Traditional Venture Capital Sure Seems Broken - It's About Time

The traditional venture capital model formula in technology was simple from 1945 to 1995. It was a form of arbitrage based on two scarcities -- risk capital and understanding of technology.

Starting in 1995 the scarcity of both these drivers began to disappear. Technology became globalized and widely accessible in the 1990s. Lots of investors saw the same basic phenomena of technology evolution driving platform changes driving disruptions. The venture capital contraction of the early 90s created a scarcity which, together with a monster platform change, caused triple digit rates of return. Suddenly the world was awash with venture capital.

The boom was followed by a bust post-2000, sort of. Normally you would expect investors to run from the venture capital asset class when the class posted negative rates of return for several years in a row. But this is what is broken. Capital continues to pour in, perpetuating the abundance that makes capital cheap, despite the poor performance of the asset class.

I was at a dinner about two years ago with a bunch of VCs. Two were long-time partners in venture funds, each having been through at least six fund cycles, each with a (then) current fund in excess of $1B. One was lamenting to the other that venture capital “may become a fee-based business because capital gains were likely to be zero for a long time. “ The other concurred, stating “how hard it is to attract new partners because $2M per year in current income wasn’t enough to attract the right people.” Since that dinner one has raised a new fund (>$500M) and added two new partners. The other left the VC business and is raising a hedge fund.

I am sure you are as aghast as I was at hearing this, on so many levels. But their fundamental point was correct. The traditional venture capital model has been “fund twenty, pray for two.” Since you could only lose 1X your money, you could make it up with a couple of big hits. But big hits are fewer and much farther between than ever before. To make a modest venture return on a $500M fund, you need to generate $1B. Assuming you own an average of 20% of companies at the exit, you need to create $5B of shareholder value. If the average IPO valuation is $216M (per VentureOne, according to a WSJ article last week), that means you need 23 IPOs in a portfolio of 30 companies. The math worked when venture funds were $200M and exits were $500M. It doesn’t work when the numbers are reversed.

Venture capital is a three parameter problem. Buy low, Sell High, Sell at the Right Time. Most people seem to have ignored the third parameter. Time-to-exit used to be 4-6 years. Then it collapsed to 2 years in the Bubble. Now it seems pretty much infinite. Divide by Zero and get infinite IRR. Divide by infinity and get -100% IRR. The proof is left to the Investor.

I can only see two venture capital strategies that make sense in this environment. One is to be small, focused, and totally aligned with market realities and founder incentives. There is no magic to this strategy. It just takes discipline. If you have a small fund, place small bets, be maniacal about capital efficiency. (Paradoxically, you can get further on less capital than ever before.) Place small bets in multiple companies along an investment theme. (My theme is the Semantic Web – its precursors and its implications. We’re not there, yet, but the progression is inevitable and undeniable.) Then even the small outcomes can provide a venture return. Turn $100M fund into $200M. Competing for good deals as a small firm means educating entrepreneurs about the reality of exits. You will lose deals to big players who have more capital to throw around. But the ones you win will be more sophisticated and more aligned with the fundamental objective of making an ROI.

You would think that cheap, abundant capital was a great boon for entrepreneurs. It isn’t. The reality of startups is that you spend what you have. The more cash you have in your pocket, the less you value each dollar. It is human nature.

Lots of cheap capital, available at high valuations seems great, until you do the exit math. Raise $8M at $12M pre-money and your post-money valuation is $20M. Your investors want to sell for $200M. Raise $2M at $4M pre- and your investors get the same rate of return at $60M. But a $60M exit is 10X more likely than $200M. Few VCs will write the $2M check these days, precisely because a $20M return doesn’t move the needle in a $500M fund. That’s why valuations are moving up – the need to invest more money – not the intrinsic value of startups. Higher valuations and high venture rounds may feel good in the short term, but with IPOs as scarce as they are, they can price you out of the very exit you seek.

The other strategy is to treat venture capital as one of many capital markets to search for inefficiencies across the private-public spectrum. Private equity firms have tended to specialize in stages and sectors. As the scarcity of risk capital and technology insight have disappeared, opportunities no longer align well with stages or sectors and they don’t last very long. Therefore sector-based or stage-based funds can’t rely on a 4-5 year window for finding opportunities in their focus area. But this sort of “venture banking” model is not easy for most private equity investors to understand. It is decidedly opportunistic and its strategy cannot be easily explained to an investment committee. But without the ability to flow capital into public or private, debt or equity, long or short, it is hard to see how a $500M fund is going to generate cash-on-cash return in a short enough time frame to create a venture rate of return.

