One of my favorite VC bloggers, Josh Kopelman, has an interesting piece on the VC math problem as first envisioned by Fred Wilson. Having gone through the fund raising process, and hearing this nonsense from VCs, I always gnashed my teeth when a VC was setting valuations based on what they needed to own. Not any intrinsic value of the business, but rather what they felt their ownership percentage needed to be. This was much more of a problem with the earlier stage VCs, and, interestingly enough, with some of the spray and pray VCs, where you would think they might care less about overall percentage due to the fact that they were investing everywhere.
Josh references a paper by Paul Kedrosky which takes a very detailed research approach to examining this issue. The paper has been downloaded and will be read tonight. However, the math that blew my mind was contained in the following section of Josh’s post:
Take a $400M venture fund. In order to get a 20% return in 6 years, they need to triple the fund — or return $1.2B. Add in fees/carry and you now have to return $1.5B. Assuming that the fund owns 20% of their portfolio companies on exit, they need to create $7.5B of market value. So assume that one VC invested in Skype, Myspace and Youtube in the same fund – they would be just halfway to their goal.
My head just exploded. Despite my own please for my co-workers to be more intellectually curious with their jobs, I had never done this math. I am left absolutely shaking my head at the reality that is facing any VC not in the top 5 (as in top 5 VCs, not 5%). Good luck. The tactical play for a fund is to invest early and small. This is at odds with the 2 and 20 model. I mean how are VCs going to feed their Cayenne Turbos?
Worse, I worry about the companies that the other VCs are funding. With such a challenging economic model now staring them in the face (hey, at least before they didn’t have to answer to the data which could refute ridiculous forward looking statements about future “internet” or “new economy” fund performance), are they going to just start swinging for the fences? Will they just pile on the risk and do whatever they can to justify the fees? Or will they find a way to raise money and do next to nothing, and simply collect their management fees? I wonder if LPs will now start wanting to have claw-back mechanisms in place when returns fall below a certain threshold.
The really hard problem facing entrepreneurs is that while it costs less and less money to start a company, VCs have more and more money piling up in the form of capital call commitments due to a dearth of deals over the past couple of years. They want to deploy more capital, and that leads to capital inefficiency within small companies.