Why VC Performance Has Fallen Off A Cliff

Fred Wilson has a great blog post today entitled The ‘We Need to Own’ Baloney.  In it he discussed the fact that many VC’s apply arbitrary ownership thresholds to investments.  I couldn’t agree with Fred more – but I’d take it even further.  This is not just limited to ownership requirements.  Rather, VC’s often impose “VC maths” on companies in three areas:

  • The amount VC’s “need” to own
  • The amount VC’s “need” to invest
  • The return VC’s “need” to generate certain exit returns

These “requirements” are a direct result of the mathematical model that venture funds are optimised for.  And as fund’s have gotten larger, their maths has gotten more difficult.  We’re now witnessing the conclusion of a “10 year experiment” where money invested in venture funds has exploded and fund sizes have more than tripled in size.  A decade ago, 75% of all venture funds raised were under $100 million.  In 2007, fewer than 25% of all venture funds raised were under $100M. 

I don’t think it’s a coincidence that VC performance has fallen off a cliff during this time period.  Indeed, we’re approaching a point where the 10-year return in venture capital is negative.  Paul Kedrosky recently authored a paper for the Kauffman Foundation which discusses this in great detail and proposes that the venture industry needs to be “rightsized” — and suggests a 50% reduction.  It’s a great paper — but if you don’t have time to read it, the money chart is below:

Fred Wilson has previously written about the VC maths problem — but he approached it from the macro/industry perspective.  I agree, and think it’s even more scary when you look at it from a micro/fund perspective.  Take a $400M venture fund.  In order to get a 20% return in 6 years, they need to triple the fund — or return $1.2B.  Add in fees/carry and you now have to return $1.5B.  Assuming that the fund owns 20% of their portfolio companies on exit, they need to create $7.5B of market value.  So assume that one VC invested in Skype, Myspace and Youtube in the same fund – they would be just halfway to their goal.  Seriously?  A decade ago, any one of those deals would have been (and should have been) a fundmaker! 

As a result of this new maths, VC’s end up super-focused on the longbets (or moonshots) and frequently remove optionality for mid-tier exits.  It has, as Super LP Chris Douvos has written, become a game of finding the next Curtis Sharp.  It is because of the challenges of “VC maths” that First Round Capital chose to raise a relatively small fund — allowing us to continue to make initial investments that average $600K. 

I understand the importance of aligning one’s time and capital to the upside opportunity, and recognise that there is some minimum threshold of ownership that is required for a VC to commit the time and attention to an opportunity.  Does it make sense for an investor to spend the time and join the board of a company they own 2% of ?  Probably not.  However, the difference between 25% and 20% ownership — or even the difference between 20% and 10% — should not prevent a VC from investing in a promising opportunity. 

It is the same “VC maths” which drives a VC to seek to deploy a larger amount of capital into a company.  (Often taking a capital efficient company and helping it become capital inefficient).  And it is the same maths which sometimes creates a lack of alignment between a founder and a VC around exit opportunities.  I have previously written these issues when I discussed the “unwritten terms on a term sheet“. 

A company’s outcome should drive VC returns.  When VC’s required returns drive company’s outcomes, it’s a recipe for trouble.

Josh Kopelman is Managing Director of First Round Capital.This post was originally published on Redeye VC.

NOW WATCH: Tech Insider videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at research.businessinsider.com.au.