A VC - Latest Comments in The Venture Capital Math Problem (continued)

Re: The Venture Capital Math Problem (continued)

fredwilson — Fri, 08 May 2009 00:10:13 -0000

Its a lot easier to make these numbers work if the investments are smaller amounts

Re: The Venture Capital Math Problem (continued)

Marc Step — Thu, 07 May 2009 15:31:10 -0000

So here is another way to look at it. Assume you have $1,000 in the fund and do ten deals at $100 each. Then, of those ten, two are great exits (stars), two are just good and so on as per the table below. The stars obviously dominate the math, and you can see that to get a 3x return in five years (with no dilution) the stars have to return 8.9x.

Assumptions:
Time to Exit = 5 years
% Dilution Upto Liquidity = 0.00%
Number of Investments @ $100.00 each = 10
Annual Return for Star = 55% or 8.9x

(probably won't show up as nice table but….)
Dispose As Investment ROI/yr % Return$
=============================================
Star $200 55% $1,789 or 8.9x
Good $200 30% $743 or 3.7x
OK $200 15% $402 or 2x
Alive $200 0% $200 or 1x
Write Off $200 -100% $0 or 0x
==================================================
TOTALS $1,000 $3,134 or 3.1x

This means that a $20M investment for 50% of the company has to yield at exit of $356MM. Therein lies the problem. Except for the outliers (Google, eBay, etc) the exits just cannot support the returns expected, even assuming 1 in 5 venture deals have great exits.

Yet another qualitative thought. As business models and types of company have changed to require less money, why do funds get bigger and bigger requiring larger and larger investments. The venture industry needs to be innovative just as it expects its investment portfolio companies to be.

Re: The Venture Capital Math Problem (continued)

fredwilson — Thu, 07 May 2009 11:54:03 -0000

I am sure there will be new structures emerging like Y Combinator but they are net additive to the existing VC business

Re: The Venture Capital Math Problem (continued)

Lloyd Fassett — Wed, 06 May 2009 12:56:22 -0000

I was commenting on the same, but I wasn't clear. I was questioning the ability to go back to that structure because the environment is different now and that perhaps a new structure to this part of the industry will emerge.

Re: The Venture Capital Math Problem (continued)

fredwilson — Wed, 06 May 2009 07:15:11 -0000

By back to the future, I meant the way the VC business is organized and structured, not what we invest in

Re: The Venture Capital Math Problem (continued)

fredwilson — Wed, 06 May 2009 07:02:09 -0000

Don't be fooled by how much money twitter has raised. Focus on how little money they have spent in three years.

Re: The Venture Capital Math Problem (continued)

fredwilson — Wed, 06 May 2009 06:52:13 -0000

Venturxpert from thomson reuters

Re: The Venture Capital Math Problem (continued)

Lloyd Fassett — Tue, 05 May 2009 20:01:36 -0000

I was surprised at the comment at the end of the last post that the VC industry would go ‘back to the future’, because I thought you created the future. I don’t think there’s any way to get back to the future anymore than to have record labels, neighborhood book stores, video stores, classified advertising or having a Normal Rockwell come to life.

I really enjoyed your talk at Columbia B school that you posted not too long ago where you talked about going from generalist to web centric in focus. I think that trend of specificity will continue, not go back to the way it was. The limit on creating software/web driven solution used to include capital, now it’s not as much. I bet the VC model will continue where there are higher capital needs and fragment along those lines. If you keep focusing on Web services, eventually you’ll know what you’re looking for so well you’ll be able to build it more efficiently than waiting for someone to come along who has traction, experience and no competition for investment dollars.

One way to create scarcity in web/software deals though would be to go where people don’t want to go, which is concept businesses with first time entrepreneurs. For good reason too. The next way to create scarcity might be to use what you know to create businesses that creates new solutions for existing industries because VC as a class are smart and well connected. That can translate to sales early to key customers across many different industries for web-centric solutions that need to exist for existing demand.

