DISQUS

kyle_s · 1 year ago

Fred,
I enjoyed this post and the perspective it brings. When I was modeling out your earlier scenario "at home", this is one aspect that I initially modeled wrong but when I fixed it the model made much more sense.

I have a couple of questions. First, I assume you have to decide within a year or so whether a deal is likely to at least break even, because you run into needing another round of capital at that point. Have you ever had situations where it was a close call whether to raise another round or close the doors? How did you decide one way or another? I imagine it can be pretty difficult to get an entrepreneur on board with closing up their shop...

fredwilson · 1 year ago

the close call happens all the time. as fnazeeri explains below, the temptation is to do another round. i think we certainly lean in that direction. it's hard to be really mercenary in this business.

fnazeeri · 1 year ago

From what I've seen, VCs find it hard to give 1/3 of their portfolio the stiff-arm after one round and 12 months of treading water. There's always hope going into the 2nd round and usually there's another firm walking around saying, "well Fred invested in it..." so they jump in and you can't not take your pro rata so there goes the "reluctant round." Add to that the fact that VCs are playing with OPM ("other people's money") and that the compensation structure rewards wins heavily but punishes losses lightly. And lastly, VCs don't really want the reputation of bailing after 12 months and gaining a reputation amongst entrepreneurs as "fast money."

You make a good point though, that's the way it's supposed to be done, but, like most things, reality seems to get in the way...

fredwilson · 1 year ago

correct on all counts

Krassen Dimitrov · 1 year ago

Excellent points! There is one other major factor, though: timing of write-offs relative to new fund raises. Because of the things that you mention (playing with OPM, living on fees) there is a very strong incentive not to write-off while you are raising your next fund...

fredwilson · 1 year ago

Everytime VCs think about fundraising in relation to their investments they
are making a mistake

You have to do what's right for your portfolio and your portfolio companies
and let the chips fall where they may

Krassen Dimitrov · 1 year ago

Sure, it's easy for you to say, you are a winner. I saw an amazing presentation a couple of weeks ago: more than 66% of VC have negative returns. For these folks the fees are their livelihood and the portfolio be damned...

Krassen Dimitrov · 1 year ago

Sure, it's easy for you to say, you are a winner. I saw an amazing presentation a couple of weeks ago: more than 66% of VC have negative returns. For these folks the fees are their livelihood and the portfolio be damned...

Krassen Dimitrov · 1 year ago

Excellent points! There is one other major factor, though: timing of write-offs relative to new fund raises. Because of the things that you mention (playing with OPM, living on fees) there is a very strong incentive not to write-off while you are raising your next fund...

Don Jones - VentureDeal · 1 year ago

I'm seeing VCs allocate capital quite stringently these days, by quickly shutting down companies that they think are under-performers and re-allocating capital to their portfolio companies that are doing better or have better chances of success.

fredwilson · 1 year ago

that's what we are supposed to be doing, but it's not that easy.

Tim Dierks · 1 year ago

Why doesn't your model account for the fact that return on a later round at a higher valuation is going to be lower? It seems to me that if you can get an overall blended 5x return on 3 rounds of investment in a single company, then the first round probably returned 20x or higher.

Jake · 1 year ago

I imagine that the model gets much more complex if you want to work in the step-up in valuation. While the B or C round is probably more expensive, Fred is also probably putting in 5 million instead of 1. The return multiple on the later rounds is likely to be much less than the earlier rounds but a realization event is probably closer meaning that despite the lower return multiple, the IRR will be strong.

fredwilson · 1 year ago

tim, you are right. the initial round in a winner is usually going to be 10x or higher

charlie crystle · 1 year ago

Slightly off topic, and at the risk of pushing something stupid or illegal:

Founders' Exchange Fund....
Founders are investors too. But they are fully invested in a single deal, typically--their own. This concentration of assets and energy is likely far riskier than any venture deal.

Given that, I'd like to propose that the venture industry--or at least some firms that care about their founders--set up something likean Exchange Fund for founders to give them some diversification.

Founders would contribute shares based on dollar-value equivalent to the fund, and get shares back in the fund. The fund acts sort of as an index. Let's say round 1 is valued at $3 million post, and the founders have $2 million of that in shares. Maybe there's a minimum buy-in of $50,000, so a founder would allocate $50,000 in shares (based on closing price of that round) and get back $50,000 of equity in the fund. Let's say you get 10 other founders in your fund to do the same, so you have $500k in the pool, and they all get to participate in your investment expertise.

