VC isn't necessarily designed to have returns that are better than the public markets, only to have returns that are different from the public markets. If you have billions of dollars to invest, you want to diversify. So the core part of the message that VC is broken because most of them don't beat the public markets doesn't really matter.
> One-two years for scouting and finding 10 A-round startups, four-five years for growth. Add some non-stop pressure on the founders to sell all the way around.
Holy moly. How well would this have worked for Google to sell to Yahoo or Facebook to sell to Google? You are throwing out the baby with the bathwater here.
If a company blows up, the vast majority of the returns are coming after 4-5 years. I mean, look at GOOG, and only returns since it went public (~6 years after founding). Google's stock is up 1700%, the public markets are only up ~150%. You want them to sell those returns to somebody else? And obviously this post-IPO gain is just a multiplier on the returns from Series A --> IPO which is just astronomical returns you'd be not getting.
> Invest in more startups/less cash in each.
Just doesn't make sense. For many VCs the limiting factor is their ability to spend their time and effort trying to help their portfolio companies. Good VCs don't just give money, they give guidance, advice, strategy, etc. You can do this with 2-3 companies, not so much with 20-30.
> The ancient “2 percent and 20 percent” should be killed off and replaced with something that endorses higher alignment. Let the VCs fight for their supper.
Returns need to be better if there is more risk and less liquidity, right?
One possible fee structure would be a reasonable fixed amount to cover expenses including supporting portfolio companies (maybe 2% isn't crazy), and an incentive fee on returns above some reasonable hurdle or benchmark.
If the investments yield an 8% gross annual return, the VC who is not at risk is getting paid a rich 3.6%, the investor a paltry 4.4%. Maybe it should be e.g. 20% on the excess over 7.5%, 30% on the excess over 15%.
Then if the investments yield 8% gross, VC gets 2% and investor 6%, and if the investments yield 20%, VC gets 5% and investor gets 15% (if I did that right, would have been 6%/14% under 2/20, at some higher point crosses over and VC does better)
When selling a company or taking a company public, the sale price factors in future growth and earnings, so it's not like you're "missing out" on that growth (assuming you get a fair price).
It's easy to conclude that 'All companies should hold out on selling' because if you look at the data for companies that held out, they outperform.
However, there's extreme selection bias. When your true value is in the tens of billions (FB/GOOG), you're never going to get acquired for a fair price because no company can afford you, so you are always going to be in the 'held out' cohort.
There are plenty of businesses whose true value (future discounted cash flow) is in the hundreds of millions or low single digit billions. At this price, many of these companies could find a suitable buyer at a fair price. Since liquidity is a good thing, there's no reason not to.
> If a company blows up, the vast majority of the returns are coming after 4-5 years. I mean, look at GOOG, and only returns since it went public (~6 years after founding)
Using GOOG as an example of expected returns is an absurd generalization. By definition, the expected return on a public stock following an IPO roughly aligns with the rest of the public market (4-8%).
Is there evidence of fund returns non-correlated to the public markets? Big IPOs in down markets? I see a lot of dot-bomb kinds of things, and the latest IPOs have been taking full advantage of the froth in the public markets. It's hard to imagine Snapchat making a go of it without the current stock pricing being so lenient.
I'm not sure I agree with them or their particularly analysis, but I'm very convinced they are different because the way I see it, VC and the public markets are completely different things. It's like the farm system for baseball teams. VC is investing in the upcoming prospects, and the VC is investing in the existing major leaguers. Sometimes you'll have a farm system full of A+++ prospects that pay off huge (Google, Facebook), and sometimes you won't (pick a 5 year period where there were no massive VC payouts). And obviously the returns on those prospects will only go to whatever team they happened to be on (which VC picked them), whereas public market returns can go to anybody. But they are different companies at different ages doing different things. Thus to me it would be quite surprising if their returns were all that correlated.
And at some sense "froth" is irrelevant. A VC doesn't have to sell their Facebook or Google stock when it IPOs, they can hold onto it as long as they like. They are basically investing for the chance to get that amazing stock at a huge discount by getting it at the "prospect" stage, and once it goes public they can ride the public market waves as well.
> So the core part of the message that VC is broken because most of them don't beat the public markets doesn't really matter.