Maybe some version of an incubator will end up working by being more predictable and include larger %’s of ownership. Perhaps more than ½ right out of the box. When you do your next posting on this topic, perhaps you can use the exit assumptions as fixed and vary the % of ownership assumptions. That’s another way to skin this cat.

I bet your instinct has been steering you and Brad this way (toward a leveragable position and process) since way back when you raised only $125m from a feeling about how your business scales. You also commented on having too many partners in a previous firm recently.

All this math is subterfuge. To me it’s obviously a power distribution to me and if there is too much money chasing too few qualified deals, that need less and less money, the model falls apart, on average. It's a business model issue. The math is a trailing indicator.

Something new will come though, just like newspapers, video rental, books, whatever.

Re: The Venture Capital Math Problem (continued)

Jason — Tue, 05 May 2009 11:23:21 -0000

But this does show how to fix the problem. Moving forward - the real world answer to the venture capital math problem starts with demanding capital efficiency. I commented on Azeem's answer here: http://azeemazhar.com/?p=25... - Someone replied with an example of Google, but the reply didn't apply to what I was really trying to say. Google is the model for capital efficiency. Look at this http://news.cnet.com/8301-1... - capital efficiency at play. If you look at their search engine's code you can see that they are attempting to save dollars on each nanobyte. Now take Twitter. I am the first to say I LOVE TWITTER. But $56mm in funding and the first thing we hear is that they are an overpriced Apple tech company very well known for a Fail Whale. Sure you can't put a price on innovation, and I see Twitter's game changing future ahead, yet I see Sergery Brin and Larry Page both smacking their foreheads! I even read an article in Rolling Stone a few years back about a few upcoming tech stars who would use their venture capital funds for nights out. I even recall reading about prostitution! WTF! The venture capital industry needs to find companies and innovative individuals that cost less to IPO and M&A. That would fix your numbers moving forward. At least choose companies with clear paths to exits with no break in their internet business models. This is not right! http://twitter.com/copeters...

And while I am on this kick. I understand capital efficiency and am seeking seed money for master programmers, graphic designers, and refurbished Dells to build patentable internet technologies. (sorry had to do it.) one of them is the internet version of Walmart. Not what you are thinking, what I am SEEING and engineering. http://categorykiller.info

Thanks for the reads Fred. I am learning so much about this industry from you.

Re: The Venture Capital Math Problem (continued)

Supply Sider — Tue, 05 May 2009 09:58:31 -0000

Thanks.

Well, it would certainly take a very long time to "grow" that many good VCs...so that point of the debate may be moot anyway.

Do you know of data to test the thesis about the returns for the top VCs?

Re: The Venture Capital Math Problem (continued)

fredwilson — Mon, 04 May 2009 13:03:28 -0000

I agree with most of this analysis. Though I can't say that I'm convinced we can put $25bn per year to work productively even if we had an industry full of experienced and capable VCs

Re: The Venture Capital Math Problem (continued)

fredwilson — Mon, 04 May 2009 12:59:49 -0000

thanks Tom

great points

Re: The Venture Capital Math Problem (continued)

Supply Sider — Mon, 04 May 2009 10:27:52 -0000

Supply and Demand?

A theory:

The VC industry's aggregate returns are starting to behave like a mature industry with excess capacity. The excess capacity was created when money flooded into this once red-hot asset class, causing returns to suffer greatly. Unfortunately the flood of money created "sticky" excess capacity-- too many VCs, continuing to invest and raise too many dollars. Redeploying money and people (VCs) didn't really happen.

The return to equilibrium and average risk-adjusted returns is a long one, since:
-- Funds lives are long (therefore accountability to the investor is very muted in the short-term)
-- Data on real returns takes a long time to season, since investments take a long time to season
-- Data on real returns is hard to measure (opaqueness, black swans, etc)
-- New VC capacity like their carries and careers (and why not?)

Having said all of that, the VC industry has a strong ability to create its own demand-- Say's Law. Great VCs, investing in great ideas with great managment teams, will create their own markets. The World economies can easily absorb $25 billion of new investment per year with strong returns, IF the money is invested productively. The excess capacity argument would not apply if most of the money went to work int he right places.

