Thursday, November 18, 2004

Venture Economics

I have always wanted to better understand the Venture capital business reading the various posts by various VC's is giving me some detailed insight into this area.

I wish more people blogged, From different lines of work/walks of life. It would enable all of us to learn a lot of things just sitting in front of my computer, I know that sounded geeky and that people would rebut saying that it is important to touch and feel it in person. But I have an answer for that, time is a limited/fixed resource for all of us and given that there are only a few things that we can manage to do in person, while there is a whole lot more happening out there, which though I might not be able to touch and feel, but I can read and imagine about. This takes learning for me to a whole new plane. ITs really great.

But immediately the one thing that comes to my mind is information overload, All of us need to find a way around it. I was listening to a podcast a couple of days , the guy talking for a proff and he said technologies are good only if they reduce the amount of garbage/information/data that we have to sieve before we get the information that is useful to us or we are looking for. Blogging as barraged us with a lot of information, if only I could find the right sieve than wouldn't it be a perfect combination.

Reverse Engineering Venture Economics

entrepreneurs don't really understand how their VC investors actually make
money, so I thought I'd take a shot at explaining it in general

Let's say a venture
firm raises $100 million from a series of what they call Limited Partners, or
LPs.  LPs can be anything from diversified institutional investors like pension
funds or banks to high net worth individuals.  The partners in the venture firm,
or General Partners (GPs) typically derive money from two

First, they receive
a small percentage of their fund as an annual management fee to pay basic
operating expenses.  These fees range in size, but a typical one is 2% per
year.  So on the $100 million fund, the GPs will take $2 million per year to pay
their salaries, staff, and office expenses.

Second, they
receive a percentage of what's called the carry, or the profits from their
investments.  Carry percentages have a range as well, but again a typical one is
20%.  Here's where the math starts to get interesting.

Let's say the GPs
invest $4 million in your company at a $12 million pre-money valuation, so they
buy 1/4 of the company.  You end up selling the company for $40 million a couple
years later without taking in additional capital (good for you!), so their 1/4
stake in the company is now worth $10 million.  They've made a 2.5x return on
their invested capital, bringing back a profit of $6 million to their LPs, and
they're entitled to keep 20% of it, or $1.2 million, for themselves. 

Fred Wilson talks
about the rule of 1/3 in Valuation,
where, from a VC's perspective, 1/3 of deals go really well, 1/3 go sideways (he
defines sideways as a 1x-2x return), and 1/3 go badly and they lose most or all
of their money. 

So based on
this rule, let's say a "good" VC will generate an average return of 2.5x on
their LPs' money over a 5-year period (an IRR of 20%). 
Now let's say on average, the GPs make 22 investments of $4 million each to fill out
their $100 million fund (less the $10-12 million
spent on management fees over the life of the fund)
, and, again on
average, each returns 2.5x (recognizing that many will return zero and a few
will return 10x).  The VCs will have returned $220 million to their LPs on $100 million
invested, for a gain of $120 million (good
for them!).  The GPs get to keep 20% of that, or $24 million, to split among themselves.  Not a
bad bonus, on top of their salaries, for 5 years of work across a small number
of partners and associates.

Let's attempt
now to compare those earnings to the earnings of an entrepreneur, assuming equal
annual cash compensation.  An average entrepreneur of a venture-funded company
probably owns somewhere between 5-10% of the company by the time the company is
sold.  In this same average case above, the company is sold for $40 million, so
the entrepreneur's equity will be worth between
$2 and $4 million for the same 5
years of work.  In this simple case, the GPs in the venture firm have earned a
collective $1.2 million, much less on a per-person basis than the entrepreneur. 
However, in the 5 year period of time where the entrepreneur is working solely
on one business, the GPs are working on 25 businesses, earning a collective $30
million.  A senior partner in a small firm will
end up with $10-12 million.  A junior
partner maybe more like $2-4 million, comparable
to the entrepreneur.  However, and this is an important point, most
entrepreneurs probably operate at the "seinor partner"

So on average, I think the economics probably work out
in favor of VCs over entrepreneurs in the long run, mostly because VCs operate a
diversified portfolio of companies and entrepreneurs are putting all their eggs
in one basket.  But on any given deal, I'd rather be the entrepreneur any day of
the week - you have more control over value creation, and more of a personal win
if things go well.  And in the 1/3 of deals that are home runs for the VC,
it's better to be the entrepreneur,
since you're much further along the risk/reward
curve and have that chance of seeing your
equity turn into $20 million or more in that one

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