The New Reality of Venture Capital – Take II

Earlier this week I read Joe Dwyer’s blog post – “The new reality of venture capital”. Joe’s thorough post criticize the VC industry for many of its deficiencies.

I agree with many of Joe’s arguments: VC returns over the last 10 year have been below the S&P. The average is 3.9% for early stage ventures, while LPs (Limited Partners) are expecting a 20% IRR. Joe re-iterates something I spoke about a number of times – the size of funds. A 20% IRR on a $250M fund means $500M worth of returns. Assuming a VC has a 20% ownership at the time of exit, that translates to total exits valued at $2.5B. Taking into account that the average exit is below $100M and that 40%-50% of VC backed startups fail…well you get the odds of that. Finally, Joe criticize, again, rightfully so, current valuations. Too much capital, chasing deals, leads to highly competitive rounds, high valuation that then drive the need for higher exits. Tomasz Tunguz of Redpoint Ventures shared this graph a while ago:

Median Series A Pre-Money valuations at a 10 years peak

Now let me speak to some of the arguments I found more debatable:

The “2 and 20” structure – Most VC funds have a 2% annual management fees used to pay salaries, office rent etc. Since the lifetime of a fund can be as long as 10 years, that adds up to 20%. Most VCs actually manage multiple funds at the same time but just doing the math for a single $250M fund, gets you to a $50M management fee. I agree with Joe that this is a significant amount but what happens if you are a micro-VC with a $30M fund. Now you have $600K to manage your fund. Just for reference, 500 Startups fund I was a $30M fund. Jeff Clavier’s SoftTechVC fund II was a $15M fund.

Opening the floodgates – Dollars managed per partner – Joe argues that more VCs are launching mega funds. NEA recently announced a $2.8B fund. True. Andreessen Horowitz, KPCB and other VCs are raising mega funds but at the same time you see more and more VCs raising $100M-$200M funds: First Round Capital ($175M), Upfront Ventures ($200M), SoftTechVC ($85M), Union Square Ventures ($150M) and others. Small micro-funds have a few advantages: spearing the risk, return expectations are more realistic and the flexibility to react to changing landscape by raising additional funds with different investment thesis.

In summary, VCs have had great impact on our lives. Cisco helped us connect globally removing boundaries. Google gave us access to so much knowledge. Apple made this information available to us at the tip of our fingers. Udemy made everyone a teacher and a student. VCs are here to stay but the industry is changing, for the better I believe. New funds and investment vehicles (e.g AngelList syndicates), partners with more operating experience (e.g Andreessen Horowitz) and early-stage micro-funds alongside mega funds (which I question their sustainability in the long-run).

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About shanishoham

After 14 years of General Management and incubating/scaling new businesses & organizations for enterprises (established a $55M mobile business and a $100M/400 employees global division), I became an investor Today I’m a board member/mentor with 5 incubators & micro-VCs and involved with many other private & public incubators around the world. I also founded a VC firm named 2020 and I'm a member with a number of angel groups so i get to see & work with many startups, innovation centers and other parties across the ecosystem. I’m an alumnus of the Stanford Graduate School of business - Sloan Master in Management program, a 10 months intensive program for 57 carefully selected experienced Executives and leaders from all around the world.

4 comments

  1. Great to see articles like this. I’ve written a few posts about the big (riskless) returns that VCs (GPs) make. My own estimate was that a VC could walk away with about $30M of every $100M invested having only provided $1M of the capital. 30X at little risk – what a business model! Here’s one of my posts with a diagram that describes the process – http://www.startupvice.com/the-venture-capital-business-model – Hope you don’t mind the link.

    In fairness I didn’t quite realise the outsized impact that VC money has had on the overall economy – which is important.

  2. It’s interesting. Until seeing your article, I didn’t realize that the VC’s were causing the over-leveraged valuation curves between later-stage financing and liquidity events.

    I kind of thought it was the risk-seeking stock market (forget bonds, buy stock!) imposing its peculiar economics onto smallerm David-sized companies who displace their Goliath old-style competitors.

    I thought such companies are rockets which often explode. They grow quickly as they displace, but explode if traditional market leaders adapt or quick followers reduce margins?

    • Ryan, valuations is a combination of supply and demand. High demand startups lead to highly competitive rounds.
      I was trying to figure out a case where the market leader trumped such a company. Many examples i can think of for the other way around: Uber, Airbnb, Zipcar, Linkedin, Netflix etc. I think the challenge is not in those companies “exploding” but rather making an exit at a valuation that makes a decent return to their investors after such a high valuation round.

  3. Shanishoham,

    Thanks for clarifying. I understand your key point better now.

    Ryan

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