Both these strategies focus on time to return in addition to absolute return. Time is a precious asset in the investment business. When P/Es were high and the public market was accessible, returns swamped time in the calculus. Now Time is as important as Return and investment strategies have to optimize for time to liquidity as well as absolute outcome. If you see early exits in early stage investments, it can look like "build-to-flip." It isn't. It is building a company with multiple exits paths along the way. If you see rapid exits from public market investments in small companies, it, too, is about anticipated future return divided by time.

Undoubtedly there are other strategies to produce above-market returns in a world with too much capital. These are two I like and understand the best. If there are others out there that seem to work, I’d like to hear about them.

The new scarcity in the venture business is the Big Exit, not the Big Fund. At least not yet. It's about Time.

Comments

[Andrew Fife]

Peter:
I've never fully understood the "need to move the needle" argument for focusing on larger deals instead of quality smaller deals. Its clear to me that a $500K deal may take as much time as a $5M deal and with a limited number of venture/general partners larger funds need to focus on larger deals. What I don't understand is why this funds don't hire more people and switch to an investment banking structure bringing on less experienced (but still very smart) people to manage the smaller deals and/or take some of the less nuanced work off the partner's desk. What do you think?
-Andrew

[Peter Rip]

Well, the leverage model doesn't really solve the problem. The problem is the scarcity of big exits.

If you are going to go earlier, paradoxically you need more senior investment professionals. I have never met (or been) and entrepreneur who relished the idea of being the site of on-the-job-training for an associate. You still need a partner involved.

[Andrew Fife]

It does seem like its common to work with young smart people in other lines of business like the management consultants, investment bankers and corporate attorneys where you may have a senior partner managing your account but an analyst is doing most of the dirty work. I certainly do think there are a lot of entrepreneurs that are desperate enough for capital that they don't care who it comes from. However, if these desperate entrepreneurs do not represent quality deal flow than your point would clearly still hold.

[John Koontz]

Peter,

The problem that my partners and I have is not that we don't foresee a big exit, but that we don't require the typical first round of investment. $1M-$2M, or maybe even $500k, would get us going. We're cash flow friendly (we think), but are heavily dependent on the network effect. Thus, we need a strong push at the launch of the service. $5M and the requisite dilution is overkill. While Angel funding is an option, VCs bring much more to the partnership.

(I'd list our URL, but we're not quite live.)

-John

[John Furrier]

One analysis grossly missed here is the venture development build cycle reality overlaid on the time series.. in other words a big fund can compete when you look at the "option to abandon" as a variale in the overall return calculation.

In other words the time it takes to evaluate the ventures traction is accelerated and optimized in the new Internet environment so the ability to cut or abandon the deal skews the NPV and IRR calculation in favor to the venture firm. So the sooner a VC firm can abandon the more distibuted the 'joint probabilities' of wins will be across the working ventures.

Peter, I agree it is about 'time'.

The new axiom is "invest fast and abandon quickly"

[Frank Miller]

I've also observed this trend from the other side. Lots of deals with small initial and even second round amounts. However, I'm curious about your thoughts on another factor. Venture capital is just one type of product for an Entrepreneur looking for money. There are Angels and simple lending vehicles. The small amounts required for the new early rounds make these other vehicles much more attractive because they are not as "expensive" to the company seeking the funding. When you look at this as a force in a simple supply and demand equation for the capital market in general, it only exacerbates your argument about how its getting harder for VCs to get their needed ROI. One might think that a natural result would be that VCs would have to become "less expensive". However, I still hear about lots convertible debt and liquidation preferences. It does seem that something is broken, I'm just not as sure about what you are suggesting as the central cause.

[John Koontz]

It's not just the money, though; at least from my perspective. A VC also brings management experience, industry connections, recruiting help, more street cred, board of directors input, etc... So the product is more than just dollar signs.

