That is a horribly naive analysis. Did you even read the article? $50M can be a great outcome or a terrible one depending on the circumstances. What valuation did you buy in at? If you bought in at $100M, a $50M exit means a 50% loss. How much time did it take to exit? A 50% return after 1 year is a very different outcome from a 50% return after 10 years.
I agree with your point, but you are vastly overstating the return on government bonds. Current yield on the 30 year is 2.31% and everything with a shorter maturity is way less than that.
If you read this before the article it may help: I always thought that VC meant "Venture Capitalist" or referred to the capital the investor invested (Venture Capital), this article doesn't mean either of those things, rather, it means the company that has accepted this money.
A Venture Capital firm, or VC firm, is the company which manages Venture Capital. That's the colloquial meaning of VC and amusingly leads to phrases like VC money.
"VC money" is more specific than "venture capital".
Venture capital refers to any capital provided to a venture. Some of this may come from a venture capital firm. That would be VC money. Some may come from friends and family, lenders and strategic investors. The latter are providing venture capital, but are not commonly referred to as venture capitalists.
This distinction is useful because VC firms structure their investments in ways that are better suited for some companies over others.
Yes. My point is in agreement with yours. VC money isn't a redundant phrase, though taken literally it would seem so. (Venture Capital Capital essentially...). The implicit "firm" is very important. VC money is money from a Venture Capital Firm, not just any venture capital.
You may be doubly confused. VC here does refer to venture capital firms - sometimes they're no more than a few people running the firm, in which case you could refer to the individuals as venture capitalists. These firms invest in startups, businesses which create a product. Their job is to "choose winners." But where do the individuals making up a VC firm get that money to invest? It's very rarely their own wealth. Instead, they get it from LPs - endowments, pension funds, big banks, family offices (which manage multi-millionaires' money), all of whom want to get on the Silicon Valley wave. And those LPs certainly expect to get better returns than if they just put it in the bank, or into the stock market. So there are two levels at which a "company" must "raise" money - the startup from the VCs, and the VC from the LPs.
If you this before the article it may help: I always thought that VC meant "Venture Capitalist" or referred to the capital the investor invested (Venture Capital), this article doesn't mean either of those things, rather, it means the company that has accepted this money.
great post but it misses several important dynamics (in addition to subtler effects):
1. LPs invest in multiple VCs - they have their own portfolio effect.
2. not even VC investment is equal -- there's 10-50x difference between their largest and smallest bets.
3. there's non-financial benefits to being an investor in Uber (and doubly, for being able to say it publicly). There's no benefit in saying you're an investor in the stock market. Subtly, if you're a top VC and NOT an investor in enough Uber's (and only investing in unknowns) then LPs and entrepreneurs don't take you seriously.
These effects combine to dampen the effects you mentioned. Consider FriendFeed - small $50M acquisition by Facebook, but given its non-financial impact, do you think the VCs regretted the investment? They'll make their $$$ somewhere else, perhaps the entrepreneur's next startup... which turned out to be quip, acquired for $750M last week...
This is a great, insightful comment, and I agree with everything you said except for the part about FriendFeed.
1) Unfortunately, VCs have to care about financial impact over everything else. That's the only thing their LPs pay them for. So an amazing mission-driven company with a modest exit will make a VC and their LPs much less happy than a company that doesn't do anything particularly meaningful but exits for $2b. Put differently, if I invest in 50 companies that make the world better but don't product great returns, I won't have a job in 5 years; if I invest in 50 companies, one of which exits for $10b, I'll be able to raise VC funds for a long time.
2) That said, I bet FriendFeed was a fantastic exit for investors and employees. The acquisition was for a combination of cash and .5% of facebook's stock (https://techcrunch.com/2009/08/10/the-cost-of-friendfeed-rou...). That .5% would have appreciated about 15x by the time Facebook IPO'ed a few years later, and even more if investors are still holding on to the stock.
I find this argument inadequate. The conclusion may be true (that most venture funds lose money) but this article does a poor job of elucidating why this may be the case. There are many directions we can approach this from.
