If it's already a success in a global market, with a complete team, a fully complete product, clearly making plenty of money with tens of thousands of paying customers (we'd really prefer to see millions) and all risk removed then WE INVEST!
Given the dismal returns on the median venture capital firm, perhaps the criteria identified in the paper should be a guide to how NOT to make investment decisions.
Agree! I'm far more interested in how they con LPs into paying them to lose money. Why should entrepreneurs do all the work to build companies, create jobs and solve problems for customers when we could just get paid to lose money for pension funds?!
The explanation completely went over your head. The numbers weren't from measurements of actual firm performance, they were demonstrative examples to explain why measuring the median isn't very useful in this case.
And no, my example was 6 firms with the median having -1% growth rate, for the record.
Well, more than 50% of the companies have negative returns in the public market. So why do people invest in the public markets? For LPs, investing in VC firms is just to way to diversify and invest in private markets.
Far from it the median company on the stock-market has positive returns just about every way you slice it. That's not beating the market, but the median VC firm does not just fail to keep up with the stock market, they also flat out lose money.
Are you sure? Net market growth is positive since 2009, so that would mean that the growth would have to be limited to an increasingly smaller number of companies.
Excuse my limited knowledge of statistics, but I thought the mean is considered an improper metric for the "average" value of asymmetric distributions.
If not mean, nor median, what metric would you suggest to approximate a typical value?
* 30 return 0.5X (i.e. half of the initial investment)
* 30 return 1X
* 25 return 3X
* 10 return 6X
* 4 return 10X
* 1 returns 20X
The fund class overall returns 2.4X, but the median fund is very underwhelming (investors just get their money back). The "average" fund return (2.4x) is also kind of underwhelming because that's so much worse than the top funds. However, if an investor either a) has broad exposure to multiple VC funds or b) has some insight that helps them pick out the top 20% or 40% of fund managers, then the asset class is a pretty good investment. I think a good evaluation metric for VC as an asset class would a combination of expected returns and variance, and how those two quantities compare to other assets like public stocks or bonds.
b) You can't generalize having magical abilities to pick top quartile managers ex ante.
a) Some bigger LPs diversify across multiple VC firms and smaller LPs may access fund of funds (though very expensive). Either way broad diversification across VC funds is not significant in the industry. One reason is because VC fund returns and broad exposure to multiple VCs is not really the main point here - it is the startups behind the VC layer that generate returns to LPs. Thus VC firms themselves are the conduit by which LPs get diversified exposure to the growth/returns of multiple startups, which is the goal for this asset class. Diversifying on top of your diversification gets expensive and impractical.
I agree with you risk adjusting returns is important. Sharpe ratios would use standard deviation and historical returns. Of course caveat emptor "past performance does not necessarily predict future results." https://en.wikipedia.org/wiki/Sharpe_ratio
There is no official must do approach to looking at VC performance. In practice median and mean are both used, along with some other measures that look at consistency and write off ratios etc...
For those interested one can google search for a professional VC analysis to see what they do. https://www.preqin.com might have something not behind a paywall.
b) Probably true, but in VC some of the top managers seem to be fairly consistent. I think that's one reason that LPs invest in emerging funds: if they hit the next Benchmark or Lowercase, that fund will soon be closed to new investors, so the only way to have an allocation is to be an early backer.
a) I generally agree. I was just trying to illustrate why mean and median aren't great for analyzing asymmetric distributions.
Well ya, if some VCs aren't open to new investors then LPs must invest with emerging managers. The extent to which top managers will revert to the mean is anyone's guess and years away from an answer.
Why not just call it like it is...VC is really just a people business, there's money involved, but trying to quantify the process at all can be misleading. A VC firm is a small group of people (partners) using their best judgement and experience to find another group of people (founders) worth investing in. That's it, there's a ton of key man risk and there's no secret sauce.
Lowercase and Matt Mazzeo are a great example: VCs are basically just like Hollywood talent agents who get to find the next movie stars and help them along a bit - but in VC they are finding the next big tech founders instead of actors. These are people businesses, numbers can't really capture it but they can distract.
I didn't mean to get into a statistics debate on here. The great thing about VC and startups is everyone gets to be right until they're not :)
Sidenote: I hear you guys are running one the best shops in the space. Congrats on the recent close. Best of luck to you and your portfolio co's.
Due to the law of large numbers (LLN, either the weak or the strong version), the mean is what matters, and the median, mode, etc. don't.
E.g., in coin flipping, if assign 0 to heads and 1 to tails and flip coins for a long time and take the empirical average, then that average coverges to the mean of 0 and 1, that is, 1/2. Of course, here the 1/2 is not even a typical value.
Similarly, to estimate what a venture firm will return in the long run, just take the average of what they have returned so far.
