The Math of VC Returns…

…or how important winners are to venture returns and how difficult it is to find them. Excerpts from a recent Seth Levine post (emphasis added):

Based on their data, a full 65% of financings fail to return 1x capital.  And perhaps more interestingly, only 4% produce a return of 10x or more and only 10% produce a return of 5x or more.

…This really underscores the challenge of creating a venture portfolio that produces reasonable returns. If you were to actually construct a portfolio based on these averages, a $100M venture fund investing in 20 companies would produce a gross return of approximately $206M (that’s before fees and expenses). The resulting fund would have an IRR in the range of 10% (the exact IRR would depend on the timing of the cash flows, but I constructed a few models to approximate this and 10% was the average return). That’s hardly something to write home about and underscores the challenge of being “average” in this industry.

Hidden in this exercise – and perhaps more important – is the challenge of finding companies at the right side of the distribution chart. In my hypothetical $100M fund with 20 investments, the total number of financings producing a return above 5x was 0.8 – producing almost $100M of proceeds. My theoretical fund actually didn’t find their purple unicorn, they found 4/5ths of that company. If they had missed it, they would have failed to return capital after fees. Even if we doubled the number of portfolio companies in the hypothetical portfolio, a full quarter of the fund’s return comes from the roughly ½ of a company they invested in that generated 10x or above. Had they missed it, they would have produced a return that roughly approximated investing in bonds – not the kind of risk adjusted return they or their investors were looking for.

…All of this math simply underscores how important winners are to venture returns and how difficult it is to find them.

Here’s the sobering chart that accompanied the post:

Related Posts: A very sobering and a humbling reminder..

Sobering. Very Sobering.

From Kauffman Foundation Bashes VCs For Poor Performance, Urges LPs To Take Charge

The Kauffman Foundation, which has ties to the venture industry, has issued a damning study of the business that addresses long-running concerns about poor performance..

…Looking into its portfolio of nearly 100 VC funds, including what it says are some of the most notable and exclusive names (confidentiality agreements barred it from naming them), the foundation found that only 20 of them beat a public-market equivalent by more than 3% annually, and half of those started investing before 1995.

…The report also offers support for the belief that small venture funds are the most successful. Only four of 30 VC funds in the foundation’s portfolio with more than $400 million in committed capital produced returns better than those from a publicly traded small-cap stock index fund.

…The foundation promises to take its own medicine. It said it will invest in venture funds of less than $400 million whose partners have consistently shown they can outperform public markets and who commit at least 5% of the fund’s capital. It also plans to do more direct investing to avoid paying management fees and sharing profits with VCs. And, it plans to shift money from venture capital to the public markets.

A Sobering (and humbling) Reminder…

Courtesy Fred Wilson, this chart and the data below (via Mark Suster)…

…using the math I laid out yesterday (roughly 1,000 startups funded each year by VCs), this means that on average between 1% and 3% of venture funded startups get to an IPO.

To recap, 1-3% get to an IPO and 5-10% get to an M&A exit over $100mm. So 85-95% of all venture backed startups will either fail or exit below $100mm.

Nanopost of the month…

…in which I break my self-imposed period of silence.  I have a very good reason.  I am very pleased and excited to now be formally involved in an extraordinary enterprise in India: Vindhya. Vindhya is extraordinary because:

…almost 95% of its staff of 200 youngsters comprises differently-abled and physically challenged youngsters

Read more about them in this post on my personal blog...and wish us luck in our bold plans for the future.

Characteristics of Great Investors

Chanced upon this great post by Matt Blumberg on “10 Characteristics of Great Investors“.

Should be read by ALL investors, I think.

I am listing my favourite five of the ten characteristics below:

• Great investors know how to give strategic advice without being in the operating weeds of a company
• Great investors get to know whole management teams, not just CEOs
• Great investors invite you to do diligence on them by giving you a list of every CEO they’ve ever worked with and asking you to pick the ones you want to talk to
• Great investors ask great questions
• Great investors don’t publicly take credit for the success of their investments, even if they were major drivers of that success

Thanks Matt.

Feeling the chill in Goa

Just back from an exhausting and intense 10-day visit to India, part of which was taken up by the Capvent VC/PE Conference in Goa.

I shared a panel on “New Media” with Rajesh Sawhney of Reliance Entertainment and Harel Beit-On of Viola Private Equity…and talked briefly about Enqii and an Indian start-up that I am very enthused about (it takes Out-of-Home advertising to a new level – leveraging the ubiquitous cycle rickshaws that you see across large parts of India – more on them later)

Interesting conversations on the sidelines and during the panels…but the “chill” in Private Equity was unmistakable – even as Goa seared at 33 degrees…

India seems to be holding up better though…and the sentiment is mildly optimistic…not least because of a rebounding stock market that has jumped 40% in the last three months – as it recovers from its multi-year lows.

