In venture capital, returns on investments is the ultimate metric and although it is not very difficult to understand, there are many little tricks worth knowing about!
The reason of this short post is a recent article my friend Fuad advised me to read from the Financial Times : The parallel universe of private equity returns by Jonathan Ford. If you are not a subsciber to the FT (and I am not), you may not be able to read the article so here are short extracts: “Ever wondered about the extraordinary performance figures that listed private equity firms trumpet in their official stock market filings? […] Not only do the firms generate stratospheric numbers — far higher than anything produced by the boring old stock market — but they can apparently do it year in, year out, with no decay in returns. […] The reality is that these consistent IRRs show nothing of the kind. What they actually demonstrate is a big flaw in the way the IRR itself is calculated.”
When I looked at venture capital (VC) returns in the past, I learned you must carefully look at what IRR means. It looks simple at first sight as the next table shows, just simple math:
So the first question you care about is what matters: IRRs or multiples? And my simple answer is “it depends”. Up to you!
Secondly, measuring returns makes a lot of sense when you have your money back. Of course! But IRR and multiples can also be measured while you are still invested and when your investment is not liquid, which is the case for private companies in which invests private equity (PE) – venture capital belongs to PE. You can have a look at a former post of mine, Is the Venture Capital model broken? and among other figures look at this:
The VC performance according to the Kauffman foundation
The peak IRR is measured when your assets are not liquid whereas the final IRR is when you have your money back… A fund as usually a 10-year life (or 120 months) and you can check the peak IRR month.
Even more tricky, the money is called by periods to make the holding as short as possible: basically, when the money is needed to invest, though you commit to it for the full life of the fund. Measuring the real IRR begins to be complicated but what matters to me is the multiple from the day of commitment to the finaldah when the money is back… And to you?
A final point I love to mention all the time is that VC is not so much about a portfolio of balanced investments. In the same post mentioned above, I added two links, and one of the best quote is “Venture capital is not even a home run business. It’s a grand slam business.”
“Prediction is very difficult, especially about the future.” attributed to Niels Bohr.
I was asked yesterday which startups I knew were the most promising, not to say the greatest. So I prefer to refer you to the quote above as I did not understand the potential of Google and Skype when I first heard of them. I am less shy of my lack of talent as this difficulty in predicting has been acknowledged by others.
First from the book The Business of Venture Capital on page 207:
Legendary investor Warren Buffet admired Bob Noyce, cofounder of Fairchlid Semiconductor and Intel. Buffet and Noyce were fellow trustees at Grinnell College, but when presented, Buffet passed on Intel, one of the greatest investing opportunities of his life. Buffet seemed “comfortably antiquated” when it came to new technology companies and had a long-standing bias against technology investments.
Peter O. Crisp of Venrock adds his misses to the list: One “small company in Rochester, New York [came to us, and one of our junior guys] saw no future [for] this product… that company, Haloid, became Xerox.” They also passed on Tandem, Compaq and Amgen.
ARCH Venture Partners missed Netscape – that little project Marc Andreessen started at the University of Chicago. An opportunity that, according to Steven Lazarus, would have been worth billions! “We just never knocked at the right door,” he would say. Eventually, ARCH decided to hire full-time person to just keep tabs on technology coming out of the universities to “make certain we don’t miss that door next time.”
Deepak Kamra from Canaan Partners comments on his regrets: “Oh, God, I have too many … this gets me depressed. A friend of mine at Sun Microsystems called and asked me to meet with an engineer at Xerox PARC who had some ideas to design a chip and add some protocols to build what is now known as a router. The drivers of bandwidth and Web traffic were strong market indicators, and he was just looking for $100,000. I really don’t do deals that small and told him lo raise some money from friends and family and come back when he had something to show” That engineer was the founder of Juniper Networks. He got his $100,000 from Vinod Khosla. Khosla, then with KPCB, added an IPO to his long list of winners. Juniper slipped out of Kamra’s hands because it was too early.
And of course, those were frothy times when everyone was deluged with hundreds of opportunities each day.
KPCB missed an opportunity to invest in VMWare because the valuation was too high: a mistake, according to John Doerr.
Draper Fisher Jurvetson (DFJ) was initially willing but eventually passed on Facebook (ouch!), as the firm believed the valuation was too high at $100 million pre-money.
