Venture Capital - Thoughts On The Asset Class
I wrote a post a week or so ago thinking outloud about what a good "venture return' is.
Yesterday, one of our investors, Lindel Eakman of UTIMCO, stopped by this blog and left a very interesting comment on that post.
Lindel pointed out that UTIMCO's portfolio return on all VC funds over the past 10 years was in the range of 9pcnt and that he thought that wasn't very good.
He did point out that VC is well ahead of the public equity markets in their portfolio and so to the extent they have their equity dollars in VC (or other private equity), that is better than public equity right now.
The punch line to Lindel's comment is important. He wonders if VC can't do better than 9pcnt across a diversified portfolio, would UTIMCO simply be better in bonds given the illiquidity and greater risk of the VC asset class?
And sadly, it may well come to that. VC has not proven that it can scale as an asset class since the mid 90s. The vast amount of money that has come into the sector from public pension funds in the past fifteen to twenty years has not been put to work very well and returns for the asset class as a whole have come down.
It may well be the case that the public pension money (and other money) may leave the asset class as CIOs and the investment committees ask the hard questions that Lindel is asking.
Peter Parker, a long time VC and entrepreneur, replied to Lindel with the observation that a downsizing of the VC business would be a good thing for the LPs that remain because the best firms in the business are doing very well and are generating returns well above the 9pcnt which may well be the average performance for most investors in the VC asset class over the past 10 years.
I note that the industry returns I posted on this blog a month or two ago show a 10 year average return of 17.3pcnt so UTIMCO's portfolio is in theory below the average, but those 10 year returns are heavily influenced by the late 90s internet bubble and also the phenomenal returns delivered by KP and Sequoia on their Google investment. I would not be surprised to see that 9-10pcnt returns are the average for funds that did not take advantage of either of those big return generators.
Many will argue that this is not good news for entrepreneurs. And that may well be true. But I think entrepreneurs in the web sector have done a great job of figuring out how to build companies on much lower capital needs and we also have a vibrant angel and early stage (pre-VC) market developing.
So it may be that the real problem is that there is simply too much money looking to get put to work in the VC asset class (certainly that is true in information technology) and that as money starts to leave the sector, we'll have a smaller and healthier VC business to operate in.
I don't know what this means for biotech and cleantech and it may well be that those sectors can handle larger sums of venture capital and still generate acceptable returns. I'll leave it to those who know something about them to comment.
Perhaps the relatively lower VC returns being seen in the IT sector are emblematic of a maturing industry?On the one hand, web/IT startups need a lot less capital to get going (giving rise to the micro VC niche), on the other hand, the funds have gotten so big they can’t put enough capital to work in the really disruptive corners. Plus too much competition among the mega-funds drives down returns.I think you are right that there will always be room for the talented VCs in this sector, but the shakeout seems to already be under way. Plus, there are simply too good of returns that can potentially be realized in other less mature sectors (cleantech/biotech/nanotech) and other less mature geographies.
On the return being low, have we forgotten that the dot bust happened, and that the deal flow has not recovered? Instead of dividing by ten years, try seven or maybe six. There were years when there was no or zero returns.Hank’s notion of IT being a maturing industry might be dead on. We have opted 1) for everything being web, instead of moving from product to web as appropriate for technology adoption; 2) for products, instead of technologies; 3) for sustaining innovation, rather than radical innovation not just in what we are putting on the market, but how we are managing the companies, and what we see as an acceptable investment.The past eight years have been anti-entrepreurial in the IT industry, or anti-new economy, not just in what businesses get invested in, but in the way we think about business in general. We don’t read “Fast Company” anymore. Until we get back to having a knowledge economy, instead of a resource extraction economy, returns will remain low.Still we seem to have forgotten that web services equate to utility computing. Yes, the web (SaaS) is cheaper, but the returns are lower, as they should be. The web is where you go after the early mainstream market when cost management trumps wealth creation, since wealth creation is over at that point. Software companies used to die when they finished consuming their early mainstream market. Now, they live on as SaaS with the lower returns that entails.Have we really gotten to the point where there is nothing new, as in radical innovation, under the sun? Hardly.Have we really gotten to the point where all we can do is sell advertising? I don’t think so, so returns can climb higher.Averages always hide the exponential winners.We can change these numbers. They are the real metrics of the ISV industry.
Our company does a lot of work with pension investors and the asset managers that deal with them. My recent post on this topic may be enlightening. I am hearing comments similar to what Fred is hearing about the asset allocation process and the risk-return tradeoff decisions that must be made. We are neither an advocate or critic of any investment strategy or asset class. http://www.pensionriskmatte…
Thanks for the link SusanI’ll check it out
Personally, I think many of the Information Technology opportunities are down-shifting to more of the “seed financing” model. Charles River has the Quick Start program. Spark Capital announced [email protected] Kleiner Perkins iFund is a seed funding for a specific platform. Sequoia partnering with Y-Combinator.I think there will be several more in the near future. Naturally, they probabloy view these seed deals as a way to establish quality dealflow for subsequent series-A rounds.In the end – as you ask – will those seed-stage initiatives “move the needle” in a substantial enough of a manner to justify the VC management fees. I’m not sure. It goes back to the question of whether you can make a game out of hitting lots of singles (and having the low-overhead manpower to manage the production of lots of singles) or is VC inherently a “tent-pole” business (ala Hollywood).
