{"id":342537,"date":"2017-06-02T06:00:53","date_gmt":"2017-06-01T22:00:53","guid":{"rendered":"http:\/\/techcrunch.com\/?p=1485911"},"modified":"2017-06-02T06:00:53","modified_gmt":"2017-06-01T22:00:53","slug":"the-meeting-that-showed-me-the-truth-about-vcs","status":"publish","type":"post","link":"https:\/\/people.utm.my\/asmawisham\/the-meeting-that-showed-me-the-truth-about-vcs\/","title":{"rendered":"The meeting that showed me the truth about VCs"},"content":{"rendered":"

<\/p>\n

\n
\n

Tomer Dean<\/span> Contributor<\/span><\/p>\n<\/div>\n

Tomer Dean is a serial tech entrepreneur currently based in Tel Aviv. He is co-founder and CEO of Bllush<\/a>.<\/p>\n<\/div>\n

I recently had a meeting with a well-known Israeli startup investor. The talk somehow pivoted from my seed-seeking startup into talking about the macro view of venture capital and how it doesn\u2019t actually make sense.<\/p>\n

\u201cNinety-five percent of VCs aren\u2019t profitable,\u201d he said.<\/span> It took me a while to understand what this really means.<\/span><\/p>\n

I\u2019ll clarify: Ninety-five percent of VCs aren\u2019t actually returning enough money to justify the risk, fees and illiquidity their investors (LPs) are taking on by investing in their funds.<\/p>\n

Who\u2019s actually succeeding in making money?<\/h2>\n

A VC fund needs a 3x return to achieve a \u201cventure rate of return\u201d and be considered a good investment ($100 million fund => 3x => $300 million return). The graph below shows what percentage of VC firms accomplish this. As we can see, only the small green slice is bringing it home. The other 95 percent are juggling somewhere between breaking even and downright losing<\/strong> money (remember to adjust for inflation).<\/span><\/p>\n

\"\"<\/p>\n

Source: \u200aMoney Talks<\/a>,\u00a0Gil Ben-Artzy<\/p>\n<\/div>\n

The graph was hard for me to take in at first. But once you run the numbers, it all makes sense. I\u2019ll attempt to reconstruct the arguments leading to this hard-to-grasp realization of an industry so often idealized from the outside. Ready? Let\u2019s have some fun.<\/p>\n

Assumptions<\/h2>\n

Before starting, let\u2019s define what success and failure actually mean and list our assumptions:<\/p>\n

Success = 12 percent return per year<\/strong><\/p>\n

Venture capitals get their money from limited partners, who are usually traditional investors such as banks, institutions, pension funds, etc. In their eyes, throwing $50 million into a startup fund is \u201crisky\u201d business compared to their other options, such as the stock market\/real estate, which are lower cost, liquid and could \u201csafely\u201d return 7-8 percent per year. For them, 12 percent return on their money per year is good. Anything below that? Not worth the high risk they\u2019re taking.<\/p>\n

That brings us to\u2026<\/p>\n

A 10-year fund needs to return 3x the fund size<\/strong><\/p>\n

We agreed VCs need to earn 12 percent return a year, right? Most funds, while only actively investing 3-5 years, are bound to 10 years. Many newer studies are showing that 12-14 year funds are more accurate for today, but let\u2019s stick with 10 just to give the VCs a fighting chance. That annual 12 percent rapidly grows, showing the power of compounded interest. Let\u2019s see the math:<\/p>\n

\"\"<\/p>\n

Don\u2019t forget Pareto: 80 percent of returns come from 20 percent of startups<\/strong><\/p>\n

Facts of life are that startups are hard. Breaking even is hard. Profits are hard. Keeping profits growing year over year (YoY) is even harder. Out of 10 companies, only two will really explode and IPO\/M&A, giving our dear VCs some of their money back. The rest, as we\u2019ll see, will fizzle out and die \u2014 or have a small liquidation event, which is pretty much the same.<\/p>\n

Let\u2019s start<\/h2>\n

So we have 10 startups and a fund that needs to return 3x within 10 years. Let\u2019s assume it\u2019s a $100 million fund, with $10 million invested in each company over the course of its life and a desired return of $300 million. To be fair, let\u2019s also assume the VC jumped in on the A round, followed up on B and has 25 percent ownership at the end, with non-participating liquidation preferences.<\/p>\n

Let\u2019s look at a few different outcomes of our 10 startups after 10 years.<\/p>\n

They all do \u201caverage\u201d and exit at $50 million<\/strong><\/p>\n

Green marks the exit size; purple the payout amount of the VC with his 25 percent.<\/p>\n