[Frank Miller]

I think you're right but I also think that VC firms can be partitioned on this point. There are clearly a set of VCs that are very well connected. I see these VCs as basically handling the early, high-risk portion of an investment that a potential acquirer would be interested in later on. There are also a lot of VC firms that are less "connected." These firms tend to be groups that may be either delving and/or branching out into areas they may not be as familiar with and/or don't have specific partner experience with. This partitioning does refine my argument. The first group is clearly quite valuable and so the added expense associated with their investment pays for itself quite easily. This latter group is actually much MORE expensive. They will not be able to help much, be it connections or recruiting, or BD or whatever. That lack of help probably makes it harder for the company to reach its goals, which means they need more investment to get where they want to be, which means the company has give sell more of itself to get there.

[Christopher Allen]

Your analysis of the current state of the VC industry closely parallels lessons from my experience as an angel investor. You might find some useful perspectives at the lower end of venture funding in my blog entry "On Being an Angel" http://www.lifewithalacrity.com/2006/01/on_being_an_ang.html

[Paul]

Peter,

All great points, but there doesn't seem to be a solution to the overabundance of capital. If you posit that $100m is a more optimal fund size in VC (which I agree with), then how does the industry overcome the fundamental problem of institutional investors who are (a) increasing their overall asset allocation to VC, (b) can't commit more than 10% of a fund yet don't write checks for less than $20-25m, and (c) are usually understaffed, underpaid and busy outsourcing their decision process to advisors with their own funds-of-funds?

Until the industry structure completely breaks down (say after a decade or so of underperforming the S&P), the $1B+ funds will continue to swamp the market and cause havoc for us smaller, focused groups. Can't wait for them to implode.

[Zach Gentry]

I own a small company exploring a niche application for wireless sensor networks. I agree with most of your comments but wanted to amplify one of the points you made.

You stated: "Paradoxically, you can get further on less capital than ever before." Indeed, this means that there is the possibility to create excellent products faster and more responsively than market incumbents. Given the hunger of contract manufacturers for new products, it is also possible to get these products to market at a price that would be difficult to beat.

[Bill Burnham]

Hi Peter,

Amen. I agree wholeheartedly with your oberservations as well as your conclusions. If you raise a $500M+ "early stage venture capital fund" you might as well call it a fee management business.

I personally am a big believer in option #2, however it will take a sea change in LP mentality.

Bill

[Mark Montgomery]

I agree with Peter, Bill, and most others on fund size, especially at the early stages, which is where we live.

One of our competitive advantages is that since we lack a large fund and associated fees, we don't spend all of our time at conferences, but rather more on the technology and teams.

A couple of observations however from the trenches. As is often the case, generalities don't work well in VC- it's a case specific game.

For example, I find myself referring angel groups for one specific type of venture at one specific stage of its lifecycle in one specific geography and industry, but others are not suited at all for angels.

Later the same week (occasionally the same hour) I might see an early stage nano or biotech start-up that really needs a large round to make it across the valley of death to even find out if the drug in question has deadly side affects..... best have a large fund to play that game and still be able to diversify risk.

I have a great deal of respect for those funds who could have raised huge funds but have instead made the decision to remain a value creater rather than a fee collector.

While management fees are necessary- we have overhead like any business, but it can be years before we experience a decent liquidation event, the incentive should remain in the carry, not the fees. LPs have no one but themselves to blame for this trend, but we all pay the price.

I wrote a piece on this a couple of years ago if anyone is interested:

The role of institutional capital in early-stage venturing: 2003 and beyond
http://www.altassets.com/features/arc/2003/nz2060.php

Mark Montgomery

[jim Forbes]

Peter,
This is one of the best short essays I've ever seen on what's wrong with the venture capital business.
Best,
Jim Forbes

[DaveMc500Hats]

right on target. bad news for big VCs. probably good news for angels & entrepreneurs.

related post & comment (entrepreneur's perspective) on Allen Morgan's blog, who seems to arrive at a very different conclusion from Peter.

- dave mcclure
SimplyHired.com

(ps - i enjoyed the mashup panel discussion peter)

[Igor Sill]

Peter, you are absolutely correct. Smaller funds, by their nature, are required to be more focused, disciplined, efficient and participatory in their investments. The main difference is one of truly bringing the right resources to a startup versus praying that one in twenty will be a success. Nice to see that you and Leapfrog are doing well. Best
Igor

[Vinit Nijhawan]

I would add one other point that ensured “fund twenty, pray for two.” In the 80s and first half of the 90s, the venture business was collegial. As a result no space had more than three companies funded by VCs. This natural oligopoly was very rewarding for VCs and management: one of the three companies generally had a smashing exit, the second an OK exit and the third didn't make it.