Economics of the VC business

There is a lot of blog buzz this week on the VC business.  In my opinion, the market for VC investment has definitely changed over the past 5 years, but the model for success has not. Invest in great management teams, with a product or service that solves a hard problem, in a big or expanding market, and help them build a long term company.

Other opinions abound. Rick Segal started the discussion with his VC Rant and VC 2.0. Both posts basically say that VCs need to make smaller investments in a lot more companies, and that VCs need to be more open to new ideas. Doc Searls followed with Disrupting the VC Business. Dave Winer jumped in with How to Reform the VC Business which basically proposes to replace VCs with public investment companies perhaps like CMGI and ICGE. I think the results of those experiments speak for themselves.  Mathew Ingram responds that VCs Didn't Create the Bubble and Mark Evans A New VC Model. Both take a moderate view that the needs of start-ups are changing but VCs still play an important role.

Peter Rip from Leapfrog Ventures provides a thoughtful review of the boom/bust cycles of the past 15 years.  I particularly like this point from Peter;

Venture capital is a three parameter problem. Buy low, Sell High, Sell at the Right Time. Most people seem to have ignored the third parameter. Time-to-exit used to be 4-6 years. Then it collapsed to 2 years in the Bubble. Now it seems pretty much infinite. Divide by Zero and get infinite IRR. Divide by infinity and get -100% IRR. The proof is left to the Investor.... Time is a precious asset in the investment business. When P/Es were high and the public market was accessible, returns swamped time in the calculus. Now Time is as important as Return and investment strategies have to optimize for time to liquidity as well as absolute outcome.

My take is that the boom/bust cycles are driven by the IPO market. VCs are middlemen between the entrepreneurs (supply) and the public IPO market (demand) investors. Public market investors have hundreds of different asset classes to choose from, and they move in herds. IPOs is just one asset class, and is out of favor at the current time. Public market investors move in and out of asset classes quickly (quarters, months, even days) while VC investors are locked in for 4 to 6 years.

Why can't VCs make smaller investments, spread the risk, and accept smaller returns? Theoretically they could but that philosophy is more like making bets than building companies. VCs use their time, experience and network to build companies. They are not like mutual fund managers who have no direct involvement, make a few bets, and pull out if things don't go well. VCs don't have the same liquidity that mutual fund managers have. And their expertise is in building companies for the long term, not timing buys and sells for quarterly returns.

Why do VCs focus on bigger deals of $2M to $5M per round? It basically comes down to time. VC partners can only handle so many portfolio companies and still do a professional job. It takes as much time to do a $500K deal as it does to do a $5M deal. If a VC fund has 5 partners and $500M to invest, they want to invest about $10M per company over several rounds. So, the math works like this; 5 partners X 10 companies X $10M = $500M fund.

But why not have 10 partners do 10 smaller $5M deals, or have the same 5 partners do 20 deals at $5M each? The math still comes out to $500M, right? Two reasons. Compensation and professionalism. VCs are compensated based on "carrying interest", usually 1% to 2% of the money they manage. Each partner can only reasonably handle 10 companies and board seats, and still do a professional job. So, if you increase the number of partners the compensation goes down. If you increase the number of deals per partner the quality and returns go down.

Fred Wilson sums it up; "I would suggest one rule and only one. Be the entrepreneur's partner. Help him or her. Be there for them. Support them. Counsel them. Share the risk with them. Have fun with them. Laugh and cry with them. And make boatloads of money with them. It's a time tested formula and it will work forever."

Comments

[Chris Whalen]

With the dimished returns on VC investments these days, the secondary market for portfolios seems to be growing as well. During the boom years VCs typically enjoyed at 19% or so blended return on all investments. These days it is down more in the range of 12%. As a result companies like Cipio Partners are swooping in to buy portfolios. Essentially pre-scrubbed deals complete with all the diligence and negotiation done.

With the lower returns it will be interesting to see if angel investors start becoming far more active in larger deals, and will the VC industry evolve into a huge seocndary market with few firms actually hunting for and putting the effort into early stage companies.

[Dave Chapman]

The limiting factor on a VC portfolio is the
partners' time. You can't sit on more than
10 boards and do a good job, and there are
only so many full partners to go around,
so that sets a very tough lower limit on
the dollar value of a deal.

For a while there, you couldn't get a name
VC partner on your board unless the deal could
paper out to $several billion in 5 years.
Today, they may return your phone call on a
$500M upside.

Also, your point about VC investing being
highly illiquid is well taken. The market
for pre-IPO corporations is kind of like the
Real Estate market. It's illiquid, the
transaction costs are high, and every deal
is unique.

It's much more interesting than running a
bond fund.

[marcus farny]

"Why can't VCs make smaller investments, spread the risk, and accept smaller returns? Theoretically they could but that philosophy is more like making bets than building companies. VCs use their time, experience and network to build companies."
To me it seems that's already happening. VC funds have some many companies it just like a record label. Invest in a 100 companies, one will be successful and will pay for the 99 disasters. What kills me is that VCs still think that they have experience and expertise running companies. They look at historic data and run their models to analyze the return potential of an investment. The term venture capital has nothing to do with ”venture” anymore. During the Internet bubble all these VCs with many degrees from the best schools were on the boards of all these Internet companies... most of them failed as we know it and they still tell you "we have the management experience and demand board seats".