> but I thought the mean is considered an improper metric for the "average" value of asymmetric distributions.
It entirely depends on what you are looking to explain or describe.
Mean is appropriate for investment returns if you can diversify risk over many investments. Median is appropriate for looking at incomes in terms of social policy. 95th or 99th percentile might be appropriate when you are looking to ensure that your web server provides reliable response times.
Surveying might yield skewed results. Perception is reality to outside players in venture capital. I actually wrote an article about what I (a Hacker) observed sitting on the other side of the table during my time working at a Venture Capital firm.
This is a really interesting question to ask, but survey-based responses only tells us how venture capitalists think they make decisions. Obviously this is a secretive industry but I think the far more interesting question to answer is around revealed preferences rather than self-assessment.
This is very interesting research. I'm interested in anything that goes beyond Survey data to what actually happened. (VCs may say founding teams matter most, but I also say that I eat less than 2000 calories a day - memory is suspect) I'm also interested in how this would look weighted on firm size or returns. There are lots of small VCs out there who don't make money. How do the VCs who funded Google/Facebook/Apple/Oracle invest?
There's a ton of academic research on public equity investment decision theory. It's great to see private market investment get some focus.
> In fact, Kaplan and Stromberg (2001) and Gompers and Lerner (2001) argue that
VCs are particularly successful at solving an important problem in market economies|connecting
entrepreneurs with good ideas (but no money) with investors who have money (but no ideas).
IMHO, for information technology (IT) venture capitalists (VCs), this statement about "ideas" is mostly wrong. One reason the statement is wrong is that VCs will rarely even look in any detail at an idea.
In contrast the US NSF and DoD will look very carefully at ideas, e.g., GPS, stealth, measuring the 3 K background radiation. So, will Ph.D. dissertation committees, reviewers at peer reviewed journals of original research, and more. IT VCs won't do such things.
IMHO what IT VCs look at is current traction, that is, users or revenue, and want that traction to be significant and growing rapidly. Then if nothing else is wrong -- team, competition, scalability, etc. -- an IT VC can get very interested.
So, the VCs want the idea already implemented in hard/software (usually software) and in the market and in front of users/customers.
In the world of VCs, the idea is not something from research, that could be in a peer-reviewed papers, etc. but is just a short description of what the business looks like externally to a casual observer, the common man in the street. That there could be anything from a research idea as the crucial core of the business, crucial for getting the traction, being defensible and scalable, etc., is just ignored.
So, suppose some IT founding team has the coveted traction. If they have lots of users, then the team should be able to run ads and get significant revenue. If they have lots of customers, then they should also have significant revenue.
With that revenue, there will be some serious question if the team should accept equity funding, that is, accept the terms, a Delaware C-corporation, the BoD, reporting to the BoD that can fire team members, etc. A C-corp and a BoD bring a lot of overhead.
Really, the example of the romantic match making service Plenty of Fish (PoF) starts to look more important as a example for IT startups in the future. PoF was long just one guy, two old Dell servers, revenue just from ads and the ads just from Google, and $10 million a year in revenue. As in
on about July 14, 2015, the solo founder Markus Frind sold out for $575 million.
If a solo founder has a good idea that needs mostly only software, then there is a good chance they can just write the software, bring it to market, get traction, and have revenue enough for rapid organic (that is, funded by earnings from revenue) growth.
That is, a solo founder who invented the idea can keep costs, time on communications, etc. low, write the software, go to market, and get the traction. That day is the first a VC wants to hear from that founder, and it is likely the last day the founder would be willing to accept a check, term sheet, etc. from a VC.
Net, with the VC rules, by the time the VC is willing to invest, the solo founder is beyond willing to accept the check.
Of course, if there are several founders, some high burn rate, maxed out credit cards, each of the founder with a pregnant wife, etc., then the VC's check might be more welcome.
But we need to understand: All across the US, entrepreneurs start and grow businesses -- pizza shops, auto body repair, dentist's office, etc. -- without VC investing. Then, the big difference for an IT startup is that some software and current computing, the Internet, etc. can let an entrepreneur make money much faster than a pizza shop. E.g., suppose the founder's business is a new Web site, and a lot of people like to connect. Suppose the site sends 10 Web pages a second with each page with five ads. Suppose get paid (from a report from Mary Meeker at VC firm KPCB) $2 per 1000 ads displayed. Then the monthly revenue would be
10 * 5 * 2 * 3600 * 24 * 30 / 1000 =
259,200
dollars. Heck, sending even just 1 page per second would yield $25,920 a month. Then one founder with $25,920 a month in revenue growing rapidly is just the traction VCs want, but, with that traction, why should the founder want to accept the VC's check?