The problem with the flood of new money was (and is) the VC industry's ability to absorb it quickly. The money is only spent productively when there are enough seasoned VCs to continue to choose the time proven:
-- right idea
-- right time
-- right team

This aint so easy. So, capacity needed to grow more organically for returns to stay high.

To test this theory, I suspect returns from the Top VC Firms have stayed high; perhaps they are lower than historic levels, but are they still higher than alternative asset classes (risk adjusted)?

Thoughts?

Re: The Venture Capital Math Problem (continued)

fredwilson — Mon, 04 May 2009 06:24:11 -0000

i totally agree with that last point

the value of a business is the present value of future cash flows

Re: The Venture Capital Math Problem (continued)

David Semeria — Sun, 03 May 2009 18:40:29 -0000

Fred, ever since your original post there's been something about the logic of your initial argument that's been bugging me, but has been annoyingly out of reach...

Finally, my sub conscience spoke to me, so here it is: as a person who spent a lot of time crunching flow of funds numbers for the stock markets, one thing you learn pretty quickly is that the money to fund a prolonged market rally just appears (as if by magic). Even when you think that all the players have put their last penny into the markets, new funds can just keep on coming in for years after you called the top.

This implies that there is no practical limit to how high markets can go (from a flows, not *valuation* standpoint). The same is surely true of the IPO and M&A markets. If there is an appetite for deals then the money to finance them will come from somewhere.

So I would argue that the current sorry state of the exit market reflects a lack of *appetite* for what's on offer, not a lack of capacity. And as such does not represent a physical cap on the size of the VC industry.

Speaking on (slightly) less solid ground I would further argue that your original thesis doesn't so much reflect on the state of VC industry, but on the business models that VCs are currently funding.

For internet stocks in particular, once the market realized that simply buying traction was a risky business, exits started to dry up. When web companies find a way of generating some good old cash flows then the appetite for acquisitions and IPOs will surely return.

Re: The Venture Capital Math Problem (continued)

David Cottingham — Sat, 02 May 2009 10:51:13 -0000

Off-the-wall thought: we're concentrating a lot on the _value_ of exits (and hence the overall total ROI that the VC asset class has). We've noted that a lot of the exit values might well be in a "long tail", which would not necessarily be included in, say, the top 200 deals.

What about the ROI of individual investments? That distribution would provide insight into whether VCs generally do achieve 2x to 3x returns on any size of investment (and hence they're "good" for a company, whatever the size of the investment). If VCs' investments' ROIs follow a Gaussian distribution, what's its mean? Moreover, has it changed over time, as the total amount being invested has grown? My guess is that given the old rule of "3 out of 10 fail, 4 do OK, and 3 work well" (or similar) that it's nothing like Gaussian, because return rates on a few deals have to be huge to make the mean 2x or 3x.

If the distribution is unchanged over time, that provides some hope concerning the scalability of the asset class. This is irrespective of the _size_ of the deals being conducted.

Also, if one could compare the distributions for different VCs, one could see which ones were good to have invest in your company: if a VC achieves 3x returns consistently across the board (if only!) they're far more preferable from an entrepreneur's point of view to those that rely on huge returns very occasionally, even if both funds have the same ROI overall.

However, I've no idea if this data is available...! Does anyone else think it would be useful?

Separately: can whoever supplied the Thomson data (and hence has a subscription) produce a scatter graph of exit values and post it somewhere? Just an image would do, no raw data. That would give us a vague feeling for whether we're anywhere near correct on distribution shape.

Re: The Venture Capital Math Problem (continued)

fredwilson — Fri, 01 May 2009 17:04:51 -0000

VC is a local business

We need to see local VCs emerge and help them get funded

Re: The Venture Capital Math Problem (continued)

Rogelio De Los Santos — Fri, 01 May 2009 17:01:16 -0000

Hi to everyone, new to the group but interested in offering some perspective from an emerged market.
Entrepreneurship has and will continue to provide new solutions to the inefficient systems in place we use on a daily basis and it better be promoted at all levels.
Regarding scalability, shouldn't VC's be looking at new markets in search for oxygen in these troubled times? The industry is well underdeveloped and opportunities to cherry pick the low hanging fruit are overwhelming.
My approach as a new participant in the VC industry is an entrepreneur. I have done it for almost 20 years in a series of deals and it has worked with far better results than those being shared here.
I agree that VC's should align their interest with the LP, entrepreneur, and stake holders to be able to generate and distribute value, so bootstrapping your VC operation is the best example you can give; fees should be based on bottom-up budgets not on fixed %'s. In my experience sometimes great ideas fail because too much money is given at any time; there should be a bare to the bone use of resources philosophy to make the business burn only as much needed but close to what you are able to generate.
If you guys question the number of quality startups in the US, what do you leave to our emerging markets. Good ideas with experienced entrepreneurs are out there but one has to go and dig them out. Here, money is not after the deals, the deals are after money because the PE/VC industry is none existent. This scenario allows the entrepreneur to achieve great things with minimal resources. Like first concentrating in nailing the concept to then scale it. What I have found to validate with some LP's is that it works well when the GP creates its own entrepreneurial thesis for the market and builds around it to capture the value of the sum of the proposals.
Exits? That is the art part in this industry.
I enjoy reading your posts today and look forward to participate in future conversations.

Re: The Venture Capital Math Problem (continued)

fredwilson — Fri, 01 May 2009 16:54:26 -0000

I hadn't thought of that

Re: The Venture Capital Math Problem (continued)

Jason — Fri, 01 May 2009 13:56:37 -0000

using the data you gather from the math answer, it will be amazing if you are able to somehow show a mathematical correlation of IPO exits into the NASDAQ to further justify the correctness of your blog here http://www.avc.com/a_vc/200...

Re: The Venture Capital Math Problem (continued)

Rob K — Fri, 01 May 2009 13:56:10 -0000

Perhaps, but since this is an analytic exercise, it probably doesn't make sense to use a high water mark of 2007 or 2000, but a figure more normalized.

Re: The Venture Capital Math Problem (continued)

Steve Kane — Fri, 01 May 2009 13:46:25 -0000

for sure!

why doesn't somebidy do this simple exercise:

use whatever assumptions and distributions you like, but

1) cut management fees in half (from 2% of committed capital down to 1%)
2) assume all that freed up capital returns the same as any other invested capital

and watch what happens to the overall returns as an additional $0.10 of every LP dollar gets put to work

seriously, with all the math whizzes around these comments, somebody do the exercise. i put on my swami hat and predict the asset class suddenly starts to look like a reasonable risk

Re: The Venture Capital Math Problem (continued)

Adrian Palacios — Fri, 01 May 2009 13:04:34 -0000

Well, you did good, this makes perfect sense. Thanks for giving me a jumping off point as I read through all the other comments :-)

Re: The Venture Capital Math Problem (continued)

Ted Rogers — Fri, 01 May 2009 12:58:57 -0000

Essentially, because at some point more money is put into the VC asset class than can ever be returned, at least not returned at the kind of multiples that VC investing needs to justify itself. There just aren't that many grand-slam companies and/or exit possibilities.
For example, assume that LPs invest $200 billion in VC funds in year 1, is it reasonable to assume that there will be liquidity events in the next 3-5 years that return $1 trillion (5x gross returns)? Probably not. Again, there just aren't that many grand-slam companies and/or exit possibilities. On the other hand, if $200 million is invested in VC funds in year 1, it is reasonable to assume that there could be $1 billion returned (5x gross returns) over 3-5 years? Probably.
In sum, VC doesn't scale because at some point there is too much money chasing too few good deals and returns in the VC asset class overall plummet.
(There are probably 50 people on this blog that could do a better job of explaining this than I can but there you go...)
vc-brazil.com

Re: The Venture Capital Math Problem (continued)

fredwilson — Fri, 01 May 2009 12:12:39 -0000

I think that's a temporary dip