KPCB, not wanting to be left out of an opportunity like Facebook, invested $38 million alt a $52 billion valuation.
Tim Draper of DFJ, turned down Google “because we already had six search engines in our portfolio.”
K. Ram Shriram almost missed his opportunity to invest in Google when he turned the founders away. “I told Sergey and Larry that the time for search engines had come and gone but I am happy to introduce you to all the others, who may want to buy your technology. But six months later, Ram Shriram, who had once turned Google down, now invested $500,000 as one of the first angel investors.
Now some examples of the updated BVP antiportfolio:
AirBnB: Jeremy Levine met Brian Chesky in January 2010, the first $100K revenue month. Brian’s $40M valuation ask was “crazy,” but Jeremy was impressed and made a plan to reconnect in May. Unbeknownst to Jeremy, $100K in January became 200 in February and 300 in March. In April, Airbnb raised money at 1.5X the “crazy” price.
Facebook: Jeremy Levine spent a weekend at a corporate retreat in the summer of 2004 dodging persistent Harvard undergrad Eduardo Saverin’s rabid pitch. Finally, cornered in a lunch line, Jeremy delivered some sage advice, “Kid, haven’t you heard of Friendster? Move on. It’s over!”
Atlassian: Byron Deeter flew straight to Atlassian in 2006 when he caught wind of a developer tool from Australia (of all places!). Notes from the meeting included “totally self-financed, started with a credit card” and “great business, but Scott & Mike don’t ever want to be a public company.” Years and countless meetings later, the first opportunity to invest emerged in 2010, but the $400m company valuation was thought to be a tad “rich.” In 2015, Atlassian became the largest tech IPO in Australian history, and the shares we passed on are worth more than a billion dollars today.
Tesla: In 2006 Byron Deeter met the team and test-drove a roadster. He put a deposit on the car, but passed on the negative margin company telling his partners, “It’s a win-win. I get a great car and some other VC pays for it!” The company passed $30B in market cap in 2014. Byron paid full price for his Model X.
eBay: David Cowan passed on the Series A round. Rookie team, regulatory nightmare, and, 4 years later, a $1.5 billion acquisition by eBay.
When I published the book which is the “raison d’être” of this blog, I had shortly analyzed the correlations between venture capital level in the USA, the Nasdaq index and their relationship to “crises”. Each peak and bottom level could be easily explained. I updated it to today levels with idea of revisiting when we zill be out of the Covid19 crisis. Comments welcome!
I just learnt the death of Don Valentine, the founder of Sequoia. For those of you who may not know him, you could visit my previous posts that mentions him, either through tag #sequoia or even better search Valentine. Just be aware he invested in Atari, Apple, Oracle, Cisco, Electronic Arts…
Or you may just read some of my favorite quotes of him:
“There are only two true visionaries in the history of Silicon Valley. Jobs and Noyce. Their vision was to build great companies … Steve was twenty, un-degreed, some people said unwashed, and he looked like Ho Chi Minh. But he was a bright person then, and is a brighter man now … Phenomenal achievement done by somebody in his very early twenties … Bob was one of those people who could maintain perspective because he was inordinately bright. Steve could not. He was very, very passionate, highly competitive.”
“Well, look, we’ll put up all the money, you put up all the blood, sweat and tears and we’ll split the company”, this with the founders. Then if we have to hire more people, we’ll all come down evenly, it will be kind of a 50/50 arrangement. Well, as this bubble got bigger and bigger, you know, they were coming and saying, “Well, you know, we’ll give you, for all the money, 5 percent, 10 percent of the deal.” And, you know, that it’s a supply and demand thing. It’s gone back the other way now. But, in starting with a team, it’s a typical thing to say, well, somewhere 40 to 60 percent, to divide it now. If they’ve got the best thing since sliced bread and you think they have it and they think they have it, you know, then you’ll probably lose the deal because one of these guys will grab it.”
I just read about Sebastian Quintero’s data analyses on start-ups on his web site Towards Data Science. Thanks Martin H. 🙂 I was really fascinated about his original way of looking at them, their failure rate, the valuation prediction, their runway between rounds, and his Capital Concentration Index or Investor Cluster Score. You should read them.
