Sunday, February 19, 2006

Raising Capital: Why VCs Need Grand Slams

The difference between a fundable and a lifestyle business is essentially how big and how fast a company can grow, but why do venture firms need such outlandish returns? Venture firms invest other people’s money and they need to return an appropriate premium for the risk they take. I’ve found looking at the structure of how a venture firm is run to be helpful in elucidating why VCs can’t invest in even the most successful lifestyle businesses.

Generally speaking venture firms are made of two types of partners. Limited partners provide capital for the venture fund. Limited partners are generally wealth individuals, pension funds, universities, fund of funds, etc. Limited partners do not play a day-to-day role in the management of the fund. However, occasionally general partners will invest some of their own money in the fund along side the limited partners. General partners manage the capital in the venture fund by investing it into startups. It is the responsibility of the general partners to return as much capital to the limited partners as possible. If the general partners under perform it is unlikely that they will be able to raise a second fund from their limited partners.

The general partners need to create higher rates of return than other competing asset classes such as hedge funds and private equity funds. I would be surprised if a VC could raise a second fund with annual returns below 20%, although, this does depend heavily on the investment climate of the industry and time period in which the fund is invested.

Time is also a critical element for venture firms. General partners are usually supposed to return capital to their limited partners with in 10 years. This means that investments that may take longer than this to get liquid aren’t fundable. Furthermore, time has a huge impact on the IRR calculation. For example, a 10X return in 7 years is 39% return, but over 10 years, a 10X return falls to 26%. Yet, realistically general partners do not deploy all of their capital in year one, so most of the investments will need to have maximum time horizons of 5-7 years.

In order to succeed venture firms need to invest in businesses that create more than just 20% annual return. The venture firm will also have management fees that they have to cover, a carry (success fee) that they need to retain top general partners and the reality that not all of the investments they make will be successful.

As a first time entrepreneur, I admit that I’m really not in a position to know exactly what venture firm management fees look like, but I’ve heard figures from 2 - 6%., which pushes the annual return minimum of staying in business upward.

Next there is the carry that is used as a success fee to provide incentive for the general partners and align their interests with the limited partners. After the original capital is returned to the limited partners, the carry represents the percentage of the additional profits which the general partners share. For example a $100 million fund that has a 25% carry and returns $1 billion dollars would net the general partners $225 million.

(returned - original) x carry
($1,000,000,000 – $100,000,000) x 25% = $225,000,000

20-30% carry fees are standard in venture investing but the exact figure is dependent on how much prospective limited partner demand there is for the firms general partners. For instance, KPCB, Sequoia, Benchmark, Menlo, Mayfield and Accel probably command higher carry fees than newer firms. Thus, not producing returns high enough to create meaningful carry fees hurts the venture firm’s ability to retain top general partners, which in turns increases the difficulty of raising new funds from the limited partners.

Lastly, and most importantly, not all funds investments will succeed, so the good investments need to create returns high enough to cover the bad ones. John Nesheim (read his blog here) sites the following data on the returns of venture portfolios from Saratoga Venture Finance on page 181 of his book High Tech Startup:

60% = Bankruptcies with 5 year return multiple of 0X
12% = Breakeven with 5 year return multiple of 1X
10% = Fire Sales with 5 year return multiple of 1.3X
8% = Zombies with 5 year return multiple of 1.6X

This data suggests that 90% of VC investment make little or no money. If we assume that capital is invested evenly across in $100 million dollar fund, the $90 million invested in these non-performing investments leads to a net loss of $12 million dollars. Under these circumstances, the successful 10% of the portfolio needs to actually generate over a 100X return to pay back then entire fund at a 10X multiple.

I’ll jump right out and say that these numbers from Saratoga Venture Finance numbers look funny to me and I’ve never heard of a VCs looking for 100X investments that they imply. However, the general point holds that if a venture firm wants to return 10X to their limited partners, they need to look for investments with potential for higher than 10X returns to account for the losers in their portfolios. I suspect the reason why the Saratoga Venture Finance data looks funny is primarily because represents the entire venture investing industry and not any particular firm. In the process of doing my own research on prospective Cryptine Networks investors with data from Venture Source, I’ll estimate the average firm that I investigated had approximately 25% rate of bankruptcy.

I believe the divergence between my own estimations and the data collected by Saratoga Venture Finance, is that I was only looking at successful venture firms, where as they have also researched firms that failed. However, firms manage themselves to achieve success not failure, so for the purposes of this discussion, I believe my estimates may be more useful than Saratoga’s. A 25% bankruptcy rate would imply that the rest of the portfolio would need to create an average return of 13.34X in order to produce a 10X overall return for the fund. Yet, some of these investments will also create zombies or only breakeven, which pushes the required return of the successful investments even higher.

Thus, venture firms really can’t consider investments of where they don’t see potential returns of greater than 10X because the economics of their own business models don’t work out. One last point worth reiterating is that VCs care about lump sum cash returns, not dividends or paper returns. Venture firms need to return capital to their limited partners, not stock, thus a wildly successful business with tremendous cash flow that cannot achieve liquidity through either acquisition or IPO doesn’t fit the venture model either.

For further reading, I would suggest Tim Oren’s (Pacifica Fund) post titled No Exit: When Venture Capital Isn't Right and Jason’s (CXO Ventures) post titled VC Primer: The Carry. I found both of these blog postings to be very helpful in writing this article.


At February 19, 2006 10:55 PM, Anonymous Charles Eric O'Donnell said...

Your calculations are off.

The staggered deployment and distribution of capital implies a much lower multiple for a fund. Returns of 20%+ can be achieved with 2x-2.5x return of capital.

That means that home runs are more in the 4-8x range, not 100x.

Also, fees range from 2-2.5%. VCs do not take more than that. Not only that, but most funds return the management fees taken before they take their cut of the profits.

Perhaps, instead of criticizing the license plates of blogs you clearly do not read regularly, you should be doing some more research.

My plate is a combination of my initials and the city I live in.

That's pretty far from ridiculous as far as I'm concerned.

At February 18, 2009 6:32 PM, Blogger michael said...

Whilst your calculations are, as Charles says,"off", your intention to shed some light on the reasons why VCs need big wins is clearly in the interests of the masses.

Really it is as simple as VCs have 1/3rd, 1/3rd, 1/3rd rule of thumb. one third of their investments will be write-offs, one third will be sideways exits at no more than 2x, and one third will need to give the expected IRR to the limited partners. When you add to this dynamic that, for example in a $100M fund with life of 10 years at 2% p.a. fee to manage, that $20M is not available to invest, i.e. only $80M goes into companies, you begin to understand what Charles is correct in saying; namely that home runs need to be in the 4-8x range.

In short, the gains for limited partners will, on average, for a $100M fund will come from only $53M of wise investments, since the other $47M is lost or spent on management fees.

Too many numbers can begin to confuse rather than enlighten. 1/3rd model and 4-8x range based on only half the cash generating any returns - that's easier to understand for most of us.

I'm building my blog as we write. I'm completely knew to the whole concept of even talking online, let alone trying to create information that is valuable. I dont want to re-hash what's been said before, so I am open to anyones ideas on the training side of commercialisation and the conversation piece between investors and investees. That will be my focus. What do you all think of that as a forum?



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