No, it matters. Investors want investments that are not closely correlated with the public markets, but they still want something that is going to have a decent Sharpe ratio (~return/risk).
Furthermore, is it even true that VC returns are not well correlated with the public equity markets? My guess is that they would be pretty closely correlated.
> Furthermore, is it even true that VC returns are not well correlated with the public equity markets? My guess is that they would be pretty closely correlated.
On the contrary, I would posit that they're not correlated, or perhaps only weakly so. One of my primary concerns with the venture capital industry and the private equity markets in general is that there is no mature mechanism for the market consensus to reflect short opinions.
In public markets, there can be significant dissenting voices expressed by short interest which will have a material impact on the price of an equity. In the private markets, pessimism from many parties cannot be used to directly influence the consensus price. In my view, this leads to a natural bias towards successful private companies rising in valuation over time, whereas public companies swing more easily in either direction and have a harsher regulatory climate.
While both markets are influenced by things like interest rates, I would default to assuming that they significantly diverge in aggregate returns over time. They also have significant differences in liquidity, which means unhealthy economic trends in one may take a relatively long time to manifest in the other, even if they were otherwise correlated.
It's easy to dump on the management fee, especially seeing the world through the underfunded entrepreneur's eyes.
But the VC fee structure is probably among the most honest and legit setups in all of finance.
Look at Private Equity (PE) fees. In addition to whatever the LPs are directly paying, portfolio companies themselves are posting up huge fees back to the PE firm. Plus dividends, director fees, you name it. "Promotes" for putting a deal together with a syndicate. Etc. etc.
Look at lending. You've got stated rates but all kinds of extra fees, origination expenses, etc. baked in. When your lender gives you an APR, he is looking at a projected IRR that is way higher, I guarantee.
Early stage VCs -- with few exceptions, and those mainly during weird downturn / recap scenarios -- are generally getting plain vanilla convertible preferred stock. No management fees. No origination / finder's fees. No director fees. No promotes.
There are, by the way, some mechanisms for dealing with absurd fees (in VC and other asset classes). They're well known, and already practiced by savvy LPs with leverage.
If you take away the 2% return, you've basically said that only super rich people that can afford not getting paid for 5-10 years should be VCs. Do you think that all the best investors in the world are super rich people?
Also, when to take that 20% is an issue. Perhaps a VC that is strapped for cash would push a company to exit sooner, or sell the stock right after the IPO, so they could take some of their profits off the table and thus get some working capital. However maybe they'd get a better return for both themselves and their investors by waiting another 5 years. Sequoia has very famously said that they've gotten more returns from their companies post-IPO --> now than they have from initial investment --> IPO. If you believe in the long term prospects of a company you essentially want to never sell the stock.
I'm not suggesting there isn't an alternative, but I'd like to see it. The LPs who continually agree to this fee structure aren't idiots.
That's not realistic. It can take many years before there is a return even for a successful fund and during that time you somehow have to rent some space, keep the lights on, pay the secretary, pay the associates and pay for the DD costs for deals that went very far but eventually did not go through.
> The ancient “2 percent and 20 percent” should be killed off and replaced with something that endorses higher alignment. Let the VCs fight for their supper.
I agree, this is a stupid fight. Higher alignment is called "Private Equity" and it already exists as a model. VCs will go where the market (i.e. the money) tells them, which right now is 2/20. All of the VCs that don't return their funds will simply stop getting LP money and cease to exist.
> I recently had a meeting...talking about the macro view of venture capital and how it doesn’t actually make sense....It took me a while to understand what this really means.
Ok so the author just had a meeting with an angel investor, decided to do all of the research (that's already freely available mind you) and came to the same conclusion as everyone else. Ugh.
>>>Higher alignment is called "Private Equity" and it already exists as a model.
That is NOT what PE is at all! PE is about buying WHOLE companies that have established businesses but are struggling. PE does NOT invest in growth companies that are new to the market / not yet proven, nor do they take small percentage ownership.
Just for context, the old "two and twenty" is the fee structure for most (still? many?) hedge funds. Who I assume VCs are competing with for investor money.