\"\"<\/p>\n

Ten companies, they all exit at $50 million. The VC would return $12.5 million on each. Outcome: 10 * $12.5 million\u00a0= $125 million. We needed $300 million, right? Not good. Let\u2019s give them better odds.<\/p>\n

Half do average like before, and half do better<\/strong><\/p>\n

\"\"<\/p>\n

Five sold at $50 million, so $12.5 million return on each. The other five did much better and pulled off $100 million exits. The founders are overnight millionaires and their picture is in the paper. The VC? Not so much. Return: (5 * $12.5 million) + (5 * $25 million) = $187.5 million return. Still not quite at $300 million. No good.<\/p>\n

Majority do \u201caverage;\u201d we\u2019ll throw in an overachiever<\/strong><\/p>\n

\"\"<\/p>\n

So here let\u2019s take our previous example, but make one of them a star. The 10th company, instead of selling for $100 million as before, now does $500 million. So our original five still sell at $50 million, four sell at $100 million and our new one at $500 million. Total returns for our VC: (5 * $12.5 million) + (4 * $25 million) + (1 * $125 million) = $287.5 million. We\u2019re almost there! Just a bit more.<\/p>\n

I think you see where this is going\u2026 we need one big fat unicorn exit!<\/strong><\/p>\n

\"\"<\/p>\n

We would need one large exit to see good profits. Something like this would work: nine startups sell for $50 million each and one goes for $1 billion: (9 * $12.5 million) + (1 * $250 million) = $362.5 million. We finally made it! Everyone is happy.<\/p>\n

But is the last scenario actually feasible? Can you realistically expect all 10 companies to exit? Indeed, a 100% success rate sounds too good to be true. The more realistic scenario is that out of those 10, five will be complete losers, three will sell for small-medium amounts (which we just saw barely move the needle) but one or two will be big unicorn hugging exits ($1 billion-plus)<\/p>\n

The realistic case<\/strong><\/p>\n

\"\"<\/p>\n

Five startups fail and do $0, three exit at $25 million, one exits at $200 million and our superstar does $1 billion. Let\u2019s see the return on that one:<\/p>\n

Return: (5 * $0) + (3 * $6 million) + (1 * $50 million) + (1 * $250 million) = $318 million<\/p>\n

We\u2019ve finally made it. Phew that was hard. Here we see some good returns, but is it actually realistic to think that the average fund can find this golden unicorn ticket? Probably not. The apparent truth is that most VCs aren\u2019t doing as well as our \u201crealistic case.\u201d Only the good ones. Only the top 5 percent (not the top quartile!). And if the fund size is bigger, like the $1 billion funds we see being raised, then the math only gets harder, and the likelihood of a 3x+ return gets even lower.<\/p>\n

But VCs always seem successful, right?<\/h2>\n

Yes and no. How are the rest of the 95 percent of VCs making ends meet? Not on their investing prowess, but rather on the fees that their investors pay. Most VCs are well (and primarily) compensated from the 2 percent annual fees on committed capital that they charge their investors ($100 million fund => $2 million\/per year fees).<\/span><\/p>\n

Even when they don\u2019t generate great returns \u2014 and most don\u2019t \u2014 their personal compensation is guaranteed from the fee stream. If that\u2019s not enough, remember this: If one of their startups does see a liquidation event, they get 20 percent of the profits as a bonus. They\u2019re sharing the upside, without any risk if things go south. As an entrepreneur, I wish I had that downside protection!<\/span><\/p>\n

There\u2019s still hope<\/h2>\n

It\u2019s still hard for me to accept the fact that the only realistic way for a fund to get acceptable returns is to try to find only the companies that could be the next Ubers, Facebooks and Airbnbs. Under these rules, it doesn\u2019t make sense for VCs to invest in anyone that can\u2019t get to unicorn stage. There\u2019s just no place for \u201caverage\u201d companies looking to be worth and sell less than $500 million. At least not with VCs.<\/p>\n

The way the numbers are worked out, it doesn\u2019t look promising for any startup founder with less than shooting-to-the-moon goals. Even less so as a VC who\u2019s fighting to keep his head above water and secure a follow-up fund. And don\u2019t get me started on the LPs, who are the real losers here. They are the ones paying the fees, taking on the risk and then realizing disappointing returns at the end of the 10-year fund (which actually takes 15 years to liquidate).<\/p>\n

But does it have to be like this? One place we can try to play around is our assumptions tab. Assumptions can and should be challenged:<\/p>\n