I wonder if the seed finance model is better to execute independently anyway. From an entrepreneur’s perspective, the the risk is that the sponsor VC does not follow through with the larger Series A round and the issuer not only has to explain why this is the case to other potential investors, but now also has a VC as seed-stage investor with maybe a different agenda than new VCs coming in. From the sponsor VC’s perspective, investing in seed stage may require more hand-holding and active management than the size of the opportunity is likely to justify, as you point out, at least relative to the VC’s core investment focus. With this said, the Sequoia/Y-Combinator approach is “one step removed”, as it were, but I’ll be curious to watch how [email protected] and the others pan out.
This is a big problem Chris and it’s one reason we have not done thisWe do participate in a number of seed rounds but a full blown seed programis something I struggle with
it seems that there is a boat load more activity in the seed stage from institutions. Why is this? is it strategic?
What do you call institutions? Spark, crv, ycombinator/sequoia?
yes – as opposed to the angel networks that proliferated in the early part of the century.
One major problem in the web sector was the focus on “cool” over “real” for the last 4 years. Far too many investments were made in apps that had little to no chance of generating revenue, let alone become a business. Check the TechCrunch Death Pool for confirmation.Blame for this falls primarily on VC’s making these investments and blogs such as TC that glorified them. The combination created a toxic ecosystem that spiraled downwards as entrepreneurs, taking their cues from the “smart” money and blogs, focused their efforts on cool, rather than using Web 2.0 to create utility for business and people.I know this first hand b/c I created a company with 7-digit revenues and VERY healthy profits that bored most VC’s because it was used by a gazillion people sharing a gazillion files. Never mind that it didn’t have to be, nor was it ever intended to be, it just came down to the fact “real” wasn’t sexy enough for VC’s looking for a major score.I was frustrated – but my biz intuition told me VC’s were going to crumble under their own need for speed. More than just lip service, I’ve been pounding the table for 3 years that time and talent was being wasted on diminishing returns. YouTube, Facebook, MySpace, Flickr and others had their spaces pretty locked up. Sure, incumbents go down … but did we need to fund 50 separate video companies? Especially when none of the incumbents had figured out how to make money in the first place. Yet, VC’s wanted to find the next successor. Dumb.You say one result is that entrepreneurs will now learn to build with less. I say, they’ll be forced to grow up and build real solutions now that they know being the next Zuckerberg/Hurley is not as important as putting their time into creating something people will actually pay for. Getting paid … how radical:http://blog.agoracom.com/20…Better late than never – but we wouldn’t be here if VC’s and bloggers had done their jobs.Regards,George
i am sorry i dont get this. you say techcrunch deadpool? ever heard of F**ked company? you cant even compare the sizes. i was part of that bubble – this one is not even close in terms of deal quantity or capital committed.
What mark said
There’s still plenty of inefficiencies waiting to be removed, as every bit of information we use moves to the web.It’s possible that the past few years were too sweet too early on and a new focus on startup performance from the get go would be more reasonable than a focus on eyeballs. Not a stick and carrot approach, but perhaps putting the carrot a little further away.There may be a tipping point where there’s just not enough low-hanging fruits for so many gatherers and you need to start looking out for hunters out in the wild.
The trend to Y-combinator funding is predictive of changes to the venture funding model (On a side note I think USV should start one in partnership with someone but that is for another time). Many of the VC funded companies aren’t ever going to do well as an investment. They are good companies and will return a steady revenue stream over time but a significant capital gains is unlikely. Unfortunately, they are crammed into equity raising model that isn’t suited to them.There needs to be a third leg to the venture funding class. This third leg would allow a group of investors to invest in an early stage company with the payback being regular dividends rather than an exit. The dividends may not occur for say first 2-3 years but must occur after and must be paid out before the founders.This leaves an asset class with Y-Comb/SeedCamp-like funds providing the initial prototype/on-the-job training for new coys, which can then either be funded for exit (traditional VC) or funded for dividends depending on nature of the product/service and the potential for exit. This mix I think would make better use of resources and allow a larger variety of companies to be successful.
facebook is a good example for a phenomenal growth of productivity through technology combined with a difficulty to measure the real profit rates, e.g. a lack of a real business model which is not just “taxing” user attention like google does. google or wikipedia, which basically look like public institutions in disguise, just more efficiantly organized, probably show new types of corporations which essentially serve the public good and are based on unpaid labor of the users. the sucess of these services and their astronomical valuation have not only to do with the ammount of capital looking for two digit profits, but the amount of time and energy people spend online, which strangely doesn’t directly translate back into value extraction. use value is not translated into exchange value anymore and the other way around. the old money machine is broken, a cycle is over and many markets have dried out due to the overexposure to ponzi style investments. the good thing is that there is still enough creative destruction ahead to give place to smart and creative startups with the right attitude. what has been called web2.0 grew out of the ruins of the dot com boom. and this time, the internet cannot be blamed for the crisis, but probably shows already where the next type of economy is heading towards, a strange kind of knowledge socialism?
