By Rob Adams
The asset class known as venture capital has been swirling around the drain since the dot-com bubble burst ten years ago. Like all forms of private equity the nature of these funds require decade long investment horizons and their investors demand opacity. Now, a decade after the bubble burst, the carnage is becoming apparent as the results slowly see the light of day.
There have been two recent articles articulating the details that make the point really well. The first is John Jannarone’s WSJ Heard on the Street article “Venture Capital Should Shrivel Away” and the other Steve Blank’s “Welcome to the Lost Decade (for Entrepreneurs, IPO’s and VC’s).”
The real question is can the asset class survive? Note by the nature of the question I’m taking the view of the limited partner investor in the funds, not the typical entrepreneur looking to secure an investment. The world is rife with urban legends on how venture capital works, and all of them come from the entrepreneur’s view versus the fund investor’s perspective.
Explaining the industry and what’s going on takes the form of several audiences; one being the overly-optimistic entrepreneur who still has aspirations of raising capital to get their company to a liquidity event, another being the up and coming venture capitalist in training (think decades long training cycles) who recently finds themselves a free agent as the asset class shrinks and wants to start their own fund, and the final being ambitious MBA’s switching careers and see venture capital as the preferred destination.
It all comes back to the asset class. If returns are low and the risk component high capital stops flowing. In this case index funds, with their objective diversification, minimal management fees, instantaneous liquidity and flat returns over the last decade have trounced venture with its negative returns, narrow diversification, high management fees and illiquidity over the same time period. It’s all about risk-adjusted returns and in the case of venture, the asset class flat out isn’t performing.
Responses to this reasoning point to specific deals that have produced good returns, news of quarterly increases in capital invested, and new funds being formed. The challenge is the consistency is not reliable hence the asset class is not producing. There are and will continue to be death kick strategies and tell-tale signs of life; smaller more narrowly focused funds, deal-by-deal funds, and a focus on trendy categories like life sciences and alternative energy.
Okay, so now that I’ve shot down the current model, let’s look at the new normal for what was venture capital. I call it “in with $5 million, out with $50 million.” Exit events today for venture backed companies are no longer IPO’s and their typically $150 million plus exit values. They are acquisitions with typically a $50 million or less exit. This means the lifetime capital raise for the company must be less than $5 million given the exit value will be under $50 million. This investment math yields a 3-10X return on that individual investment depending on when the investment was made.
This gives the new normal investor the same returns as the old normal institutional venture investor but on a much lower capital outlay. The economics of a venture fund pretty much dictate a $150 million exit to cover the overhead (management fee paybacks, administration, covering bad investments and overall fund return expectations). So the new normal is a similar percentage return on a smaller gross investment.
This naturally pushes early stage investing to smaller investment sources; angels and government sources like SBIR’s, economic development funds, and state focused specific funds for a start-up’s first round of investment. This is typically a one comma capital investment (measured in the hundreds of thousands of dollars) and in many cases, thanks to the way government sources are structured, can be non-dilutive. The new normal requires significant revenue traction on this level of investment, and if that is achieved the two comma capital investments (meaning millions of dollars) will flow from sources that are typically angels and smaller, more focused venture funds that are still scratching out a living.
What’s the evidence that this model works? The most substantive results are eight deals done over the last 5 years that I have been involved with coming out of the University of Texas at Austin’s Texas Venture Labs. The formula has been consistent across these deals using the new normal outlined above; all eight companies raised one comma, typically non-dilutive capital, executed well and raised follow on two comma capital. Two have been sold and two more will probably sell in the next year. And for those of you with quizzical looks, I need to point out that in all cases these companies raised capital over the last five years when it’s been scarce, and this was done by freshly minted MBA’s, who in most cases are still at the helm. If someone with 10 years work experience can do this in a tough investment period following this approach, a team with more experience and execution intelligence should be able to readily best them.
So, the new normal is what I’m terming adventure capital or in with 5, out with 50. And you have two options; the first is to hang onto the old model in the vain hopes it will resurrect. The second is embracing the new normal and exploit it before the world catches on.