VC’s get put on pedestals all the time, called legendary at the first sight of a decent exit whilst they glide around town deciding which entrepreneurs deserve their funding. Pretty much everyone who’s been into the venture game long enough got involved in some notable success that allows him or her to seduce the press and maintain a perception of greatness, warranted or not. Entrepreneurs for their part are either amused or annoyed at the giant exit numbers that VC’s drop like calling cards.
But the reality is often very different. It’s REALLY challenging to make the venture model work.
[Note: I’m not trying to compare the hardships and risks involved with being a startup entrepreneurs to the relative comfort of the VC life. What I’m saying is simply this: to consistently produce top quartile returns in venture land is hard].
You can toil for years on promising companies that end up taking so much capital that your return and IRR actually look dismal. You can expensively invest in hotshot companies that do well but where your ownership is so low that you hardly have any impact on your fund. None of this matters.
A herd (or harass?) of unicorns
Say you run a $500M fund and you want to return 3X (I’m keeping it simple here, so no fees or carry). This means you need to return $1.5BN; that’s a truckload of hard-to-get cash. Or a herd of hard to corral unicorns.
If you’re a no-seed series A fund, the way to get there typically involves investing in 30-odd companies. If you’re very disciplined and able to resist price pressure (or able identify winners very early), you might get 20% ownership which will get a bit diluted over time. Say your return profile looks like this:
- one investment returns the fund (12.5% ownership → $4BN exit value)
- the next two to five provide another turn on the fund (20% ownership → $500M to $1.5BN in exit value each)
- the rest of the portfolio returns the fund again (that’s another $500M in exit value across c. 25 companies which is no mean feat…)
Whether this scenario is “right” is besides the point — the idea here is to use this example to highlight the hard task of providing high returns on large funds.
To really make money in venture you need Access, Upside and Impact.
Access means you can get in front of the best-of-the-best and convince them to take your money on reasonable terms. A small group of venture firms reliably outperform the rest of the industry primarily because they have nailed the Access problem.
Upside means you invest in companies that have a glimmer of greatness, that scenarios exist under which a company can offer “unlimited upside”. Mediocrity is in my mind the greatest enemy of European venture capital,or what you might called the “meh” investment portfolio.
Impact means that you as an investor have had an opportunity to invest enough cash and / or own enough of a company to have a real impact on your fund. If you make a 60X return on a $1M invested that’s actually not that earth shattering for a large fund despite the crazy multiple.
If you cannot get all three to work properly, you need not bother (or you need a properly differentiated fund strategy, like a vertically focused smaller fund to solve for the above).
Hopefully this helps in understanding why VC’s talk big outcomes all the time. It’s the name of the game.