roomFrom a business perspective, I would add one more stage:4. When it is marketed and distributedSo this means that incremental investments can be made. And they are. Here is a typical investment line (with sample investment levels required from the studio in parentheses — these can vary widely depending on the project):1. A writer pitches an idea to a studio (FREE!)2. Studio options the pitch ($100K)3. Studio invests in script rewrites/development ($1MM)4. Studio invests time to further develop project — hire cast, Above-the-Line talent, etc (JUST EXECUTIVE TIME)5. Studio greenlights project and invests in its production — this included editorial ($40MM)6. Movie is completed and screened for studio7. Studio commits to marketing and distribution budget ($25MM)8. Film is released[For the sake of time, I will skip the post-theatrical revenue lines like DVD]The point here is that a studio can “pull out” of an investment at several stages.The first decision point is in the script development phase. If the script doesn’t turn out well or if they aren’t able to attract good talent (actors, directors, etc) to the project, the studio can decide not to invest in production. This happens a lot. Some projects slosh around in “Development Hell” for years before either being greenlit or thrown into “turn around” (kind of Hollywood’s version of free agency).Rob is right that the biggest investment in the life of a film is in its production. Once the decision to invest in production is made, the studio must fund the entire production. There is really no way to know how a film will turn out during production. The good news is that the studio can adjust the production budget before committing. For example, if they get Will Smith to commit to star, they can decide to invest more than if they get a lesser star (from a commercial perspective).Once the film is completed (shot and edited), the studio has another decision point where it can decide on how much money to invest in marketing and distribution . At this point the studio screens the film and asks, “Do we have it?” If the answer is yes, then they can make a full investment in the marketing. If the answer is no, they can choose to cut their losses and “dump” the film (stick in a small number of theaters with little marketing support).So, I actually think the studios operate much like VCs. A rule of thumb for studios used to be 1 out of 7. One success would pay for the next six films. A better ratio would produce a profitable portfolio.While I agree with Rob that it is very hard to learn from mistakes in the movie biz, it’s a little more predictable than he infers. The real risk in the movie biz relates to, in my opinion, the long lead time of time it takes from script to screen. It can take anywhere from 18 to 48 months to make if from the script phase to the theaters. This means that one would have to be able to predict the tastes of the fickle, movie-going audience 2-3 years in advance. This is not easy…

            1. Well, of course it all depends on the studio and the project. But it’s a rare project that follows your financial outline, with 100k spent on an option and only $40 million spent on the budget, with a paltry $25 million spent on P&A (Prints & Advertising).Each step of the way — especially #4 in your list — involves even more dollars sunk, even bigger slices given away to above-the-line talent — and in reality, most of this happens all at once, in a weird kind of frenzy. A “small” budget picture often balloons into a “big” budget picture over a weekend, if the right talent suddenly gets involved.Studios have all sorts of formulas and schemes for predicting the market’s reaction to any film, but those are basically teddy bears — they make them feel good, but have little or no predictive power. The best way to lose all of your money is Hollywood is to be convinced that you have a “system.”Arthur Devany writes rather convincingly about this in his book Hollywood Economics.

