What Is A Good Venture Return?

Lawrence Aragon at PE Hub used the news that Cisco paid $590mm (in stock) for Pure Digital the maker of the super popular Flip Cam to ask this question.

it sounds like a pretty good deal, but you have to understand that the
VCs put $95 million into Pure, which makes the Flip digital video
camera. Assuming they own half of the company, that’s a return of just
over 3x their money. For a middle-of-the road VC firm, that would be a
decent return, but for big name backers Benchmark Capital and Sequoia
Captial that’s pretty much a dud.

It's a good question and worthy of a discussion. That's what blogs are for, so let's have it.

My friend Mike Feinstein points out in the comments to Lawrence's post that the VCs probably made well over 3x on their money:

I’ve got no knowledge of the specifics of this deal, but once $95M is
into a deal, you can be pretty sure that the VC’s own 70-80% of the
company. So, the VC’s probably took at least $440M of the exit value.
It’s still about a 4.5x, so your sentiment may be right in the
aggregate. But, the early investors may have done better than that
because they probably had a lower average share price than the later
stage investors.

So let's move away from the Pure Digital story. Anytime you turn $95mm into ~$450mm in the span of three or four years, I'd say that was a good return.

But is 3x a good venture return? It depends entirely on the stage you invest in and your "batting average".

Most people know that "batting average" is the percent of times you get on base (based on the number of times at bat). In VC parlance, the batting average is the number of times you make a successful investment divided by the total number of investments you make.

Let's call a "successful investment" one that you get at least your money back. That's not really accurate, but let's do it anyway.

If you are a late stage investor, like IVP or TCV (two of the better known Silicon Valley late stage firms), then your batting average is very close to 100%. You wait until the early stage risk (technology, team, market) is wrung out of a deal and you invest on a set of price and terms that almost insures you'll get your money back and you attempt to make three to five times your investment if everything works out right. Since there are very few total losses in the portfolio, a 3x on average would be a good return for someone with a 100% batting average.

If you can return 3x on your portfolio before management fees and carry, you can deliver 2.25-2.5x net to your investors and over a ten year period (with an average investment duration of 5 years), that is an acceptable return to the LPs (18-20% IRR).

However, if you are an early stage investor (like our firm Union Square Ventures), then it is a different story. I've said many times on this blog that our target batting average is "1/3, 1/3, 1/3" which means that we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments.

If you do the math with that batting average, and assume the return is 1.5x on the middle third, then you need to average 7.5x on the 1/3 of the investments that make the bulk of the returns.

So does that mean that early stage investors who get a 4-5x on a "good deal" are not going to deliver for their LPs? Not exactly. It depends on how you think about that portfolio of "winners" (the 1/3 that produces the bulk of the returns). I've also said on this blog a bunch of times that we look for one investment to return the entire fund. In the case of our 2004 fund, that would be a $125mm return on one single investment.

If we have $10mm in that investment that returns $125mm, that is a 12.5x on our best deal. So if you need to average 7.5x on the portfolio of winners, you can certainly have some 4-5x deals in that basket as well.

The way I like to think about this is one deal returns the fund, another 3-4 deals returns it again, and the rest return it a third time to get to the 3x gross that a fund must hit to deliver good returns to the LPs.

Going back to the Pure Digital deal to wrap this up, if Sequoia and Benchmark are investing funds of roughly half a billion, and they each took out roughly $100mm in this deal, then Pure Digital is most certainly in the winner category that will produce the bulk of returns for the fund. It's not the deal that will return the fund outright, but its in the next category. It's an investment that worked out well for the investors and I am sure they are quite happy they made the investment and with the returns.