{"id":198,"date":"2010-08-12T11:00:46","date_gmt":"2010-08-12T18:00:46","guid":{"rendered":"http:\/\/www.danshapiro.com\/blog\/?p=198"},"modified":"2010-08-12T14:53:29","modified_gmt":"2010-08-12T21:53:29","slug":"vc-insanity-economics","status":"publish","type":"post","link":"https:\/\/www.danshapiro.com\/blog\/2010\/08\/vc-insanity-economics\/","title":{"rendered":"VC insanity, explained"},"content":{"rendered":"

…or, why VCs do what they do<\/strong><\/h2>\n

(Note: this post also appeared as a guest post on Techflash<\/a>)<\/p>\n

VC behavior sometimes looks insane, but generally it’s just sound economics.\u00a0 It’s crazy but true: if you know how a VC gets paid, you can pretty much read their mind.\u00a0 Here\u2019s a few examples:<\/p>\n

VCs don’t actually seem to want to take any risk.<\/strong><\/h2>\n

\"Dice<\/a>You’ll be forgiven for thinking that a VCs job is to take investment risk.\u00a0 It’s a common misconception.\u00a0 But here’s the bizarre little secret: the VC takes their biggest risk the day they close their 10-year investment fund.\u00a0 That single defining moment is the absolute apogee of risk taking.\u00a0 From that instant forward, the VC\u2019s goal in life is trying to do is safely return the money they’ve taken – hopefully with lots of gravy on top – to the eager hands of their watchful LPs.<\/p>\n

What’s an LP, you ask?\u00a0 It’s another common misconception that VCs are investing their own money.\u00a0 In fact, most of the money they invest (typically 98%+) comes from Limited Partners like college endowments, pension funds, and even the occasional individual Uncle Pennybags<\/a>. Even when they invest in their own funds, it’s often just a slight of hand – cash is redirected from their management fee (their “salary”) and shuttled right in to the capital calls.\u00a0 Folks who put their own dimes on the line are known as angel investors, not VCs.\u00a0 Venture Capital is strictly a game of other people’s property<\/a>.<\/p>\n

So the day the fund closes is the day our friends at Hypothetical Partners have just committed to invest $135mm of other people’s money in startup companies and, ten years later, return it in spades.\u00a0 That money will<\/em> be spent on early stage company investments – their job from that point forward is to meet their commitments in the safest way possible.\u00a0 Modern venture capital is one shining moment of derring-do taking followed by 10 years of risk mitigation.\u00a0 It’s sort of like breaking a mirror.<\/p>\n

They’re trying to make me take more money than I need.<\/strong><\/h2>\n

<\/a>\"Big<\/a>This is a classic example of behavior that makes perfect sense to someone who understands VC economics, and no sense at all otherwise.\u00a0 Consider this: average VC fund size in 2009<\/a> is about $135mm. if we give our friends at Hypothetical Partners 4 full investing partners, they’ve each got to invest about $27mm.\u00a0 That doesn’t sound so bad, right?\u00a0 Well if HyP is a $135mm fund, that probably means they\u2019re investing first in Series A ($2mm) or B ($5mm), allocating a total of $10mm in either case for later funding rounds (C or more) if things go well. So doing the math, each HyP partner has to do about 3 investments from this fund.\u00a0 Sounds simple – one person can probably handle 5 or 6 boards with no problems.<\/p>\n

But this isn’t HyP’s first time around.\u00a0 They’ve probably raised a few funds before – 3 would be on the low side. HyP I is probably mostly done by now, but HyP II and HyP III have companies going strong (or weak), and each partner had 3 investments in each of those<\/em> funds.\u00a0 So it’s very possible, even likely, that our partner may have 5 board seats already, and there are some pretty tight demands on their schedule.\u00a0 Golf games may be in danger of abbreviation.<\/p>\n

So once they finally decide that you are the least risky place to stash their funds for the next semi-decade – the more, the better.\u00a0 It increases their ownership percentage meaning that they get more of the good result they think you\u2019ll produce.\u00a0 It reduces a big area of risk (running out of money). And if they invest enough, they may get themselves out of doing an investment later, which means fewer board seats, less time in due diligence, more time to see the company succeed before the fund expires, and potentially a measurable improvement to their golf handicap.<\/p>\n

They raise big funds, but small ones perform better.<\/strong><\/h2>\n

The verdict is in: Silicon Valley Bank researched hundreds of venture funds over a period of decades, and found that small funds outperform big ones (the original data is here<\/a>).\u00a0 Yet absent market forces forcing otherwise, VCs tend to raise enormous, ever-growing funds.\u00a0 Why is this?\u00a0 Isn’t it in everyone’s interest for the fund to perform better?<\/p>\n