And lets not forget about the huge negative impact of excessive (or at least, unwarranted) feesIn his comment, Lindel Eakman of UTIMCO says one of the issues with the VC asset class that they see as vexing is”VCs are proud of their fees and often themselves.”VC management fees of 2% of committed capital, per annum are breaking the back of the asset class, harming Lps and entrepreneurs alike. (For the uninitiated, that means VCs collect 2% of TOTAL CAPITAL COMMITMENTS, every year, whether or not that capital has actually been called in or invested. $2MM per year in fees for every $100MM in fund commitments.)Why? Because 16%-20% of the dollars of every VC fund disappear, off the top, before any money even gets put to work in the portfolio. Worse, its not even “off the top”, its worse, its “before the top even exists” (that is LPs pay management fees on funds before they even provide the funds.)So only $0.84-$0.80 of every LP dollar makes it way to entreprenuers — yet LPs look for returns on $1.00 of every $1.00I don’t mean to imply VCs don’t deserve huge compensation. They do. But only when earned. Right now most partners are earning huge compensation (literally seven figures) per year, and for what — for managing negative return portfolios.That’s simply silly, and unsustainable. Yet it continues on and on and on.Imagine if VCs received 1% managment fees, or even had to submit operaying budgets to their LPs (as the VCs require their own portfolio companies to submit to them)? Or even limited partner fee-based compensatioin to be the same as received by the CEOs of their portfolio companies — $150k-$300K per year? And imagine if “carried interest” (the bonus compensation VCs receive when portfolios deliver superior returns) were increased from 20% to 30%?In the short term, a lot of VC partners would disappear — they wont work for $150K-$250K per year and they would have to admit their likelihood of receiving carried interest is essentially nil, so they would move on. The partners that remained would be totally committed and optimistic about the VCa set class, and their interests would much more closely aligned with portfolio companies and LPs. Best of all, an addition 8%-10% of LP dollars — again, 8%-10%!!! — would end up invested in portfolio companies, where the dollars would work to create returns, not pay exhorbitant salaries and super high end class A office space and legions of assistants and associates for the fund managersA very unlikely scenario, I admit — who would volunteer to reduce one’s own compensation? I wouldn’t. — but a plausible one, I think.
Great points steveI don’t want to belittle any of this but let me at least correct severalthings1. Most VCs recycle their management fees so we do invest 100 cents on thedollar 2. most mgmt fees start going down in year 5, so total fees are more like13-15% of the fund 3. most VC firms have to recoup the fees before the carry is calculatedAgain, none of those in any way negates the point you are making, one Iwholeheartedly agree with, but I just want to make sure everyone is as wellversed in this issue as you areAnd I do love Lindel’s comment about VCs
thanks for the correctionmaybe not here but i am not clear on how management fees are recycled? i was under the impression fees are not always recycled (but admittedly dont understand the process.) if you have a minute can you please educate me how that works?
We have the right to keep some of our sale proceeds and instead ofdistributing them, we reinvest them so we get 100 cents of the committedcapital at workNot all funds do this but the LPs push really hard on it and most funds doitfred
Fred,Appreciate your blog and your open attitude to discussing the VC business.1. Most VCs recycle their management fees so we do invest 100 cents on thedollarI would argue against your point regarding recycling management fees. Most VCs do not effectively recycle their management fee, because this happens only when firms return enough capital to do or, or survive long enough to be successful. Most firms 2% or 2.5% goes into their pockets. This is cash vs. obligations – there are no clawbacks on management fees.It sounds like your firm does recycle fees – good for you. If you talk to LPs about how much of their commitment typically goes to management fees, they’ll agree far too much – and they don’t see most of those fees injected back into investments.Given $100M, even after a 5 year reduction to 1% that’s still $15MM of cash goes into partners pockets.Steve’s point is that VCs todays are incented by management fees as opposed to carry. I know that applies to the vast majority of them today. The number of VCs that have received carry checks greater than their management fees in the past 5 years can be counted on your hands. The recycling point doesn’t in practice change this point in today’s VC marketI think Steve’s points are all excellent.
I think his points are great too ent1And I would take only one small exception to what you wroteTo say they fees go into the VC’s pockets is not entirely trueMuch of them do, but they also go into real estate, admin, accounting, staff, travel, legal fees, etc
Steve, really thoughtful response. Fred already address a lot of my thoughts in his response to your comment, but I’ll add $0.02 quickly.Anytime there is an asset class that involves both fees and carried interest (VC, PE, Hedge Funds), there’s a question of what’s the right balance between the two. Lower fees and higher carry would probably align LPs performance with GPs interests well, so I agree with your intuition there. If more LPs mandated lower fees and higher carry cut, then I suspect you’d see more funds moving earlier stage looking for outsized returns compared to putting a ton of money to work at a later stage looking for a quick 2X. However, larger cut in the carry will mean lower upside potential for LPs. So, it’s a give-and-take that has evolved over time to a “standard” 2-and-20 model. I know very little about how it evolved there, and I’d be fascinated to see some information visualization on GPs fees and carry over time; though I’m not sure where a reliable source of data on this subject would be available.