The Kauffman foundation published a study about venture capital a few years ago; we read it in my Tech Entrepreneurship class. They reached similar conclusions:
> Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional
high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years.
EDIT: This is actually linked from the article but I thought it was worth calling out nonetheless.
Haven't read your study, but did they take into account the trillions in losses the public markets would have taken in 07/08 if not for the government & Fed bailouts? VC's and their portfolios would have taken losses too, but 1) they tend to have a longer (~10yr) time horizon, and 2) at least the VC equity-based investment model doesn't cause credit bubbles.
Clickbait title for a naive look at a pretty well-understood, much-scrutinized topic.
Digging in further:
- assumptions are bad. 7-8% in RE / public equities? Hmm, dubious.
- poor understanding of TVM. 12% is 3x? Except, in the real world, there are incremental cash flows on both capital calls and returns ... so IRR.
- completely ignores cyclicality. Vintage year is the single biggest determinant of venture performance.
One big plus: takes a bit of the wind out of the "we VCs are paid to take risks" strutting. Of course, professional VCs gauge risks and make informed bets. But as the author points out, it's mostly with other peoples' money. True. Entrepreneurs are the ones taking the real, personal risks.
It is important to understand that these studies really are looking at the 'post dot com' VC industry or perhaps more succinctly "what it became after that event."
And it would be wrong to assume that there aren't market forces, working even as we type, to 'correct' the imbalance. If it had not been for the exceptionally anemic returns to be had in general, I expect this correction would have happened sooner.
But unlike startups that post 'incredible journey' type farewells, VC firms that evaporate are rarely reported on. There are firms which are contractually following through on their existing funds, raising no new funds, and entertaining no investments in companies they aren't already invested in. These are dead venture capital companies that are waiting for the end of life support.
I am curious what the next chapter will look like. A lot of people think it will be more 'integrated' VCs that look more like Y-combinator and less like Sequoia. Hard to say.
The math in the article seems to be based on the assumption that the money committed for the fund is payed by the LP up-front. My understanding is that that's typically not the case -- instead, the LPs commit to some dollar amount, but only actually write checks when the VC round makes an investment.
I haven't done the numbers to see how this changes the outcomes in the article, but it seems like it probably has a pretty big impact, considering how much the article focuses on the liquidity aspects. I wonder what the contribution graph tends to look like over the lifetime of a typical fund.
The problem is the market only cares about companies that have the potential to be the next Tesla, Facebook, amazon, etc., so unless you're in a this very special and exclusive niche, exiting is very hard. It's not like in the 90's when all tech sectors did well...now it's just social networking, apps, Tesla, and Uber. A very lopsided, winner-take-all market.
Nice, clear statement of the fundamental theorem of VC funds: ...the only realistic way for a fund to get acceptable returns is to try to find only the companies that could be the next Ubers, Facebooks and Airbnbs. Under these rules, it doesn’t make sense for VCs to invest in anyone that can’t get to unicorn stage. There’s just no place for “average” companies...
Sure there is: bank loans, growth capital, corporate backers through a JV, et cetera. This is how new business was financed for centuries. If you're talking about companies that grow up to be "average" but still fail at the rate and with the recovery rates of aspiring unicorns, then ofcourse not.
None of this is "news", just another re-hashing of "yet another explanation of how VC works, because VC's will never admit their mode plainly". Here ya go:
EDIT: Just re-read, makes sense why this is "news"... "I recently had a meeting...talking about the macro view of venture capital and how it doesn’t actually make sense....It took me a while to understand what this really means."
Readit News
> One-two years for scouting and finding 10 A-round startups, four-five years for growth. Add some non-stop pressure on the founders to sell all the way around.
Holy moly. How well would this have worked for Google to sell to Yahoo or Facebook to sell to Google? You are throwing out the baby with the bathwater here.
If a company blows up, the vast majority of the returns are coming after 4-5 years. I mean, look at GOOG, and only returns since it went public (~6 years after founding). Google's stock is up 1700%, the public markets are only up ~150%. You want them to sell those returns to somebody else? And obviously this post-IPO gain is just a multiplier on the returns from Series A --> IPO which is just astronomical returns you'd be not getting.
> Invest in more startups/less cash in each.