First, to simplify, instead of talking about an A and B and having 25% ownership after these rounds. Let's assume $10M is invested in the A for 25% ownership ($10M on a $30M pre-money valuation / $40M post-money.) Of course if each of these companies exits at exactly $50M and money just sits there for 10 years then the returns will be garbage. But in reality if you're investing at a post-money of $40M, very few of your companies will exit at $50M.
What actually matters here is what happens with money after exits. If money is returned to investors immediately, then what we want is to solve:
$100M * (1.12)^Y <= .25 * (exit price)
For example, if ONE company goes from $40M post and exits at $562M after 3 years, and then this money is distributed back to investors, then investors receive .25*$562 = $140.5M as a return, which is more than 12% per year for these three years ON THEIR ENTIRE $100M investment. (This assumed no subsequent dilution but you get the idea.)
If money isn't returned directly to investors then it needs to be re-invested. The point is, of course your venture returns will be poor if you just place your cash under a mattress post exits. The math becomes much more favorable for the VCs with realistic time assumptions.
Evidently, a $10M investment that compounds at 12% p.a. will return $31M after 10 years.
The article however shows that dilution of that initial "round A" investment by subsequent rounds of capitalization needs to be taken into account (as well as when such a "round B" occurred, but that isn't addressed). It is this dilution that reduces the returns, requiring one or more "unicorn exits" to make the hoped for returns from the initial investment
So why isn't there an organization that distributes the risk of startup failure across many companies (kind of like how insurance distributes the risk of catastrophe)? That way, one unicorn would satisfy everyone, and all the startups that failed wouldn't matter. (I say this as someone who knows nothing about startups and VCs of course...)
Yup, that's literally the definition of VCs. Instead of a single LP having to choose one startup to invest their $10M into, they buy shares in the dozens of startups that the VC then invests in. The risk and reward is shared between all the LPs in that fund.
I have no idea why you're being downvoted. there are approximately 2.8 billion people in the world whose annual income is < $2/day which is $730 per year. If you invested $300 into a lucky 5% of them - to give them six months of runway - then it would cost you 2.8B * 5% * 300 = $42 billion and you get 142M entrepreneurs.
Let's say 1,000 companies, 8 worth > $1B. 8 in 1000 is 1 in 125.
Let's reduce 1 in 125 to - not 1 in 1250...or 1 in 12,500...but 1 in 125,500.
Everyone else goes to 0.
Okay, now you have created 142M / 125500 = $1131B in value at a cost of $42B.
That means if you took a 10% stake (a valuation of $3000 in everyone), you have now earned an approx. 30% return on your $42B.
I think the above estimates are more than reasonable and anybody anywhere in the world who wants $300 for 6 months of runway to build anything they want should be given it at a $3K valuation no questions asked - because it is free money and it is enough for 1 in 100,000 people to succeed. Those chances are better than the chances of a high schooler drawn at random (without regard to whether they have any interest whatsoever) making it into the NBA, since there are 360 people in the NBA but less than 36,000,000 high-schoolers.
$300 is more than enough for every tool an Internet entrepreneur needs - and remember, we are starting with the 5% who want to be one. the figures work just fine and your question is perfectly reasonable.
Entrepreneurs doing what, exactly? If someone is making $2 per day, they live with other people making $2 per day, and there isn't much spending going on.
>$300 is more than enough for every tool an Internet entrepreneur needs
Oh, except an education. And a way to not be immediately steam-rolled by anyone with more money than you if your business is even remotely reasonable.
I think you missed the part where I require 1 in 125,000 to succeed?
you're saying it's harder to get an education with an Internet connection and $300 than to start playing for the NBA without any particular interest or background in sports, just picking a high schooler at random? Well, okay.
plus, you say "if your business is even remotely reasonable" you'll get steamrolled by anyone with more money, but under our scenario there are more investment rounds if you succeed. (since that's the only way to end up with a $1b valuation.) in short I'm afraid you've missed the point of my calculation entirely.
My biggest criticism of this analysis is his wild overstatement of the benchmark return. Where in the world do you get 8% safely in equities and/or real estate? It's more like 3-5% because the world is awash in capital with precious few places to put it into play.
Which in a way would support his main point more strongly: venture returns are inevitably coming down from 12% to 7 or 8% annually.
>criticism of this analysis is his wild overstatement of the benchmark return. Where in the world do you get 8% safely in equities and/or real estate?