InterestingBut I respectfully disagree that fees structures evolved. More like,managers pushed to see the max they could get, and this is where they endedup.Also, carried interest at 30% need not harm LPs remember, carried interestshould/would only get paid after return of capital plus base return. Definebase return as X% to insure Lps only collect carried interest when LPs havebeen amply rewarded for illiquidity and riskOr better yet, lower management fees and leave carried interest at 20%. Itsthe management fees that are the real problem.
Certainly they did evolve, but possibly in a different period with different economics at play
Sorry dont mean to nitpick but “evolve” (to me) suggests ups and downs,advances and retreats — Have fees ever gone down?
Our original deal at flatiron on the first $150mm we raised was $1mm of annual fees and a 5% carrySo yes, there have been fluctuations
Fred, you make a good point about IT companies being able to start up with less capital than before. I very much agree that’s a good thing. I’ve been helping a friend’s company raise money to launch their service, and I’ve been surprised by one answer I’ve heard from some in the VC community: “You’re asking for too little funding.” In other words, our request is less than their “floor” of investments. It seems as if these companies either haven’t clued in to the fact that a leaner startup is a good thing, or are still seeing things through a 1998 lens.regards, John
That drives me crazyLess is better for everyone
Is it possible to make the asset class more liquid, perhaps by pooling shares into a venture capital ETF? Seems like there are more and more ETFs being established that are “derivative” of other securities, and a broad mix of venture funds could potentially pool assets to create a more liquid security.I’m sure it’s more complicated than it seems, but seems like it might have material benefits.
Definitely sounds good in theory, but how do you value / mark to market such portfolios?
It’s true that the amount of initial capital required to bring a product to market and scale growth is lower than it’s ever been due to open source software and cloud based services such as AWS. As mentioned, this opens up the market for Y Combinator type seed financing, probably at the expense of traditional venture capital funding (unless of course, venture funding starts to compete for seed financing as Spark and others are doing).The other part of the equation is that through the seed financing stage only a handful of companies will breakthrough and establish themselves as viable, profitable businesses. As a result, only a select few early stage companies will emerge as candidates for what we now call Series A and B venture financing. Over the next investment cycle, I expect that this change in funding dynamics will actually result in a slight increase in average venture returns as early risk capital is increasingly absorbed by seed financing firms and venture funding starts to look a little more like mid-stage private equity financing. The corollary, of course, is that there will likely be fewer venture deals going forward and probably at higher valuations as the supply-demand equilibrium shifts. If this shift does occur, it also suggests that the more established venture firms with more experience and track record in scaling businesses to the $100 million benchmark are likely to emerge as the main source of venture funding.
Mark,You are right on. I posted about this a few years backhttp://www.avc.com/a_vc/200…
The venture model adds real value to the world. It’s a great way to get smart people together and solve a problem that the world needs solving. Most of the economic value flows to the users of the technology, but there’s plenty left over to reward the founders and investors. When it works, everybody wins, and the total amount of money risked is a rounding error in big corporate terms.There’s another style of venture investing which is based on fads and crony connections. The basic idea is to hype a trend, convince some exec at a big public company that he’s falling behind it, and get him to pay top dollar for a project that gradually dissolves inside the acquirer. This is the kind of venture investing that is dying off, and rightly so.
ExactlyThat’s what happened with delicious, feedburner, and TACODA and it kills meAll three were great companies/services, all three were bought not sold (iethe buyer came after us), and all three died off inside the buyerIt’s awful to watch
Totally agree with the previous comments about misalignment of fees and carry on large funds. We do something different 30% carry but with a 12% preferred return to Lps. Our thought when we started our first formal VC fund after a successful career as an entrepeneur and angel type investor was that if we couldnt generate 12% to our LPS after mgmt fee, we didnt “belong” in the venture business. Also we have kept the fund size small ($10m+ and $20m+ for Funds I and II) so that we could stay focused on our strategy and adding value to portfolio companies. I do have to admit that in order to do this we charge a 3% management fee but our expense budget is pretty much an open book with LPs and I do get compensated in the range discussed above after everyone else gets paid (and pretty much all goes back into the fund as my GP and LP committments). We also only charge this full fee for three years on “new investment” not five so the five year average is quite a bit lower than 3%. We do mitigate the 80% investment rule by investing 120% of the fund via recycling as many others do,
For super small funds, 3% is probably too low, and a budgeted fee makessenseAs steve points out, a budgeted fee makes sense in all cases
Steve makes some very interesting points, I wonder if the comfortable fee structure has stifled innovation in this asset class? What about raising VC type funding for a new VC model that has no fixed fees, only pay for performance? I wonder if you wrote a pitch for the VC business anyone would invest? I could imagine this conversation:”How do you scale the business?” – “When our partners run out of time we stop growing.””What is your global strategy?” – “We work with companies located within 30 minutes of our office.””How do you know your approach is valid?” – “Sometimes we make some money.””How many potential customers do you have?” – “Thousands.””Great, how many do you serve in a year?” – “Maybe five.””Ok, great meeting you, well call if we are interested…”Looks like a great space for innovation (that and investment for dividends, slow steady, solid growth).
