Company Math vs VC Math
Fred Wilson has a great blog post today entitled The 'We Need to Own' Baloney. In it he discussed the fact that many VC's apply arbitrary ownership thresholds to investments. I couldn't agree with Fred more - but I'd take it even further. This is not just limited to ownership requirements. Rather, VC's often impose "VC math" on companies in three areas:
- The amount VC's "need" to own
- The amount VC's "need" to invest
- The return VC's "need" to generate certain exit returns
These "requirements" are a direct result of the mathematical model that venture funds are optimized for. And as fund's have gotten larger, their math has gotten more difficult. We're now witnessing the conclusion of a "10 year experiment" where money invested in venture funds has exploded and fund sizes have more than tripled in size. A decade ago, 75% of all venture funds raised were under $100 million. In 2007, fewer than 25% of all venture funds raised were under $100M. And I don't think it's a co-incidence that VC performance has fallen off a cliff during this time period. Indeed, we're approaching a point where the 10-year return in venture capital is negative. Paul Kedrosky recently authored a paper for the Kauffman Foundation which discusses this in great detail and proposes that the venture industry needs to be "rightsized" -- and suggests a 50% reduction. It's a great paper -- but if you don't have time to read it, the money chart is below:
Fred Wilson has previously written about the VC math problem -- but he approached it from the macro/industry perspective. I agree, and think it's even more scary when you look at it from a micro/fund perspective. Take a $400M venture fund. In order to get a 20% return in 6 years, they need to triple the fund -- or return $1.2B. Add in fees/carry and you now have to return $1.5B. Assuming that the fund owns 20% of their portfolio companies on exit, they need to create $7.5B of market value. So assume that one VC invested in Skype, Myspace and Youtube in the same fund - they would be just halfway to their goal. Seriously? A decade ago, any one of those deals would have been (and should have been) a fundmaker!
As a result of this new math, VC's end up super-focused on the longbets (or moonshots) and frequently remove optionality for mid-tier exits. It has, as Super LP Chris Douvos has written, become a game of finding the next Curtis Sharp. It is because of the challenges of "VC math" that First Round Capital chose to raise a relatively small fund -- allowing us to continue to make initial investments that average $600K.
I understand the importance of aligning one's time and capital to the upside opportunity, and recognize that there is some minimum threshold of ownership that is required for a VC to commit the time and attention to an opportunity. Does it make sense for an investor to spend the time and join the board of a company they own 2% of ? Probably not. However, the difference between 25% and 20% ownership -- or even the difference between 20% and 10% -- should not prevent a VC from investing in a promising opportunity.
It is the same "VC math" which drives a VC to seek to deploy a larger amount of capital into a company. (Often taking a capital efficient company and helping it become capital inefficient). And it is the same math which sometimes creates a lack of alignment between a founder and a VC around exit opportunities. I have previously written these issues when I discussed the "unwritten terms on a term sheet".
A company's outcome should drive VC returns. When VC's required returns drive company's outcomes, it's a recipe for trouble.