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:
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).