A Second(ary) Chance for Venture Capital

note: the article below was first published yesterday in BusinessWeek — please check it out.

Troubled VCs need to rethink how long they invest in startups; many
should fund early and then sell to a secondary firm after a few years

There's plenty of fretting in Silicon Valley and beyond over the
venture capital industry, how broken it has become, and what needs to
be done about it. Proposed solutions abound, with some favoring a
government bailout, others saying the ranks of venture capitalists need
to be slashed dramatically, and some proposing the creation of a market
where equity in startups is bought or sold like shares of publicly
traded companies. Each has its merits and weaknesses.

But in my view, what's needed is a fundamental rethink in the way
startups get backing. VCs need to take a fresh look at when they
invest, and for how long. VCs and other investors that have expertise
in early-stage companies ought to invest at the outset for a few years,
but then sell to companies that specialize in—and have more to
offer—more mature companies. To understand why this approach makes
sense, consider the shortcomings of the existing model.

Currently, many investors buy stakes early on and then add to those
investments in later years. For instance, a typical early-stage firm
might invest $3 million to $5 million in what's known as an A or B
round. Then over the life of a startup, they'll put in another $3
million to $5 million to maintain their share of ownership and the
rights that come with it. The model has been sacrosanct for the past 30
years.

A 10-Year Life But the wait for an exit, through an
initial share sale or a buyout, can take a decade from the time of the
A round. Remember that most VCs have a "life" of about 10 years. And
if, say, a VC invests in a company in year three of its fund, there's a
good chance the firm will be managing the investment past the life of
the fund.

What's more, the time to exit is getting longer, not shorter. Companies like YouTube, purchased by Google (GOOG) for $1.65 billion less than two years after it was founded, are rare. In the future, big wins will more closely resemble Zappos,
an online apparel retailer. Zappos is incredibly well run, and all VCs
wish it were in their portfolio. But Zappos is having its 10-year
anniversary this year, and it might be another few years before its
exit.

Longer waits are bad not just for the VC calculating the return on
investment (ROI). They also result in impatience on the part of limited
partners such as university endowments that invest in venture firms.
It's also demoralizing for individual venture capitalists. There are
many well-regarded VC partners that have never had an exit. Some
venture capitalists are leaving the profession altogether and firms are shrinking.

Here's where secondary VCs can play a vital role. These firms, most of
which did not exist 10 years ago, specialize in buying stakes in
private companies from VC firms. Some examples include Saints Ventures and W Capital Partners,
which are among the most successful firms this decade. Secondary firms
now account for roughly 3% of the VC market, but their clout is
increasing as they do more deals. San Francisco-based Saints now has
more A-list portfolio companies than most traditional VC firms. Its
investments include Facebook, eHarmony, and QuinStreet.

Increased Return It helps that increasingly, many VCs are open to
selling their positions to secondary firms. While selling early will
lessen the long-term value of investments that become hits, it could
increase a VC's actual return on investment by letting them realize
returns much faster—say, three years rather than 10 years.

What's more, increased dependence on secondary investors will let VC
partners focus on what they do best. Different skills are required for
an A-round investor than for a late-stage investor. A venture capital
firm should deliver and focus on its core competency and move on. Just
like startups change CEOs as they mature, shouldn't companies change
VCs as they mature? If there is a good startup CEO, shouldn't there
also be good startup VCs? Some people can take a company from startup
idea to billion-dollar business, but most need to be replaced along the
way—this is true for both management teams and board members.

Early-stage VCs could focus on early-stage issues and later-stage
VCs could focus on later-stage issues. Their investing timelines could
be shorter, they can better plan for the future, and they'll need to
keep less undeployed capital, or "dry powder," on reserve. They'll
probably also do more deals.

My guess is that firms that invest in an A round might not
necessarily invest in the B round. Instead, they might look to unload
some or all of their shares in the C round.

Take Gains Early

I know a few angels who already follow this model. One sold half his
interest to a particular VC in the C round and later sold the rest of
his interest to that same VC. He made about 250% in three years. That's
not bad—especially when compared with the current market. Sure, he may
miss a big pop in share price. But he's become a very successful
investor through his strategy of taking gains early.

Why don't more VCs and angels follow this strategy? As an angel, I
have a lot of good advice for a company that's just getting off the
ground, but if I'm intellectually honest, I don't usually add much
value after the second venture round. Still, I haven't followed the
model I outline here. Maybe it's time I should.

8 thoughts on “A Second(ary) Chance for Venture Capital

  1. Steve Schlenker

    Auren,
    The problem with your model is as follows: most venture funds in most vintages try to make 2.5x-3.0x across the entire fund, and for early stage investors roughly 40-50% of the deals return between 0x and 0.5x (so less than half the money back, 30-40% of the deals return 1.0x-3.0x, and it is only roughly 10-15% that are real stars. If you take out the stars, the portfolio often fails to generate any carry and almost certainly underperforms other publicly traded asset classes, so without the stars LPs will not give money to VCs. This creates a strange tension, then. If a GP believes his LPs have faith in him, he will sell his winners in one fund that was unlikely to generate much carry, resulting in that fund generating no carry at all and underperforming liquid asset classes, in the hopes that by returning SOMETHING to his investors they will let him raise a new fund and try again. So in good markets, the secondary direct buyers are not able to get in at all. If GPs want consistent 2x fund returns, they move into growth equity and buyouts, trying to avoid the temptation of shooting for 3x fund returns by leveraging their investments (and getting into trouble when macro-economic factors hit them) – but this does not help the start-up entrepreneur, because he requires VCs willing to swing for the fences.
    The solution is not to sell out your winners. The solution is to sell out or shut down your losers faster, and have greater patience with your winners, and think of your venture career as a 20-year career, not a series of 3-4 year fund-raising cycles.