The answer lies in a little secret called the 2-20 rule.\u00a0 It says that VCs get 20% of the fund’s profits – and 2% of the fund’s investment.\u00a0 Each year.\u00a0 For ten years.\u00a0 Fred Wilson has laid the economics of his venture fund<\/a> bare for the world to see, and it makes the point quite clear.\u00a0 If HyP raises that $135mm fund, they get $2.7mm each year – enough to cover modest salaries, travel, and a nice office for the partners.\u00a0 But if those same six partners raise a $500mm fund… well, let’s just say that a case could be made that their investment management skills are now of secondary importance.<\/p>\n

They don’t appear to be particularly interested in making large amounts of money.<\/strong><\/h2>\n

<\/a>\"Mo'<\/a>You’re about to pitch HyP on an outstanding plan: a virtual certainty that they will get a 100% ROI in two years.\u00a0 It’s a double-your-money sure thing.<\/p>\n

Before you can even start, they tell you – truthfully – that they’re not interested.\u00a0 It’s not that they don’t believe you (although that’s probably true as well); it’s that they actually have no interest whatsoever in doubling their investment in two years.\u00a0 Why?\u00a0 Because their LPs want to make 9% annual returns.<\/p>\n

You see, VCs operate within three peculiar rules:<\/p>\n

Rule number one is that the fund is 10 years long.\u00a0 They need to provide 9% returns over the course of a decade, not next year.<\/p>\n

Rule number two is that there’s no recycling.\u00a0 Once they cash out of a deal, the money goes away – never to be invested, for the rest of the decade. So your 100% return gets divided by 10 years, not by 2.<\/p>\n

And rule number three is that those returns have to take in to account the compounding interest they would have received on both the principal and the management fees.<\/p>\n

A little math: to get 9% per year, a hypothetical $100mm investment must increase to 100*e^(10*9%)<\/a>=$246mm.\u00a0 But $20mm of the principal (2%\/year) goes to management fees and can’t be invested.\u00a0 And the VCs get 20% of the profits (the carry).\u00a0 So actually, $80mm invested needs to yield $290mm, a 3.6x return.<\/p>\n

Suddenly you can see that your deal actually sets them back significantly (never mind the risk that the “sure thing” might not be).\u00a0 When you hear that VCs aim for a 10x return, it’s not greed – it’s because if a third of their companies fail and a third just barely get them their money back, a 10x return on the winners puts them in the same place as the S&P 500<\/a>!<\/p>\n

They don’t let you sell the company, even though it’s enough to make everyone rich.<\/strong><\/h2>\n

Remember that target of 10x?\u00a0 Yeah, there’s another catch.\u00a0 It’s not a 10x return on what they invested.\u00a0 It’s 10x return on what they reserved to invest – a bigger number that takes in to account the total amount they predicted you’d need over the course of your company’s future, set aside so that they don’t come up dry during follow-on financings.\u00a0 By the time your company exits, it’s probably too late to invest those reserves, so they count against you when calculating return.<\/p>\n

Consider this: HyP invests $2mm in YouCo at a premoney valuation of $2mm, meaning they own 50% of a company worth $4mm.\u00a0 Someone offers $40mm for the company.\u00a0 Hallelujah!\u00a0 A 10x win!\u00a0 You each get $20mm!<\/p>\n

Not so fast.\u00a0 If they invested $2mm and reserved $5mm for a follow on investment, it’s probably too late to invest the other $5mm.\u00a0 They’re actually getting just shy of a 3x investment on their allocated capital – not even the 3.5x they need to approach the S&P 500. No deal.\u00a0 If they let you sell the company and pocket that cool $20mm, they would actually be coming out behind.\u00a0 The simple economic calculation is to block the sale, and force the company to take additional investment.\u00a0 Consider: if the second round is under duress, best case it’s a flat round: that means $5mm on $4mm premoney, and voila!\u00a0 They own 78% of the company.\u00a0 For the very same purchase price a day later, $40mm (plus $5mm for the $5mm in the bank), they now get 78% x 45mm = $35mm, or a 5x return – not 10x, but enough to clear their 3.5x requirement.<\/p>\n

They all invest in the same things.<\/strong><\/h2>\n

\"Lemmings<\/a><\/strong>It makes no sense at all to invest in the fifth URL shortener, or social network, or group purchasing site.\u00a0 You’re wading in to a pot of competition, and there may be more than one winner – meaning the pie gets split.\u00a0 Better to invest in novelty, where you can have the field to yourself!<\/p>\n

Sounds good, but it ignores two things: thesis risk and excuses.<\/p>\n

You see, before a VC makes an investment, they’ve got to do a ton of background research on the market to create their investment thesis.\u00a0 How big is it? How fast is it growing? Who are the competitors?\u00a0 Is there a “venture scale exit” (10x ROI) here?\u00a0 Now, there’s two ways to do it.\u00a0 One is a lot of work.\u00a0 The other involves copying your neighbors’ homework, which is usually a very poorly kept secret.\u00a0 If your neighbor is someone who does a lot of work putting together their investment thesis – and on Sand Hill Road, everyone’s everyone else’s neighbor – it’s probably a lot easier to borrow their thesis and just fund something else along those same general lines.<\/p>\n

