The traditional start-up venture investing formula needs a re-think or limited partners will take their money elsewhere.
LPs are bruised from VC busts and corporate buy-outs, and their returns have generally been much lower than in previous years. Most LPs are facing some level of liquidity issues and thinking about debt bubbles in the coming year. They’re looking for more from VC than the conventional model has traditionally delivered – multiples of cash back rather than straight IRR. They also want a safer, more diversified investment base from which to drive reasonable returns, across shorter investment cycles, three to five years versus five to 10 years.
They still do, however, expect the periodic homerun. But VCs must do away with the “boom or bust” mentality that assumed roughly one “homerun” for every nine write-offs. Capital efficiency is critical and there is still too much money being spent on a per-company basis. The reality is that most early stage venture deals over the past decade achieved 5x on exit, or less, rather than the promised 10x; they exited later (eight to 10 years); and they consumed more capital along the way. The model no longer works and LPs are getting frustrated.
One way to meet LP expectations is to restructure the 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 common. These smaller funds must achieve a higher number of 3 to 5x multiple returns (a.k.a., “singles”), more quickly, while delivering fewer, more carefully funded “homeruns.”
To do this, each portfolio company must initially be funded as though it will be a modest success, in pursuit of a clear exit point in the 2x to 5x range. The next step is to identify those with homerun potential and fund them accordingly and write off the ones with insufficient prospects.
In contrast, many firms still fund their portfolio companies as though each will be a homerun, while assuming nine out of 10 will be losers. Risk and big write-offs can be greatly reduced by assuming a majority of “singles” plus a home run or two. Yes, VC firms still need homeruns to drive desired overall fund returns and we only invest in homerun candidates that have large and growing teams, differentiated products and technology and other attributes. But even if a homerun is not realised, a portfolio should still be able to achieve positive IRR.
The key is not to fund companies so heavily that a $50 million to $150 million exit yields a break-even 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 10x “homerun” yields, or better. This capital-efficient model also requires that “homerun-level” investment decisions be made after the initial investment – not before. Making these decisions prematurely is like picking winners by throwing darts at a board. Successful homerun outcomes are built on much more than speculation.
A more capital-efficient investing model is also the best way to make VC truly competitive and successful in Europe, where the number of funds continues to decline. And it’s the right strategy for Israel, where the number of deals and amount of investment has dropped dramatically as compared to prior years. Many promising start-ups 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.
It is no longer “business as usual” in the VC industry. Many knowledgeable observers anticipate that several household-name VC firms will either close funds or raise much smaller ones, leading to major layoffs. But VCs who follow a new, more capital-efficient investment model can reduce risk, deliver industry-leading returns, shorten investment cycles, and still deliver carefully managed homeruns.
Charles Irving is the co-founder and general partner of Pond Ventures.