Yes the comfortable fee structure is an issueSmaller funds are better because 2% of $100mm is only $2mm and you have topay for the office, travel, admin staff, a junior investment team, andpartners2% of $500mm is $10mm and that is a recipe for comfortBut LPs are paying attention to this issue. They demand reduced fees onolder funds when new funds are raised. They demand the GPs repay the feesbefore they take carry.What we need to do is get to smaller fund sizes as an industry and a lot ofthese problems will go away
This is also what has happened (in a different way) to the public markets. EVERYONE is in. Automatically, every month, buying stocks they have no idea about in their government-approved 401k or IRA plan.A generation has flooded the market with money, chasing the returns of the previous generation.The more participants in an auction on the BUY side, the lower the chance of a great deal…..and the lower the average returns for the group.
Interesting post. I’m certainly not surprised by your LP’s returns in any way, and I think you hit the nail right on the head when you properly point out that unless you were in KP and Sequoia, then the average return would be a lot lower. In fact, almost all indicies have survivorship biases that I believe would lower returns further if it were all properly accounted for. However there are a few points to make as an asset class:1. VC should be almost exactly correlated to the equity markets. VC’s realize investments when companies go public in an IPO (and you need a good equity market for this) or get taken out by strategic purchaser (and they need to feel good about their prospects to make the investment) There are very few Flip deals where a cash rich buyer just steps up to the plate. So absent a good equity market – VC returns should necessarily be low.2. Look at the big winners. You can really count them on one hand or two – yet as fund sizes get bigger – you either need a big winner in the fund – or a whole lot of doubles to make the business work. Given the difficulty of nurturing that many companies to decent exits – it is no surprise that returns have been lowered. I don’t believe there is a lack of things to invest in – there’s probably a lack of ability among managers and VC’s to grow those businesses to a level of maturity where they can be harvested.3. In my small way, I’ve seen a good bit of the VC business – and I’ve rarely met a more insular group of investors. I find the Silicon Valley folks more insular than anywhere else – and so when a small group of well capitalized investors all look at the same deals at the same time – the founders make out well – but prices get out of hand and there is an awful lot of reacting to what others are doing – none of which makes for a great return environment.4. As you correctly pointed out, it is cheaper and easier to start something up. What that also translates to is that it is cheaper and easier to copy the idea once it is in the open, and your “moat” is narrower and narrower to the point where many products become real niche products. This is not a bad thing, but it does somewhat self limit the sizre that many business’ can grow to – thus limiting the return in gross $ that a VC can pull from an investment. It is more work for less return (same risk however – that’s just the world today) Because most partnerships are not set up to operate on a $100M fund – there is a mismatch. USV seems to be in a good place with its fund size and its focus – and perhaps KP and Sequoia are as well – but most VC’s are squarely in the middle – and that is not a great place given the dynamics of the world today.So as an investor class is VC a good class of investment? Yes for sure it is. An no, it is a terrible investor class. VC can be great as long as the fund you are investing in has the proper structure, and a great set of GP’s. Otherwise you are certainly better off in treasuries. And this is the same fact for any investor class. For the past 3 years I worked at a distressed debt fund. Last year most of our contemporaries jumped into distressed too early (they had staffed up for the distressed cycle and couldn’t believe the”bargains” they were seeing and couldn’t justify to LP’s why they were holding 50% cash) – got crushed – and are now almost out of business. The firm I was at was up on the year and never waded in to deep – setting them up for a potentially great 09 and beyond.It’s not the asset class – it is the managers of the capital!
Last point is the key point
All of this takes a back seat to the concern over how to get good companies liquid after 5-7 years of building. With the IPO market all but shut down this industry must invent a new way for shares to change hands or the trend may continue to get worse.
Totally agreeI know of about six secondary markets trying to get going so I am optimisticwe’ll find a way to do that
Fred, can you talk about these potential secondary markets? Either here, or in a new post? I’m curious to learn about this.Pete
i second this request, if this is a subject you (fred) are open to discussing in greater detail
Yes, I’d like to do thatI did write something on it beforehttp://www.avc.com/a_vc/200…But I know more now
If you believe there is too much money going into the VC asset class, does that imply a shortage of entrepreneurial talent? Does it imply VCs aren’t effectively deploying capital (not taking enough risk)?There are clearly market examples of “too much money chasing too few trades/deals” in traditional investing, but shouldn’t the number of ideas and “trades/deals” be limitless in the venture sphere? Who is dropping the ball on this one?
Not a shortage of entrepreneurial talent as much as just too much capital
Fred, this was a fascinating post (at least for me). When I pursued my MBA a few years ago I did a paper on the VC industry and developed a system dynamics model of the industry that tried to explain the historical return pattern (which as you know has oscillated between periods of very high and very low returns). One of the assumptions I made in the model is that the number of good, investable opportunities at one time is exogenous (or fixed) … throwing more money into the industry will depress returns because there are only so many good opportunities to invest in at once, so more money chasing the same number of opportunities will result in lower average returns. [In relaity what happens is that more marginal opportunities are funded, but returns from those opportunities will be lower. What also happens is that more VC firms are started, but the experience and performance level for these new firms tends to be lower.] I wasn’t able to find any evidence that the prevelance of more VC money actually increases the number of good opportunities to be funded; my analysis showed that the number of good opportunities to fund is actually more a function of the size of the economy or the sectors. So the VC industry should grow (in terms of committed capital) over time only in relation to the size of the economy or the sector(s) that VC is investing in.Unfortunately what my model showed also happens is that the supply of LP money responds to past venture returns … so after periods of very high returns, more capital is committed to VC, which only serves to depress future returns. And the inverse is also true; periods of low return (like now) tend to dry up capital, which can lead to an under-capitalized scenario in which there is insufficient capital available with which to fund all of the good opportunties out there. I would not be surprised to see ten years from now stories or anecodtal evidence about how good companies with good teams and good business models can’t get funding.
