The Meeting That Showed Me The Truth About VCs And How They Don’t Make Money

I had a meeting with a well-known startup investor yesterday. The talk somehow pivoted from my seed-seeking startup into talking about the macro view of venture capital and how it doesn’t actually make sense. Or maybe it does make sense? Guess it depends on your point of view.

“95% of them aren’t profitable.” he said.

I’ll clarify what that actually means: 95% of VCs aren’t actually earning enough ROI to justify the risk their investors (LPs) are taking.

I’ll attempt to reconstruct the arguments leading to this hard-to-grasp realisation of an industry so often idealised from the outside.

Assumptions

Before starting, let’s define what success and failure actually mean and list our assumptions:

1) Success = 12% return per year

Venture capitals get their money from limited partners (LPs), who are usually traditional investors such as banks, institutions, pension funds, etc. In their eyes, throwing $50M into a startup fund is “risky” business compared to their other options, such as the stock market / real estate, which could “safely” return 7–8%. For them, 12% return on their money per year is good. Anything below that? Not worth the high risk they’re taking.

That brings us to…

2) A 10-year fund needs to return 3x the fund size

We agreed VCs need to earn 12% return a year, right? Most funds, while only actively investing three–five years, are bound to 10 years. That annual 12% rapidly grows to show the power of compounded interest. Let’s see the math:

3) Don’t Forget Pareto: 80% of returns come from 20% of startups

A fact of life is that startups are hard. Breaking even is hard. Profits are hard. Keeping profits growing year over year (YoY) is even harder. Out of 10 companies, only two will really explode and IPO/M&A giving our dear VCs some of their money back.

Let’s Start

So we have 10 startups and a fund that needs to return 3x within 10 years. Let’s assume it’s a $100M fund, with $10M invested in each company over the course of its life and the desired return of $300M. To be fair, let’s also assume that the VC jumped in on Series A round, followed up on B and has 25% ownership at the end, with non-participating liquidation preferences.

Let’s look at a few different outcomes of our 10 startups after 10 years:

1) They all do “average” and exit at $50M

Green marks the exit size; purple the payout amount of the VC with his 25%.

10 companies that all exit at $50M. The VC would return $12.5M on each. Outcome: 10 * $12.5M = $125M. We needed $300M, right? Not good. Let’s give them better odds.

2) Half do average like before and half do better

5 sold at $50M, so $12.5M return on each. The other 5 did much better and pulled off $100M exits. The founders are overnight millionaires and their picture is in the paper. The VC? Not so much. Return: (5 * $12.5M) + (5 * $25M) = $187.5M return. Still not quite at $300M. No good.

3) Majority do “average”, we’ll throw in an overachiever

So here let’s take our previous example, but make one of them a star. The tenth company, instead of selling for $100M as before, now does $500M. So our original 5 still sell at $50M, 4 that sell at $100M and our new one at $500M. Total returns for our VC: (5 * $12.5M) + (4 * $25M) + (1 * $125M) = $287.5M. We’re almost there! Just a bit more.

4) I think you see where this is going…We need 1 big fat unicorn exit!

We would need 1 large exit to see good profits. Something like this would work: 9 startups sell for $50M each and 1 goes for $1B. (9 * $12.5M) + (1 * $250M)= $362.5M. We finally made it! Everyone is happy.

But is the last scenario actually feasible? Can you realistically expect all 10 companies to exit? 100% success rate sounds too good to be true. The more realistic scenario is that out of those 10, 5 will be complete losers, 3 will sell for small-medium amounts (which we just saw barely move the needle) but 1–2 will be big unicorn hugging exits ($1B+)

5) The Realistic Case

5 startups fail and do $0, 3 exits at $25M, 1 exits at $200M and our superstar does $1B. Let’s see the return on that one:
Return: (5 * $0) + (3 * $6M) + (1 * $50M) + (1 * $250M) = $318M
We’ve finally made it. Phew, that was hard. Here we see some good returns, but is it actually realistic to think that the average fund can find this golden ticket? Probably not. The apparent truth is that most VCs aren’t doing as well as our “realistic case”. Only the good ones. The top 5%.

Source: Gil Ben-Artzy — Money Talks

How are VCs doing?

Not looking too good. The graph shows what percentage of VC firms are returning what multiple X of their fund size. As we showed earlier, most funds would need a 3x return to be a good investment ($100M fund => 3x => $300M return). As we can see, only the small green slice is bringing it home. The other 95% are juggling between breakeven and downright losing money. (Remember: to adjust for inflation)

There’s still hope

It’s still hard for me to accept the fact that the only realistic way for a fund to get acceptable returns is to try to find only the companies that could be the next Uber’s, Facebooks and AirBnBs. Under these rules, it doesn’t make sense to invest in anyone that can’t get to unicorn stage. There’s just no place for “average” companies looking to be worth and sold less than $500M. At least not with VCs.

The way the numbers work out, it doesn’t look promising for any startup founder with less than shooting-to-the-moon goals. Even less so as for a VC who’s fighting to keep his head above water and secure a follow-up fund. And don’t get me started on the LP’s, who are going to be disappointed at the end of the 10-year fund.

But does it have to be like this? One place we can try to play around is our assumptions tab. Assumptions can and should be challenged.

• 10-year fund? Why not 6? Reducing the fund length from 10 to 6 years decreases the expected return from the whopping 3x to 2x. Much less pressure for a VC to return $200M rather than 300. How can it be done it less time? 1–2 years for scouting and finding 10 A-round startups, 4–5 years for growth. Add some non-stop pressure on the founders to sell all the way around. The counter argument could be the lack of liquidly after only 6 years while needing to find secondary markets (not ideal).
• Screw traditional investors, move to the “cloud”. We should be able to find better access to capital that isn’t looking for 12% returns. Can’t we find investors willing to get a 8% stable yield in a $1B+ fund diversified over hundreds of startups? Moving from 12% to 8% reduces the required return by a third. More lenient investment legislation (Jobs Act) are breeding more P2P and crowdfunding venture arms. And at 8% yield, you’ll find much more non-traditional investors joining the game. The counter argument here could be you can find similar returns just by dumping some cash in the stock market and waiting it out.

To summarise, being a VC is a tough business, for all parties. It’s not natural for a founder at stage one to know how he’ll grow from zero to billion. So many things will change along the journey. It’s also not an easy task for VCs to “guess” which startup will be tomorrow’s Uber. Is there actually no way to support and properly invest in a startup aimed at only 9 figures?

Food for thought. Give it a like if you like.

Sources:

• Venture Capital Funds — How the Math Works
• Does the Size of a VC Fund Matter?
• Cambridge — U.S. Venture Capital Index (2015 Edition)

Thanks to Gil Ben-Artzy for the insightful meeting / feedback and of course can’t forget Liat Aaronson and Dr. Ayal Shenhav for the countless hours of VC lessons at the Zell Entreprernurship Program that covered all the basics of this world.

[Tomer Dean is a serial tech entrepreneur based in Tel-Aviv working on an ecommerce SaaS startup Bllush. This post was first published on Medium and has been reproduced with permission.]

Note: We at Inc42 take our ethics very seriously. More information about it can be found here.