By Scott Huish
Venture Capital is the case for ambitious risk-taking and has been credited with advancing our societies with companies such as Apple, Google, and Uber. No doubt there has been much good that has come from it with entire ecosystems built around innovation, bold entrepreneurship, and high stakes for all shareholders.(1)
You know the story, someone comes up with a way to create a better widget and goes to pitch it to investors in hopes of getting access to their capital, relationships, and expertise. If successful they are on a rocket-like trajectory of growth with new ‘fuel’. If denied, they continue to refine the widget or how they talk about the widget in hopes of finding a more positive response.
This has become such a dramatic and entertaining experience that there are tv shows (‘Silicon Valley’ and ‘Shark Tank’ and ‘Dragon’s Den’) depicting the wild emotional roller coasters and the newfound fame and fortune that seem to accompany venture capital. Surely this is an exciting proposition for anyone with an appetite for risk.
But what risks are being taken? And is venture capital worth the risk? Let’s look at venture capital and the venture angle and what it means for investors, for managers, and for entrepreneurs.
First off, venture capital, or VC, generally refers to a pooled investment fund with investors (limited partners), managers (general partners), and entrepreneurs (leading portfolio companies). Though each fund is unique, they generally have a target which defines the type of company or asset class, the stage or maturity of the company, and other defined criteria such as targeting certain geographies, entrepreneur demographics, or other such as length of time. Often times specific sub-categories may be classified under other names such as ‘search fund’, or ‘hedge fund’, or credit fund’, but are often within the realm of private equity and specifically venture capital.
The managers generally charge a ‘2 and 20’, which means they charge a 2% management fee per year as well as 20% carry on the overall profits. This is normally based on the amount of money invested in the fund. This ‘fee and carry’ are deducted from the investors’ pooled accounts and gets paid to the management team. Funds are invested into portfolio companies that fit the stated criteria where entrepreneurs eagerly await the needed capital to fuel the growth of their organizations.
[The simplified math:
Here is an example with intentionally simplified numbers. Let’s imagine that ten investors put $10 each into a 10-year VC fund for a total of $100. And that 10 portfolio companies receive an equal portion of investable capital, and each grows 10% compounded per year. Keep in mind the 2% management fee gets applied over the 10 years for a total of $20 to the managers, so only $80 of the $100 can be invested into portfolio companies. Now, the $80 grows to $207.50. And then before distributions back to investors there is a 20% carry to the managers. ((207.50–100) * 20%) for $21.50 to management leaves $186 remaining to be distributed back to the 10 investors for their combined $100. Consider state and federal taxes at 30% leaves each investor with an increase of $6.02.]
The summary at the end of 10 years?
The entrepreneur receives $8 to fund his business.
The manager(s) receives $20 plus $21.50 for a total of $41.50
The investor who invested $10 now has $16.02, for a gain of $6.02.
(Again, this is intentionally over simplified)
This gives the investor a 10-year IRR of 4.825%, which is not motivating for most investors, particularly considering the lack of liquidity. In order for venture capital to work, the returns need to be much larger. The venture angle is that there needs to be more risk in hopes of receiving greater returns to attract investors.
Generally, a fund will target at least 20% per year and push the portfolio companies to grow very quickly, often with debt or leverage strategies or pursuing growth at all costs. This is why venture capital portfolios will often have some large winners in the group. Unfortunately, they will often have some large losers in the group as the increased risk leads to more failures.
The Kauffman Foundation published a widely read report, “We Have Met the Enemy…and He Is Us,” about the venture capital industry and its returns. [They] found that the overall performance of the industry is poor. VC funds haven’t significantly outperformed the public markets since the late 1990s, and since 1997 less cash has been returned to VC investors than they have invested. A tiny group of top-performing firms do generate great “venture rates of return”: at least twice the capital invested, net of fees. We don’t know definitively which firms are in that group, because performance data are not generally available and are not consistently reported. The average fund, however, breaks even or loses money.
Venture capital investments are generally perceived as high-risk and high-reward. The data in [the] report reveals that although investors in VC take on high fees, illiquidity, and risk, they rarely reap the reward of high returns.(2)
One common strategy for venture capital firms is to raise a new fund every few years, thus further diversifying the risk for the managers between varied funds. Surely, with three or four funds going at a time and with hundreds of portfolio companies within those funds, there will be some big winners to highlight.
But to be fair, most venture capital firms do provide consultative advice and introductions to relationships that can be quite helpful to portfolio companies. In this case they become extremely valuable to an entrepreneur who is seeking help in growing and scaling their business. And many fund managers do work very hard as the go-between of investors and portfolio companies as they balance a role that requires them to satisfy both sides. And there are a lot of additional benefits with venture capital — including diversifying among asset classes, geographies, and among several winners and losers in hopes of getting access to some of the winners.
So is venture capital worth the risk? Is the venture angle worthwhile? Like most things, it depends. Finding a great fit may take some time and patience. Entrepreneurs often rely on the relationships and advice more than the money received. Investors may have additional investment rights where they can be strategic with the use of their capital as they seek synergies beyond a return on investment and invest more heavily into direct investment opportunites. And managers are in a position to create significant value within their ecosystem that can greatly benefit their communities. And ultimately, the venture angles can be rewarded and all participants can be satisfied if properly managed.
By Scott Huish
Scott Huish has directed technology driven companies in finance, agriculture, energy, construction, and real estate. Scott has completed advanced education at Oxford, Harvard, and London School of Economics and Political Science. www.ScottHuish.global