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 about 95% of VC profits. Is this true? Why? What are the implications?
Here is why few VCs earn most of 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 have to pay for the failures and offer a return. VC portfolios that do not have home runs will not be in the Top 20 (Designing Successful Venture Capital Funds for Area Development: Bridging the Hierarchy & Equity Gaps Dileep Rao, Applied Research in Economic Development, 2006. Volume 3. Number 2).
· Due to the high level of losses in its fund, Y-Combinator (a noted Silicon Valley incubator) is said to have earned a mediocre return in its fund that included an investment in Google.
· Noted VC Marc Andreessen of Netscape and Andreessen Horowitz notes that about 15 ventures are said to account for ~97% of VC returns. VCs who fund these ventures are likely to be in the Top 20.
So, whether it is 20 VCs or 40, and 15 home runs or 30, the reality is that there are very few home runs, and VCs need 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 hunt where the home runs roam. VCs do not start home runs. Unicorn-entrepreneurs do. And unicorn-entrepreneurs have mainly been in Silicon Valley. That is why VCs have mainly succeeded in Silicon Valley.
· Importantly, the Top 20 VCs invest at the best stage of the venture for VCs. VCs need to see evidence of potential, i.e., Aha, to earn 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 key goal. This is one key reason the Top 20 VCs often replace the entrepreneur, like Pierre Omidyar (eBay) was with a professional CEO, in order 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 venture’s potential is evident for all VCs to see and the high interest from VCs to invest puts entrepreneurs in control. Entrepreneurs such as Jan Koum (WhatsApp) and Mark Zuckerberg were able to select their VCs and dictate the terms. The high demand also increases valuations and reduces annual returns.
Implications for VC-Based Ecosystems Outside Silicon Valley
· The belief that there is a VC shortage because so many “deserving” entrepreneurs are rejected, and the assumption that everyone can succeed as a VC just by starting a fund, has led to the launch of many targeted VC funds. Few seem to be asking the right question: if there was such a shortage, why do so few VCs succeed and so many VC-funded ventures fail? To earn high returns outside Silicon Valley, VC-Based Ecosystems need to develop Unicorn-Entrepreneurs to start potential unicorns.
· Without home runs that can go public, VCs cannot earn the huge returns that public valuations offer during euphoric times. This means that VCs outside Silicon Valley have to mainly exit via strategic sales, but few of these strategic sales give home-run returns.
· Areas outside Silicon Valley that are starting VC funds should instead focus on developing Unicorn-Entrepreneur-Based Ecosystems if they want sustained success.
Implications for Entrepreneurs and Entrepreneurial Ecosystems outside Silicon Valley:
· Entrepreneurial ecosystems (EE) outside 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 avoided or delayed VC.
· Areas that use VC to develop high-growth ventures have another problem. For their ventures that are successes, but not home runs, the most likely exit is going to be via strategic sales where the venture is sold to a corporate buyer who may move the venture and its potential growth elsewhere. The area does not gain.
Implications for Sustainable Development
· Any constraints that are added to the development of ventures reduces the range of investment options. This means that VCs that fund “sustainable development” have a smaller universe to fund, with a lower probability of home runs. This also means that sustainable developers need to reduce risk and increase potential by developing Unicorn-Entrepreneurs who can grow more with less. .
MY TAKE: Few VCs outside Silicon Valley do well because they try to build unicorns using venture ecosystems, which is a frontal assault on Silicon Valley. They would do better by building the entrepreneurial ecosystem and launch a guerilla attack.