Why the VC Investment Model is Broken

 

Before anyone worries about my title, Sequoia, Kleiner, and NEA will be fine.  Any of the very top Valley firms see hundreds of deals a month, only do a handful every year, and have all the capital they need to finance even the largest startup plans.  Since they are on sitting on a series of large funds, their management fees allow them not only to make sufficient money per partner, but also pay for any resources they need to both attract good deals, but also bring on board luminaries to help them understand where the market is going. 

In contrast, the small and medium size firms (and anyone on less than fund 4) have a very different situation, particularly if they are not in Silicon Valley or Boston.  Let me illustrate this with an example.  Let’s say Fund X has $200M under management, has 5 partners, and plans to have their money allow for four years of investment.  Then each partner invests about $40M during the life of the fund or about $10M each year.  Considering that each partner does on the average about 1 deal per year, which means that each deal must be about $10M invested and reserved into each company.  Very few of the small or mid-tier VCs work alone, so that means that 2 or 3 VCs per deal – all with the same model.  Therefore, the plan is that each startup take in at least $25-30M in invested capital.

So given this reality, what must this company’s exit look like to get a venture return of 5-20x? Let’s use an example – an early-stage startup called Putrats.   Assuming that the VCs own 50% of the company, with the Putrats option pool being about 30% and the founders and seed investors having only 20%, then the value of the company must be about $50M to break even.  (Of course, things like liquidity preferences change that.  And could make a $50M acquisition valueless for the employees and founders!  More on that in another blog.)

For Putrats to qualify for an A round with a $10M pre money valuation, it must be an advanced startup, with product, revenue, and customers.  (You could quibble and say that’s not really a startup, but then you would be making my point!)  It is for this reason, that most VCs are no longer doing the same kind of seed and early stage investing that VCs of the last generation did.

So how does this work for the VCs?  This model will work if the IPO market is robust, but it is not and I don’t believe it will come back any time soon.  Most companies get their liquidity from acquisition.  (I used to be in the corporate acquisition business at Microsoft.)  While a very few exceptional acquisitions will occur at $250M, most will be in the $20-50M range.  The VCs that control the board and the preferred equity won’t accept a $50M buyout.  Instead they will continue to pump more capital into the company to grow bigger, eliminating all but a few acquirers.  This further dilutes the founders and seed investors.

So why do VCs do this?  And why to Limited Partners continue to invest?  The answer is a great paper story.  Let me explain. 

Let’s assume that Putrats’ first financing was done at a $10M pre-money and raised $8M, with each of 2 VCs taking $4M, or a post money valuation of $18M.  In the second round, they were joined by another VC who puts in $10M and the 2 previous ones each put in their pro rata of $6M.  In this example the post money valuation would be almost $50M and the VCs would now own 60% of the company.  This is fairly typical example. 

So why does this appear good to investors?  The first VCs in the deal get a write up on their $4M, since the value of the company has increased from $18M to $50M.  On paper, their original $4M investment is now worth over $8M.  Since the second round is usually within 18 months of the first, this looks like a fabulous return!

But at a $50M post money valuation, Putrats would need to be worth well more than $100M in acquisition value to get the same return on the new money, so the investment syndicate (now in firm control of the company) will reject any acquisition offer that is less than that.  It is a vicious spiral for the entrepreneur, who finds that their share of the company shrinking and exit options fewer.

This will catch up with the VCs sooner or later.  Management fees are 2-3% per year.  So for FundX, that is 2.5% of $200M or $5M per year.  Assuming that the active investment period allowed by the LPs is 5 years, and then the management fee decreases by half, then the total fees for a 10 year fund is $37.5M.  That means that FundX only invests $200M – $37.5M = $162.5M.  In order to break even (make a positive return), FundX needs to make 23% just to dig itself out of the hole. 

So why isn’t this obvious? – the J curve.  Historically, every VC fund loses money in first few years and then makes it up later; this is called the J curve.  Because the average time from investment to liquidity is about 7 years for a startup (except during the bubble years of the late 90s when the time to liquidity was very short), the only real metric that can be used to value the portfolio is the post-money valuation of the latest round!  So, on paper the VC return looks good for many years past when the result is set in stone. 

So… unless market conditions go back to very highly valued companies, one can expect lots of fallout.  I expect that VC will fall out of favor.  There will be consolidation, and dislocation ahead.