In recent years there have been some incredible success stories for start-ups that have had an accelerated growth into very large and profitable businesses, including Snapchat, Uber, Whatsapp. Even well known global businesses such as Facebook, LinkedIn, Box and Dropbox are still relatively new!
The vision and skills of the entrepreneurs that created and built them are both celebrated and highly envied. The venture capitalists that had the incredible insight to invest heavily in them have cultivated a reputation of having a 6th sense in identifying the next success story.
It reads like a compelling story of bold investments and awesome returns. The reality is a bit different! More venture-backed start-ups fail than succeed. For over a decade the stock markets has also overall outperformed venture capital business, and in the last 20 years VC funds have mostly just about broken even!
The Kaufmann Foundation recently noted in a controversial review in the Wall Street Journal that, of its past 20 years of investing in nearly 100 venture funds, “Only four of thirty venture capital funds with committed capital of more than $400 million delivered returns better than those available from a publicly traded small cap common stock index.”
Perhaps this is partly responsible for a reduction in the number of VC firms globally by around 25% in the past 15 years, and fund capital raised being slightly lower at $32.9 billion as opposed to the $39 billion in 2001 (National Venture Capital Association) when the VC market was at its strongest.
Probably more significant is that in the past few years friends & family financing, which is estimated to be a $100 billion industry and angel activity estimated at $20 billion have been providing the bulk of start-up funding. Less than 3% of start-up deal investment is now generated via venture capitalists.
How does a VC make money?
It’s worth bearing in mind that in many cases VC firms are far less at risk than alternative investment businesses as typically the VC partners’ own money accounts for just 1% of the total.
Many VC’s actually generate most of their income through additional charges, including annual fees of typically 2% on committed capital over the life of the fund (e.g. 10 years) along with a percentage of the profits when the business exits. The Kaufmann Report recently estimated that around 66% of compensation for VC partners comes from fees, not performance. By way of an example a VC firm that has raised a $1 billion fund and charges a 2% fee would receive a fixed income of around $20 million per year. VC firms raise new funds every three or four years and each round will add further annual fee income.
These fees help to protect VC’s from poor returns, and enable their partners to be well rewarded irrespective of the fund’s actual performance. It’s also worth noting that VC performance is only measured at the end of a fund’s cycle (e.g. 10 years) and this avoids some of the more pressing pressures that other investors have to cope with!
The Kaufmann Report also highlighted that smaller venture funds with significant capital commitments from general partners deliver superior results. No surprise there as increased personal risk drives more interest in creating profitable fund returns! In sharp contrast large fund managers can earn significant compensation from the 2% annual management fee without having to invest much time and effort and this may account for their poorer relative performance.
If you asked a range of business owners how helpful their VC’s are the feedback would probably range from being a core part of the strategic management team through to just providing funds! Funding is the primary driver for most businesses but it does make a lot of sense to carefully select your VC partner to bring valuable experience, operational and industry expertise to bear, along with a network of relevant contacts.
The advice then is to consider a VC with smaller size funds, and more capital commitment across the partners. Conduct your own due diligence, just as your investor would run on your business prior to making any commitments. Take a look at our earlier article ‘A Good Time to Invest’ (https://korolit.com/2015/06/agoodtimetoinvest) for some more suggestions, and please also feel free to contact us at Korolit to discuss (https://korolit.com/contact).