I agree. It's true that most VC funds have poor returns but so do most hedge funds and most mutual funds. I don't know the success statistics offhand for private equity (Carlisle Group, Blackstone, etc)
How do VC funds compare to all other types of actively managed funds?
Even Warren Buffet's Berkshire Hathaway "only" had returns of ~9.6% (not 12%) annualized return from 2005 to 2015[1] which stated that $1000 invested 10 years ago grew to $2496 (~2.5x).
Over the long term, it's not hard to find. You can get 8% annually by buying a broad based index fund and holding. Vanguard Total Stock Market would've worked over the past 10 years.
Look back 50 years and you'd have been saying "stocks are expensive" every few years, missing out on massive returns. Invest for the long term and don't worry about it. Today's expensive is tomorrow's cheap.
Generally, you would look at the relative risk of different asset classes to define the relative return goal.
The relative risk would be a function of factors like the volatility of the asset class (the higher the volatility, the higher the return required), or the liquidity (the longer the money is locked-in, the higher the return required), etc.
Up until 10-15 years ago, it was common to refer to return targets for a certain asset class as a multiple of risk-free rate (what government bonds yield), eventually, when the risk-free rate started converging to zero, it became more common to refer to return targets as risk free rate + X.
So, for example, a simplified ranking from the lowest to the highest return could look like this:
- government bonds
- AAA-rate corporate bonds
- US equities
- international equities
- risk-neutral hedge funds
- macro hedge funds
- private equity funds
- real estate funds
Whereby you would have the first half of the list generating single digit yearly returns (say, 8% for US equities), and the bottom of the list generating double-digit returns (say, 15% for risk-neutral hedge funds and 20% for private equity). This is just an example - with realistic numbers.
One of the implications of the above is NOT that private equity investments are better than US equities, or real estate investments are better than hedge funds: they have different risks, so they have to deliver different returns in order to be EQUALLY attractive.
Also, consider that there are many types of hedge investing and private equity strategies, each with different risk factors and target returns.
Correlations are another important factor: they measure how the return of a certain asset class moves relative to the others (what happens to your returns when US equities returns are negative?)
In order to increase their assets, VCs have to justify to their investors the returns they target vs. the risks they ask their investors to undertake. That's not easy for all VCs.
I don't quite agree with the math and illustrations.
If they put in 10M, get 25%, and exit is at 50M, that approximately zero growth over valuation (probably down from series B)
This is why VCs don't always take series B, and series A is much smaller so they can place more investments and see which ones are worth it.
A 100M series A fund with only 10 deals seems unrealistic.
Six years is not enough to IPO for most startups. Much less 4, if the A comes towards the end of the placement phase. That's not a change that helps anyone.
VCs are just doing the same investment strategy that record labels used to do... before file sharing decimated their mechanical royalty agreements. For every Britney Spears, you had 10+ other acts that could barely produce a break-even single. It's highly Pareto-driven.
Combine that with the fact that 2016 has only seen 7 tech IPOs...
And the fact that investment in sub-25M cap is dead thanks to Sarbane-Oxley/Basel III...
And GDP growth forecasts being cut by the IMF...
The only thing propping up the tech market right now is the fact that Apple, Microsoft and Google hold 23% of all U.S. corporate cash. Exit strategies pivot around whatever initiatives these three players choose, which means they, in essence, control the direction of tech innovation without having to acquire a single business. VCs will automatically organize their investments based on the acquisition habits of those three players in the hopes they get caught in the net as well.
From the 1970s to about 2000, venture capital firms as a class were profitable. Since 2000, venture capital as a class has been a lose. What keeps this going is that each VC thinks they're better than average. Most of them are wrong.
Venture capital in Silicon Valley used to be about finding someone who had a good technical idea, and getting them enough money to make a working prototype or a small production run. New technology and intellectual property were the key. That was a good business.
In the first dot-com boom, this changed. Technology wasn't the issue. It became about buying market share to achieve a "first mover advantage". That resulted in a focus on growth and a race to out-spend the competition. There were winners and losers, but in the end, mostly losers.