Of course, it rang strong bells with all the data analyses I have done in the recent past 8see end of the post if you wish)
So as an appetizer to Quintero‘s work, here are a couple of figures taken from his site…
Introducing the Capital Concentration Index™ Where c is the percentage capital share held by the i-th startup, and N is the total number of startups in the defined set. In general, the CCI approaches zero when a sector consists of a large number of startups with relatively equal levels of capital, and reaches a maximum of 10,000 when a sector’s total invested capital is consolidated in a single company. The CCI increases both as the number of startups in the sector decreases and as the disparity in capital traction between those startups increases.
Yesterday, in Do Ex-Startup Founders Make The Best Venture Capitalists? I mentioned CB Insights analysis about the background of the top VCs, and expressed my doubts about comparing founders vs. non founders. So I used the Top100 list and had a different look: what about the background in high-tech or not? Here are some charts. Quick and dirty so do not take it as a scientific analysis. Still…
First a point of caution. This list is a little strange and the authors know better than me, but I am sure this list is not highly subjective… Now it seems founders were never a majority and VCs with no high-tech experience always a majority. Now what is puzzling is that these VCs are rather young and that a high majority of them having been in the business for less the 20 years… interesting. What would have been the results of the VCs active in the 70s and 80s? Not sure…
Also the change in the last 15 years is not the ratio with a tech background, but the ones who are founders has increased and the ones with no tech background has decreased…
Interesting question as I have often claimed that there was a difference between US and European venture capitalist (VC), which had been also illustrated in the past by Tim Cruttenden (see below).
CB Insights, a leading firm analyzing data about start-ups, looked at the experience of VCs: Do Ex-Startup Founders Make The Best Venture Capitalists? The next figure illustrates their results and they additionally claim: “Of the 100 VCs, 38 founded or co-founded a company before becoming venture investors, while 62 did not. Six of CB Insights’ top 10 investors haven’t founded a company. That includes the top two: Benchmark’s Bill Gurley and the recently retired Chris Sacca.”
However interesting, I would have preferred a different analysis: how many had a direct experience in technology firms, whether in product / technology development or on the business sides such as sales or marketing compared to teh ones who were “only” consultants or bankers. This would be highly important as the value you bring t the board level may be entirely different. Look at what Tim Cruttenden explained in 2006.
Indeed Cruttenden says “entrepreneurs” too, but if we remember that Kleiner Perkins and Sequoia had a lot of managers more than entrepreneurs then, we might have obtained another measure of what makes a good VC…
After my initial notes (part I), the importance of culture (part II), the recipe (part III) in the Rainforest by Hwang and Horowitt, here are my final notes about venture capital. It may indeed be their best chapter, even if the topic has produced probably hundreds of books and thousands of articles… Their (apparent) bias as venture capitalists is only apparent. Their description is close to what I experienced but I may be biased too!
The subtitle of the chapter is “Big V, Little C” and their quote to begin the chapter is “if you want to make money, do private equity. If you want to have fun, do venture capital”. They then borrow to AnnaLee Saxenian: “In Boston it was the entrepreneurs who dressed nicely and showed up on time to impress the investors. In Silicon Valley it was the opposite.” […] “In other words, the venture – that is the startup – is always more important than the capital, with a Big V and a Little C.” [Pages 218-21]
They explain why investing in the seed and early stage is costly for venture capitalists. “It’s better to buy a wonderful company at a fair price than a fair company at a wonderful price. […] Investing earlier in a deal must be counter-balanced by a strong potential of a massively disproportionate payout at the end. Otherwise, it is simply not worth the risk. […] Lowered transaction costs due to trust and social norms make high-risk seed-stage and early-stage venture capital more profitable [in Silicon Valley].” [Pages 228-29]
In other areas, subsidized capital plays a role. But it does not mean VC should not be understood: “There are two ways to build a venture fund. One takes as little as thirty minutes to learn. The other can take twenty years or more. The short course is to learn the formal legal structuring and financial processes of a typical venture fund. […] the more difficult and time-consuming course is to learn the human behavioral dynamics that happen in and around venture funds. […] Questions such as:
– how do you treat others in situations where mistakes and failures happen almost daily?
– how to build a reputation for trust, candor and integrity when millions of dollars are at stake?
