A VC - Latest Comments in Venture Fund Economics: Allocating Follow-On Capital

Re: Venture Fund Economics: Allocating Follow-On Capital

fredwilson — Sat, 06 Sep 2008 09:18:19 -0000

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

Re: Venture Fund Economics: Allocating Follow-On Capital

O.M.A — Sat, 06 Sep 2008 04:39:54 -0000

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?

Re: Venture Fund Economics: Allocating Follow-On Capital

fredwilson — Mon, 01 Sep 2008 08:10:27 -0000

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

Re: Venture Fund Economics: Allocating Follow-On Capital

FN — Sun, 31 Aug 2008 19:06:22 -0000

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.

Re: Venture Fund Economics: Allocating Follow-On Capital

fredwilson — Sun, 31 Aug 2008 16:13:08 -0000

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

Re: Venture Fund Economics: Allocating Follow-On Capital

sethlevine — Sun, 31 Aug 2008 14:40:18 -0000

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

Re: Venture Fund Economics: Allocating Follow-On Capital

Guest — Thu, 28 Aug 2008 10:17:55 -0000

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...

Re: Venture Fund Economics: Allocating Follow-On Capital

Guest — Thu, 28 Aug 2008 10:17:54 -0000

Re: Venture Fund Economics: Allocating Follow-On Capital

fredwilson — Wed, 27 Aug 2008 15:17:21 -0000

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

Re: Venture Fund Economics: Allocating Follow-On Capital

David — Wed, 27 Aug 2008 14:23:24 -0000

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?

Re: Venture Fund Economics: Allocating Follow-On Capital

fredwilson — Wed, 27 Aug 2008 07:10:07 -0000

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

Re: Venture Fund Economics: Allocating Follow-On Capital

fredwilson — Wed, 27 Aug 2008 07:01:08 -0000

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

Re: Venture Fund Economics: Allocating Follow-On Capital

Guest — Tue, 26 Aug 2008 20:51:58 -0000

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...

Re: Venture Fund Economics: Allocating Follow-On Capital

Guest — Tue, 26 Aug 2008 20:51:57 -0000

Re: Venture Fund Economics: Allocating Follow-On Capital

Anonymous — Tue, 26 Aug 2008 17:59:06 -0000

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?

Re: Venture Fund Economics: Allocating Follow-On Capital

vincentvw — Tue, 26 Aug 2008 11:29:47 -0000

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.

Re: Venture Fund Economics: Allocating Follow-On Capital

fredwilson — Mon, 25 Aug 2008 17:20:01 -0000

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

Re: Venture Fund Economics: Allocating Follow-On Capital

fredwilson — Mon, 25 Aug 2008 17:19:15 -0000

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

Re: Venture Fund Economics: Allocating Follow-On Capital

fredwilson — Mon, 25 Aug 2008 17:18:41 -0000

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

Re: Venture Fund Economics: Allocating Follow-On Capital

fredwilson — Mon, 25 Aug 2008 17:18:15 -0000

correct on all counts

Re: Venture Fund Economics: Allocating Follow-On Capital

fredwilson — Mon, 25 Aug 2008 17:17:44 -0000

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.

Re: Venture Fund Economics: Allocating Follow-On Capital

davidu — Mon, 25 Aug 2008 16:02:02 -0000

Not an equity exchange, although those exist as well.

Re: Venture Fund Economics: Allocating Follow-On Capital

charlie crystle — Mon, 25 Aug 2008 15:03:08 -0000

sure, but in an equity exchange or cash investment?

Re: Venture Fund Economics: Allocating Follow-On Capital

davidu — Mon, 25 Aug 2008 13:56:48 -0000

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.

Re: Venture Fund Economics: Allocating Follow-On Capital

charlie crystle — Mon, 25 Aug 2008 13:29:55 -0000

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