The second reason happens when the sector blows up and everything goes sideways.\u00a0 If you took the leap to invest in caffeinated soap<\/a> all by yourself, good luck explaining that to one to your LPs.\u00a0 But if you and everyone else thought that Push Technology would be the next big thing<\/a>, well, you’ve got an excuse that hopefully gets you forgiven for having your investment explode next to 31 others<\/a>.<\/p>\n

So perhaps VCs aren’t crazy.<\/strong><\/h2>\n

In fact, I’ve sat on boards with a dozen partners representing funds sizes ranging from $10m to $10bn, and there wasn’t a kook in the room.\u00a0 They were smart, likable, helpful folks with an unusual job.\u00a0 In fact, if there was one thing I’d say that set them apart from the average technology business person, it would probably be that they all seemed to have an outstanding grasp of advanced economics.\u00a0 No surprise, then, when they act just the way their pocketbooks would predict.\u00a0 Remember that next time you see otherwise-inexplicable behavior\u2026 like news reports wondering why a VC pushes aggressively for the sale of a promising portfolio company… that happens to sit in a fund<\/a> that is nearing the end of its 10-year life.<\/p>\n

And before you take money from a VC, make sure you have an open conversation about just where their money comes from and what strings they have attached.\u00a0 There’s simply no way a person can surprise you if you know how to read their mind.<\/p>\n

Disclaimer section<\/strong><\/h2>\n

To keep this short and help it read well, I glossed over a lot of details.<\/p>\n

    \n
  • Some funds do allow partial recycling (re-investing proceeds from exited companies) – typical constraints are only during the first 5 years of the fund, and\/or an amount equal to the management fees.<\/li>\n
  • There are some funds that have significant investment from their partners, but the standard is 1%-2%.<\/li>\n
  • I didn’t get in to capital calls, where VCs don’t get the money from their LPs until it’s needed, and the interaction between that and management fees.\u00a0 I think, but I’m not sure, that the VCs don’t get their management fees unless the capital is actually invested.\u00a0 I\u2019ve also heard that at least some firms don\u2019t get management fees after a company exits, which adds fuel to the \u201cdon\u2019t invest in a company that will exit next year\u00e2\u20ac\u009d fire.\u00a0 Perhaps someone can add more information in the comments.<\/li>\n<\/ul>\n
      \n
    • Some firms build a brand out of entrepreneur-friendly behavior.<\/li>\n<\/ul>\n
        \n
      • These are generalities based on averages; the exception is the rule.\u00a0 Big funds look for smaller multiples with a higher likelihood (e.g. low-risk 3x returns).\u00a0 Funds near the end of their 10-year life look for companies that will exit fast.<\/li>\n
      • I\u2019m a startup guy, not a VC.\u00a0 This is all hearsay and second hand, and I hope folks who know more about this than I will chime in and correct what I\u2019m sure are many mistakes.<\/li>\n<\/ul>\n

        And perhaps the most important point: Acting against economic interests and in favor of relationships is quite common, even the norm.\u00a0 It helps deal flow, which helps fund economics, if you have a reputation as being a nice person, and… most VCs I know actually are<\/span> nice people.<\/p>\n

        But\u2026 when you come across a bit of the insanity described here, try not to be too surprised.<\/p>\n","protected":false},"excerpt":{"rendered":"

        Modern venture capital is one shining moment of derring-do taking followed by 10 years of risk mitigation. It’s sort of like breaking a mirror.<\/p>\n","protected":false},"author":2,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[21],"tags":[],"class_list":["post-198","post","type-post","status-publish","format-standard","hentry","category-startups"],"_links":{"self":[{"href":"https:\/\/www.danshapiro.com\/blog\/wp-json\/wp\/v2\/posts\/198","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.danshapiro.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.danshapiro.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.danshapiro.com\/blog\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/www.danshapiro.com\/blog\/wp-json\/wp\/v2\/comments?post=198"}],"version-history":[{"count":1,"href":"https:\/\/www.danshapiro.com\/blog\/wp-json\/wp\/v2\/posts\/198\/revisions"}],"predecessor-version":[{"id":203,"href":"https:\/\/www.danshapiro.com\/blog\/wp-json\/wp\/v2\/posts\/198\/revisions\/203"}],"wp:attachment":[{"href":"https:\/\/www.danshapiro.com\/blog\/wp-json\/wp\/v2\/media?parent=198"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.danshapiro.com\/blog\/wp-json\/wp\/v2\/categories?post=198"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.danshapiro.com\/blog\/wp-json\/wp\/v2\/tags?post=198"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}