– what type of value can you provide an entrepreneur who probably knows far more about the business than you do?
– how do you actively listen to an entrepreneur, and then see beyond their words to the true prospects of a company?
– how do you know when a CEO is not fit to run a company anymore?
– how do you help a tiny company build life-or-death relationships with huge, powerful customers or strategic partners?”
It reminds me what I learnt 20 years ago: it takes 5 years and $10M to make an investor.
The authors conclude their chapter with marvelous documentary SomethingVentured: “[VCs]’re working really hard, they’re very bright, they’re working together, and they’re collaborating. And there’s a lot of fun involved in achieving things together as a group. So I don’t think you can underestimate how much fun the people… had doing what they did. I think they’re extremely proud, but when they talk about these stories, they’re laughing, they’re smiling. There’s just this excitement and energy about building something.” [Page 242]
Again and again, I am asked how VCs make money, or more precisely what is their success and failure rate. A typical answer is they fail with 90% of their investments which is balanced by the remaining 10%…
I had also looked at Kleiner Perkins 1st fund in 1972: About Kleiner Perkins first fund. In that fund of $7M, Tandem and Genentech generated >100x returns and 90% of the fund returns. Six of the 17 investments did not make a positive return.
Now Horsley Bridge, a famous fund of funds, shared data on 7’000 investments made by VC funds between 1985 and 2014. This was shown in two blogs articles (In praise of failure & the ‘Babe Ruth’ Effect in Venture Capital) and the overall result is
• Around half of all investments returned less than the original investment,
• 6% of deals produced at least a 10x return, and those made up 60% of total returns,
to the point that the second article claims “Venture capital is not even a home run business. It’s a grand slam business.” Basically venture capital is not about portfolio diversification, it is about Black Swans. I add here two charts coming from the 1st article and which are particularly striking:
The Kauffman foundation explained in 2012 that the returns of venture capital have not been as good in the last 10 years as they were in the 80s and 90s. The reports also shows something which is quite well-known I think: the VC “industry” is much bigger than in the 90s, but with fewer funds. The explanation is simple: individual funds have grown from $100M to $1B+… The conclusion of the Kauffman foundation is that funds of funds, pension funds, limited partners (LPs) should be careful about where and how they invest in venture capital. Here are some graphs provided in the study.
The VC industry according to the Kauffman foundation
The VC performance according to the Kauffman foundation
In particular, you may see that IRR is a tricky measure as it changes over time (from peak value to final value) during the fund life. The Kauffamn suggests the following:
– Invest in VC funds of less than $400 million with a history of consistently high public market equivalent (PME) performance, and in which GPs commit at least 5 percent of capital;
– Invest directly in a small portfolio of new companies, without being saddled by high fees and carry;
– Co-invest in later-round deals side-by-side with seasoned investors;
– Move a portion of capital invested in VC into the public markets. There are not enough strong VC investors with above-market returns to absorb even our limited investment capital.
The Cambridge Associates report
Cambridge Associates (CA) does not show a very different situation, i.e. there are indeed more bigger funds and a slightly global degraded performance. But CA also claims that the VC performance is not concentrated in a small number of high profile winners. Some elements of information first:
The VC gains according to Cambridge Associates
The VC gains vs. fund size according to Cambridge Associates
Cambridge Associates is not saying the VC world is doing OK, but that the increase in fund size has an impact on the investment dynamics. On the performance, the next figure (from another report) illustrates again the fact that performance may indeed be an issue…
The VC performance according to Cambridge Associates
Bill Curley about unicorns
Bill Gurley is one of the top Silicon Valley VCs. So if he has something to say about the VC crisis, we should listen! No graph in his analysis, but a scary conclusion:
The reason we are all in this mess is because of the excessive amounts of capital that have poured into the VC-backed startup market. This glut of capital has led to (1) record high burn rates, likely 5-10x those of the 1999 timeframe, (2) most companies operating far, far away from profitability, (3) excessively intense competition driven by access to said capital, (4) delayed or non-existent liquidity for employees and investors, and (5) the aforementioned solicitous fundraising practices. More money will not solve any of these problems — it will only contribute to them. The healthiest thing that could possibly happen is a dramatic increase in the real cost of capital and a return to an appreciation for sound business execution.