I think this is all trueI’ve been told of some research a VC firm did a few years ago where they went back and looked at all vintage years going back to the early 70s and looked at how many companies that got their first round in that year ended up being worth more than $1bn at exitIt turned out that the number was very consistent and had no correlation at all to the market or anything else (even tech cycles)If these home run deals produce a significant portion of venture returns (and I believe they do), then its all about how much money is being invested in a given year
I think good companies with good teams get funded in most VC cycles. As VC’s we often think that there isn’t a shortage of money (if we’ve raised a fund), or a shortage of good ideas, we say talented management is the short resource. Since a lot of the comments here are about the LP perspective, it is important to recognize that from their seat, the short resource is GP talent. It isn’t a secret that there are perhaps 25-50 firms that warrant an LP’s investment (I’m speaking of venture – not hedge, buyout, distressed, etc). That number has grown precious little over 20 years. That’s because it takes at least 10 years to become a good GP. It is truly an apprenticeship business and I say that despite having 15 years of what I thought was highly germane experience coming into it that I thought would let me leapfrog the learning. It didn’t. To Stephen, the models which look at dollar flow into the business are OK, but I think the key is to look hard at whether, in the up cycles, new GP’s came into the business, did well, and stayed through a down cycle. And in enough numbers to replace the good ones who left in the interim. That analysis is what good LP’s should be doing and some do, some don’t. It is hard work, and not ammenable to the latest Sloan School faculty publication. I think because the business is so interesting and downright sexy that there is a lot of misinformation that gets traded around.Fred, no one answered your query about biotech or cleantech – I have invested in only biotech since 1994. It is quite similar, it cannot handle a large influx of capital. One good thing that happened is that in the tech bubble of ’96-’99, a lot of firms (IVP, Brentwood, Accel, Battery, Charles River etc.) effectively exited the life sciences arena and it didn’t have the investment explosion IT experienced. Biotech also benefits from the fact that the public market has almost never been the panacea. One must invest in companies that can be sold to strategic acquirers. And luckily there have always been a lot of them, although the recent consolidation among several mega-pharmas is a big cloud over that statement.
PeterThanks for answering my question and contributing to this discussionI appreciate both your comments and your expertise
If we assume for the sake of simplicity that the cited historical returns for the VC class refer mainly to sums invested in traditional tech (ie. not in bio and clean) then is not the case that the falling returns reflect (at least partially) the declining profitability of traditional tech as a whole?And if we further assume that a good chunk of this VC money has gone into web startups, do these figures not further reinforce the view that the web has evolved to the point where it’s actually quite difficult to make money online?In other words, is it any surprise that it’s quite hard to make a dime in a sector where users expect just about everything to be free?
I believe the answer to most of this is yes, but I believe the answer to that last question is no
I think web innovation will actually benefit from a drop in VC money. I think the abundance of VC funding has stifled web business model innovation as popular startups know they will always be able to raise finance so can always put off the evil day when they have to show a return. There is no pressure to come up with revenue so there is no pressure to innovate in the area of business models.
If a VC investor could capture an additional 35% of the amount invested, would that have an appreciable impact on returns?
How would they do that?
This is something I wrote about in VCJ back in December. The gist of it is that you lose your NOLs if you have a liquidity event but you get to use them if you don’t. (Your NOLs are worth, roughly speaking, the top corporate tax bracket multiplied by your dollars invested.) There is no logical reason for this result. The explanation is that many years ago Congress corrected an unrelated tax abuse by passing overbroad rules. Reconsideration of NOL rules is in the air now, but I can’t seem to raise any interest from the venture industry. For a little more on this topic see http://bit.ly/K8BZc .
I read the postI have always been able to get credit for the losses I’ve taken in the vc business from a tax perspective so I don’t understand the issue
In a common situation, your portfolio company has accumulated losses (NOLs)approximately equal to the amount invested. When the portfolio company becomes profitable, it can use the losses to offset taxable gain. There is a resulting tax benefit. When there is a change of ownership (as defined in the relevant rules) the ability to use those losses to offset future profits is vastly diminished. So, if, by way of example, a profitable company, such as Microsoft, buys your portfolio company those losses are essentially useless to Microsoft. Microsoft cannot take advantage of the tax losses to the same extent that your portfolio company can. If Microsoft could take advantage of those losses, the acquisition would have a greater value than without the useable losses. Presumably, the portfolio company would command a higher price than it could if it could not deliver useable losses. The key here is the change of ownership rules. As a result of these rules, your portfolio company can lose the benefit of NOLs in the context of an IPO and, even, where there are multiple rounds of venture financing with large new investors in each round. The concept of requiring continity of ownership to retain the full use of NOls, is antithetical to the venture model, which relies upon exits (i.e. changes of ownership) to provide returns to its investors.