    Reply
  2. Tim DIck

    Auren –
    This generic theme is topical in the VC world at present. It’s an interesting idea that was also “hot” in 1998-2000 when it also went nowhere. There appear to be several reasons.
    A market requires sellers and buyers. There are almost no secondary buyers in the venture market. Why? Shareholder rights often improve for new investors. Buying previous series Preferred shares that have subordinated rights to the brand new series is not generally attractive.
    Would a buyer be available for a company that is really really hot and shooting the lights out? Maybe, but who is going to sell that really really hot stock, even if they “should?”
    To complicate matters, Board consent is often required to transfer these restricted shares and the many rights conferred upon Preferred shareholders including voting rights, etc.
    Two strategic share owners (one US and one foreign) are looking to sell shares in good VC backed companies for exactly the reasons you are suggesting. They have been unsuccessful at finding a buyer for these reasons, and particularly, because VCs almost always want a meaningful % ownership so they can influence decisions.
    The two or three secondary markets & investors have not thusfar found much success. Gary Kremen (match.com) attempted to found another in 1999 – he would be worth chatting to.

    Reply
  3. Touraj Parang

    Good thoughts Auren, although the current portfolio strategy and the returns expected of the VCs is fundamentally at odds with a 3-year-flip strategy as Steve also notes above. Furthermore, most VC’s that I know claim to add value in the hyper-growth stage of companies rather than the time-and-effort-consuming very early stages. That’s how they manage to juggle 10+ board seats.
    And yes, Amazon did buy Zappos for almost a $1B:
    http://www.techcrunch.com/2009/07/22/amazon-buys-zappos/
    Touraj Parang
    http://tparang.blogspot.com

    Reply
  4. Ric Merrifield

    Auren – I think this is a great post, and I particularly like your use of the word rethink (which is the name of my book, I would be happy to send you a copy if you send me an address).
    What I think you have touched on is the opportunity for VCs to define themselves in terms of their risk strategy. Some VCs take more risks than others, so they are going to be less interested to cash out in the C round, as you suggest, whereas, especially in an economy like this, some would be very smart to take the “bird in the hand” when even though it looks like a company is doing, well, getting an assured 2x-5x return is a nice thing to have. There are so many companies that looked promised a year or two ago, that are now gone, I am sure some VCs wish they had cashed out, but that’s always going to be the case, so I do think your idea makes sense. My suspicion though is that because VCs are an unregulated bunch, is that they won’t be motivated to move to and sort of standardized definition so that investors can select them based on their risk approach, but it would be fun to see something like this.
    -Ric

    Reply
  5. Peter Nixey

    Steve that would be true if you were not taking time as a variable that mattered.
    In time-independent terms an investment that returns 2x is obviously worse than an investment that returns 10x. However, the cycle-time on the first fund is much faster which gives you compound growth.
    Numbers for a fast-cycle fund:
    – assume that a Series A valuation is 10x on a seed valuation ($3M v. $300k).
    – assume that series A can be closed within 2 years of the seed valuation.
    – assume that 1 in 6 seed investments will actually make series A
    Overall return on six seed investments of $50k:
    Return = (1 success + 5 failures)
    = 1 x $50k x 10 + 0
    = $500k
    This means the fund’s ROI over 2 years was $500k/$300k in 2 years = 66% ROI
    Over 20 years a fund modelled on a 1.66x return every 4 years will ultimately return 1.66^5 = 12.6x. Far stronger than the 2.5-3x benchmark you describe.
    Whether you could find that many companies to invest in (without actually being Y-Combinator) is another question but the numbers are sound.
    There is another huge advantage to early investors selling out is that entrepreneurs do not get unnecessarily diluted. I have seen some investors take exactly this approach but the risk tends to be that the Series A investors will not play ball.

    Reply
  6. Gopan Madathil

    What if each VC or one of their funds was treated itself (as a stock). Would you (or they buy it as an insider)? In other words, post the initial euphoria of closing a $100M or $500M round, are they managing (nee operating) like a traded stock that has ‘responsible’ shareholdere?
    The past few years, we’ve also seen angels operate more like venture capitalists and VCs operate like investment bankers.. and that’s unfortunate for the entrepreneurs

    Reply
  7. Pamela Hawley

    Auren, I may be completely old school here. But many of the older vcs wanted to invest in companies and stick with them for the long-term because they believed in the people.
    It was not all about the money; it was not about the quickest exit strategy. It was about an idea, building a lasting company, and, critically, investing in people. The really great vcs want to stick with a good idea and invest in the people they are backing. That can take 3 or 13 years.
    Pamela Hawley
    Founder and CEO
    UniversalGiving
    http://www.universalgiving.org
    Living and Giving
    http://wordpress.pamelahawley.com

    Reply

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