In this, the tail end of the second dot-com boom, we see the same pattern. The big difference this time is that nobody is going public. There's just round after round of private capital. The extreme case is Uber, with a valuation greater than General Motors while still losing money at a huge rate.
This is fueled by low interest rates. There's so much capital sloshing around looking for yields that too much money is being funneled into marginal companies. That's why there are no IPOs; it's cheaper to borrow.
"What keeps this going is that each VC thinks they're better than average"
Another thing keeps them going is that the VC Partners get a nice salary for 10 years. Many of them will make more money than many C-level executives. I don't see a downside in being a VC.
"What keeps this going is that each VC thinks they're better than average. Most of them are wrong."
Only some have this belief and only some of those are wrong, but it isn't what 'keeps VCs going' generally. That would be the high pay and our prestige culture.
As to the point about interest rates, you may be correct, but for the conclusion to follow we need an account of why capital makes yield chasing more aggressive in the private vs public markets. With public markets on all-time highs, cost of capital there doesn't look historically expensive. I suspect that you are correct about rates distorting the private market but for different reasons.
Source: am a vc, am professionally obligated to speak with vcs.
8% return in equities market? Wow... I did not know what I can just invest money in the stock market and get rich...
The 8% annual return is impossible to achieve (BTW, that is number what sharks tell to "retail investors"). Between 1998 to 2008 the annualized return on SP 500 was about -1.35% (yes negative and there was huge boom during 2000s). And that is excluding all fees.
I think 8% would be an excellent return for limited partners who invest into VC funds...
It's possible to achieve if you invest for the long term and stay the course. Between 1992 and today you would've gotten over 9% annual return with just the Vanguard Total Stock Market Index fund.
> Screw traditional investors, move to the “cloud”. We should be able to find better access to capital that isn’t looking for 12% returns. Can’t we find investors willing to get a 8% stable yield in a $1B+ fund diversified over hundreds of startups?
8% return means returning 2x in 10 years. The author /already told us/ that 85% of venture funds are unable to do even this. How will this "cloud" diversified fund do better than 85% of funds?
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[ 3.4 ms ] story [ 119 ms ] threadAlso, I'm sure a full-time VC could sit on 25 boards - that's why some VC's have a chauffeur to drive them from meeting to meeting.
Second: you don't /have/ to have a /personal/ board seat
Third: funds typically have multiple partners
If there is one lead and five follows in a series A, do you really think there are six new board seats created?
You would have made nearly twice as much (with virtually no risk) if you had bought a government bond with the money instead.
You're right about current yields, but they're also at all-time historical lows right now.
Venture capital refers to any capital provided to a venture. Some of this may come from a venture capital firm. That would be VC money. Some may come from friends and family, lenders and strategic investors. The latter are providing venture capital, but are not commonly referred to as venture capitalists.
This distinction is useful because VC firms structure their investments in ways that are better suited for some companies over others.
VC does mean "Venture Capitalist", and they are the company that invests on behalf of LPs (financial institutions) who give the VCs money as a "fund."
These effects combine to dampen the effects you mentioned. Consider FriendFeed - small $50M acquisition by Facebook, but given its non-financial impact, do you think the VCs regretted the investment? They'll make their $$$ somewhere else, perhaps the entrepreneur's next startup... which turned out to be quip, acquired for $750M last week...
1) Unfortunately, VCs have to care about financial impact over everything else. That's the only thing their LPs pay them for. So an amazing mission-driven company with a modest exit will make a VC and their LPs much less happy than a company that doesn't do anything particularly meaningful but exits for $2b. Put differently, if I invest in 50 companies that make the world better but don't product great returns, I won't have a job in 5 years; if I invest in 50 companies, one of which exits for $10b, I'll be able to raise VC funds for a long time.
2) That said, I bet FriendFeed was a fantastic exit for investors and employees. The acquisition was for a combination of cash and .5% of facebook's stock (https://techcrunch.com/2009/08/10/the-cost-of-friendfeed-rou...). That .5% would have appreciated about 15x by the time Facebook IPO'ed a few years later, and even more if investors are still holding on to the stock.
(source: I'm a VC.)