Just doesn't make sense. For many VCs the limiting factor is their ability to spend their time and effort trying to help their portfolio companies. Good VCs don't just give money, they give guidance, advice, strategy, etc. You can do this with 2-3 companies, not so much with 20-30.
> The ancient “2 percent and 20 percent” should be killed off and replaced with something that endorses higher alignment. Let the VCs fight for their supper.
What is the suggestion?
One possible fee structure would be a reasonable fixed amount to cover expenses including supporting portfolio companies (maybe 2% isn't crazy), and an incentive fee on returns above some reasonable hurdle or benchmark.
If the investments yield an 8% gross annual return, the VC who is not at risk is getting paid a rich 3.6%, the investor a paltry 4.4%. Maybe it should be e.g. 20% on the excess over 7.5%, 30% on the excess over 15%.
Then if the investments yield 8% gross, VC gets 2% and investor 6%, and if the investments yield 20%, VC gets 5% and investor gets 15% (if I did that right, would have been 6%/14% under 2/20, at some higher point crosses over and VC does better)
It's easy to conclude that 'All companies should hold out on selling' because if you look at the data for companies that held out, they outperform.
However, there's extreme selection bias. When your true value is in the tens of billions (FB/GOOG), you're never going to get acquired for a fair price because no company can afford you, so you are always going to be in the 'held out' cohort.
There are plenty of businesses whose true value (future discounted cash flow) is in the hundreds of millions or low single digit billions. At this price, many of these companies could find a suitable buyer at a fair price. Since liquidity is a good thing, there's no reason not to.
> If a company blows up, the vast majority of the returns are coming after 4-5 years. I mean, look at GOOG, and only returns since it went public (~6 years after founding)
Using GOOG as an example of expected returns is an absurd generalization. By definition, the expected return on a public stock following an IPO roughly aligns with the rest of the public market (4-8%).
I'm not sure I agree with them or their particularly analysis, but I'm very convinced they are different because the way I see it, VC and the public markets are completely different things. It's like the farm system for baseball teams. VC is investing in the upcoming prospects, and the VC is investing in the existing major leaguers. Sometimes you'll have a farm system full of A+++ prospects that pay off huge (Google, Facebook), and sometimes you won't (pick a 5 year period where there were no massive VC payouts). And obviously the returns on those prospects will only go to whatever team they happened to be on (which VC picked them), whereas public market returns can go to anybody. But they are different companies at different ages doing different things. Thus to me it would be quite surprising if their returns were all that correlated.
And at some sense "froth" is irrelevant. A VC doesn't have to sell their Facebook or Google stock when it IPOs, they can hold onto it as long as they like. They are basically investing for the chance to get that amazing stock at a huge discount by getting it at the "prospect" stage, and once it goes public they can ride the public market waves as well.
No, it matters. Investors want investments that are not closely correlated with the public markets, but they still want something that is going to have a decent Sharpe ratio (~return/risk).
Furthermore, is it even true that VC returns are not well correlated with the public equity markets? My guess is that they would be pretty closely correlated.
On the contrary, I would posit that they're not correlated, or perhaps only weakly so. One of my primary concerns with the venture capital industry and the private equity markets in general is that there is no mature mechanism for the market consensus to reflect short opinions.
In public markets, there can be significant dissenting voices expressed by short interest which will have a material impact on the price of an equity. In the private markets, pessimism from many parties cannot be used to directly influence the consensus price. In my view, this leads to a natural bias towards successful private companies rising in valuation over time, whereas public companies swing more easily in either direction and have a harsher regulatory climate.
While both markets are influenced by things like interest rates, I would default to assuming that they significantly diverge in aggregate returns over time. They also have significant differences in liquidity, which means unhealthy economic trends in one may take a relatively long time to manifest in the other, even if they were otherwise correlated.
But the VC fee structure is probably among the most honest and legit setups in all of finance.
Look at Private Equity (PE) fees. In addition to whatever the LPs are directly paying, portfolio companies themselves are posting up huge fees back to the PE firm. Plus dividends, director fees, you name it. "Promotes" for putting a deal together with a syndicate. Etc. etc.
