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Venture C(r)apital: Myth And Reality

Tyler Durden's picture




 

Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years. As The Kauffman Foundations finds, from its 20-year history, investment committees and trustees should shoulder blame for the broken LP investment model, as they have created the conditions for the chronic misallocation of capital (no doubt driven by the failure of 'hope' over experience). All is not lost to the money-pumping narrative-followers though as five myths are destroyed and five recommendations made that may help LPs allocate and follow-through more effectively.

 

It’s become a bit of a sport among venture capital (VC) insiders and observers to assert that the venture capital model is broken. Industry returns data show that VC returns haven’t beaten the public market for most of the past decade, and the industry hasn’t returned the cash invested since 1997, certainly a compelling sign that something must be wrong. It’s so easy to point the finger of blame directly at VCs—there are too many of them, they’re raising too much cash, they’re sitting on too much cash, they’re investing too much cash, they’re taking home too much cash...

 

We believe that to really understand and constructively address what’s ‘broken’ in VC, we need to follow the money. And the money trail leads right to the LP boardroom, where investment committees oversee venture capital investing.

 

Assumptions (Reality):

  • Assumption 1: ‘Top-Quartile’ and ‘Vintage-Year’ performance reporting is, at best, not fully informative, and is, at worst, misleading.
  • Assumption 2: The average VC fund barely manages to return investor capital after all fees are paid.
  • Assumption 3: VC mandates do not produce “VC returns” that exceed a public equity benchmark by 3 percent to 5 percent per year.
  • Assumption 4: The life of a VC fund is frequently longer than ten years. VC funds are structured to invest capital for five years and to return all capital within ten years, but we see a large percentage of our fund lives extending to twelve to fifteen years.
  • Assumption 5: Big VC funds fail to deliver big returns. We have no funds in our portfolio that raised more than $500 million and returned more than two times our invested capital after fees.

The following recommendations constitute the most important actions that investment committees can take to repair the broken LP investment model:

  • Recommendation 1: Abolish VC Mandates: The allocations to VC that investment committees set and approve are a primary reason LPs keep investing in VC despite its persistent underperformance since the late 1990s. Returns data is very clear: it doesn’t make sense to invest in anything but a tiny group of ten or twenty top-performing VC funds. Fund of funds, which layer fees on top of underperformance, are rarely an effective solution. In the absence of access to top VC funds, institutional investors may need to accept that investing in small cap public equities is better for long-term investment returns than investing in second- or third-tier VC funds.
  • Recommendation 2: Reject the Assumption of a J-Curve: The data we present indicate that the “J-curve” is an empirically elusive outcome in venture capital investing. A surprising number of funds show early positive returns that peak before or during fundraising for their next fund. We see no evidence that the J-curve is a consistent VC phenomenon or that it predicts later performance of a fund. Committees should be wary of J-curve-based defenses of VC investing.
  • Recommendation 3: Eliminate the Black Box of VC Firm Economics: Institutional investors aren’t paid for taking on the additional risk of investing in VC firms with ‘black box’ economics. Investment committees can stop accepting that risk by requiring consultants and their investment staffs to acquire and present information on VC firm economics, including compensation, carry structure, GP commitment, and management company terms and performance, in order to obtain investment committee approval.
  • Recommendation 4: Pay for Performance: The current market standard 2 percent management fee and 20 percent profit-sharing structure (“2 and 20”) pays VCs more for raising bigger funds and, in many cases, allows them to lock in high levels of fee-based personal income regardless of fund performance. Creating and negotiating a compensation structure that pays fees based on a firm budget, and shares profits only after investors receive their capital back plus a preferred return, would mean LPs pay VCs for doing what they say they will—generating excess returns above the public market.
  • Recommendation 5: Measure VC Fund Performance Using a Public Market Equivalent (PME): Evaluate VC fund performance by modeling a fund’s cash flows in comparable indexes of publicly traded common stocks. We use the small capitalization Russell 2000 as a benchmark as we believe it better reflects the higher price volatility, higher beta, and higher sensitivity of small companies to economic cycles than the large capitalization S&P 500 index does. Adopt PME as a consistent standard for VC performance reporting, similar to the Global Investment Performance Standards.3 Require consultants or investment staff to present PMEs as part of any investment decision. Reject performance marketing narratives that anchor on internal rate of return (IRR), top quartile, vintage year, or gross returns.