First, to simplify, instead of talking about an A and B and having 25% ownership after these rounds. Let's assume $10M is invested in the A for 25% ownership ($10M on a $30M pre-money valuation / $40M post-money.) Of course if each of these companies exits at exactly $50M and money just sits there for 10 years then the returns will be garbage. But in reality if you're investing at a post-money of $40M, very few of your companies will exit at $50M.
What actually matters here is what happens with money after exits. If money is returned to investors immediately, then what we want is to solve:
$100M * (1.12)^Y <= .25 * (exit price)
For example, if ONE company goes from $40M post and exits at $562M after 3 years, and then this money is distributed back to investors, then investors receive .25*$562 = $140.5M as a return, which is more than 12% per year for these three years ON THEIR ENTIRE $100M investment. (This assumed no subsequent dilution but you get the idea.)
If money isn't returned directly to investors then it needs to be re-invested. The point is, of course your venture returns will be poor if you just place your cash under a mattress post exits. The math becomes much more favorable for the VCs with realistic time assumptions.
The article however shows that dilution of that initial "round A" investment by subsequent rounds of capitalization needs to be taken into account (as well as when such a "round B" occurred, but that isn't addressed). It is this dilution that reduces the returns, requiring one or more "unicorn exits" to make the hoped for returns from the initial investment
Let's look at YCombinator's stats. YCombinator has funded something like this: https://blog.ycombinator.com/yc-stats
Let's say 1,000 companies, 8 worth > $1B. 8 in 1000 is 1 in 125.
Let's reduce 1 in 125 to - not 1 in 1250...or 1 in 12,500...but 1 in 125,500.
Everyone else goes to 0.
Okay, now you have created 142M / 125500 = $1131B in value at a cost of $42B.
That means if you took a 10% stake (a valuation of $3000 in everyone), you have now earned an approx. 30% return on your $42B.
I think the above estimates are more than reasonable and anybody anywhere in the world who wants $300 for 6 months of runway to build anything they want should be given it at a $3K valuation no questions asked - because it is free money and it is enough for 1 in 100,000 people to succeed. Those chances are better than the chances of a high schooler drawn at random (without regard to whether they have any interest whatsoever) making it into the NBA, since there are 360 people in the NBA but less than 36,000,000 high-schoolers.
$300 is more than enough for every tool an Internet entrepreneur needs - and remember, we are starting with the 5% who want to be one. the figures work just fine and your question is perfectly reasonable.
>$300 is more than enough for every tool an Internet entrepreneur needs
Oh, except an education. And a way to not be immediately steam-rolled by anyone with more money than you if your business is even remotely reasonable.
you're saying it's harder to get an education with an Internet connection and $300 than to start playing for the NBA without any particular interest or background in sports, just picking a high schooler at random? Well, okay.
plus, you say "if your business is even remotely reasonable" you'll get steamrolled by anyone with more money, but under our scenario there are more investment rounds if you succeed. (since that's the only way to end up with a $1b valuation.) in short I'm afraid you've missed the point of my calculation entirely.
Which in a way would support his main point more strongly: venture returns are inevitably coming down from 12% to 7 or 8% annually.
I agree. It's true that most VC funds have poor returns but so do most hedge funds and most mutual funds. I don't know the success statistics offhand for private equity (Carlisle Group, Blackstone, etc)
How do VC funds compare to all other types of actively managed funds?
Even Warren Buffet's Berkshire Hathaway "only" had returns of ~9.6% (not 12%) annualized return from 2005 to 2015[1] which stated that $1000 invested 10 years ago grew to $2496 (~2.5x).
[1]http://www.businessinsider.com/warren-buffett-berkshire-hath...
Beating the market is tough.
- 76.7% over the last 10 years (5.87% annualised)
- 90.0% since inception 15 years ago (4.3% annualised)
That is very far from 8% - at that rate with compound interest you'd have gotten 217% of returns from VTI over 15 years.
The relative risk would be a function of factors like the volatility of the asset class (the higher the volatility, the higher the return required), or the liquidity (the longer the money is locked-in, the higher the return required), etc.
Up until 10-15 years ago, it was common to refer to return targets for a certain asset class as a multiple of risk-free rate (what government bonds yield), eventually, when the risk-free rate started converging to zero, it became more common to refer to return targets as risk free rate + X.