            2. Thanks. That is helpful. Can the studio sell the film to someone else at various points along the timeline?

            3. Well, not once it goes into production. For studio films (not independent films), the studio can sell a project in the development stage by putting it into “turn around” (again, like free agency). In this case, another studio can sweep in and buy the rights to the script and project while it’s still in development.More likely than a sale is the production being funded through a co-financing deal (a “syndicated deal” in VC-speak) between two studios with one studio taking domestic rights and the other taking foreign. In essence, the original studio is “selling equity” to another in this co-financed structure, but I wouldn’t consider it a “sale” in the way you are referring. It would be like asking if a VC can sell their stake in a company to another VC before an exit. Maybe, but it’s just not the way the business works.With that said, there are sales to foreign distributors. This used to happen only after the film was finished, but more recently, foreign rights are “pre-sold” and used to finance production. It’s a very interesting dynamic that could be the subject of another post…In response to Rob — yes, those numbers I gave are very loose. The actual dollar values are very much dependent on the project, studio and talent involved. Development costs can range from $0 (if a complete back-end deal is struck with the writer) to $10MM. Production can go from $15MM (very low end studio film) to $200MM. P&A can range from $10MM to $100MM+. And those financing levels are made based on predictive models for how the final product will perform in the marketplace. While I agree there are no “fool proof” systems and that a Hollywood movie is still a speculative investment, there are some guidelines (if you will) that help to lower the risk. For example, if you’ve got an action adventure movie starring Will Smith and Julia Roberts, directed by Ridley Scott, based on a novel by Michael Creighton — it’s fairly safe to assume that that film will break $100MM at the domestic box office and take in $300MM worldwide (in fact, I bet you could pre-sell it foreign for $100MM+). All that before ancillary revenue. So, would you invest $100-150MM on that film? Yup. Would you invest $150-$200MM. Hmmm…maybe. Would you invest $300MM? Probably not.On the flip side, if you’ve got an intimate story about a Russian family growing up in a post-Chernobyl Russia with Cate Blanchet as the only known star, directed by smaller, independent director, the chances are this one is going to make between $20MM and $60MM at the domestic box office. If you think you’ve got a real Oscar contender, then maybe push the range to $40MM to $80MM. So, how much are you going to invest in this one? $35MM? Yup. $100MM? Nope.That’s a very simplistic look at a studio “system” and it’s much like a VC’s system. What is the potential range of return for this investment? Is this a technology/business that can become a $1B business or it a more niche product that will likely only get to $30MM. If so, how much am I going to invest? The only different question that the VC asks is, What percent of the company am I going to take? Studios really don’t ask this question…DS

      3. Here’s an example of a studio icing a project as it compares the potential return against required investment:”Fox Searchlight has arrested production on Brit cop thriller “The Sweeney” following concerns about its international prospects.Project was being produced by DNA Films, the U.K. venture backed by Fox Searchlight, and had been set to start lensing in the next few weeks.DNA reps said Fox execs are believed to have had doubts the $16 million pic, while looking a sure-fire hit in Blighty because it’s based on a cult 1970s TV series, would sell elsewhere without a major star.”http://www.variety.com/arti…

   2. I’ve long thought of a different Hollywood model: the music industry. Actually only partly Hollywood, but I lived through it in a band when I lived there in the early 90’s.At least at that time (pre-internet, iTunes, and direct distribution a la Radiohead), it really was similar in many ways to startups, the record labels being the counterparts to VC’s.Most of the big and small labels do the portfolio approach not too different from what we’re talking about in this post/series. While A&R folks sign up bands they think will sell, they *really* have no idea who will hit, whose personnel will have enough days out of rehab or even survive the contract, etc. So they sign a number of bands (each of which immediately thinks they’ve made it but soon realizes it’s truly just the beginning), but give them only a token amount of support, then if they see some success, start rationing out more promotion and support.Record labels have been doing this longer than VC’s– they certainly took a big leap-of-faith risk when the Beatles started on Decca, and Elvis before that, etc. There are some differences of course. One is about the numbers. You might be able to get about 100 bands going for a similar price as 10 startups. And it only takes a few big hit bands, each of which might churn out multiple hit records over time.The IRR charts given those twists would be interesting!Also interesting is that just as current trends show startups requiring less capital and thus needing less VC due to decreasing tech costs, etc, so too can bands greatly reduce 2 of their greatest costs–recording and promotion–significantly, and thus need the record labels less these days.

   3. This is why like this site, you get such stimulating cross-perspectives from other industries. Very interesting comment!My perspective is that of an avid NBA fan. There a lot of similarities between drafting players and betting on startups.For example, tt must be hard for some of these GMs to see a 17-year-old kid who has no idea how to play the game and say “you know, his length-agility-athleticism is tremendous, let’s draft him and give him guaranteed money that is ten times more than what his entire family would make in their lifetime and hope that he would learn and develop into an All-Star player.” Sometimes it works, sometimes it doesn’t. I guess that’s the equivalent of your home-run.Then you have the conservative types: “This guy is 24, has had four years in college and led his team to a conference title. He’s a bit too slow and a bit too short for the pro game, but you know what you are getting”. you rarely ever get a home-run out these situations, but the stink-bombs are fewer.Then you have this famous expression that says “You can’t teach 7ft”. Most NCAA 7-footers get drafted under the assumption that even if they don’t develop at all they would still be useful for their size alone. Some of the biggest mistakes in NBA draft history have come from this logic: Sam Bowie was drafted before Michael Jordan. Michael olowakandi was drafted #1 in 1998. Frederick Weiss did not play a single game in the league. What would be the equivalent of that mindset in the venture world? The fire-proof CEO myth? “This guy has made us money before; even if the technology fails, he’ll figure out a way to save the company”? I don’t know…Then you have all these fads and copy-cats. Once Nowitzki proved that he can be a star in the NBA, for a few years a whole bunch of Euros were drafted very high and labelled the “next Nowitzki”. Then you had a string of Chinese players all labeled as the “next Yao Ming”… It seems that this approach is very common among VCs.Then you have the “specialists”. This guy will not be an All-Star but he is a good shooter and he will help us. This company has a nice niche technology and will be the perfect acquisition target for Big Company X.Then you have the “psychoanalysis” or “chemistry” experts. I don’t know a lick of basketball and cannot tell a pick-and-roll from a post-up, but this kid has a “great character, no ego, great work ethics, great teammate” etc. The Orlando Magic GM from a couple of years ago was like that, he came from hockey. Complete disaster. Tons of VCs are like that.What I find very interesting is that in the NBA world there is a clear shift towards quantitative analysis and other sophisticated analytical techniques. A good example is Daryl Morrey , the Rockets GM, a true whiz-kid from MIT. His drafts the last few years have been absolutely spectacular! Many VCs (not all obviously) are much less sophisticated. Many invest in technologies that contradict the laws of physics, are completely blind to market trends, and keep reciting superficial cliches like “we invest in teams with strong leadership” or “technologies that address unmet needs” as if these mean anything… It’s amazing how much capital is controlled in such spurious manner…

