A VC - Latest Comments in The Venture Capital Math Problem

Re: The Venture Capital Math Problem

fredwilson — Fri, 23 Oct 2009 18:10:43 -0000

Yup. Think of this blog in that context

Re: The Venture Capital Math Problem

fredwilson — Fri, 23 Oct 2009 18:09:53 -0000

Its only speculation if you have no vision

Re: The Venture Capital Math Problem

fredwilson — Fri, 23 Oct 2009 18:09:30 -0000

Web services are largely a winner take all market if you define the market narrowly enough

In ecommerce, we've got amazon, ebay, craigslist, gilt group, etc

You'd say 'its not winner take all"

But each of them owns a category

Re: The Venture Capital Math Problem

fredwilson — Fri, 23 Oct 2009 18:08:51 -0000

It is success leads to more success until you let success get to your head. I try so hard not to do that. Its hard

Re: The Venture Capital Math Problem

Sean Glass — Wed, 21 Oct 2009 11:22:10 -0000

Great comment. I think that in addition to better information, the way that top tier VC's separate themselves from 2-4th quartile VC's is through better relationships. If you consider the idea that the value of a network grows at an exponential rate (the size squared), then the VC's that build a large network of close relationships will build a proportionately large differentiator versus other funds. This is why great VC's keep up relationships with so many different people (entrepreneurs who have succeeded, failed, are too early, that they missed out on investing in, etc...)

Re: The Venture Capital Math Problem

Sean Glass — Wed, 21 Oct 2009 11:13:41 -0000

Great point re: asset class... your comment makes me think of some of the arguments Ben Graham and David Dodd make in Security Analysis.

Graham would say that there is no more an apt example of speculation than venture capital. He would term it "Venture Capital Speculation" and would probably quiver at the idea of it being called Venture capital "investment" as there is no safety of principal and no margin of safety :-)...

He does say speculation done right (intelligent speculation) can be very profitable, just that it's much harder than through intelligent investment

Re: The Venture Capital Math Problem

Sean Glass — Wed, 21 Oct 2009 11:00:55 -0000

But doesn't lower startup costs + more capital = creation of more competition = lower margins = lower returns unless you back the company that ultimately wins and absorbs the others?

Re: The Venture Capital Math Problem

Sean Glass — Wed, 21 Oct 2009 10:59:07 -0000

I think you're saying that there is a "Brand" effect that increases returns for funds that have had success in the past. That is definitely the case. Entrepreneurs know that there is value to having Union Square or First Round or KPCB as a backer. If this brand lift gives the company a 1% greater chance of success, that can go directly to the IRR of the fund. I suppose it could lead to a reinforcing effect. Non-linear models may also be interesting to consider when modeling out a multi-found game (combined with a predator-prey or "genetic" model).

Re: The Venture Capital Math Problem

Sean Glass — Wed, 21 Oct 2009 10:48:52 -0000

Fred,
This is a great post. I've been noodling with this same problem myself recently. I think that your basic assumptions are correct. Part of what I've spent time thinking about is that there are artificial limitations that reduce returns for funds as well. For instance, if you invest in a company later in your fund cycle, you may be forced to look for an exit before the ideal time. This can lead to forcing the company into a recap or liquidity event before full value would be realized. This can also lower the ultimate return. Also, there is certainly a reinvestment risk. If you have a company that you get an exit from 4 years into the fund, you will reduce further capital calls perhaps, but the full amount of the fund is ultimately not being invested - this can lead to the opposite issue of waiting too long to move to an exit.

Azeem, your comments are spot on. It definitely seems like there is a big distinction between funds where the partnership is dedicated to building businesses and knows it will build wealth through the carry, and funds which have been raised for partners to live off of the management fee. This is certainly less of an issue with small early stage funds (2% of a 10-$40MM fund is a good amount of money, but not a HUGE amount). Your idea for top tier funds to reduce the management fee makes a lot of sense. One top tier fund I know in SV actually insists that at least 10% of the money in the fund comes from the partners themselves and that the partner sponsoring a deal participates individually as well. I think this certainly creates more alignment between the GP's and LP's.

Top LP's (think University endowments such as Yale which led the way into the VC and PE asset classes) won't invest in first time funds. Period, end of story.

One of the great separators in Venture Capital (at least according to the top VC's I know) is being able to pick out top tier teams. As there aren't great quantitative screens for human capital (What is a tier A team vs. tier B team when you're considering investing in 2 CS students in a garage at Stanford or a Harvard dropout named Bill or Mark?), great VC's tend to have both market foresight and the ability to pick great people to back. Once someone has shown evidence of this (i.e. through successful angel investment or a first fund), then the I would posit the likelihood of future success is higher.

