In the business of investing, ownership matters — a lot! At Accolade Partners, a private equity fund of funds, we believe that portfolio company ownership is a significant driver of returns in the Micro VC market.
The VC model is predicated on exits: either write downs (which nobody wants), secondaries (albeit not a common option yet), IPOs or M&A. Unfortunately, the IPO market has not been robust, with less than 25 tech VC-backed IPOs in 2017. While up from 2015, during which there were 19, there are still not enough to support the exits needed by the hundreds of Micro VC firms. In fact, IPOs are rarer than unicorns! It turns out that when looking at the M&A market, billion-dollar plus exits are equally rare, with 93% of M&A occurring below a $500 million valuation and 64% below $100 million.
Unfortunately, based on their fund size and ownership in underlying companies, many Micro VCs need to have not one, but multiple billion-dollar exits to achieve 3x+ funds. As the data suggests, unless you’re one of the few elite VCs — such as Accel, Andreessen Horowitz, Benchmark, Floodgate, Founders Fund, Greylock Partners, IA Ventures, Sequoia or Union Square — this is very hard, if not close to impossible, to achieve. Semil Shah recently wrote a piece about founders, which we think also applies to VCs who believe they will have multiple unicorns. “It’s hard,” Semil notes, “because those [VCs] are living it and by nature feel they’re the exception.”
So, what do we at Accolade look for in Micro VC managers?
In addition to important factors such as pedigree, track record, network and brand, we focus heavily on portfolio construction, especially as it relates to fund size and portfolio company ownership. How do firms generate 3x+ funds at sub-billion dollar exits? Modest fund size with high ownership. We see many firms that are $50 million in size with an average of 5% ownership in their companies, or $100 million in size with 10% ownership. If you do the math, a billion-dollar exit returns only 1x their fund. These firms need 3–5 billion dollar exits to achieve 3–5x returns. At Accolade, we prefer sub-$100 million funds with concentrated models that target 10–20% ownership. Mike Maples is famous for saying, “your fund size is your strategy.” Jason M. Lemkin tweeted, “up to a $20 million fund, there are many ways to do a 3x+, up to a $60 million fund, there are several ways, after $150 million fund, there is probably one way.” We agree with this wholeheartedly, especially when considering ownership.
To those VC managers who embody this belief in ownership and portfolio construction, we at Accolade want to get to know you — and you should know us. We are specifically seeking managers with your investing approach. And, to those managers who want to become more ownership-focused as they mature in their careers, Accolade also wants to get to know you. It’s quite common for new, emerging managers to start with lower ownership with hopes of growing into stronger positions over time. We pride ourselves in helping and coaching these managers as they plot this evolution. As LPs, we get into the weeds with our managers with respect to fund design, specifically focusing on portfolio construction, reserves, fund modeling and more.
We have such strong conviction in this approach that not only do we preach ownership to our managers, but we embody it ourselves with our own funds as well. Each of our Accolade fund of funds has only about 15 commitments across VC, growth equity and buyout. As a fund of funds, our top 10 companies typically return our whole fund, because individual companies matter and drive returns. We’ve invested in a number of small funds with high ownership. For example, we’re invested in a $40 million fund with 10–15% ownership ($267 million exit returns the fund), a $35 million fund with 20% ownership ($175 million exit returns the fund) and a $25 million fund with 10–15% ownership ($167 million exit returns the fund). This thesis is being validated by managers in our portfolio with outsized returns.
The best part of it all, our managers take the biggest risk in writing meaningful checks into companies with minimal to no syndicates, and we’re thrilled to see them rewarded for their conviction!