      1. Ahh. The sports analogy. that’s a good one!

         1. Fascinating discussion… Not to overstate the obvious, but in VC world there is no ability to trade properties to other VCs, like players can be traded. By the same token, the pieces of a VC portfolio may, but don’t have to, complement each other (like players on a team need to). In that last respect, I think the sports business is much tougher – because it isn’t just the ability to pick the right asset, but the ability to make that asset fit precisely within a portfolio – and this is mitigated by the sports GM’s ability to trade away pieces… or execute short-term contracts.

   4. That was as entertaining as it was informative.

9. i would LOVE to see a post on exits.

10. someone on SAI made an interesting observation:despite that VCs don’t call capital commitments 100% on day, LPs have to allocate capital and ready to fund capital calls at any given timeergo (this commenter says), the IRR calculation should assume that un-called capital is sitting on the sidelines, say, in T-bills, earning, say, 3%fred?

    1. They can do their irr calcs however they want but that would incent the vcs to call the capital quickly and put it to work quickly and that’s not a good ideaMost of our lps have sophisticated cash management solutions that allow them to optimize their yields while being liquid enough to make the capital calls. That includes being able to borrow short term to make the calls

       1. but the VC are not incented on IRR. I think Steve Kane’s point is very valid from point of view of how the LPs themselves value their investment in venture capital. The opportunity cost of having to keep cash reserves (or to borrow) to meet capital calls cannot be ignored, and it matters when deciding whether to invest in the class at all or to look for more liquid options. I don’t buy that the VC would be made to make quick bets if they were measured by IRR on committed capital, you still want to make good bets. It’s similar to cash in mutual funds; it depresses your returns in bull markets and helps you out in bear markets. In normal times you would want to pick stocks wisely and timely and would not worry too much what your cash allocation is.

       2. Thanks. That’s how I do it too.

11. Thus, could than one look at a slowing economy as the Sieve that forces start-ups to reconstruct their venture into one that fits your VC fund strategy?

    1. I don’t think so. I don’t think a bad econony affects a startup in the same way as a big company. In fact some of the great startups were started in bad economies

       1. Or captured leading market share in a bad economy – Google in the post dotcom bust recession.

12. Fred: Your outline leads to being an average VC, if there is such a thing. If you want to be an outstanding VC and you examine the subset of outstanding VCs (those that return 4-5x or better consistently from one fund to the next), they have to have one deal that returns a multiple of the committed capital in that fund. That way, even if none of the other companies in the portfolio succeed, the LPs still get an outstanding return….Stewart

    1. Stewart,Congrats in Ribitt. No revenue $100M+ exit. God bless America.

    2. We have begun investing the seventh vc fund I’ve been a GP in stewart and I’ve seen 3-4x gross happen twice without the mega home run you describe. There’s more than one way to skin a cat

13. This article and it’s comments were terrific. Something is happening here, on the AVC blog…

    1. But what it is aint exactly clear 😉

       1. ummm doesn’t that belong on @lotd?

          1. Yes it does

14. Its easy to say but hard to do

15. At the bottom of this page is a list of most of the well known VC blogshttp://networks.feedburner….I hope that helpsFred