> Net, with the VC rules, by the time the VC is willing to invest, the solo founder is beyond willing to accept the check.
This is what I don't understand. So often someone is in this position, dips their toe in the VC pool, and a VC says "here, have two million dollars but give me control." Then suddenly their formerly highly-profitable startup has to have 50 staff, a big office building with board rooms and lots of shiny glass, and before they know it they're living off successive rounds of funding then filing for bankruptcy, because a $1mil/quarter 1-man company can't magically produce $50mil/quarter from the same banner ads just by hiring 49 more people.
Why would you not just tell the VC "no thanks, I'm doing fine without interference"? Your company is real at that stage. The dollar signs being waved in your eyes by the VC are not.
Both of you seem to conflate seed stage and growth stage, where the latter is generally series A and beyond.
The below reflects enterprise, and probably in some form, consumer:
1. Seed stage is likely before growable revenue. This may still be an idea. If technology advances are involved, not just a CMS to power PoF (think university startups vs. most Y Combinators), there may be real capital costs (time, equipment, enterprise POC cycles, ...) before there's something growable. This is also known as turning a technical invention into an adopted innovation. A $500K-$2M seed grant for an AI/infrastructure/etc. company would often need that. Without it, they could only really innovate on stapling together other people's technology.
2. In growth stage, there's a link between money spent on sales + marketing + field engineers and generated revenue, and likely, adding bells & whistles to grow into nearby markets. At this point, first mover advantage gets pretty real. Even cooler, revenue should be predictable within some range, so as soon as sales KPIs aren't being hit, hiring etc. can be scaled back to reflect reality. Or, just keep growing because the market is worth it.
In both cases, the goal is to go big fast, e.g., world leader in 3-7 years, vs. the 5-10 year plan. This isn't necessarily about greed: dealing with competitive industry, the desire to work on big things, the desire to work on many things, hiring certain folks, etc.
Of course, if you can do all of the above with a PoF idea, great. However, if you're that good, maybe just pick the right numbers for lottery tickets and use the proceeds to start a research lab? :)
> 1. Seed stage is likely before growable revenue.
In which case from all I can tell, essentially no VC in the country will pay any attention at all. That is, the startup didn't have traction significant and growing rapidly.
For university startups, okay, but have to look in detail at the project plans. As I mentioned, that's possible: E.g., the first version of GPS was a back of the envelope thing by some guys at the Johns Hopkins Applied Physics Lab. That envelope was converted to a project plan; the plan was executed and successful. Lesson: If look carefully, should be able to evaluate the project technology just on paper long before soft/hardware or traction. If the technology really is overwhelmingly powerful for some commercial need, then, sure, should have a successful company. But IT VCs won't look at the details and, instead, just want to look at traction.
For funding of on-going companies, sure, there is a big industry for that from later stage VCs, private equity, M&A, IPOs, etc. There to evaluate a company, make heavy use of accountants and lawyers.
I'm a very stupid and naive person when it comes to this kind of thing, but if I were such a founder, I'd be a little worried that such a VC would invest in a direct competitor to me if I didn't take their check. Of course, they might do that anyway (and other's surely would,) but at least I can imagine competing better if I had more funding.
You want to be defensible, to have a barrier to entry, e.g., to have done some original research that is a bit too obscure for nearly everyone in IT VC and their entrepreneurs, some research that is the powerful, valuable, crucial enabling core of the whole project. That is, want some secret sauce -- no secret sauce, no Big Mac. You want the product/service of your startup to be difficult to duplicate or equal.
If it is really easy for others to duplicate or equal your work, then do some work that is not so easy.
It's interesting sure but I feel like a different method is needed. I think qualitative research would be more valuable at this stage. A large field study would be ideal. Embed researchers with VCs possibly also with startups who try to raise for an interesting overall picture. Obviously not the easiest thing to pull off.
This paper is simply a comprehensive survey of VC opinion broken down statistically, rather than a genuine study into how VCs work.
In other words, the singular focus on survey data without a sharp focus on correct interpretation has killed the spirit of digging deep and understanding the VC setup, with the result that it's not very actionable or insightful.
If the findings were perhaps informed by cross referencing with a survey of others in the ecosystem who aren't VCs, the authors would probably have been more skeptical and possibly better educated on reality. It'd have been extremely valuable to go to entrepreneurs and ask.
Reading one of PG's essays provides a far more useful perspective.
The challenge with a generic survey such as this is that while it gives an (really long) introduction into how VC works, it misses all the subtleties. A better researcher would have looked into that, and turned this into a legendary paper. Why is that important? Because as a VC, decisions are the most important thing you make, and subtleties play a huge role in that. If you don't dig deep, then you're just documenting interviews rather than understanding and interpreting reality correctly.
What the authors should actually have focussed on is:
