— An Op-ed by Andrew Vo
I often get asked what will happen to Silicon Valley during the inevitable “Unicorn Burst” and I always go back to the story of China’s “Ghost Cities.”
After the Global Financial Crisis 2008, in an attempt to cushion the economy and create growth again, China’s government announced a 4 trillion yuan (USD 600 billion) stimulus. A good portion of this stimulus package was used to build massive infrastructure projects, extravagant government buildings, and entire cities throughout the country.
China’s government, like Silicon Valley’s Venture Capitalists, was hoping that “if you build it, they will come,” but that hasn’t proven true for many of the country’s brand new cities and malls that now almost completely devoid of people. There are an incredible 65 million empty apartments in China, which amounts to approximately a fifth of the housing supply.
These cities, completely devoid of life, like the one below by Meixi Lake near the city of Changsha, paint a cautionary tale for Venture Capital, one called China’s Ghost Cities.
Similar to the misallocation of capital that resulted in China’s numerous empty “Ghost Cities”, Silicon Valley has been the beneficiary of this misallocation from the capital markets as investors have been struggling to generate returns in a low rate environment driven by global “quantitative easing” by the world’s central banks.
That said, and due to overwhelming interest for the much anticipated released of Aidos op-ed on why “Silicon Valley is Broken”, I want to change gears and review the mathematical basis for the argument in the op-ed.
I apologize in advance as the following content will be a bit dry, but for all the Finance Rockstars, please critique it as much as possible.
Please try to study this before reading the op-ed so we can have a common point of agreement, so that you can evaluate the op-ed for its factual merits, without any emotional biases coming into play.
If you find any gap in what I am saying, please don’t conclude against me, because in a brief amount of words, I am trying to convey some very startling realities that is the venture capital investment model.
Assumptions behind why “Silicon is Valley is Broken”
- Success = 12% annualized return which is about the long-term return of the U.S. stock market as measured by the S&P 500 Index.
- The Venture Capital Fund Life is 10 years.
- Given (1) & (2), we find that a fund needs to generate at least 3X MOIC (money on invested capital) in order to break even before the VC even collects management fees. The math here is simple: 3x target return = 3^(1/10)-1 = 11.6%, slightly less than 12% but we give the VC a conservative 3x minimum.
- This brings us to fees: VCs charge two fees according to the “2/20 model”: management fees, typically 2%, and “carry”, typically 20% of profits. Some brand names like Kleiner Perkins have been known to charge upwards of 40% carry in their heydays long ago.
- Assume the VC makes 10 investments per fund.
- Let’s assume the fund size is $100 million.
- Without management fees, this implies $10 million per investment deal.
- With management fees at 2%, this accumulates to $20mm ($100mm x 2%) over 10 years. This means the investable amount is only $80mm ($100mm — $20mm of fees), so the “deal size” is only $8mm vs. $10mm from (7).
- Exit Strategy: Let’s assume the VC jumped in during the A round, followed up on during the B round and has a 25% ownership at the exit, with non-participating liquidation preferences.*
- Cashflow Timing: to keep the analysis simple and understandable, and without detracting much from the central thesis, I’d keep the timing of the capital commitments, investment ramp-up, and VC fees payout simple. We will assume the $20mm of management fees from (8) is taken out at the onset, not annually over 10 years. We assume that the capital is called during the first year of investment.**
*Without getting into the weeds, non-participating liquidation preferences are pretty standard today in deal term sheets, as it is favored by holders of common stock (i.e. founders, management and employees).
**This is actually what is happening right now with the mega-sized funds (>$1bn). See this revealing article that highlights that Kleiner Perkins burned through $600mm in 2019, and has the audacity to raise another presumably, larger fund this year, even in the wake of the visionary female VC, Mary Meeker’s departure from the firm for “uncited reasons.”
Sorry, I know that’s a lot to digest.
That said, please study those assumptions carefully as they are crucially important to understand Venture Capital Returns and reflect actual terms of most VC funds nowadays.
Borrowing from Harvard Business School’s Case Study, let’s use this approach to evaluate the economics for a VC fund, separately between two general cases without (A) and with (B) management fees.
Note: the Exit Multiple required for each scenario is listed as well as the VC’s profit, MOIC, and implied IRR over the 10-year life of the fund.
Remember, most Venture Capitalists are pitching investors claiming that they will beat the 12% annual return of the S&P 500 Index by at least 2–3%, BEFORE they start layering on additional fees.
Let’s see how challenging it is to achieve this goal based on Math.
Case A: No Management Fees
Our base case is a 5x return on each investment, no management fees, and 25% VC ownership at the time of exit, with non-participating liquidation preferences.
Scenario 1: All 10 Exits at 5x
This result is quite disastrous!
For 10 years, investors are earning a measly 2.26% annual returns, which is about the rate of inflation — so essentially earning the rate of a bank CD tied to inflation.
What if we bumped up the exit multiples for half of the investments to 10x?
Scenario 2: 5 Exits at 5x, and 5 Exits at 10x
Still not good enough at 6.5%, which is about the expected rate of return of the stock market over the next 10 years, including a long-overdue Global Recession, widely accepted by most investment managers.
Okay, so what does it actually take to just earn the long-term return of the stock market?
Scenario 3: 3 Exits at 3x, 5 Exits at 5x, and 1 Exit at 50x
Finally, success!
But what happens, when you add in reality, which is the “innocuous” 2% management fees charged by every VC investor, including the mega-sized funds like Sequoia Capital?
Sparing you the painful details (lackluster returns), but the VC underperforms the stock market when you add in management fees across the above three exit scenarios.
Okay, what would it take for a Venture Capitalist to just beat the stock market assuming management fees are included (reality)?
Case B: Management Fees of 2%
Let’s start with this realistic “base case”, which assumes 9 exits at 5x and 1 exit at 100x, or in VC jargon, a magical “moon shot” startup like Uber or WeWork, including unsuccessful moon shots like the Softbank-backed Brandless, which declared bankruptcy this week.
Scenario 4: 9 Exits at 5x, and 1 Exit at 100x (moon shot)
Just for some context on what 7.2% means on a relative basis.
7% is about the return for an average, active U.S. core equity mutual fund manager — most likely included as “default option” as part of your 401K employer retirement plan.
Ok, so what does it take in this realistic scenario for VCs to beat the stock market?
Scenario 5: 9 Exits at 0x (losers), and 1 Exit at 150x (unicorn)
Yep, you read that right.
Assuming 9 complete losses and the magical “Unicorn” success at a staggering 150x multiple, a VC will earn just barely the return for the stock market, BEFORE they start charging fees for their “services” to investors.
Note: the stock market return is readily available to anyone with a brokerage/bank account, which allows them the option to invest in an “S&P 500 ETF”, available for a few “basis points” (less than 5bps or 0.05%) from an asset manager like Vanguard or BlackRock.
Sanity Check: 150x return investment — that sounds like a lottery to me.
Well, what is a more realistic scenario that matches the stock market return?
Scenario 6: 8 Exits at 0x, 3 Exits at 5x, 1 Exit at 50x, and 1 Exit at 100x
So in order for a VC to even beat the stock market by just 68 basis points or 0.68%, the VC has to have the Extraordinary Skill to pick a 50x awesome startup and a 100x moon shot startup, in addition to 3 nice exits at 5x.
Do you think the average Venture Capitalist can achieve these results, let alone any investor?
Stay tuned for the much-anticipated release of the op-ed on “Silicon Valley is Broken.”
By Andrew Vo, CFA
Founder and CEO of Aidos
About Aidos:
Aidos provides a range of advisory, capital raising, and investment services for our clients in the venture capital ecosystem. These services are delivered through the following products: Aidos, Athena, Adelphos, and Atlas.
With an overarching social impact mission, Aidos has five lines of businesses:
- Aidos: an equity crowd investing platform for early-stage startups.
- Athena: a knowledge database for exceptional founders and entrepreneurs.
- Adelphos: an exclusive network connecting exceptional co-founders.
- Atlas: a visionary project to tokenize portfolio companies in venture capital.
- Advisory: a consultant agency for founders and investors in venture capital.
Source: Aidos Inc.
Related Links
— Published on February 11, 2020