Look at lending. You've got stated rates but all kinds of extra fees, origination expenses, etc. baked in. When your lender gives you an APR, he is looking at a projected IRR that is way higher, I guarantee.
Early stage VCs -- with few exceptions, and those mainly during weird downturn / recap scenarios -- are generally getting plain vanilla convertible preferred stock. No management fees. No origination / finder's fees. No director fees. No promotes.
There are, by the way, some mechanisms for dealing with absurd fees (in VC and other asset classes). They're well known, and already practiced by savvy LPs with leverage.
If you take away the 2% return, you've basically said that only super rich people that can afford not getting paid for 5-10 years should be VCs. Do you think that all the best investors in the world are super rich people?
Also, when to take that 20% is an issue. Perhaps a VC that is strapped for cash would push a company to exit sooner, or sell the stock right after the IPO, so they could take some of their profits off the table and thus get some working capital. However maybe they'd get a better return for both themselves and their investors by waiting another 5 years. Sequoia has very famously said that they've gotten more returns from their companies post-IPO --> now than they have from initial investment --> IPO. If you believe in the long term prospects of a company you essentially want to never sell the stock.
I'm not suggesting there isn't an alternative, but I'd like to see it. The LPs who continually agree to this fee structure aren't idiots.
This really adds up.
Hedge funds are all the same at the end of the day.
I agree, this is a stupid fight. Higher alignment is called "Private Equity" and it already exists as a model. VCs will go where the market (i.e. the money) tells them, which right now is 2/20. All of the VCs that don't return their funds will simply stop getting LP money and cease to exist.
> I recently had a meeting...talking about the macro view of venture capital and how it doesn’t actually make sense....It took me a while to understand what this really means.
Ok so the author just had a meeting with an angel investor, decided to do all of the research (that's already freely available mind you) and came to the same conclusion as everyone else. Ugh.
That is NOT what PE is at all! PE is about buying WHOLE companies that have established businesses but are struggling. PE does NOT invest in growth companies that are new to the market / not yet proven, nor do they take small percentage ownership.
http://www.kauffman.org/-/media/kauffman_org/research-report...
> Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years.
EDIT: This is actually linked from the article but I thought it was worth calling out nonetheless.
Are those really the definition of a VC success story?
Digging in further:
- assumptions are bad. 7-8% in RE / public equities? Hmm, dubious.
- poor understanding of TVM. 12% is 3x? Except, in the real world, there are incremental cash flows on both capital calls and returns ... so IRR.
- completely ignores cyclicality. Vintage year is the single biggest determinant of venture performance.
One big plus: takes a bit of the wind out of the "we VCs are paid to take risks" strutting. Of course, professional VCs gauge risks and make informed bets. But as the author points out, it's mostly with other peoples' money. True. Entrepreneurs are the ones taking the real, personal risks.
And it would be wrong to assume that there aren't market forces, working even as we type, to 'correct' the imbalance. If it had not been for the exceptionally anemic returns to be had in general, I expect this correction would have happened sooner.
But unlike startups that post 'incredible journey' type farewells, VC firms that evaporate are rarely reported on. There are firms which are contractually following through on their existing funds, raising no new funds, and entertaining no investments in companies they aren't already invested in. These are dead venture capital companies that are waiting for the end of life support.
I am curious what the next chapter will look like. A lot of people think it will be more 'integrated' VCs that look more like Y-combinator and less like Sequoia. Hard to say.
I haven't done the numbers to see how this changes the outcomes in the article, but it seems like it probably has a pretty big impact, considering how much the article focuses on the liquidity aspects. I wonder what the contribution graph tends to look like over the lifetime of a typical fund.
Sure there is: bank loans, growth capital, corporate backers through a JV, et cetera. This is how new business was financed for centuries. If you're talking about companies that grow up to be "average" but still fail at the rate and with the recovery rates of aspiring unicorns, then ofcourse not.
https://blog.wealthfront.com/venture-capital-economics/
https://blog.wealthfront.com/venture-capital-economics-part-...
https://medium.com/startup-grind/technology-due-diligence-or...
EDIT: Just re-read, makes sense why this is "news"... "I recently had a meeting...talking about the macro view of venture capital and how it doesn’t actually make sense....It took me a while to understand what this really means."