The Venture Capital big Mistake - seek a huge exit

In one of my former posts I mentioned a mistake that in my opinion most of the venture capitals (VCs) are making and I promised to elaborate on it.

A big VC typically has much money to invest. The money is not correlated to the VC personnel. Suppose that a VC manages 100 million and has 5 partners. A much larger VC, that manages 500 million will not have 25 partners, but probably also 5 or slightly more.

A VC requires a seat or two in the board of the companies they invest in.

Now lets make some more assumptions and do some math

• VC has 5 partners
• A partner has an attention span for about 5 companies
• the VC requires only a single seat (A very conservative assumption)
• Therefore, the VC can support effectively 25 investments

For a small VC of 100 milllion it means an average investment of 4 million.
For a medium-large VC of 500 milllion it means an average investment of 20 million.

This is no wonder that a VC seeks for the next big thing. Even if they are fully aware that no one can identify upfront what the next big thing is. This is a high risk game.

Due to the high risk, the VC knows that most of their investments will fail.  In most cases, even the investments that succeed are not sufficient to cover for the ones that failed, unless the VC is very lucky. טes, luck is a huge factor here.

To cover for most loses and make money in this game, the VC must do at least 10 times on their money and they seek much much more since they want a high return. Lets assume that a typical investment provides the VC 25%-35% of the company and lets even assume that the VC share will not be diluted (yes, I know that this is rarely the case).

This means that if a VC makes a 4 million investment, gets 25% of the company and seeks a "modest" factor of 15 for their money, the exit should be about about 240 million. For a 20 million investment the exit should be almost 1 billion dollar.

There is another factor that serves as an expediter. Most VCs expect a return on their investment in 5-7 years. So, not only they seek the next big thing, they wish to have make it ultra quick.

During the crazy bubble years, when companies were sold for huge ridiculous sums and companies making a loss could have an IPO, this model worked just fine. However, when the economy does not allow it anymore, reality smashes back.

It is no wonder that we see that VCs are not surviving, and the ones that still exist raise very little new capital.

There are two extremes that will flourish though. The first one is the VC with a very specfific expertise in a specififc market and where their partners are very well connected. These VCs provide a real advantage to their portfolio. These VCs are rare, but they exist.

The other VCs are the new ones, called micro VCs. They avoid the problem by being small (say 5-20 million) and investing much smaller sums. They do not seek a huge return but a healthy one.

The wierd thing in my eyes is that a good model does exist and yet I have not heard on VCs that endorses it. To me an adequate model is:

1. Invest smaller amounts in healthier companies.
2. A healthy company chance of succeeding and providing a nice return on investment is not too bad
3. Since most companies now succeed, there is no need to ask for a huge return of investment to cover for loses
4. In addition, a healthier company requires much less VCs attention so the VC management can control many more investments and have an even broader portfolio
5. This create a very positive cycle of investments

It would be interesting to see what will happen in the next two years. I expect the VC world to be a different one.

Amir