Explaining VCs part 2 - The VC Model

Last time around I gave a general introduction to what venture capital is. This let’s look at how VCs make money, which in turn influences which companies we choose to invest in.

I’m talking about the infamous “VC Model” which (if you’ve been reading the blogosphere in recent months) a lot of people claim is broken.

Marc Andreessen explains the model very succinctly:

The whole structure of how the technology industry gets funded -- by venture capitalists, angel investors, and Wall Street -- is predicated on the baseball model.
Out of ten swings at the bat, you get maybe seven strikeouts, two base hits, and if you are lucky, one home run.
The base hits and the home runs pay for all the strikeouts.

Say we raise a fund of $150-200M from our investors. With that money we will make, something like 20 investments averaging $8-10M over the lifetime of the company. In order to make the returns that our investors expect we assume that of the 20 investments:

•    Two will be huge successes and return 10X on the money
•    4-5 will return 2-3X their investment
•    The rest will either just return their investment or else get written off entirely

The successes, as mentioned above, need to be big enough to cover the inevitable losses from those companies that fail.

So how does this influence our investment decisions? For one thing it means that we need to focus on those companies which we believe at least have the potential to be home runs and return 10 times their investment.

One of the most common reasons we have for passing on companies – including a lot of companies where we think the team is great and the idea is solid – is that we feel that the opportunity is too small.

(How small is too small, you may ask. We don’t have any fixed rules, but if your total addressable market – in other words the total revenues that you could theoretically get if you cornered your target market – is less than at least half a billion dollars if not a billion, it’s probably too small for VC).

While the investment multiple is important, it’s not the only consideration. The actual amount of money which is returned is important as well. Small exits (let’s say under $40M) can be very good for a company’s founders but not so great for the VCs who invested in them. In other words, if a VC makes a seed investment of $2M and the company exits for $20M, this is not considered a big success even though it had a multiple of 10.

Why is this? Even if the VC held 30% of the company at exit (which is on the large side) it only got back $6M. In order for a $150M fund to make the returns is investors expect, it would have to have 30 or 40 exits like this, which is unrealistic. So, again, we look for exits we believe will be have the potential to be in the $100M range or greater.

Obviously we know that most companies will not have $100M+ exits. But since 7 out of 10 companies that we invest in are likely not to succeed as hoped, we need to know that the three who do at least have the potential to succeed big time.

So, why are we hearing that the model is broken?

There is a feeling that the size of exits has shrunk over the course of this decade. Fewer companies are going public, and the ones who do are doing so at a much late stage after much more money has been invested in them. With fewer IPOs, more companies exit by being acquired, which often means smaller exits.

It’s unclear to what extent these assumptions are true, but if they are then the number of exits that return a 10X multiple shrinks, which affects the model greatly. On the other hand, the costs of starting up a company, especially in the Internet world, are a lot smaller. Perhaps a larger number of companies will produce moderate exits, which will cover the ones that don’t.

So we may find that the VC model will have to be adapted. If it’s not broken, it may yet have to bend.

Comments

[Aner Ravon]

But what about some real life parameters?

For example fear of making a mistake? The baseball model is true IF YOU SWING AT EACH AT BAT. A baseball player does not have the option of not stepping to the on deck circle....

I personally found that VCs choose their investments based on:
1. Past familiarity with the founders. By far, the most important parameter. It doesn't have to be personal acquaintance, it could also be familiarity with the founders history.
2. Perceived value of the investment - how it will impact the other investments, the VCs new fund in the pipe, etc.
3. Partner's own ambition within the VC - desire to "own" a sector, etc.
4. VCs overall portfolio ("we need a web 2.0 company")

You get my drift.

It's not that the text book doesn't matter, of course it does, but it isn't remotely just a rational process.

[shai]

I am certainly not arguing that the process is 100% rational. Obviously, all manner of personal considerations come to play. I don't think the fear of making a mistake is necessarily a major one of these. As we know, the vast majority of startups fail for any of a hundred different reasons and that's part of the risk we take as venture investors.

In addition to personal considerations, there is also the matter of the fund's overall strategy (for instance trying to build a portfolio of diversified companies versus focusing on companies within a particular sector).

None of this contradicts the overall framework of looking for companies that we believe have the potential for an outsize exit. It's less a textbook than a general heuristic.

[amit shafrir]

what is the average lifespan of an investment (from initial to exit)?
what is the expected return from a fund for LPs ?