Few succeed. Why?
In an excellent article on early stage venture capital (VC), former VC Andy Rachleff notes that the top 20 VCs, i.e. about 2%, earn approximately 95% of VC profits. Is this true? Why? What are the implications?
Here is Why few VCs earn the most VC profits:
· Home runs are key to VC returns because VCs fail on about 80% of their investments. Only about 19 are successes and one is a home run, and these profitable ventures must pay for the failures and provide a return. VC portfolios that have no home runs are not in the Top 20 (Designing Successful Venture Capital Funds for Area Development: Bridging the Hierarchy and Equity Disparities Dileep Rao, Applied Research in Economic Development, 2006. Volume 3. Number 2).
Due to the high losses in the fund, Y-Combinator (a well-known incubator in Silicon Valley) reportedly earned moderate returns in its fund, including an investment in Google.
· Noted VC Marc Andreessen of Netscape and Andreessen Horowitz notes that about 15 companies would account for about 97% of VC returns. VCs financing these ventures are likely to be in the Top 20.
So whether it’s 20 VCs or 40, and 15 home runs or 30, the reality is there are very few home runs, and VCs have to invest in these few VC home runs if they want to be in the Top 20.
Here is How the Top 20 VCs invest in potential home runs and earn most of the returns:
· They chase where the home runs roam. VCs do not start with home runs. Unicorn entrepreneurs do. And unicorn entrepreneurs have mostly been in Silicon Valley. That’s why VCs have mostly succeeded in Silicon Valley.
· Importantly, the Top 20 VCs invest in the best stage of the business for VCs. VCs need to see evidence of potential i.e. Aha to get high returns and reduce risk. Rachleff notes that the Top 20 VCs finance after the Value Model (Strategy Aha) and before the Growth Model (Leadership Aha) for better value and reasonable risk. After Strategy Aha, venture leadership is the most important goal. This is a major reason why the Top 20 VCs often replace the entrepreneur, as Pierre Omidyar (eBay) did with a professional CEO, to grow faster and increase the chances of leading the emerging industry. Risk averse VCs (an oxymoron) invest after Leadership Aha. But by then the potential of the venture is clear for all VCs to see and VCs high interest in investing puts entrepreneurs in control. Entrepreneurs such as Jan Koum (WhatsApp) and Mark Zuckerberg were able to select their VCs and dictate the terms. High demand also raises valuations and lowers annual returns.
Implications for VC-based ecosystems beyond Silicon Valley
· The belief that there is a venture capital shortage because so many ‘deserving’ entrepreneurs are rejected, and the assumption that anyone can succeed as a venture capitalist just by starting a fund, has led to the launch of many targeted venture capital funds. Few seem to ask the right question: if there was such a shortfall, why do so few VCs succeed and so many VC-funded ventures fail? To achieve high returns outside of Silicon Valley, VC-based ecosystems must develop unicorn entrepreneurs to launch potential unicorns.
· Without home runs that can be made public, VCs cannot achieve the huge returns that public valuations offer in euphoric times. This means that VCs outside of Silicon Valley must exit primarily through strategic sales, but few of these strategic sales yield returns.
· Areas outside of Silicon Valley that start VC funds should instead focus on developing unicorn entrepreneur-based ecosystems if they want sustainable success.
Implications for entrepreneurs and entrepreneurial ecosystems beyond Silicon Valley:
Entrepreneurial ecosystems (EE) outside of Silicon Valley need more Unicorn entrepreneurs who have the skills to start and launch home runs without VC. They can learn from the 94% of Unicorn entrepreneurs who have avoided or put off VC.
Areas that use VC to develop high-growth businesses have a different problem. For their ventures that are successes but not home runs, the most likely exit will be through strategic sales, selling the business to a corporate buyer who can move the business and its potential growth elsewhere. The area is not gaining.
Implications for sustainable development
· Any constraint added to enterprise development reduces the range of investment options. This means that VCs that fund “sustainable development” have a smaller universe to fund, with a smaller chance of hitting home runs. This also means sustainable developers need to reduce risk and increase potential by developing Unicorn entrepreneurs who can grow more with less. .
MY TAKE: Few VCs outside of Silicon Valley are doing well because they are trying to build unicorns using venture ecosystems, which is a full-frontal assault on Silicon Valley. They would do better by building the entrepreneurial ecosystem and launching a guerrilla attack.