 

From the myth of the J-Curve to the reality of mis-aligned compensation structures along with a plethora of intermediaries who 'need to get paid' even as LPs force money to work in ever-increasingly crazy investment narratives... it seems the liquidity of central banks has been washing ashore in many places for much of the last decade enabling a dismal level of mal-investment (cognitively dismissed by every investor who dreams of the next Facebook)

Full Kauffman paper below:

Kauffman

 

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Mon, 10/01/2012 - 14:44 | 2846063 Colombian Gringo
Colombian Gringo's picture

I suggest creating a fund that will invest in hunting down and convicting banksters of their crimes, and then distributing the proceeds seized from these criminals to unit holders.

Mon, 10/01/2012 - 14:53 | 2846098 Schmuck Raker
Schmuck Raker's picture

Call it the "M.I.T. Fund" - Men In Tights - and I'm in.

Mon, 10/01/2012 - 20:18 | 2846923 JuliaS
JuliaS's picture

What's Kickstarter's policy on assassination funding? Hmm...

Mon, 10/01/2012 - 14:49 | 2846069 Cognitive Dissonance
Cognitive Dissonance's picture

I guess the real question to ask is how is the CIA's Venture Capital Program doing?

Very well........thank you for asking. Data mining investments in Google, Facebook, Wikipedia et al are doing just fine.

Mon, 10/01/2012 - 15:21 | 2846177 Unprepared
Unprepared's picture

 

 

"Vulture Capital is doing fine. Thank you."

the Carlyle Group

Mon, 10/01/2012 - 14:47 | 2846076 bugs_
bugs_'s picture

VC -> flippers

Mon, 10/01/2012 - 14:48 | 2846078 Skateboarder
Skateboarder's picture

Fuck VCs. Fuck PEs. Leeches, all of em...

Mon, 10/01/2012 - 14:51 | 2846090 rtalcott
rtalcott's picture

Eric Wesoff: September 29, 2012

MiaSolé, the most technologically and commercially advanced VC-funded CIGS thin film firm, was just sold to China's Hanergy for $30 million, according to documents sent to MiaSolé shareholders this week, obtained by the San Francisco Chronicle.

The remaining MiaSolé employees get to work at least another year.

MiaSolé has raised in the neighborhood of $500 million in VC funding since its founding in 2004. The firm raised most of a $125 million round F in February last year at a pre-money valuation of $550 million. Investors included Voyageur Mutual Funds III, Kleiner Perkins, Firelake Capital, and VantagePoint Venture Partners. Board members include KP's John Doerr, Firelake's Marty Lagod, VantagePoint's Stephan Dolezalek, and Rob Chandra of Bessemer. The firm also closed on $55 million in convertible debt earlier this year.

We have communicated with a party with direct knowledge of the deal. Here are the highlights from that conversation.

·         "The bottom line is a $30,001,000 consideration from Hanergy to merge MiaSolé into Hanergy. The consideration would go first to secured creditors, and then noteholders."

·         "Series F, which has a liquidation preference over the other preferred series would get $1,000.00. This series had $106 million of investment so you might as well call it zero return."

·         "Series A through E get nothing. Common gets $0.00. The same for warrant and options."

·         Merle McClendon, CFO, is getting a $1.65 million retention bonus, John Carrington, CEO, is getting $3.6 million and Bob Baker, COO, is getting $300,000, according to the source.

The new owner of MiaSolé is Hanergy, one of China’s largest providers of renewable power. According to The Chronicle, the deal looks to close on Oct. 31, 2012, and the firm will operate as a subsidiary of Hanergy. 

Mon, 10/01/2012 - 14:59 | 2846111 Schmuck Raker
Schmuck Raker's picture

Hmmm, ok...that's interesting.

And how does that make you feel?...

[doodling on patient's chart]

Mon, 10/01/2012 - 15:34 | 2846214 knukles
knukles's picture

(sound of last gasp wheeze)

Mon, 10/01/2012 - 14:57 | 2846107 LawsofPhysics
LawsofPhysics's picture

The article is crap.  the two VC guys I know are doing quite well.  They are closer to the "free money" faucet than you or I, same as it ever fucking was.  What is the real value of their labor?  These leaches extract pounds of flesh and do not care whether or not the companies go bust. Again, just more fucked-up, no-consequences for bad behavior bullshit.

