The Difficulty of Scale in VC
Brett Munster
Originally published at www.roadlessventured.com.
The scalability of the VC model has sparked much debate among industry participants and observers. While many have pointed out the difficulty of large VC firms obtaining the required returns and therefore have questioned the sustainability of the model, many top tier VC firms continue to raise larger and larger funds.
Very successful and well respected firms such as Sequoia Capital, Greylock, Andreessen Horowitz, and Bessemer have all raised funds over $1 billion. Furthermore, as the VC industry continues to consolidate, the large firms are receiving the lion’s share of capital as evidenced by the fact that the top five venture capital funds have accounted for 55% of total fundraising in the last year.
However, many analysts are questioning the practicality of this model. A recent EY survey showed that 54% of those surveyed believed a VC fund should be less than $300 million, with another 41% saying $300 — $500 million was optimal. Few respondents thought that funds greater than $500 million were optimal, and no respondents felt that a VC fund larger than $1 billion was appropriate.
In order to understand the criticism, first we must understand a fundamental law of Venture Capital, which Peter Thiel described as the Power Law Distribution. This rule is as follows:
The vast majority of a fund’s return is supplied by very few of the investments within that fund.
Early stage investing is risky because most startups fail. On average, about 50% of venture backed companies fail, 40% return moderate amounts of capital (1x-2x), and only 10% or less produce high returns (10x or more). Therefore, it is the small percentage of high return deals that are most responsible for the performance of a fund.
If a VC has used a particular fund to invest in 25 start-ups, only two or three companies will supply the majority of the returns. This phenomenon leads to the need for a VC to constantly find that “homerun” or “unicorn” in order to satisfy his LP’s. As you continue to scale, this becomes increasingly difficult to pull off.
To illustrate the concept, let’s start by taking a look at the economics of a relatively small, $100 million fund (industry fund average in 2010 was about $150 million). In this example, I assume a venture capital firm charges 2% in management fees for 10 years, takes a 20% carry (the VC firm keeps 20% of the profits in excess of $100 million while the remaining 80% is returned to the LP’s) and that the LP’s are seeking a 3x return on their investment over the life of the fund.
This means that the VC needs to turn $80 million ($100 million less the 2% management fee per year for 10 years) into $350 million in order to satisfy the LP’s expected return of 3x. The VC keeps $50 million (20% of the profit above $100 million) and the LP’s get their expected return of 3x or $300 million (see summary table below).
If the VC owns on average 20% of the companies they invest in, that’s $1.75 billion worth of exits that two or three companies must generate the bulk of. Even VCs managing smaller funds need at least one unicorn in their portfolios in order to generate the desired return. The topic of the proliferation and sustainability of unicorns today is a topic for another post.
What happens as you attempt to apply the model at a larger scale? Let’s take a look at a $1 billion fund. In this case, the VC firm needs to generate $3 billion in returns for their LPs. If the VC owns on average 20% of the company they invest in, that’s $17.5 billion worth of exits that need to be generated by only a handful of companies within the portfolio.
This is much more daunting.
For example, Andreessen Horowitz, an early investor in Instagram, turned a $250,000 investment into a reported $78 million for the firm. At 300x, this was an amazing investment. However, this wouldn’t put a dent into the returns needed in our second example. At $78 million profit, a $1 billion fund would need 45 Instagram-like investments in order to reach the necessary $3.5 billion in returns the fund needs to generate. That’s more companies than the fund’s entire portfolio.
If the necessary returns are so much more difficult to achieve on large sized funds, why have numerous VC funds ballooned over the billion-dollar mark? The answer is simple: it is much more lucrative.
Management fees, originally designed to cover the cost of operating the firm, are now sufficient to provide managing directors with seven-figure salaries, regardless of the performance of their funds. Please note, I don’t know the returns of some of the largest funds and they very may be performing extremely well and earning those large salaries. I am simply pointing out that larger the fund, the harder it is to generate the same kind of returns.
If a VC firm does decide to increase its size, it has to invest differently than smaller VC funds. Angel investors and small VC funds can generate adequate returns by investing relatively small amounts in early rounds and living off of smaller exits. However, as the fund grows the economics change and so to must the investment strategy.
VCs are increasingly investing at the revenue generating stage and focusing less on product development and pre-revenue businesses. By moving to later rounds and increasing the size of their investments, large VC firms can lower their risk and generate an adequate return with a lower multiple.
As a fund increases in size, the business model and investment strategy has to change. For VC firms managing large funds, it is not enough to ask whether a company will succeed. The more important question is: If the company were to succeed, to what scale would it succeed? If this business model and investment strategy continues to take hold, the limited number of large exit opportunities will force the industry to continue to bifurcate between large and small funds.
