VCs need one large exit to see good profits
techcrunch.com
techcrunch.com
> One-two years for scouting and finding 10 A-round startups, four-five years for growth. Add some non-stop pressure on the founders to sell all the way around.
Holy moly. How well would this have worked for Google to sell to Yahoo or Facebook to sell to Google? You are throwing out the baby with the bathwater here.
If a company blows up, the vast majority of the returns are coming after 4-5 years. I mean, look at GOOG, and only returns since it went public (~6 years after founding). Google's stock is up 1700%, the public markets are only up ~150%. You want them to sell those returns to somebody else? And obviously this post-IPO gain is just a multiplier on the returns from Series A --> IPO which is just astronomical returns you'd be not getting.
> Invest in more startups/less cash in each.
Just doesn't make sense. For many VCs the limiting factor is their ability to spend their time and effort trying to help their portfolio companies. Good VCs don't just give money, they give guidance, advice, strategy, etc. You can do this with 2-3 companies, not so much with 20-30.
> The ancient “2 percent and 20 percent” should be killed off and replaced with something that endorses higher alignment. Let the VCs fight for their supper.
What is the suggestion?
One possible fee structure would be a reasonable fixed amount to cover expenses including supporting portfolio companies (maybe 2% isn't crazy), and an incentive fee on returns above some reasonable hurdle or benchmark.
If the investments yield an 8% gross annual return, the VC who is not at risk is getting paid a rich 3.6%, the investor a paltry 4.4%. Maybe it should be e.g. 20% on the excess over 7.5%, 30% on the excess over 15%.
Then if the investments yield 8% gross, VC gets 2% and investor 6%, and if the investments yield 20%, VC gets 5% and investor gets 15% (if I did that right, would have been 6%/14% under 2/20, at some higher point crosses over and VC does better)
It's easy to conclude that 'All companies should hold out on selling' because if you look at the data for companies that held out, they outperform.
However, there's extreme selection bias. When your true value is in the tens of billions (FB/GOOG), you're never going to get acquired for a fair price because no company can afford you, so you are always going to be in the 'held out' cohort.
There are plenty of businesses whose true value (future discounted cash flow) is in the hundreds of millions or low single digit billions. At this price, many of these companies could find a suitable buyer at a fair price. Since liquidity is a good thing, there's no reason not to.
> If a company blows up, the vast majority of the returns are coming after 4-5 years. I mean, look at GOOG, and only returns since it went public (~6 years after founding)
Using GOOG as an example of expected returns is an absurd generalization. By definition, the expected return on a public stock following an IPO roughly aligns with the rest of the public market (4-8%).
I'm not sure I agree with them or their particularly analysis, but I'm very convinced they are different because the way I see it, VC and the public markets are completely different things. It's like the farm system for baseball teams. VC is investing in the upcoming prospects, and the VC is investing in the existing major leaguers. Sometimes you'll have a farm system full of A+++ prospects that pay off huge (Google, Facebook), and sometimes you won't (pick a 5 year period where there were no massive VC payouts). And obviously the returns on those prospects will only go to whatever team they happened to be on (which VC picked them), whereas public market returns can go to anybody. But they are different companies at different ages doing different things. Thus to me it would be quite surprising if their returns were all that correlated.
And at some sense "froth" is irrelevant. A VC doesn't have to sell their Facebook or Google stock when it IPOs, they can hold onto it as long as they like. They are basically investing for the chance to get that amazing stock at a huge discount by getting it at the "prospect" stage, and once it goes public they can ride the public market waves as well.
Generally, there are restrictions in the LP agreements that may limit the amount of the fund that is in publicly-traded securities. There may also be requirements for distribution to the limited partners of public-traded securities.
VCs are paid to make illiquid private investments and massage them through to the point that they are liquid (cash, or marketable securities). LP investors, as a whole, are less than sanguine on the VCs subsequently becoming public markets equities horse-bettors.
I was basing my comment on something a Sequoia partner said that they'd never sold a share of their Google stock, but that might have been their own personal investment (or frankly I have no idea how it works -- do LPs always get cash as returns or do they get shares of the post-IPO stock?).
Unless a special deal is arranged it is cash in, cash out.
No, it matters. Investors want investments that are not closely correlated with the public markets, but they still want something that is going to have a decent Sharpe ratio (~return/risk).
Furthermore, is it even true that VC returns are not well correlated with the public equity markets? My guess is that they would be pretty closely correlated.
On the contrary, I would posit that they're not correlated, or perhaps only weakly so. One of my primary concerns with the venture capital industry and the private equity markets in general is that there is no mature mechanism for the market consensus to reflect short opinions.
In public markets, there can be significant dissenting voices expressed by short interest which will have a material impact on the price of an equity. In the private markets, pessimism from many parties cannot be used to directly influence the consensus price. In my view, this leads to a natural bias towards successful private companies rising in valuation over time, whereas public companies swing more easily in either direction and have a harsher regulatory climate.
While both markets are influenced by things like interest rates, I would default to assuming that they significantly diverge in aggregate returns over time. They also have significant differences in liquidity, which means unhealthy economic trends in one may take a relatively long time to manifest in the other, even if they were otherwise correlated.
But the VC fee structure is probably among the most honest and legit setups in all of finance.
Look at Private Equity (PE) fees. In addition to whatever the LPs are directly paying, portfolio companies themselves are posting up huge fees back to the PE firm. Plus dividends, director fees, you name it. "Promotes" for putting a deal together with a syndicate. Etc. etc.
Look at lending. You've got stated rates but all kinds of extra fees, origination expenses, etc. baked in. When your lender gives you an APR, he is looking at a projected IRR that is way higher, I guarantee.
Early stage VCs -- with few exceptions, and those mainly during weird downturn / recap scenarios -- are generally getting plain vanilla convertible preferred stock. No management fees. No origination / finder's fees. No director fees. No promotes.
There are, by the way, some mechanisms for dealing with absurd fees (in VC and other asset classes). They're well known, and already practiced by savvy LPs with leverage.
If you take away the 2% return, you've basically said that only super rich people that can afford not getting paid for 5-10 years should be VCs. Do you think that all the best investors in the world are super rich people?
Also, when to take that 20% is an issue. Perhaps a VC that is strapped for cash would push a company to exit sooner, or sell the stock right after the IPO, so they could take some of their profits off the table and thus get some working capital. However maybe they'd get a better return for both themselves and their investors by waiting another 5 years. Sequoia has very famously said that they've gotten more returns from their companies post-IPO --> now than they have from initial investment --> IPO. If you believe in the long term prospects of a company you essentially want to never sell the stock.
I'm not suggesting there isn't an alternative, but I'd like to see it. The LPs who continually agree to this fee structure aren't idiots.
You can take away the 2% and leave some value value that still pays the investors. The problem with 2% is that the fund managers often taken home %1 type wages without actually performing. A %1 fee with a clause that caps all fund managers salaries at $60k (or some livable wage) ensures that the investors can live, but puts all of the income incentive on their bonuses which is tied to fund performance.
Right, and fund managers will work for free instead. I know quite a few of them and I would not want to trade with them. Spend half your life in transit lounges of airports and the other half in hotel rooms, maybe if you're lucky you get to see your kids on the weekends. I know divorced couples that get more family time than some of the VCs I work with, they're the hardest working people that I know, much harder than most founders.
I suspect that your viewpoint is not illuminated with actual experience of the VC world.
Note that people that made enough money to start a VC fund usually value their time well and if you want to get them to pull your cart for you (as an LP you have to do absolutely nothing) they expect to be compensated for their time.
This really adds up.
Hedge funds are all the same at the end of the day.
I agree, this is a stupid fight. Higher alignment is called "Private Equity" and it already exists as a model. VCs will go where the market (i.e. the money) tells them, which right now is 2/20. All of the VCs that don't return their funds will simply stop getting LP money and cease to exist.
> I recently had a meeting...talking about the macro view of venture capital and how it doesn’t actually make sense....It took me a while to understand what this really means.
Ok so the author just had a meeting with an angel investor, decided to do all of the research (that's already freely available mind you) and came to the same conclusion as everyone else. Ugh.
That is NOT what PE is at all! PE is about buying WHOLE companies that have established businesses but are struggling. PE does NOT invest in growth companies that are new to the market / not yet proven, nor do they take small percentage ownership.
> PE does NOT invest in growth companies
I've advised over 50 transaction on behalf of Private Equity firms. These are not true statements.
http://www.kauffman.org/-/media/kauffman_org/research-report...
> Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years.
EDIT: This is actually linked from the article but I thought it was worth calling out nonetheless.
Are those really the definition of a VC success story?
Digging in further:
- assumptions are bad. 7-8% in RE / public equities? Hmm, dubious.
- poor understanding of TVM. 12% is 3x? Except, in the real world, there are incremental cash flows on both capital calls and returns ... so IRR.
- completely ignores cyclicality. Vintage year is the single biggest determinant of venture performance.
One big plus: takes a bit of the wind out of the "we VCs are paid to take risks" strutting. Of course, professional VCs gauge risks and make informed bets. But as the author points out, it's mostly with other peoples' money. True. Entrepreneurs are the ones taking the real, personal risks.
And it would be wrong to assume that there aren't market forces, working even as we type, to 'correct' the imbalance. If it had not been for the exceptionally anemic returns to be had in general, I expect this correction would have happened sooner.
But unlike startups that post 'incredible journey' type farewells, VC firms that evaporate are rarely reported on. There are firms which are contractually following through on their existing funds, raising no new funds, and entertaining no investments in companies they aren't already invested in. These are dead venture capital companies that are waiting for the end of life support.
I am curious what the next chapter will look like. A lot of people think it will be more 'integrated' VCs that look more like Y-combinator and less like Sequoia. Hard to say.
I haven't done the numbers to see how this changes the outcomes in the article, but it seems like it probably has a pretty big impact, considering how much the article focuses on the liquidity aspects. I wonder what the contribution graph tends to look like over the lifetime of a typical fund.
Sure there is: bank loans, growth capital, corporate backers through a JV, et cetera. This is how new business was financed for centuries. If you're talking about companies that grow up to be "average" but still fail at the rate and with the recovery rates of aspiring unicorns, then ofcourse not.
https://blog.wealthfront.com/venture-capital-economics/
https://blog.wealthfront.com/venture-capital-economics-part-...
https://medium.com/startup-grind/technology-due-diligence-or...
EDIT: Just re-read, makes sense why this is "news"... "I recently had a meeting...talking about the macro view of venture capital and how it doesn’t actually make sense....It took me a while to understand what this really means."
Ummm, yeah, that's right because those investors are called growth equity investors. They don't get the attention VCs do but they are out there.
Illiquidity? Well given the huge amount of capital in the markets, there is next to zero other way to invest your big monies while also wanting some above-inflation return... the only real exceptions are pennystocks (aka spread and hope for a unicorn, just without a VC as "middleman"), real estate (which may or may not crash soon-ish, given that the bubble in Western markets, esp. London, has been created by Chinese and Russian investors hoping to stash money away before capital flow regulations) and VC.
Everything other is dead: State bonds, e.g. the German bonds, even pay negative interest, "conventional" lending is also downhill, and the market is too short-term-thinking to go long on "classic" stocks.
To summarize: Yes, there is a huge amount of risk and fees involved when investing with VCs, but they are not creating illiquidity when there's next to nothing where liquidity can flow into. And only when looking via this viewpoint one can understand how Yo could get 1.5M $ VC at 10M $ valuation.
This isn't the reasoning behind it. The actual reasoning is more like constraints in number of worthwhile investment opportunities.
If the fund has $100M to invest and a hundred startups that meet their criteria, the fund has to average $1M per investment in order to invest all the money that they want to. If they have $200M, the average investment has to go up to $2M.
VCs are already talking to as many companies as they can. Investing in more opportunities means lowering their standards. Assuming that VCs are rational about their standards, this is a poor choice.