Understanding Venture Capitalists
I have been a banker for a long part of my career, I also remember that I took a course already in 1982/83 at NYU in New York about Venture Capital. Pretty much the first statement of the guy teaching the class stuck with me until today. He was a partner in a VC-Fund and started like this: “VC is pretty simple: you have to have a track-record to be able to acquire money from LPs, you then have to invest relatively quickly in 50 companies since your fund will only run for approx. 7 years and your results will be: 1 company hits it big, 2-3 will be ok and the rest you probably have to write off. But that way you will yield 25% p.a. and everybody will be happy!”
Well, looking at today’s landscape it seems a lot harder to reach these results and it also seems that LPs, even though especially the fixed income investments have been very tricky with the zero interest policies, are still confident in the value VC can provide, but there have been critical comments as well since most performances have not been that great. How come that the results are not as expected?
To me it seems that the strategy mentioned above, probably to be described as “Spray and Pray” is not the favored strategy anymore. Today VCs talk about engaging in 3-5 investments a year and analyse every possible investment very diligently. That means that you also must be pretty sure that it then really works, especially when you are committing to participate in following financing rounds and end up with substantial amounts of money invested. If that does not work, a write off of 5-7% of your total fund can hurt significantly and also means that all others have to bring in even better results. Now if you are still having to face the statistics the guy I described above mentioned, you have to have results like this, assuming a 100 Million fund:
Total companies invested in: 20
Individual commitment: 5 Million
Average shareholding: 25%
Write Offs: 17 companies
Amount written off: 85 Million
Needed results: 25% p.a.
Assumed 5 year term of fund: necessary return without fees 305 Million
Has to now be based on: 3 Companies and a 15 Million investment
What do they have to exit for? 1.22 Billion!!!
So you really need a Unicorn or hopefully more to get the results to make a difference. Is this possible? Yes and no: If you are one of the leading funds having the means to follow rounds of companies on their way to become a Unicorn and eventually hit it big with an IPO or selling really well to a strategic investor etc.: Yes! If you are a smaller fund just following the major ones and therefore of course not being able to have shareholdings of 25% in a single promising company like that: No!
Does that make sense? Did I make a mistake? So what could be a better strategy? Honestly, I don’t know, I feel that especially in the early stages a spray and pray strategy makes sense; you follow your gut and you can achieve the shareholdings necessary to achieve the results described above.
Harder in later stages, when there are already more investors in there and valuations have gone up. Example: you were not able to acquire 25% of a Facebook in a later stage or of an Uber today without compromising the targeted risk-average of your fund.
See how difficult it is? Now, despite a possible disappointment when receiving a rejection letter by a VC you can understand why that is and maybe even have sympathy for the VCs – they are under as much pressure as a startup they invest in to perform!
Picture above: By Mark Coggins from San Francisco (prologue) [CC BY 2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons