Investments and Venturing — Overview
A little over a year ago I was introduced to several discussions about the venture model and the seemingly unquestioned premise that one needs to swing for the fences in order to return the fund. I had often wondered about this and so started to research this premise. over the last four months I found that and sought to reverify this assumption and assess if current market conditions remained the same. So, I set out on a quest; pulled data, conducted interviews, and consulted secondary sources.
My next 4 posts shares this journey on what I have learned specifically about the Industrials and Dual Use Sector: 1) Overview and Venture Capital, 2) Founders and Angels — the Earliest Investors 3) The Lower Mid-market of M&A, and finally, 4) Now What?
Post 1: Overview — Framing Today — Venture Capital Math
With the Lyft IPO taking place, and Pinterest, Uber to follow closely behind, I thought it would be a good place to start this dialogue, since big named venture capitalists- Andreessen Horowitz, Capital G, Oceanic Ventures — more than a dozen firms may finally be realizing their investments. If you have funds through Fidelity or own GM shares, perhaps you’ll get a slice of Lyft shares if you don’t buy them on NASDAQ.
As an angel investor that sources, invests in and coaches pre-seed and seed stage companies, I am always searching for the right approach. How do I provide risk capital to companies while making the right decisions to help preserve my capital? This sometimes is not an easy decision. The default answer for most companies is to raise from angels and then go raise venture money, round after round after round.
After having suffered dilution on more than a couple of occasions, I started to question the wisdom of merely following venture all the way through. It depends. Follow on venture investment doesn’t always optimize outcomes. In fact, too much funding can be detrimental to a company’s performance.
A decade ago, venture capitalists seemed like genuine alchemists, able to turn even startup dross into purest gold. In recent years, however, the industry has seemed less magical than mundane. Since 2004, its average five-year return has oscillated around zero. High-priced IPOs have become rare events, even as VCs have continued to pour tens of billions of dollars into new companies every year. As Fred Wilson, a principal at Union Square Ventures, bluntly puts it, “Venture capital funds, as a whole, basically made no money the entire decade from 2004 to mid-2010s.
In fact, take a look at Cambridge Associates’ venture benchmark returns.
Cambridge Associates’ Private Investments Database is one of the most robust collections of institutional quality private fund performance. It contains the historical performance records of over 2,000 fund managers and their over 7,300 funds.
This performance data is as of the end of December 2017; Cambridge has not calculated 2018 results yet. Their data shows the general performance on an annualized basis compared with the S&P 500 benchmark. For most of the last 15 years, venture has under performed. Yet, the asset class continues to get funds in flow — and venture investing is celebrated. I think venture investing should be celebrated, but we also should be sober and realize 10% of the firms realize more than 80% of the value the asset class returns.
Note: the venture asset class did well using a 20, 25, 30 year horizon. Results are amazing. Which firms have been around this long and have been doing this well? Sequoia? Bessemer? Kleiner? They likely are those responsible for the majority of return of the asset class.
It is from Peter Basil, a Canadian investor, banker and venture capitalist, whom I first learned about the changing dynamics of the venture market place and how that shifted the returns calculus. He argued, as early 2009, that while not as much capital is required to create viable businesses, especially in the internet space, fund sizes were getting larger and larger. The result; venture investors had to look for (wait for) bigger and bigger exit opportunities to return the fund. Average check sizes were growing (and still are in 2019), holding periods are getting longer, and early exits passed up in order to potentially exit at a much higher value. The operative word is “potentially”; as evidenced by the Cambridge Associates information, not all of this potential has been realized.
Most venture investors seek a 30% gross internal rate of return (IRR) on their successful investments. According to the National Venture Capital Association, the average holding period of a VC investment is eight years; in this day and age, the company may have already had several rounds of investment by this time. This means an early-stage investor would need to garner 10x plus multiples on the winners to meet his or her IRR target.
One can potentially reduce the risk and improve IRR by reducing the holding period. A longer holding period will, by definition, require that investment generates a higher aggregate multiple to achieve the desired IRR.
I started to explore this phenomena and learned there are several ways to exit companies beside suffering further dilution by waiting for an acquisition post Series C or D — or an IPO. In fact, plenty of companies are purchased for $30M-$50M; often just after a series A, at returns ranging between 5X and 10X. These numbers are really hard to verify, but in hunting for private exits, I found the following.
One obstacle to determining real numbers is that most tech companies that are acquired do not release exit prices. This happens for various reasons. Private company buyers are not required to release prices. Meanwhile, public company buyers often do not release a price if it is not considered large enough to be “material.”
Despite the lack of disclosure, it’s still possible to analyze the industry’s exit prices and returns. One can painstakingly hunt through press releases and pull the data. I also found a no-longer-available resource called Exit Rounds.
In their Exit Report, they noted that companies with exit prices below $100 million returned on average 12.8 times their total invested capital. For comparison, Fred Wilson has written that a typical venture fund needs to get 4x return on its investments to generate a 2.5x distribution to limited partners. (Wilson’s figures include companies that have been shut down (ROI=0, or loss of investment), hence multiples are lower.)
Suffice it to say, this analysis suggests that the investment strategy to invest early in a disciplined fashion, constraining holding periods, and shape exits is a viable one. At a basic level, venture capital success comes down to the quality of sourcing, selection, access, value-add, and the exit. So, there is a definite need to focus and shape the exit. I took the time to speak with several individuals responsible for internal acquisitions — who have purchased and strive to purchase companies at the smaller range — say $30M to $50M. They note as long as there is a strategic fit, they prefer acquisitions of this size fewer intermediaries, and less internal red tape.
Stay tuned for Part 2, where I’ll expand on Founders and Angels and what focusing on exits early can do for returns….
