One of the less known facts about Venture Capital is that according to MergerStat, 95% of all acquisitions happen below $25M and 97% happen below $50M. Almost the entire venture industry is built on exits greater than $200M and that represents only about 1% of all exits.
Why do most Venture Capital firms require a $200M exit? It is really a cascading problem that is the result of 3 completely stupid factors:
First, venture firms live on their management fees, which are usually between 2% and 3% of the fund annually. This gives a big incentive to have very large funds, with the mean around $350M. In fact, of the 1,600 firms 408 are greater than $250M, 164 are greater than $500M, and 30 are more than $1B. Because these funds are so large, the amount of capital invested in each company must be very high. In fact, according to Jeffries Broadview, the average amount of venture capital invested in a company prior to exit is $25M.
Next, the venture industry tries to provide returns somewhere around 20% to their LPs (they don't do this, but it is their goal). Large venture firms are essentially playing portfolio theory and 100% of their returns come from about 20% of the investments. For the top performing firms, this works. It is similar to what is going on with the big casinos in Vegas. For most of the firms, this strategy is a complete failure to the LPs, the Angel Investors that came in early, and to the entrepreneur.
Finally, to get this size of exit, the amount of time to exit has soared to nearly 15 years. In fact, 80% of all venture funded companies require over 12 years to exit. I know that VCs all say that they like to exit in five years, but that is just not what is happening.
So you ask why on earth would an entire industry try and optimize itself around 1% of the wins. Very good question! The answer is quite easy, Management Fees. At a $300M venture firm, the management fee is $6M-$9M per year.
The bad news is that "the chickens are coming home to roost" and when things get out of whack, the market tends to correct itself. If you read the Kaufman Foundation report that came out this summer, they estimate that 40-50% of the VC funds have not and will not ever receive a carry. I have spoke with a lot VCs about this and many of them think the number is actually significantly higher. Kaufman also estimates that more than 50% of the current venture firms will go out of business in the next decade.
If you talk to a venture firm that is a >$200M fund that is out looking to raise their next pile of cash, ask them how they are doing. The LPs have all figured this out and it is absolutely brutal out there. Now the premier funds like Sequoia, Benchmark, Kleiner Perkins, etc. are going to be there. Partially because their mere mass is going to move them forward and partially because these branded firms truly provide a lot of value above their money. In fact, if a company realizes that they have found themselves in a position that they could be a $200M exit, I would encourage them to get one of these top players on their team.
But to all the firms that are living on their management fees, with no return in site on their previous funds, ran by a bunch of ex-investment bankers…."The Gig is Up!". I think you need to go find another job because both the investors and the entrepreneurs have figured out the game.
If you want more details about this information, I suggest you read the following. One of the top experts in the area of exits is Basil Peters and he wrote a great book called "Early Exits". I highly recommend that you read it. If you have not read the Kaufman Foundation report called "Right-Sizing the U.S. Venture Industry", it is a must read. Finally, Pete Ripp, formerly of Leap Frog Ventures and now at Crosslink Capital, has written a great article on venture returns.
Now I think it is "Chicken Shit" to point out a problem without at least trying to propose a solution. In my next post I am going to present a solution to how this problem might be solved. In fact, I think it is going to be the way the problem is going to be solved. Stay tuned!
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