I still have to wonder if pure luck has some role ultimately in if a particular fund is a success or not. Since a single fund doesn't invest in a smooth curve of companies, but rather has a very small sample, there is some chance that even a very well managed fund may miss out on the one "home run". Do this - build an overly simple model - single, double, triple, home run and strike out (to use an American baseball analogy). If you want to be fancier, you can use the power distribution for returns to give you an idea of how many exits you would have at each point (single = 1x double = 3x triple = 10x home run =40x). Then calculate the IRR net of fees and carry. Now what happens if you have 1 less home run? With 5% homeruns, 5% triples, 15% doubles, 15% triples, and 60% outs with 5% of the fund invested per deal, your IRR works out at just over 14%. Not bad, but not great. Now let's say you don't have that one 40x deal, but rather it's a ten bagger. If nothing else changes, the IRR drops to just over 4%. Now you can smooth this out by investing less than 5% per deal, and certainly you do better by doubling down in companies that are raising money and are looking successful and cutting out companies that you see are going down, but fundamentally my point is that if one or two exits make the fund, then perhaps timing, luck etc could play a larger role than we might like to admit? I'd be interested in hearing Fred and other current VC's opinion on this, and also how this may be more or less applicable depending on the stage of the fund, size of investments, etc.

Re: The Venture Capital Math Problem

fredwilson — Sat, 12 Sep 2009 17:35:05 -0000

20% is the assumed amount each VC owns
50% is the assumed amount all the VCs together own

usually there is a later stage investor who invests for less than 20%

i'm assuming two early stage VCs at 20% each and one late stage at 10%

Re: The Venture Capital Math Problem

Carlos T — Sat, 12 Sep 2009 17:03:19 -0000

Regarding your comment: "....each VC investor owns, on average 20% of each portfolio company". Then later you mention a higher percentage, ".....If you use my 3x gross and on average 50% ownership by VCs",

My question is, which is it? What percentage of company does a VC own in exchange for capital? 15%? 20% 50%? I look forward to a reply.

Re: The Venture Capital Math Problem

fredwilson — Sat, 05 Sep 2009 15:45:02 -0000

Great point about the global oppty. If we are to expand again, it had better be internationally

Re: The Venture Capital Math Problem

Guest — Sat, 05 Sep 2009 13:02:55 -0000

This is the correct perspective to look at VC, and unfortunately very few institutions have despite many of us screaming for over ten years. We took the 'if you can't beat them join them' approach with Initium VC, but we failed to raise our $250 million fund in 2002, despite a very strong team with far better track record than all but a few, and for example I found Google and many others long before those who invested.

However, I would like to point out one macro issue that most are missing in this debate, which is global. Not only has VC been institutionalized, complete with the foolishly applied asset allocation model, but most of the institutions are as biased as individuals. For example one chairman of a global tech giant, myself, and one of the premier VC partners who ever lived joked in an email a couple of years ago that most venture firms are really investing in real estate-- that is, most LPs have far more invested in real estate where the firms are located than they do in VC. It isn't transparent in many cases, and often denied, but there is no question at all that the majority of LPs are activist and strategic, so it's not even close to being a free market.

Now consider the changes globally in the past decade. Twenty years ago the U.S. had a near monopoly on the entire seed to exit ecosystem in technology. In the past decade venture funds have emerged all over the world at the same time that local research has improved, entrepreneurial cultures have improved, and IPO markets in many cases have surpassed the U.S.

So in much the same way as the housing bubble and investment in general, during the historic events of the rise of Asia and the creation of the EU- complete with seed to exit ecosystems in ventures that would otherwise in previous decades have likely emerged in the U.S., when investment in the U.S. should have been declining in many asset classes, instead we formed bubbles.

The tragic aspect of all this has been that the over investment in the asset class acclimatized customers with unsustainable subsidies, creating the largest price war in history-- particularly on the Web-- but in many areas, so it has become far more difficult for entrepreneurs to grow organically as partners with customers who are willing to pay for products and services rendered-- which has historically been an essential part of sustainable global economics. Of course that's the point of price wars-- way too much money in the wrong hands who have interests that are misaligned towards the broader economy-- that's the macro problem we've seen on Wall Street and in the valley.

Another related issue is the competency of so many VC partners and analysts-- what a difference between the 80s and 90s -- in the 80s almost all were deeply experienced in every aspect of building companies to include finance. By the late 90s we had hundreds who had never built a real business, but rather built false companies and profited from financial engineering (and I'm being kind here).

We will obviously continue to see a correction, but particularly in the U.S. we've seen a perm change (short of yet another devastating bubble- doubt we could survive in current form.) We've got to return to product engineering and company engineering-- moving far away from financial engineering-- otherwise our culture will continue to move towards fraud and away from fundamental value creation, which is what built this country.

Thanks for the work- MM

Re: The Venture Capital Math Problem

fredwilson — Fri, 28 Aug 2009 16:09:38 -0000

I think there are at least a dozen other firms out there that can pull it off. And most of them manage funds less than 250mm

Re: The Venture Capital Math Problem

Name — Wed, 26 Aug 2009 16:26:44 -0000

That really is such a great comment. Unfortunately I don't think VCs will ever move to a model with less fees and more carry because deep down they know its almost impossible to make money from carry in this day and age. Let's look at the math...

