
The meeting that showed me the truth about VCs - itayadler
https://medium.com/@tomerdean/the-meeting-that-showed-me-the-truth-about-vcs-and-how-they-don-t-make-money-ab72b52b50cd
======
Animats
That's been true since about 2000.

From the 1970s to about 2000, venture capital firms as a class were
profitable. Since 2000, venture capital as a class has been a lose. What keeps
this going is that each VC thinks they're better than average. Most of them
are wrong.

Venture capital in Silicon Valley used to be about finding someone who had a
good technical idea, and getting them enough money to make a working prototype
or a small production run. New technology and intellectual property were the
key. That was a good business.

In the first dot-com boom, this changed. Technology wasn't the issue. It
became about buying market share to achieve a "first mover advantage". That
resulted in a focus on growth and a race to out-spend the competition. There
were winners and losers, but in the end, mostly losers.

In this, the tail end of the second dot-com boom, we see the same pattern. The
big difference this time is that nobody is going public. There's just round
after round of private capital. The extreme case is Uber, with a valuation
greater than General Motors while still losing money at a huge rate.

This is fueled by low interest rates. There's so much capital sloshing around
looking for yields that too much money is being funneled into marginal
companies. That's why there are no IPOs; it's cheaper to borrow.

~~~
paragpatelone
"What keeps this going is that each VC thinks they're better than average"

Another thing keeps them going is that the VC Partners get a nice salary for
10 years. Many of them will make more money than many C-level executives. I
don't see a downside in being a VC.

~~~
chii
The downside being the fund investors of the VC firm.

------
blackholesRhot
I find this argument inadequate. The conclusion may be true (that most venture
funds lose money) but this article does a poor job of elucidating why this may
be the case. There are many directions we can approach this from.

First, to simplify, instead of talking about an A and B and having 25%
ownership after these rounds. Let's assume $10M is invested in the A for 25%
ownership ($10M on a $30M pre-money valuation / $40M post-money.) Of course if
each of these companies exits at exactly $50M and money just sits there for 10
years then the returns will be garbage. But in reality if you're investing at
a post-money of $40M, very few of your companies will exit at $50M.

What actually matters here is what happens with money after exits. If money is
returned to investors immediately, then what we want is to solve:

$100M * (1.12)^Y <= .25 * (exit price)

For example, if ONE company goes from $40M post and exits at $562M after 3
years, and then this money is distributed back to investors, then investors
receive .25*$562 = $140.5M as a return, which is more than 12% per year for
these three years ON THEIR ENTIRE $100M investment. (This assumed no
subsequent dilution but you get the idea.)

If money isn't returned directly to investors then it needs to be re-invested.
The point is, of course your venture returns will be poor if you just place
your cash under a mattress post exits. The math becomes much more favorable
for the VCs with realistic time assumptions.

~~~
pcrh
Evidently, a $10M investment that compounds at 12% p.a. will return $31M after
10 years.

The article however shows that dilution of that initial "round A" investment
by subsequent rounds of capitalization needs to be taken into account (as well
as when such a "round B" occurred, but that isn't addressed). It is this
dilution that reduces the returns, requiring one or more "unicorn exits" to
make the hoped for returns from the initial investment

------
mark212
My biggest criticism of this analysis is his wild overstatement of the
benchmark return. Where in the world do you get 8% safely in equities and/or
real estate? It's more like 3-5% because the world is awash in capital with
precious few places to put it into play.

Which in a way would support his main point more strongly: venture returns are
inevitably coming down from 12% to 7 or 8% annually.

~~~
icedchai
Over the long term, it's not hard to find. You can get 8% annually by buying a
broad based index fund and holding. Vanguard Total Stock Market would've
worked over the past 10 years.

Beating the market is tough.

~~~
MagnumOpus
Vanguard Total Stock Market:

\- 76.7% over the last 10 years (5.87% annualised)

\- 90.0% since inception 15 years ago (4.3% annualised)

That is very far from 8% - at that rate with compound interest you'd have
gotten 217% of returns from VTI over 15 years.