RightThat’s a big issue, but it’s been that way for quite a while nowI’ve just accepted thatMaybe I shouldn’t
Three things: (1) It was not always this way. NOLs used to be able to be transferred until Congress corrected certain abuses. The rules just went too far. (2) I understand that there is some reconsideration of the NOL rules going on. Now is the time to push for a change. Anything that would encourage exits and increase returns would be good for the industry. (3) I have been tilting at this windmill for a while, and trying to get anyone in the industry interested is, shall we say, tough. At the risk of paraphrasing Kris Kristofferson, “tax is just another work for soporific.”
should we really be classifying all of VC as a single asset class? it seems highly dependent on investment sector and size of fund. the nature of technology investment and the potential for returns has changed dramatically over the past 10 years. a $500m – $1b fund can no longer invest solely in tech to generate the returns they require. that’s why they need to get into green tech. so it seems like a gross simplification to classify all VCs under one single asset class, when the capital requirements and scale of returns vary greatly.any LP should be evaluating their VC holdings based on sector and fund size, rather than VC’s as a general asset class on its own, no? if an LP is investing in a $500mm fund that is focused on web 2.0, seems like their prospects for returns are pretty low. if i’m a pension fund, it seems more prudent to say you’re going to put 50% of your VC money in a few large greentech funds, and the other half spread across a lot of <$200mm funds that invest in tech, rather than just saying I put the whole amount in VCs in general. i would assume they already break it out this way, but based on the post, the discussion is around VCs as an industry which seems to be an over simplification.
Well all of that is true but I wrote this post because one of our LPs is questioning whether they should be in the VC asset class at all and they are in all of those sectors. So for them, it’s one big bucket and they are trying to decide if they should keep the bucket or empty it
I can speak for the biotech space and at this point, the numbers might be larger (compared to tech), but the percentages and returns are no different. I would say the summary here is that VC is a dying asset class in regards to the overall investment continuum, but it of course will always be around, because innovation at that level delivers so much more value to our financial markets and economy than can be directly measured or quantified in index or IRR form.
How do VCs see a decrease in VC funding affecting startups in the long run? From an entrepreneur’s perspective (at least one from Canada, where significant funding is very limited until a profitable business model is proven) it seems like a decrease in LPs should be a good thing for many entrepreneurs- especially the ones who are outside Silicon Valley.The amount of venture funding available to some companies seems like it has allowed them to operate without serious cost considerations, essentially undercutting potentially viable competitors that need revenue to operate. If GE sold light bulbs at a significant loss, intending to undercut the competition and push competitors out of business, that would be considered anti-competitive. Similarly anti-competitive behaviour in the startup space probably isn’t going to attract any anti-trust attention, but I wonder if this early kind of competitive advantage might lead a growing company astray as it seeks to become a profit generating company. VCs and acquirers seem to have been focused on total user base (and the underlying network effect) for the past few years, and their money has been necessary to operate many web companies given this environment so most companies have geared themselves towards this kind of growth.I wonder, however, how will the environment change in the future if companies need to focus on both growth and profitability? Growth rates would be slowed, but long-term profitability potential would be based on a user base with proven value rather than a large, but unproven user base. How will VCs interpret this? Metrics like user growth rate are fantastic for acquisitions (since the companies will hit the peak of their growth curves much quicker), but long-term profitability is the key for businesses in most other industries. If the VC model is based on 5 – 7 year investment horizons, isn’t there a major incentive to stay focused on acquisitions and t/f fast growth and possibly unsustainable business models?
I don’t think it ever makes sense to invest in unsustainable business models
Walter Wriston once said ‘capital goes to where it’s welcome, and stays where it’s well treated’.With the upcoming replacement of 1999 with 2009 in the asset return calculation, it’s clear the venture asset class has not treated its investors optimally from an absolute return perspective. Certainly so, when adjusted for risk.It’s great to see your post generating robust comments on the various aspects of the venture business model and thoughts for going forward.