Nothing changes until the moral hazard is address and by then all the VC guys will have long since feathered their nests on their own private islands.

Mon, 10/01/2012 - 15:35 | 2846221 knukles
knukles's picture

Socialopathic Investment Programs

Mon, 10/01/2012 - 15:56 | 2846294 Urban Redneck
Urban Redneck's picture

There is also the "moral hazard" of the marketplace VC funds are financing ventures in.   The entire Kauffman document doesn't appear to  include a single geographical breakdown.  The US market is corrupt and over-regulated, the EMs are corrupt and under-regulated, and the lazy IPO exit strategy is largely unique to the former.  The guys I deal with in EMs seem to be doing fine, perhaps the regulatory burden is finally overburdening developed market start-ups beyond the mitigating capabilities of ZIRP?

If so, then the blood sucking leaches should really cut the their extortion prices for EM financing to less than the going rates for silicon valley iCrap ventures.

Mon, 10/01/2012 - 16:15 | 2846358 harposox
harposox's picture

Um, are you sure you're not referring to private equity rather than venture capital? They're two very different things.

Mon, 10/01/2012 - 16:43 | 2846463 Widowmaker
Widowmaker's picture

VC is the proverbial "money on the sidelines," and I can affirm there isn't much to complain about now.

But then again, this stuffed-shirt loves the smell of nothing back from a 6-stack bet just so the 47% have another swing at the plate.

Where's my fraud bailout?

Mon, 10/01/2012 - 15:05 | 2846130 riphowardkatz
riphowardkatz's picture

see junior gold miners.  its a lottery for some but not others, there is nothing wrong with that. it serves a function for all involved.

Mon, 10/01/2012 - 15:46 | 2846269 Urban Redneck
Urban Redneck's picture

The whole model for junior miners (and wildcat drillers) is corrupt & broken.

Mon, 10/01/2012 - 15:08 | 2846146 fonzannoon
fonzannoon's picture

standing golf clap for bernanke today. one of his finest days yet. 

Mon, 10/01/2012 - 15:21 | 2846176 Payable on Death
Payable on Death's picture

Another (un?)intended consequence of ZIRP. VCs provide cash to firms in which they invest. The firms then hire and perform R&D. Firms funded by PE are saddled with debt. The high fixed cost of the debt payments causes employment and research to be cut. Result via ZIRP--malinvestment, misallocation, and all that...

Similarly, the fixed cost of student debt means young graduates (and non-graduates) cannot take a risk--start a business, work for a commission, etc.

The decline of VCs has, to me, been one of the most telling symptoms of the decline. IPOs, an extension of VC, have been thwarted due to regulation.

Yank the Bernank.

Mon, 10/01/2012 - 15:25 | 2846184 Stuck on Zero
Stuck on Zero's picture

I've worked with VCs (Vulture Capitalists) for over twenty years.  I've raised lots of VC money and helped do due-diligence for firms trying to raise capital.  In general, VCs are the worst breed I've ever encountered.  Mostly they are over-stuffed shirts reveling in their own ignorance.  Typical foolishness is to require startups to have a busines plan that projects sales out for five years.  Good grief.  That rules out the MSs, Ciscos, Fed Exes, and Apples.  A real high-tech startup enteres at the very inception of a markets and can't give you anything more than a hunch.  Once a VC gets a company started they meddle incessantly.  "You need to hire this business developer." "You need to start right now raising money for the next round." etc. 

All in all, I'd say if there is any way possible to avoid VC money do it.

Mon, 10/01/2012 - 16:49 | 2846401 Widowmaker
Widowmaker's picture

I'm your Huckleberry (see my comment below)!

Fortunately, I am happy to call your bullshit.  If you really have that much experience you would know that money does the heavy lifting, not management of it.

You sound like someone who is butt-sore because big money didn't like your drab ideas when the project was one step from the grave.   In other words you lost your ass or are telling other people's stories.

5 year projections are trendy.  But, usually it's the all too often arbitrary "value metric" or some other bullshit distraction that receives a higher priority than profitibility.