The crowdinvesting report
So when I read Victoriya Salomon’s report about new financing platforms, I was intrigued. What does she say? “The global venture capital market suffers from unfavourable exit conditions reflected in a drop in the number of VC-backed IPOs and M&As. This trend affects all markets across all regions. In Europe, VC funds have shown less risk appetite by realigning their investment choices on later-stage companies and those already generating revenue. Furthermore, because of the poor performance of many VC funds during the six last years, they struggle to raise new funds, as institutional investors, disappointed by low returns, show a preference for the most successful large funds with a perfect track record. This slowdown particularly affects traditional venture capital investments, while, at the same time, the share of corporate venture capital has significantly increased, exceeding 15% of all venture capital investments by the end of 2012. In Switzerland, the venture capital market has also entered into a phase of decline and is losing ground in the financing of innovation. In fact, Swiss VC companies are suffering from a lack of investment capital and struggle to raise new funds. According to the Swiss Commission for Technology and Innovation, the amount of venture capital invested in Switzerland has shown a disturbing decline of about 40% during the last five years. [Also] venture capital investments in early stage start-ups fell by more than 50% from €161 billion in 2011 to €73 billion in 2012. In contrast, “later stage” participations grew by more than 50% in 2012 reaching €77 billion compared with €34 billion in 2011. While the number of early stage transactions is falling, investment periods are tending to become longer (7 years instead of 4-5) and the capital gain smaller.”
So the analysis is very similar. The VC world has experienced major transformations. The author believes that one solution might be the emergence of new platforms, such as crowdinvesting, which can be described as equity crowdfunding for start-ups. This is indeed an interesting argument. It is a way to scale and extend geographically the business angel activity. Now it could be also that we just need to go back to basics, i.e. less money with smaller funds, investing again like in the 80s and early 90s in less cash spending companies… Whatever the answer, the analysis seems consistent: the VC world has moved in a direction (fewer but bigger funds, in the USA mostly) which may not be good for a world where many more start-ups appear all over the world, not only in Silicon Valley, with relatively modest needs…
First if all this looked elliptic, not to say cryptic, you should read the reports and articles. They are excellent. Then, in a recent interview; I explained that money is needed, but (too much) money can be dangerous. That is I think the main message… you may read below if you want to have my views…
“A Good but Potentially Dangerous Idea” Former venture capitalist, Hervé Lebret is now responsible for Innogrants (seed money) at EPFL. What do you think of the proposal to create a future Swiss Fund?
This may be a good idea, but only under certain conditions. It must be able to hire talented managers because it is an extremely complex business. This is what Israel did when it established its venture capital funds, it brought in experienced American managers. Without the right people, it’s a recipe for disaster. And the fund must have the freedom to invest anywhere, not only in Switzerland. If you want a fund that only invests in Swiss start-ups, we may only create mediocrity. Why?
Because no European fund can prosper by investing only in its own country. It’s a matter of scale. Only Silicon Valley has sufficient critical mass. The Californian model of venture capital is to lose money in most investments and make a few homeruns such as Google or Airbnb. So you need to have ten thousand ideas to create a thousand companies, then one hundred will grow, ten will be successful and one become Google or Airbnb. You must be able to create such a success every five years, and Switzerland just does not have the critical mass. And it is dangerous to focus too much on money. Really?
Yes. Money is a necessary, but not sufficient for success. It requires funds, but also talent, a market, a product and ambition. It is not because we make money available to start-ups that success will come – the other ingredients should also be present. It is true that Switzerland lacks venture capital, but this is not what explains that Google, Apple and Amazon were not born here. This is in my opinion rather a cultural question. We lack ambition and rebellion. And this is the only factor that cannot be decreed by the authorities. Entrepreneurs are satisfied to aim at the creation of a viable firm of modest size, in which they retain control. In Switzerland, the start-ups create fewer jobs than McDonalds. Neil Rimer (note: co-founder of venture capital firm Index Ventures) wrote two years ago: “We and other European investors constantly are looking for world-class projects from Switzerland. I think there are too many projects lacking in ambition and supported artificially by organs – which also lack ambition – that give the feeling that there is sufficient entrepreneurial activity in Switzerland.” I have to agree with him.