So, for example, a simplified ranking from the lowest to the highest return could look like this: - government bonds - AAA-rate corporate bonds - US equities - international equities - risk-neutral hedge funds - macro hedge funds - private equity funds - real estate funds
Whereby you would have the first half of the list generating single digit yearly returns (say, 8% for US equities), and the bottom of the list generating double-digit returns (say, 15% for risk-neutral hedge funds and 20% for private equity). This is just an example - with realistic numbers.
One of the implications of the above is NOT that private equity investments are better than US equities, or real estate investments are better than hedge funds: they have different risks, so they have to deliver different returns in order to be EQUALLY attractive.
Also, consider that there are many types of hedge investing and private equity strategies, each with different risk factors and target returns.
Correlations are another important factor: they measure how the return of a certain asset class moves relative to the others (what happens to your returns when US equities returns are negative?)
In order to increase their assets, VCs have to justify to their investors the returns they target vs. the risks they ask their investors to undertake. That's not easy for all VCs.
If they put in 10M, get 25%, and exit is at 50M, that approximately zero growth over valuation (probably down from series B) This is why VCs don't always take series B, and series A is much smaller so they can place more investments and see which ones are worth it. A 100M series A fund with only 10 deals seems unrealistic.
Six years is not enough to IPO for most startups. Much less 4, if the A comes towards the end of the placement phase. That's not a change that helps anyone.
Combine that with the fact that 2016 has only seen 7 tech IPOs...
And the fact that investment in sub-25M cap is dead thanks to Sarbane-Oxley/Basel III...
And GDP growth forecasts being cut by the IMF...
The only thing propping up the tech market right now is the fact that Apple, Microsoft and Google hold 23% of all U.S. corporate cash. Exit strategies pivot around whatever initiatives these three players choose, which means they, in essence, control the direction of tech innovation without having to acquire a single business. VCs will automatically organize their investments based on the acquisition habits of those three players in the hopes they get caught in the net as well.
From the 1970s to about 2000, venture capital firms as a class were profitable. Since 2000, venture capital as a class has been a lose. What keeps this going is that each VC thinks they're better than average. Most of them are wrong.
Venture capital in Silicon Valley used to be about finding someone who had a good technical idea, and getting them enough money to make a working prototype or a small production run. New technology and intellectual property were the key. That was a good business.
In the first dot-com boom, this changed. Technology wasn't the issue. It became about buying market share to achieve a "first mover advantage". That resulted in a focus on growth and a race to out-spend the competition. There were winners and losers, but in the end, mostly losers.
In this, the tail end of the second dot-com boom, we see the same pattern. The big difference this time is that nobody is going public. There's just round after round of private capital. The extreme case is Uber, with a valuation greater than General Motors while still losing money at a huge rate.
This is fueled by low interest rates. There's so much capital sloshing around looking for yields that too much money is being funneled into marginal companies. That's why there are no IPOs; it's cheaper to borrow.
Another thing keeps them going is that the VC Partners get a nice salary for 10 years. Many of them will make more money than many C-level executives. I don't see a downside in being a VC.
Only some have this belief and only some of those are wrong, but it isn't what 'keeps VCs going' generally. That would be the high pay and our prestige culture.
As to the point about interest rates, you may be correct, but for the conclusion to follow we need an account of why capital makes yield chasing more aggressive in the private vs public markets. With public markets on all-time highs, cost of capital there doesn't look historically expensive. I suspect that you are correct about rates distorting the private market but for different reasons.
Source: am a vc, am professionally obligated to speak with vcs.
The 8% annual return is impossible to achieve (BTW, that is number what sharks tell to "retail investors"). Between 1998 to 2008 the annualized return on SP 500 was about -1.35% (yes negative and there was huge boom during 2000s). And that is excluding all fees.
I think 8% would be an excellent return for limited partners who invest into VC funds...
Over the past 50 years, the average return on investment for 10 year periods has been [1]
So yes, you historically could just invest money in the stock market and get rich, and you will probably continue to be able to do so.[1] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/...
(Why do you think that many experts pick 10 year maturity bonds with a 1.5% coupon over stocks?)
8% return means returning 2x in 10 years. The author /already told us/ that 85% of venture funds are unable to do even this. How will this "cloud" diversified fund do better than 85% of funds?