Mon, 10/01/2012 - 17:11 | 2846531 Stuck on Zero
Stuck on Zero's picture

Let me give you three examples.  On three occasions I told the VCs that the potential startup had to violate the laws of physics to complete their plans.  On all three occasions the VCs went ahead and funded the startup.  Why?  The answers were: "But this field is hot."  "Even if they fail we'll have them out as IPOs and have our money back." "It's a greater fools thing." "We have the money and no better deals have crossed the transom in three months."

As predicted, all three clashed with quantum mechanics or Newton and died on the vine. 

Mon, 10/01/2012 - 17:24 | 2846567 sessinpo
sessinpo's picture

Well in general, in the good old days, a VC would be investing what would be considered pennies on the dollar.

Say $10 million for a large percentage of the company. If its a big hit, that $10 million might equal billions. At the same time, they might have also invested $10 million with 9 other companies that went bust.

The way you currently describe VC is simply a change in environment where you don't have as many hits anymore, no grand slam billion dollar winners. Thus they are trying to adjust to the new environment by requiring more solic business planning.

That goes to my post below where VC does well or okay in an innovation period, tech boom. But as the innovation period ends, the VC model no longer works.

Equity capitalist step in next and disect companies, break them up, downsize, etc.

Then it all ends because all the value has been squeezed out.

boom bust cycle, rinse, repeat.

Mon, 10/01/2012 - 15:41 | 2846255 orangegeek
orangegeek's picture

One in three deals show a return.  More cash than real opportunity out there.

 

Nothing beats a good sales pitch with some revenue that can be easily multiplied into financing.

 

File your Reg D folks and do it soon.

Mon, 10/01/2012 - 15:48 | 2846275 adr
adr's picture

Hi, welcome to Vulture Capital 101. Nobody needs a business plan or even the hope of profit. As long as the CEO of the new company worked for a successful .com or social media powerhouse, he immediately gets access to $250 million or more.

If the presentation involves posting pictures to a website and can be tagged "Social Media", it can be granted a multibillion dollar valuation overnight. Capital will be used to house the former 3 employee company in a brand new 15k sq ft headquarters, if it looks like a billion dollar company, it must be a billion dollar company.

Next the attraction of new stock grants will lure "talent" from other social media corporations and give the new company a great PR angle. By poaching "talent" that immediately makes the company newsworthy as being "The Next Big Thing".

The initial investors and employees watch as their stock option swell in value along with the proposed valuation of the next Social Media Giant. Within a few months the company will hire a few thousand workers from top ivy league schools. It won't matter if they actually work, they aren't getting paid much of a salary, that is what stock options are for. THE COMPANY ADDED 2000 WORKERS IN TWO MONTHS, IT MUST BE KILLING IT!!!!!

Then you entertain a buyout from an established tech company, but reject it. This will more than triple the value of your company, as you make it look like you know the company is worth far more. Announce a developers conference and spout an hours worth of drivel like, Company A will change the social media landscape forever allowing every citizen of the planet unparallelled access to new technology and communication, bringing people from every country closer together. Play your slideshow of comment lists, photos, and poached YouTube videos.

Have your VC guys put together an IPO package with a TBTF bank. Never actually make a profit, but kill it with projected revenue growth. Watch your IPO fly and retire at the age of 27.

--------

Look it's Pinterest!!!!

 

Mon, 10/01/2012 - 16:08 | 2846334 Skateboarder
Skateboarder's picture

I'm in the process of looking for jobs right now (going in for face-to-face with sweet Semiconductor company that makes real, useful products next Monday - hopefully the people are cool, and I'll take the job in a heartbeat) and SO many of the web-startup ads sound exactly like your parody. Fuck me dude, it's such a shitty fart-sniffin job market full of social narcissism. So much manpower and resources wasted towards completely and utterly useless shit.

Mon, 10/01/2012 - 15:49 | 2846278 Let them all fail
Let them all fail's picture

Old news...and if you are an entrepreneur, the VC is not your friend, they run an investment fund, if you don't know that going in then you are stupid to get involved. Wouldn't believe what LPs put their money into these days, most VC funds are awful, people seem to look at them like options and do so mistakenly. $2B VC fund? Seriously? You get huge winners and it doesn't even matter...To much institutional money available to VC to keep it at the size it needs to be...the less money they raise the better. And as the Kauffman Foundation complains, they are right to point the finger at themselves. Everyone knows all the returns are generated by a small list of manager, if you can't invest with them then you aren't going to do well overall outside of the occasional luck.

