Why Risk-taking is Crucial for Success in VC
What makes the greatest VC funds — the likes of Sequoia, a16z etc. — more successful than others? This is a question which you might have already thought about and it is a question which I have certainly asked myself as an undergraduate student interested in VC. The business model of your regular fund seems to be pretty straightforward, so what distinguishes the good ones from the not so good ones? Only recently did I come across a blog post by a16z partner Benedict Evans, which sheds some light on the topic.
In his 2016 post “In praise of failure”, Evans discusses the findings from a data set of more than 7,000 investments by VC funds between 1985 and 2014, provided by Horsley Bridge Partners. As this period spans pretty much the entirety of VC history — apart from some of the very early ’60s and ’70s engagements — there must be some truth to this. To make a long story short: The most important factor in being (extremely) successful is taking bigger risks. Across all funds, more or less half the investments do not return their initial investment sum. However, the funds returning at least five times their original fund size manage to have a bigger share of >10x deals (nearly 20% of all deals done), making up a staggering 90% of the overall returns. This is due to the fact that the actual return multiple for >10x deals is 64.3 (sic) for these funds, as opposed to 26.7 for the next best funds. The most extreme and eye-watering example for such a home run might be Benchmark Capital’s notorious USD 6.7 million investment in eBay during the dot-com boom in 1997. A mere two years later, this stake was worth USD 5 billion.
All of this might or might not come as a surprise for you; it was certainly nothing that I grew up with. As someone who was born and raised in Germany, I was surrounded by a society in which people tend to be very conservative in their risk-taking. It really is a question of the cultural environment as there is not much of a failure culture in Germany, either. While in the US people generally see failure as a foundation for learning and later success, Germans are typically obsessed with failure itself and see it as something bad per se. I could never understand this way of thinking and now the data backs me up on this. However, I do not mean to say that failure is something good, people should just have a more laid-back attitude towards it. As Evans phrases it in his post:
“[F]ailure is part of risk, and failing, by itself, does not mean that anyone was stupid, or screwed up. Failure just means you tried.”
Frontline Ventures partner Will Prendergast comes to the same conclusion. In a 2016 article in the Dublin Globe, he describes VC as a “career of rejection followed by failure”. What he refers to by this catchy wording is the rejection by many potential investors when raising a fund in the first place, followed by the rejection of the majority of the entrepreneurs looking for funding and the failure of about half the companies that are eventually selected to be funded.
Foundry Group’s Seth Levine wrote about the return structure of funds in a 2014 post, based on more than 21,000 U.S. venture financings. The data set collected by Correlation Ventures spans the time period between 2004 and 2013. It is even more skewed than that of Horsley Bridge Partners, with nearly 65% of all financings returning less than 1x the initial sum. With the given data and a hypothetical USD 100 million fund investing in 20 companies, Levine goes on to explain that only 0.8 financings would have led to returns above 5x, representing nearly USD 100 million (out of returns of approximately USD 206 million). If you want to dig even deeper into the data, you can find the link to this post (along with all others I referred to) at the bottom. All of this shows why VCs do constantly live on the edge. A single deal can make or break success.
This might sound like a lot of pressure to some, but should never lead to a situation in which risk is blindly accepted. VCs acknowledge this by focussing on the Total Addressable Market (TAM) and a certain minimum market share the startups should be able to gain. Thus, the funds are already aware of the fact that a substantial portion of their investees will fail and expect their few successes to pay off big time. One might argue that the VCs act cold and calculating, but once again, this is really just a matter of having a realistic approach. Nobody likes it and many investors feel like a small part of them dies every time one of the ventures fails, but this is an absolute necessity to minimise and control losses.
To wrap it all up:
In VC, Risk is nothing bad. While it is nothing good, either, it really has to be approached in a fearless manner. This is especially true in the startup world, were risk has a totally different significance than in more traditional industries. Most VC funds receive the largest portion of their proceeds from very few, highly profitable investments. Finding these opportunities and being willing to accept the higher risks associated with them is what distinguishes the very best funds from the rest.
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If you want to read more about the topic of risk-taking in VC, feel free to visit the sources I relied on for this post:
Benedict Evans, a16z (2016): http://ben-evans.com/benedictevans/2016/4/28/winning-and-losing
Will Prendergast, Frontline Ventures (2016): http://www.dublinglobe.com/ecosystem/rejection-followed-failure-career-venture-capital
Seth Levine, Foundry Group (2014): http://www.sethlevine.com/archives/2014/08/venture-outcomes-are-even-more-skewed-than-you-think.html
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