Let's say an early stage fund manages $250 million. To even *return* the fund, assuming 10% ownership at exit (most firms would be lucky to have this, although they own around 15-20% when they make their initial investment, by the time the company is ready to exit for any decent sized exit the number is usually far smaller) they need total exits of $2.5 billion.

Remember that's just to *return* the fund. To make any real money, as fred says, they need to return 3x that amount. That's $7.5 billion in exits. For that one small $250 million fund.

Assuming 100 companies in your portfolio you're talking about each and every one exiting for an average of $75 million to get that kind of return. Put another way you'd need over 7 companies in your portfolio to exit for over $1 billion.

Now I actually happen to think Fred is one of (is not the) smartest venture investor in this day and age, who gets more than most the realities of venture investing. His savvy investments means he may actually be able to pull this off.

But how many other firms can say the same thing? I'd argue you can count them on one hand, and all the others have been around for a while and like Fred have a history of successful exits under their belt.

LPs need to wake up and stop throwing money away into new and under-performing funds that don't already have a history of great returns.

Re: The Venture Capital Math Problem

Name — Wed, 26 Aug 2009 16:03:54 -0000

Remember that's just to *return* the fund. To make any real money, as fred says, they need to return 3x that amount. That's $7.5 billion in exits. For that one small $250 million fund.

LPs need to wake up and stop throwing money away into new and under-performing funds that don't already have a history of great returns.

Re: The Venture Capital Math Problem

Name — Wed, 26 Aug 2009 12:22:43 -0000

i hvve no idea mate but whatever you say sounds really cool - like the stuff they have on TV in the business channels - no one gets it - but everyone is talking it!

Re: The Venture Capital Math Problem

Michael F. Martin — Wed, 17 Jun 2009 16:29:58 -0000

Well then we need an IPO market.

I appreciate the perspective.

Re: The Venture Capital Math Problem

Ed Burke — Mon, 08 Jun 2009 13:06:31 -0000

"I think "back to the future" is the answer to most of the venture capital asset class problems. Less capital in the asset class, smaller fund sizes, smaller partnerships, smaller deals, and smaller exits. The math works as long as you don't put too many zeros on the end of the numbers you are working with."

Well said. Enjoyed the article and blog comments. Even on the other side of the deal, many entrepeneurs do not want or need the amount of funding required by the venture firms to "make the math work". In this industry, most of the time, less is more.

Re: The Venture Capital Math Problem

David Mas — Mon, 11 May 2009 08:57:08 -0000

You're right, the VC class is not scaling. I 'm not sure you need to resort to power laws to make your points, aggregate figures are already very convincing. Whether the 100$bn are coming from a single exit or from ten thousand, it doesn't matter to much for the investors, as long as they get their returns :)

This "math problem" has been investigated by Gompers & Lerner (1998): Money Chasing Deals?: The Impact of Fund Inflows on Private Equity Valuations. (http://papers.ssrn.com/sol3...

They show with a simple market model that the good deals are a scarce ressource and that too much investment in the asset class leads to les interesting deals being financed and thus to lesser returns.

That's a big point about VC : you don't only need money, you also need entrepreneurs and innovations. As all market, the VC financing market is there to adjust offer and demand. Diminishing returns means too much money invested and should lead to less investment.

The only problem of this theoretically beautifull mechanism is the time lag. Its takes years to get the returns from a VC investment. This is likely to lead to over-reaction and big cycle in VC financing volume. And this is when you don't take into account external events, like the actual financial crisis....

Hope this helps.

David

Re: The Venture Capital Math Problem

fredwilson — Sat, 09 May 2009 11:16:15 -0000

I agree

Re: The Venture Capital Math Problem

jeremylichtman — Fri, 08 May 2009 14:51:56 -0000

No industry can scale indefinitely.

That's what Warren Buffett has been saying for a number of years in his annual reports - that Berkshire is too big to get the returns that they used to get, since there just aren't that many large deals he can invest in (and the smaller ones, while profitable, aren't big enough to give a high percentage rate return overall).

Now that said, there's still a lot of room for small VCs to make very good money investing in startups.

Re: The Venture Capital Math Problem

fredwilson — Wed, 06 May 2009 06:35:10 -0000

The average valuation was 115mm?

That cannot be

We do about 20 deals a year between initial and follow ons

And maybe one of them, a late stage round, will be at that valuation

There's something wrong with that number

Re: The Venture Capital Math Problem

Sven — Mon, 04 May 2009 13:32:17 -0000

It's all about valuation of the last money in. In Q4-2007 the 12 months average post money valuation for a start up was $115m but the average Exit valuation was $75-80m the math is not working (except in Baseball and Las Vegas).

The VCs have to learn to set valuation right and to manage the portfolio towards average Exit valuations and not towards home runs.

Re: The Venture Capital Math Problem

fredwilson — Mon, 04 May 2009 12:59:45 -0000

we have those discussions too here

i'd suggest you go look at the ten most recent posts and i think you'll find plenty of that