First, Steve Kane “wins” the threat. Second, for LPs, running away from the class seems like a primitive, simplistic solution. Tweaking the system may be better: preferred returns as suggested here; clawbacks in subsequent funds, etc.I want to add a few thoughts, that some LPs may find attractive:1. Requiring GPs to invest 50% of their net worth in the fund, as determined by an independent accountant, (up to a certain percentage of the fund).2. Fee-capping, say at $300K per yr per partner, would put focus on raising optimal fund size, rather than inflating funds for the fee stream. (see the article in Forbes on DFJ from December, for example…)3.Tighter rules on marketing. OVP, for example, a firm I had to deal with, raised a record VII fund, after V and VI were total stink-bombs. How? I don’t know, but some things raise a question, such as: investing in and providing continual employment for one of the Board members on their largest LP, Oregon PERS; or using my company, nanoString, to market their brand in a way that I believe hurt us, etc. etc.Lastly, I believe that these large institutional LPs may want to look carefully at the interdependencies between their VC class and their public equity. The best example is Skype. It got sold at a huge premium relative to what most every observer thought was warranted. Good deal for LPs? Well, perhaps, given that some of the “moolah” went to fees, carry, and to cover some of the blowups at DFJ, such as GreenFuel, for example.The point, however is: if the same LPs held E-Bay in their public equity funds, they got stuck with the bill. Big money changes hands, the VCs get theirs, but at the end – since the economic value created did not match the size of the transaction – somebody has to pay the bill… And it ain’t Meg Whitman’s returning her bonuses, I have to tell you. (in fact she will likely use some of it to bankroll her campaign for Governor; something to keep in mind if you are in California)
Krassen,Your point regrading Skype and eBay is very interesting. It highlights the fact that unless a company is sold at fair value (which is generally only knowable with hindsight) there will always be a winner and a loser in the transaction.However, it’s my guess that even if the LP’s owned eBay in another part of their fund, chances are its overall weight would not be so high as to offset the positive impact from the VC component.It’s certainly food for thought, though.
It was a specific example… During the first Internet mania, many VCs made good returns through IPOs and M&A, however most of the thus resulting public shares then got slaughtered in the 2000-2002 tech bear market. For many of the institutions with public equity funds on the side, it was “take it from one pocket, put it in the other”, minus the fees and carry paid to the GPs…If I was an institutional CIO I would look into correlation and anti-correlation patterns between public and private equity funds and manage risk accordingly…
Great discussion about the merits of fair values in all transactionsOne thing I would say is there are buyers who can turn nothing into something. Cisco in the 90s was such a companyThey massively overpaid for a bunch of comm equipment companies but got huge returns on those dealsThe same could be true of some web acqusitions but they have been handled terribly for the most part. Google’s acqusitions of applied semantics and the google earth products are examples of good deals though
I wonder how much of the decreasing return profile is due to the shifting focus in the industry. As larger and larger funds become more focused on later stage investing simply because it is the only way to effectively put capital out I would expect overall “VC Industry” returns to start looking like the old VC returns blended with what was formerly the IPO market (which doesn’t have very good historic returns). In addition, if there is an overall weighted-average trend toward later stage investing then the asset class as a whole may have a different risk profile and the lower risk justifies the lower returns (although I doubt this).I think as funds and companies become the new alternative to IPOs they will preform accordingly, namely not very well..
Good pointLate stage VC is the new IPO market without liquidity for the early stage investors!
My question is why. Why is VC only earning 9 percent? Is it too much money after too few deals? Is it that the system is broken – not geared for the 21st century? Has investing in people been replaced with investing to out do each other? Is the shot gun approach bad?Might want to think about fixing the system – before all investors run to bonds or other securities.
It is a bunch of reasons, some of which you’ve identified and some that others have identified in this comment thread.In the investment world, the way sectors get fixed is capital leaves them. So its unlikely to get fixed until “investors run to bonds”
@fredwilson: You wrote: “VC has not proven that it can scale as an asset class since the mid 90s.”I would add that before the 90’s VC was too young and had too little dollars committed to it to make it scale. So effectively, VC has never really scaled. In fact, I argue that it never should be scaled to be that big. At the right size, VC can produce great returns; but those returns do not scale linearly by cranking the knob on the amount of capital deployed in the asset class. IMHO, Venture Capital should be a boutique industry (see the blog post at http://www.k9ventures.com/2….Would love to hear your opinion in a future blog post.
I agree completelyI think you nailed it in your post
I would enjoy some feedback on some number crunching we have been doing:There seems to be a significant difference between median and average returns for VC-backed company exits. We don’t have access to the best and most comprehensive data on this but what data we have suggests a median of around $40 million (completed some analysis in 2003 and recently updated it for 2008), so it excludes the bubble years.Over the past 15 years, more money has flowed into VC and there has been a significant increase in the transparency and velocity around information (so, for example, good ideas are kept less secret and often copied more). If correct, then more money, more transparency = more copies (35 ‘white label’ enterprise social media applications for instance). All things equal, that does not bode well for median values.In addition (and again with only a partial data set), the ratio of average capital under management per professional has gone up (15 year view – and certainly true of our market area). One outcome of this is that each professional individually must put more money to work which in many (most?) cases means more money per company. So, post money values have gone up as well (last point is where our data set is weak).If median exits are $40 million (with recent downward pressure due to economy and more competition), average capital invested per company is up, average post money values are up…then a firm won’t possibly meet or exceed median portfolio targets (3.5-4x gross) unless that set of professionals has a top quartile or even better portfolio. We just can’t get the median math to work. If your series A post is $12-15 million, and if you have 67% success rate, then at a median exit your proforma median fund performance is around 2x (gross).If you believe this than it suggests a smaller, less capital per partner/professional (meaning potentially less total compensation), less money per company, targeting median exits fund strategy is a model that might work. (at least we hope so)What we would really like to do is to get a comprehensive data set to test our partial data set math.
I can’t help you with your dataset issues, but your observation about top quartile is correctI’ve heard in the IT sector, 20 firms produce all of the returns