I also concluded my latest personal investment – in an Indian start-up which I believe is very attractively positioned in the education sector in India.  It is called Elements Akademia…Check them out.

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Somewhat related posts:

Feel the Shanghai sizzle…in Mumbai 

Feeling the heat in China…

In case you are wondering what I did on Valentine’s eve…

I was here…talking to a bunch of bright people and listening to some great ideas…

 

Could anything have been more exciting?!

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Double Take

Saw this headline when I woke up today morning:

GPs ‘paid more for working less’

Of course it was referring to some lesser mortals*…

Although some of the points made in the news-story appear to have an eerie similarity…e.g.:

…It also pointed out that pay for…partners had shot up by 58%……although much smaller rises had been seen for (put your own words here)…

…This happened over a period when GPs started working fewer hours – 36.3 a week compared to 43.1 in the 1990s – and productivity fell…

…Much of the criticism in this report is based on an out-of-date understanding of the current situation…

🙂

But here is some seriously sobering news, courtesy GigaOm, “…Silicon Valley Is in Trouble”

…Sequoia Capital, arguably the smartest venture capital investor in business, is sounding the alarm and asking its portfolio companies to buckle down for what could be the worst economic downturn of their relatively short lives.

…They want the companies to cut costs, to figure out way to survive and emerge at the other end of this downturn, which could last years. The speakers went through each functional area of the business and told the companies how to cut costs.

…Folks this is bad news for Silicon Valley, which has been living in a bubble, assuming that it is going to weather the global economic storm without being impacted. Sequoia had a similar meeting back before the last bubble unraveled. We know how that turned out.

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* With tongue-firmly-in-cheek

Quick notes from ATRE, Mumbai

Quick notes from a Web 3.0 panel discussion that I participated in [ at the Red Herring ATRE Conference in Mumbai y’day ]

1. Satya Prabhakar (Founder and CEO, Sulekha.com) mentioned: “Scarcest commodity in the world is human attention”
2. Seth of meebo.com talked about meebo and the challenges of monetising web 2.0 startups/ user traffic
3. Gerard Rego (MSC Software) spoke about the bottom of the pyramid markets
4. Gurudatt mentioned how the NetAlter.com might transform the current Internet architecture

I was on the panel that discussed Web 3.0.

I mentioned how:

1. Non-US users of internet (86% of total) growing at 30% vs. 3% growth of US
2. Epicentre decisively moving to Asia (driven primarily by large user base in India and China (e.g. Japan’s lead in mobile payments/ S Korea in broadband

and shared my thoughts on Web 3.0/ and how it is marked by three main features:
1. Internet Unplugged (i.e. going wireless and accessible not just through your PC/mobile but also through your game console, e-book, TV, fridge)
2. Internet 3.0 = Its all about the consumer (Consumers #1 users of semiconductors in the world (vs. IT + Government) AND  Consumer IP traffic expected to surpass enterprise in 2008
(ARM has shipped more than 6bn microprocessors to date, mainly due to mobile and the microprocessor in consumer goods )
3. NOT just about the consumer BUT its all about *me* – personalised everything (search, contetnt incl news)

The Challenge is to “How to make it pay?”

Is seed capital the new black in VC?

… or have people finally stumbled upon a good way of making money in this niche?

Red Herring reported on “The New VC Way” a few weeks back mentioning how “tiny investments in startups” may be the “the wave of the future” in venture capital.

Now I do not count myself as a veteran of the industry, nor an expert in any sense but given how hard it is to make money in venture capital, I cannot help wondering how exactly will the new wave of incubators get their returns.

But lets get back to the article.

It talks about Paul Graham’s Y Combinator although it is not strictly speaking an “Incubator”… (see the FAQ on the site) ..and mentions how Y Combinator and others “offer early-stage Internet entrepreneurs relatively small amounts of money, technical and business advice, and other assistance in exchange for small ownership stakes and little or no control over the startups’ operations.” (emphasis mine).

But is this really that much different from the incubator model that became very fashionable a few years ago – in a certain time? I dont know enough about these firms to conclusively say anything but there are quite a few similarities.

The firms themselves though prefer not to call themselves incubators (see Y Combintaor’s FAQ excerpt above); David Cohen of TechStars calls this “the professionalization of angel investing.”

However the article does mention that “TechStars and its brethren do not seek a particular financial windfall from their investments like traditional venture capitalists do” – which brings me back to the question – so how exactly do they make their returns?

I do not necessarily doubt that these operations are successful – but I am just curious as to whether they are able to beat the best upper quartile VC funds over an extended period.

Out here, I know Saul Klein is very enthused by the model and thinking of something similar…

I am going to email him to find out his latest thoughts and hopefully we will be able to share it with all of you soon.