
Why VCs Will Block Good Exits - prakash
http://www.angelblog.net/Why_VCs_Block_Good_Exits.html
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mattmaroon
This seems, to some extent, like a self-fulfilling prophecy. Part of the
reason that VCs need a 10x return is that they block a 3x return. Clearly if
every investment was a 3x return in a fund lasting 10 years, they'd be
incredibly successful.

Mathematically speaking, a good VC should aim to get the most value out of
every individual startup. To pass on a 3x return, if it consigned the startup
to failure, because they need a 10x return is idiotic. Either the VC was a
moron, or he thought the company could do better. He didn't block it because
he needed 10x, he blocked it because he thought his expected value was higher
than 3x by doing so.

~~~
gravitycop
The invisible-hand of the market selects the good strategies, Matt. If your
strategy worked, it would be used by the VC's that did _not_ fail.

 _To pass on a 3x return, if it consigned the startup to failure, because they
need a 10x return is idiotic._

Paasing on a 3x return does not _consign_ a startup to _any_ given thing.
However, it _does_ allow a startup to continue to have a potential to provide
a 10x return. Cashing out at 3x ruins that potential.

~~~
mlinsey
You have too much faith in the efficiency of the market in a field with:

a) lots of players making decisions based on very imperfect and very
incomplete information.

b) very large consequences for random events. Yes, there are many important
contributing factors to the success of a company besides luck, but the
difference between a mere success and a multi-billion dollar homerun involves
a large degree of luck. These sorts of exits are often associated with winner-
take-all markets where randomness is more important. Example: I play a
competitive game against you where you beat me 60% of the time because you are
more skilled. Given the option, I would much rather play one game against you
for $100 than one hundred games with $1 on the line each time. I contend that
the one-game option is more analogous to to businesses with lots of "lock-in"
or "network effects".

c) a relatively short history - if a funding cycle for a VC is several years,
and most venture firms haven't been around no more than a couple decades,
that's not a lot of generations for funding strategies to prove themselves,
especially in the presence of randomness (see b).

~~~
mattmaroon
d) high barriers to entry e) well-known collusion

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RiderOfGiraffes
There is a link to some math from the references article, but here's an
independent calculation.

Suppose the VCs expect 10% of their investments to succeed wildly, 10% to
mostly succeed, 30% to limp along and 50% to fail. Suppose also they want 50%
profit, which is a complete guess, but seems plausible.

For 100 investments of $10,000 each (total outlay $1m) they want a $1.5m
return. Some of that might come from the moderate successes, so let's say that
$1m needs to come from the 10 wild successes.

That's $100,000 each, a factor of 10 on the original investment.

This suggests that the factor of 10 is driven by the numbers, and not (purely)
by greed.

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cx01
I read that argument several times, but always wonder: Shouldn't VCs factor in
the subjective risk of the individual venture, like banks do (by requiring
higher premiums for riskier credits)?

So for example, if a venture has a (subjective) 10% chance of success, the VC
should require at least a 10x payoff, but if it has a 50% chance, a 2x payoff
would suffice. Or am I missing something here?

~~~
prakash
_So for example, if a venture has a (subjective) 10% chance of success_

I recently asked a VC on how they evaluate risk in their portfolio, and do
they bucket investments into low, medium & high risk and how they identify &
classify each of these investments into various buckets -- his answer was
simple, they would invest in any company that could potentially get them a 10x
return -- as simple as that.

~~~
gravitycop
_they would invest in any company that could potentially get them a 10x
return_

It's like an SAT score, though. If 10x is borderline, to be competitive
against other funding-seekers you should be approaching VC's with much-riskier
(e.g. higher-return) opportunities (100x; 1000x; etc.).

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miked
I'm very surprised by some of the comments here, as I think many of them are
missing the key point: NEVER use a sunk cost as a factor in making a decision.
What the VC paid for its investment is gone forever. All that is relevant is
how they can maximize their investment at decision time. What multiple that
works out to should be utterly irrelevant.

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sgman
This post clearly shows the market white-space that is being filled by YC and
other similar funds.

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gojomo
Note that even YC's 'Series AA' model documents [1] give them effective veto
power over exits. (See the term sheet 'Protective Provisions', (iii).)

Their power may in practice be wielded benevolently, but I point it out so
people realize even fairly entrepreneur-friendly venture deals include this
sort of provision.

[1] <http://ycombinator.com/seriesaa.html>

