Venture capitalists are expected to do more today than deliver returns to investors. Increasingly, governments are turning to the the VC industry to spur private-sector job creation. Accomplishing these twin objectives in today’s challenging business environment requires a new investing model.
Governments are learning that investing in venture-backed companies is an excellent use of capital because it accelerates the rate of innovation while incentivizing managers in ways that research grants cannot. Through efforts like the European Investment Fund in the European Union and the Startup America partnership here in the U.S., government agencies are working with the private sector to fill in the gaps in capital support for startups and high-growth firms. And they’re counting on these investments to boost employment.
To succeed in this new environment, the VC industry must abandon the earlier “boom or bust” mentality that assumed one “home run” for roughly every nine write-offs. There are still too many funds in Silicon Valley, for instance, and too much money being allocated on a per company basis. The reality of the past decade of venture investing is that most early-stage ventures achieve 5 times on exit, or less—not the promised 10 times. Plus, they’re exiting later (eight to 10 years, on average) and eating up more capital during their extended stay.
Reversing this course requires a restructuring of the traditional VC portfolio model. We believe funds will gravitate to pre- and early-growth-stage profiles with maximum size of perhaps $300 million to $400 million, although $150 million fund sizes will also be more typical. These smaller funds will need to achieve a greater number of 3-times to 5-times multiple returns (known as “singles”) more quickly, while still delivering the same number of home runs, just funding them more carefully. To do this, fund managers must fight for each portfolio investment in pursuit of a clear exit point at these lower multiples, then evaluate which ones have home run potential and fund them accordingly, and write off the ones with insufficient prospects.
Risk and big write-offs can be significantly reduced by assuming a majority of “singles” plus a home run or two. Yes, VC firms still need home runs to drive desired overall fund returns, and we only invest in companies with home run characteristics including a large and growing total addressable market and differentiated products, among other attributes. However, a portfolio should still be able to achieve positive internal rate of return even if a home run is never realized. The key is not to fund companies so heavily that a $50 million to $150 million exit yields a breakeven versus decent “single or double” ROI. With enough capital efficiency, it is even possible to find an exit in the single or double range with 10-times home run yields, or better. This also requires that home run-level investment decisions be made after the initial investment—not before.
Obviously, deciding how and when to fund are difficult judgments, requiring extensive experience executing many successful exits across a large number of investments. Successful managers specialize in sourcing and leading successful investments. They know how to build value with proprietary expertise and connections, and they know where to look for best-of-breed opportunities in new and emerging global markets. For instance, there are many attractive opportunities to be mined in Europe, where the number of private funds continues to decline, and in Israel, where deals and investment have both dropped off dramatically as compared to prior years. Many promising startups can be found in both regions, and then bolstered with a Silicon Valley presence and talent to help pave their road to a successful exit.
Clearly, it is no longer “business as usual” for VCs looking to generate returns, or for governments seeking to spur job creation. But international venture capital firms that follow a new, more capital-efficient investment model and have contacts in technology hubs around the world can continue to help startups commercialize groundbreaking technology while also delivering exit ratios and internal rates of return well above the industry average. Meanwhile, as these promising, VC-backed startups grow into high-value, global companies, they also serve as the stem cells for government-backed job-creation programs and initiatives.
