Wednesday, February 17, 2010

Is the Venture Capital Model Dead? Yes - Alpha

Venture capital has always been an investment field for dreamers and suckers. VCs and entrepreneurs get caught up in building flashy products and transforming industries. But they often forget one thing: profitability. Solid companies like Zappos, Facebook, and Starent are the exceptions in 2009 that grabbed attention. Then the truth sets in. It has been 12 years since the venture industry has returned more cash than it has plowed into investments, according to the National Venture Capital Association (NVCA). Yet bovine limited partners keep putting money into venture capital. The industry is now managing ~$250bn, up from $64bn in 1997.

Yes, the last ten years for the VC industry has been dismal, with one dollar taken in 2001 returning 38 cents and having 62 cents in leftover “residual” value (RVPI, marked by accountants paid by the VCs), for a grand sum of one dollar in early 2010. Can I be a VC and take your money on those terms? I’ll be glad to take $100mn in 2001 and give you $38mn today, with a promise to give you $62mn later!

NVCA Industry Data Shows Horrible Performance

The venture capital business model is simple. An early stage VC may have a portfolio of 10-15 companies, expecting 1-2 to generate massive returns, 2-6 to break even (barely getting their money out), and the remaining 7-12 to go bust. Late stage VCs should have more successes, but at lower expected returns. Below is a table showing promised returns and expected time frames.

The Truth Above is Much Worse Than the Promises Here

VCs like to talk about the big attention-getting deals, the 10-baggers and such. Yet they take advantage of your “anchor bias” as an investor (a limited partner in their funds), by focusing on the one star in a single previous fund, the salient star, while hiding the fact that the annualized return of the total fund is dismal (remember, you get the fund’s returns, not the star’s returns). VCs then talk vaguely about world-transforming trends, like the internet, cloud services, RNA interference technology and such. Finally comes the big leap: the assumption that world-changing technology will result in healthy, risk-adjusted returns for passive limited partners in the VC funds. Ain’t gonna happen. For a specific example, see how Tim Draper’s DFJ used Baidu and Skype in its marketing materials but delivered dismal returns to investors.

For those who want a primer on limited partner economics, here are more details about the numbers behind a venture capital fund’s returns: Primer on VC Business Model.

And there are plenty of industry stats here: NVCA Industry Statistics.

Again, look beyond the headline grabbing individual companies and look to fund’s total returns, or to the industry’s total returns. It’s a dismal place to be, as the figures below (from a prominent East Coast venture capital firm) show.

Two comments on the slides:

i) The 1980-89 returns were horrible compared to the much safer S&P 500. 2000-09 returns were worse than the dismal returns of the S&P500. Really, the brief period of positive returns in the 1990s came from what we all agree was a tech bubble. A few solid companies were born (Google, Yahoo, eBay), but more money was plunged into wasted projects.

ii) If the VCs are counting on an IPO window to redeem them, they’re screwed. Most IPOs today are coming from Asia and China, which are a small portion of VC dollars (they also tend to be larger, industrial concerns). The handful or North American tech IPOs, like OpenTable and Rosetta Stone, were solid companies run by growth fund operators and not traditional VCs.

I do believe there are a few “venture magicians” that can generate high returns for the risk taken: Mike Moritz, Ram Shriram, and Danny Rimer, to name a few (Vinod Khosla and John Doerr are TBD for the aughties, as their best returns were in the 1990s). Yet I’m doubtful about many VCs, even those that make magazine lists like the Forbes Midas List, when you take all their investments into account and calculate an annualized return.

Over the next few years, you will see a few big VC successes, like Facebook, Yelp, and possibly a123 Systems (still waiting on profitability). While the individual companies are seductive (and maybe the single fund that invested in them at the right valuation), the VC industry is a dead one. It’s where capital goes to die. While the industry dies, many current VCs realize this, and I’ve started to see partner-level resumes from big name venture capital firms hit the mailboxes of tech companies and other investment firms around Silicon Valley. (I won’t point fingers, but it’s embarrassing).

Investors (potential limited partners) in venture capital funds should heed Warren Buffett’s advice:
“If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”
For a particularly funny story, post-Webvan, see how investors turned $193 million into $7 million.

Translation: Ditch the VC commitments and invest your money in real companies, building things to make profits (not counting on an IPO cash-out window or an M&A exit).

One big test of the VC industry will be the latest $2.5bn NEA fund, which raised one out of six dollars for the industry in 2009, compared to a bond market benchmark (comparing VCs to a negative stock market isn’t much of a hurdle).

Reference Note:
To understand the VC industry better, I recommend three books:
eBoys (on Benchmark Capital and the salient superstar investment)

Creative Capital (on the VC industry founder Georges Doriot and the long view on the industry)

Startup (on a failed startup and what the majority of VC-backed companies look like)