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.