Fail Often, Fail Fast? Investors Do Half of That.
You’ve certainly already heard a VC explaining that within its portfolio of 25 companies:
8 will returns no money or very little,
13 will returns only the money invested or much more,
3 will return a multiple > 3x,
1 will return a multiple > 10x.
That assessment is true for most funds : it is observable in the portfolio of different VC firms and for different vintages within a specific VC firm.
Failing due to False Positive
So first of all, after screening between 1500 and 3000 -depending on the reputation of the firm, its stage of investment and its geographic scope- a professional teams of investment still fail 84% of the time. (Returning only the money invested 10 years before is not what we should call a success.)
Let’s call that a false positive (if you consider the investment as a diagnostic of a future financial success (positive)).
Entry Of New Players
This trend will certainly be reinforced by the massive entry of new players, who are less price-disciplined (arguably to access the rounds)). Indeed, mechanically, if investors pay companies more, all things being equal, the returns should decrease.
These new actors step in especially in early stage and late stage.
In Early Stage
In early stage, the biggest change is the entry of crowdfunding which is growing at a very fast pace and who accelerate the timing of dealmaking (sometimes with very few if any due diligence).
In Late Stages
In the late stages, we witness the intervention of asset managers, corporates (through a proprietary VC vehicle or investing directly), family offices, hedge funds and mutual funds (such as BlackRock, Fidelity or Hartford). These players, especially the last two, are investing huge amounts of money, fearing to miss the value creation which happens more and more when companies are still privately held, when it used to happen after the IPO. (This happens because company are staying private longer.)
This rise in median round size (and company valuation) also happens in the VC stages [A to C/D]. This is the result of the increasing competition between VCs and the fear of missing out the next unicorn.
This hunt for unicorns leading to many failures, since roughly 40% of these unicorn IPOs are now flat or trading below their private market valuations.
To understand better these dynamics, I recomand you this very witty article by Mark Suster who explains them through reversion to the mean and demand curve shift.
Anyway, you’ve got the point:
VCs makes a lot of mistakes, because the future is hard to predict (and because market dynamics are often not helping).
But focusing on the false positive would be missing the whole picture.
Failing due to false negative
VCs suffer also from lots of false negative: company that they thought weren’t likely to become huge successes when they eventually did.
Legendary investors, such as Bessemer, missed a lot of great opportunities. They even built what they called an “anti-portfolio”: the biggest company that they meet in their early time and they chose not to invest in (or even to avoid meeting with the founders!).
I let you guess that if legendary investor like Bessemer (which invested in companies such as Skype, Yelp, Shopify, Pinterest, Linkedin, Box, Criteo, etc.) does such mistakes, all the VCs also do.
And it’s not because VCs are dumb. It is just that their job is a lot about predicting the future, where the extrinsic forces are playing a huge part in a company’s success.
This is why there is a continual pendulum swing between high liquidity and prices, and low liquidity and prices in the VC market, shifting from too much confidence to too little.
And since these moves are occurring inside the whole funding chain (from the LPs to the startups), it s explains what we tended to hear lately (we were rather in a too much confidence stage):
“We’re coming back to normalcy where fundamentals matter.” -David Wadhwani, AppDynamics CEO
“At every board meeting, we’re reviewing burn rates,” said George Zachary, a partner at Charles River Ventures in Menlo Park.
(source)
What is sure is that funding black swans will have trouble becoming a science.
Yet, not being a science doesn’t hinder trying to recognize patterns and having framework and rules for investing… and not investing.
Let’s summarize most of the things we’ve discussed in the previous articles in our last part: what daphni will not invest in.
Want to know more about startup funding? Read our articles:
Part 1 — Startup Funding: Growth Is The Only Way
Part 2 — The Jedi Trick: You Have to Choose Between Growth And Profits
Part 3 — If Growth Was Easy To Forecast, There Would Be Only One VC fund: Nostradamus Partners
Part 4 — You Need to Lose Money, But Some Loss Are A Really Bad Idea
Part 5 — How To Have Growth AND Profits? (Part1: Transactional models)
Part 6 — How To Have Growth AND Profits? (Part2: Non-Transactional Models)
Part 7 — What About Valuation For Late Stage Startups?
Part 8 — Fail Often, Fail Fast. Investors Do Half of That
Part 9 — What daphni will not invest in
Reminder: daphni investment thesis