~~~
tim333
Also future returns from here going forward a few years are looking worse than
that. Stocks are expensive by historical standards at the moment.

~~~
icedchai
Look back 50 years and you'd have been saying "stocks are expensive" every few
years, missing out on massive returns. Invest for the long term and don't
worry about it. Today's expensive is tomorrow's cheap.

------
asah
great post but it misses several important dynamics (in addition to subtler
effects): 1\. LPs invest in multiple VCs - they have their own portfolio
effect. 2\. not even VC investment is equal -- there's 10-50x difference
between their largest and smallest bets. 3\. there's non-financial benefits to
being an investor in Uber (and doubly, for being able to say it publicly).
There's no benefit in saying you're an investor in the stock market. Subtly,
if you're a top VC and NOT an investor in enough Uber's (and only investing in
unknowns) then LPs and entrepreneurs don't take you seriously.

These effects combine to dampen the effects you mentioned. Consider FriendFeed
- small $50M acquisition by Facebook, but given its non-financial impact, do
you think the VCs regretted the investment? They'll make their $$$ somewhere
else, perhaps the entrepreneur's next startup... which turned out to be quip,
acquired for $750M last week...

~~~
bogomipz
LPs? Can you clarify that abbreviation?

~~~
phpnode
Limited Partners

------
jwatte
I don't quite agree with the math and illustrations.

If they put in 10M, get 25%, and exit is at 50M, that approximately zero
growth over valuation (probably down from series B) This is why VCs don't
always take series B, and series A is much smaller so they can place more
investments and see which ones are worth it. A 100M series A fund with only 10
deals seems unrealistic.

Six years is not enough to IPO for most startups. Much less 4, if the A comes
towards the end of the placement phase. That's not a change that helps anyone.

------
paulsutter
> Screw traditional investors, move to the “cloud”. We should be able to find
> better access to capital that isn’t looking for 12% returns. Can’t we find
> investors willing to get a 8% stable yield in a $1B+ fund diversified over
> hundreds of startups?

8% return means returning 2x in 10 years. The author /already told us/ that
85% of venture funds are unable to do even this. How will this "cloud"
diversified fund do better than 85% of funds?

------
emblem21
VCs are just doing the same investment strategy that record labels used to
do... before file sharing decimated their mechanical royalty agreements. For
every Britney Spears, you had 10+ other acts that could barely produce a
break-even single. It's highly Pareto-driven.

Combine that with the fact that 2016 has only seen 7 tech IPOs...

And the fact that investment in sub-25M cap is dead thanks to Sarbane-
Oxley/Basel III...

And GDP growth forecasts being cut by the IMF...

The only thing propping up the tech market right now is the fact that Apple,
Microsoft and Google hold 23% of all U.S. corporate cash. Exit strategies
pivot around whatever initiatives these three players choose, which means
they, in essence, control the direction of tech innovation without having to
acquire a single business. VCs will automatically organize their investments
based on the acquisition habits of those three players in the hopes they get
caught in the net as well.

~~~
pcrh
What you describe is exactly what occurs in UK biotech. Many drug-oriented
biotechs aim no more than to please the big pharma companies...

------
Xcelerate
So why isn't there an organization that distributes the risk of startup
failure across many companies (kind of like how insurance distributes the risk
of catastrophe)? That way, one unicorn would satisfy everyone, and all the
startups that failed wouldn't matter. (I say this as someone who knows nothing
about startups and VCs of course...)

~~~
pcrh
That's precisely what VCs aim to do.

~~~
chmullig
Yup, that's literally the definition of VCs. Instead of a single LP having to
choose one startup to invest their $10M into, they buy shares in the dozens of
startups that the VC then invests in. The risk and reward is shared between
all the LPs in that fund.

------
tlogan
8% return in equities market? Wow... I did not know what I can just invest
money in the stock market and get rich...

The 8% annual return is impossible to achieve (BTW, that is number what sharks
tell to "retail investors"). Between 1998 to 2008 the annualized return on SP
500 was about -1.35% (yes negative and there was huge boom during 2000s). And
that is excluding all fees.