Mon, 10/01/2012 - 16:14 | 2846344 Widowmaker
Widowmaker's picture

I have been a VC for two decades, most good but some bad experiences. 

What has changed is not the model, it's the shit-for-brains mentality of the leadership among growing startups.  Let me summarize it:

- Exceptional idea or product

- Lever up through VC to debt finance

- Incompetent management failure because they cannot execute or fail to see long term value for short term gains until the float of other people's money runs out.

- The end.

The VAST MAJORITY of VC startups only focus on the exit, not the exceptional idea or product.  Here is a classic line I very recently heard, "We need to get someone on the board with M&A experience."   Kiss of death.

Mon, 10/01/2012 - 16:56 | 2846494 Urban Redneck
Urban Redneck's picture

Fuck the exceptional ideas (they're a dime a dozen).  A skilled management team can sell ice to eskimos, and a competent & experienced management can trun a handsome profit doing so, even w/o a powerpoint slideshow or excel spreadsheets.

Mon, 10/01/2012 - 18:38 | 2846722 billsykes
billsykes's picture

Build it to sell it. a VC that holds for longer than 5 yrs has a bum company unless they can do a secondary and exit the LPs. 

My ire is focused on tech VCs, because its all crap online. I have rarely seen a online business that would make me excited or buy in- at any price.

Structure is important but its also the VCs job/priority to understand agent principal issue, I think it stems from VCs having to take a larger % of ownership to make the transaction worthwhile, thus killing motivation. 

I say blame the internet and lack of personal income growth in the last 40yrs. Things are much more expensive relative to salary. Anyone who had to see a lawyer/banker in the last decade knows this.

I would also agree that grads today are piss poor dumbasses, with little capacity or initiative.  Watch/listen to any of those standford/warton/cornell podcasts on entrepreneurship- research those speakers the CEO and the funds, teaching the kids about how "well" they did in vc startup land. Total bullshit.

 

 

 

 

Mon, 10/01/2012 - 16:34 | 2846432 sessinpo
sessinpo's picture

I think the change in VC indicates a change in the economic environment.

During a period of high innovation, VCs should do well. They will have hit and misses. The gamble is that your hits be be so profitable it will more then exceed the misses.

As the innovation period fade, VC should also as their model doesn't work in the new environment. That has been basically going on the last decade. Venture capitalist get in during the early and starting stages of a company.

 

The next phase is the equity capitalist such as Bain. They seek out companies in weak positions, access the financials and invest. Sometimes the company is broken up in pieces and sold. Sometimes the company is just cut to profitable lines. Sometimes a mix of the two.

 

When this equity capatalist period is over. Look out because at this point, those that do this work for a living are not finding value and not investing. Equitiies can go to hell at this point.

Mon, 10/01/2012 - 19:03 | 2846693 billsykes
billsykes's picture

I think VCs are scum.

Total back alley herpes infested cocksucking scammers. 

But I do admit their marketing patina is totally untouched. There are shit loads of sites like guy Kawasaki and ask the VC, y-combinator making huge publicity and have lost money on every deal they make. Ohhh a VC has 12m AUM then they act like kind tut, its so fucked.

Reams of entrepreneurs studying all sorts of shit that VCs pull with pref shares, a, b,c rounds all this complicated over the top, I need 51% with a anti-dilution clause and I get out the door first maneuvering. All to lose the LPs cash, fuck over the founder so all he has to go on is his rep after he exits.

These guys do legal back flips and all anyone ever talks about is facebook, youtube, and twitter, groupon etc- basically shit companies. It took amazon 10 years and a billion dollars spent prior to turning a profit. 

The worst is when govt. gets involved and wants to create jobs by giving them free capital to allocate, then they make it look like their own.

This is just Kaufman marketing, they will never put in XX% of capital. They will "commit" it but not fund it or it will come out of fees or the XX% is over the life of the fund- usally the end of the fund.

Get the patina off these chuckle heads, and get them to air their real audited returns and they would be packing up and moving to pursue a career as an agent or lobbyist. 

 

http://www.avc.com/a_vc/

http://www.ventureblog.com/

http://learnvc.com/

one of the worst; http://venturehacks.com/
(leave your business sense at home, if you ever read an article here)

 

 

 

 

 

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