This could be done on a per fund basis, but what enabling even more diviersification? Let's say you get 10 top-tier funds together....Benchmark, KP, etc--and make it more than a benefit, make it a requirement of doing business,effectively forcing founders to participate as part of the deal, because it's good for them to diversify.

--recovering and relapsing founder with high concentration of wealth and energy focused in one place

davidu · 1 year ago

Some funds (Greylock, for example) provide an opportunity for the executives of their portfolio companies, and other founders they work with, to participate in the funds to a limited degree.

charlie crystle · 1 year ago

sure, but in an equity exchange or cash investment?

davidu · 1 year ago

Not an equity exchange, although those exist as well.

fredwilson · 1 year ago

i've seen this done a bit but it can end really badly for some

vincentvw · 1 year ago

I'm not sure if I agree with that reasoning. Yes, founders carry more risk, but they also need to feel the pain in order to bring their venture to a success. As soon as they are diversified, their motivation & attention risks to be diluted, which can't have positive consequences on their own ventures. I imagine it's an even worse problem if you introduce this scheme to venture-employees, as they then have the incentive to just work for the best-performing business.

David · 1 year ago

While I agree with the general gist of the article, it seems that your model ignores the fact that subsequent investments in "winners" will be done at higher valuations and therefore reduce your investment return multiple.
In other words, aren't the "winner" entrepreneurs able to extract more value if they are good?

fredwilson · 1 year ago

Please don't get caught up in the model, those were very simple
demonstrations of the point I wanted to make

Yes, absolutely the follow on rounds in the winners will be done at much
higher valuations and that will lower the return on them

But the blended returns on the winners will generally be between 5x and 10x
if you do this business right

sethlevine · 1 year ago

fred –one things i’ve noticed in my venture career however is that often times the very best portfolio companies require less than average capital (in some cases they are acquired earlier in their lifecycle, in others they end up attracting later stage capital at attractive step-ups where the earlier investors participate only limitedly, etc.). on the other hand, there’s a great tendency to assume that business that are not succeeding are simply “taking a little longer to develop” and the existing syndicate continues to fund. it’s an interesting perversity of the venture business – not unlike the tendency of poorly performing portfolio companies to take up more time/attention than well performing ones. i have been thinking a lot about this capital allocation question that you raise and the corollary i’m bringing up here – having the discipline to walk away early and focus on winners (as well as the fortitude to double down on your best investments) is not easy, but in order for the portfolio model you describe to work, it’s necessary.

i’m curious if you’d agree with this and how you guys deal with this at usv.

seth

fredwilson · 1 year ago

Yes and that's why you have to 'starve' the poor performers and force them to be lean if they want time to develop

A poor performer that is capital efficient won't kill a venture fund's performance but a capital sucking big burn one will

FN · 1 year ago

But you also need to 'gorge' the winners. The question is what to do when a late stage PE investor comes in with a round of $25MM at $75MM pre and you only have $5MM invested at that stage. You won't have the opportunity to build your position. If you're not lucky, it can quickly turn into an heads-they-win-tails-you-lose scenario.

fredwilson · 1 year ago

It happens

If you have a small fund, it's not as big of a deal as if you have a large
fund

A $5mm investment can still ³return the fund² if you get 20x on it

And that's not impossible

O.M.A · 1 year ago

Great post, thanks.

You seem to assume the return on series C in a good company would be the same as the return on series A.
Is that just to simplify the model, or as a result of liquidation preferences (that should not matter much in a good exit) or other things?

fredwilson · 1 year ago

Its just to simplify the model. That's obviously not true but I did that post in about 20 mins including the spreadsheets so I had to take some shortcuts

Anonymous · 1 year ago

Does expecting 1/3 to fail make you less likely to do everything possible to try and save a business? It seems Twitter is hell bent on self mutilation and destroying all loyalty of their user base. They clearly need someone with half a brain to step in and take the reins, the backroom geeks are simply causing one PR disaster after another. Why haven’t the investors insisted on this?

fredwilson · 1 year ago

Can you be more specific about the issues you are concerned about? Stability
has increased significantly in the past month as has user growth.