I think 8% would be an excellent return for limited partners who invest into
VC funds...

~~~
JoshuaDavid
Yes, but that's because you cherry-picked the decade with the lowest return.

Over the past 50 years, the average return on investment for 10 year periods
has been [1]

    
    
        1956 - 1966    9.21%
        1957 - 1967    12.81%
        1958 - 1968    9.91%
        1959 - 1969    7.74%
        1960 - 1970    8.08%
        1961 - 1971    6.97%
        1962 - 1972    9.83%
        1963 - 1973    5.97%
        1964 - 1974    1.29%
        1965 - 1975    3.31%
        1966 - 1976    6.66%
        1967 - 1977    3.65%
        1968 - 1978    3.24%
        1969 - 1979    5.92%
        1970 - 1980    8.50%
        1971 - 1981    6.55%
        1972 - 1982    6.70%
        1973 - 1983    10.56%
        1974 - 1984    14.61%
        1975 - 1985    14.12%
        1976 - 1986    13.62%
        1977 - 1987    15.09%
        1978 - 1988    16.13%
        1979 - 1989    17.34%
        1980 - 1990    13.80%
        1981 - 1991    17.41%
        1982 - 1992    16.08%
        1983 - 1993    14.85%
        1984 - 1994    14.32%
        1985 - 1995    14.83%
        1986 - 1996    15.23%
        1987 - 1997    17.90%
        1988 - 1998    19.04%
        1989 - 1999    18.05%
        1990 - 2000    17.30%
        1991 - 2001    12.81%
        1992 - 2002    9.26%
        1993 - 2003    10.96%
        1994 - 2004    11.95%
        1995 - 2005    8.98%
        1996 - 2006    8.33%
        1997 - 2007    5.84%
        1998 - 2008    -1.36%
        1999 - 2009    -0.95%
        2000 - 2010    1.38%
        2001 - 2011    2.88%
        2002 - 2012    7.03%
        2003 - 2013    7.34%
        2004 - 2014    7.61%
        2005 - 2015    7.25%
    

So yes, you historically could just invest money in the stock market and get
rich, and you will probably continue to be able to do so.

[1]
[http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/...](http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html)

~~~
MagnumOpus
That was back when both inflation and interest rates were higher. Not
necessarily comparable.

(Why do you think that many experts pick 10 year maturity bonds with a 1.5%
coupon over stocks?)

------
toodlebunions
Often feels like everyone is a VC today.

------
staticautomatic
If you don't make enough money when every single one of your portfolio
companies exits for $50M, then you're doing it wrong.

~~~
lisper
That is a horribly naive analysis. Did you even read the article? $50M can be
a great outcome or a terrible one depending on the circumstances. What
valuation did you buy in at? If you bought in at $100M, a $50M exit means a
50% loss. How much time did it take to exit? A 50% return after 1 year is a
very different outcome from a 50% return after 10 years.

~~~
asah
actually, read the post - the point isn't about ROI, but absolute dollars. A
VC (human) can't do 25 deals because they can't sit on that many boards.

~~~
jwatte
First: yes you /can/

Second: you don't /have/ to have a /personal/ board seat

Third: funds typically have multiple partners

If there is one lead and five follows in a series A, do you really think there
are six new board seats created?

------
davidmurdoch
If you read this before the article it may help: I always thought that VC
meant "Venture Capitalist" or referred to the capital the investor invested
(Venture Capital), this article doesn't mean either of those things, rather,
it means the company that has accepted this money.

~~~
btown
You may be doubly confused. VC here does refer to venture capital firms -
sometimes they're no more than a few people running the firm, in which case
you could refer to the individuals as venture capitalists. These firms invest
in startups, businesses which create a product. Their job is to "choose
winners." But where do the individuals making up a VC firm get that money to
invest? It's very rarely their own wealth. Instead, they get it from LPs -
endowments, pension funds, big banks, family offices (which manage multi-
millionaires' money), all of whom want to get on the Silicon Valley wave. And
those LPs certainly expect to get better returns than if they just put it in
the bank, or into the stock market. So there are two levels at which a
"company" must "raise" money - the startup from the VCs, and the VC from the
LPs.

~~~
davidmurdoch
Ah. Thanks for the clarification here.

