The 10-Year Venture Capital Return Doesn’t Mean Anything

Over the past year there’s been a lot of talk about how venture capital returns over a ten-year time horizon will no longer look so hot once this year is out. This is because after this year the ten-year timeframe will no longer include returns from 1999 – a year featuring huge exits through quick IPOs in what was the last year before the bursting of the tech bubble.  The 10-year venture capital return currently stands at 14.3% (as of 6/30/09 – VC returns are always on a quarter or quarter and a half lag), but has been in a steady decline. There’s been some speculation that the decline in this return will have a negative impact on the venture industry’s attractiveness to investors, but I don't think that is necessarily the case.

Over the last four quarters, the 10-year return has tumbled from over 40% to 14%. For a visual, here’s what the recent drop in the 10-year return looks like:

Before going further, here’s some background on how the return is calculated:

The 10-year return is an end-to-end venture capital fund-level return, meaning it looks at the fund-level (read: not company level) cash flows – to LPs only, meaning it is net of fees and carried interest ( a good thing because this is the true level of return an investor in venture capital funds would have received). The return is a standard IRR calculation except that it in the period in which it starts, in this case the second quarter of 1999, the cash flow pulls in the negative starting net asset value of all the funds comprising the index. Going forward, all contributions and distributions are netted to get the cash flows for each quarter (for timing purposes, the figure is assumed at the midpoint of each quarter). For the final quarter of the calculation the current net asset value of all the funds in the index is added in as a positive cash flow.

What’s the recipe for this drop in the 10-year return? For one, huge IPOs started tapering off after 1999 while at the same time, inflated valuations made the beginning negative cash flow much larger and tougher to overcome, dragging down returns.  Then add in the fact that there hasn’t been another period of fantastic exits since, and that the past year has been absolutely dismal for venture-backed exits and you get a free-falling 10-year venture capital return.

But how important is the 10-year return really? The whole notion that the 10-year return’s fall will have a negative impact on the venture industry is actually hugely flawed. The pure numerical drop in the 10-year return should not be what deters investors. Why? Because sophisticated investors (limited partners) are smart enough to not have been looking at the 10-year return anyway. If anyone looked at the 10-year return as their reason to invest in venture, they clearly do not understand the asset class enough to be making decisions on investing in it. 10-years, despite being a round number, is just as arbitrary as any other number. Nothing makes it different than looking at 9 or 11 years. Even if you are comparing to public markets. The only thing that makes this current case unique is that we are on the brink of excluding a great period for venture. But by now, most investors have come to accept the tech bubble as an aberration, and new expectations for venture returns are much more tempered, albeit still relatively high because of the illiquidity and risk.

Plus., if you want to get technical, the 10-year return isn’t realistic for investors because to have gotten those 10-year returns they would have had to have gotten into funds in the prior one to four vintage years – the ones which were actively investing prior to the bubble and able to exit during the bubble.

Finally, no legit VC I can think of is selling their fund based on 10-year industry returns. In fact they probably look to avoid having to talk about the bubble years because the business is so different now. What happened 10 years ago is pretty much irrelevant. VCs are judged on their performance over the last five years, how their strategies can take advantage of the current environment, and their ability to exit deals over the past year and going forward.

What the drop in 10-year return does more than anything is highlight a major shift in the venture industry - a shift that investors and VCs were aware of years ago and probably ever since the bubble burst. This drop in the 10-year return is not new information and could have esily been predicited a few years ago. We’ve gone from some 250 venture-backed IPOs in 1999 to just 10 so far this year. We know there will be attrition in the industry, but investors that stick with venture capital should be better off because of it. Innovation continues unabated and top mangers continue to provide quality returns through building and growing companies - the way it should be.

Why Have Venture Capitalists Shifted To Seed Stage Investing?

On the heels of my last post on venture capital’s role in innovation, I decided to take a look at how active venture capitalists were in funding companies that are early in their innovation lifecycle. The proxy for this is the earliest stage at which venture capital can come in – seed capital or start-up investment. What I found was surprising. The chart below shows the percentage of new venture capital investment (in terms of dollar value) that went to seed /start-up stage companies each year over the last 15 years. This is the best way to look at this type of data - absolute figures tell you more about what the venture market is doing overall - to understand real deal trends you have to examine changes in proportions of investment over time.

What’s clearly surprising about this data is the recent spike in seed investment (relative to other stages) by venture capitalists. 32% of all new venture investment this year has gone to seed stage deals. What’s driving this?

I know for a fact that pure seed-stage venture funds have had trouble raising funds over the past few years (relative to balanced and later stage funds), which means that traditional venture funds are now leaning more towards seed stage deals. I can think of a few reasons why:

• Venture capital firms are being forced to engage in cheaper, earlier stage deals because syndicate partners are increasingly tougher to find for later stage deals.

• Venture capitalists are still worried about the future of the exit markets (the IPO market and M&A activity) and therefore are hesitant to engage in later stage deals. These are deals in which they would have to reserve adequate capital for if subsequent venture rounds are needed to sustain the companies. We've seen a lot of firms face reserve shortfalls over the past year as the exit markets have essentially been closed. Venture capitalists with the expectation that exit markets will remain tight would clearly be detered from making later stage investments and would perfer less capital intensive earlier stage deals.

• Perhaps venture capitalists are simply going back to their roots and finally taking more risk again. There’s probably the realization that outsized returns can only be attained by generating higher return multiples off of earlier stage deals. Some of this might be pressure from limited partners - low multiple later stage deals just are not attractive, particularly when you consider the fees and illiquidity that come with commitments to venture funds.

Regardless of the reason, this shift to earlier stage investing can only be a good thing for the venture industry. The firms that are truly good at building companies and working with entrepreneurs will stand out and perhaps help repair the image of the venture industry.

Data Source: NVCA PricewaterhouseCoopers/National Venture Capital Association.

PricewaterhouseCoopers/National Venture Capital Association. MoneyTree™ Report, Data: Thomson Reuters.

Venture's Role in Innovation

A big debate was spurred by Vivek Wadhwa last week when he lashed out at the venture community through a post on TechCruch.  Wadhwa contends venture capitalists do little, if anything, for innovation and even detract from innovation. His post comes on the heels of the National Venture Capital Association (NVCA)’s most recent “Venture Impact” report which highlights the importance and impact of venture-backed companies in the macro U.S. economy.  The report does make some outlandish claims, such as 12 million jobs, and 21% of GDP can be attributed to venture-backed companies. Clearly venture capitalists cannot realistically lay claim to those statistics. The report, meant to be a lobbying tool more than anything, includes any company that has received any type of venture funding at any point in its life under its definition of “venture-backed,” which is pretty misleading. Not to say that venture capital does not have a positive impact on the economy - it does - but it is definitely not responsible for the numbers the NVCA presents.

Wadhwa took things a bit further in his post though, and cites research (itself a bit questionable) that shows not only do the vast majority of successful entrepreneurs not need venture capital, but that those who do take it see their companies become less innovative. This leads Wadhwa to conclude that “gold digger” venture capitalists with MBAs have increasingly been simply funding “me-too” companies resulting in high failure rates and declining returns. Looking past the VC-bashing, his main argument really is that venture capital does not facilitate innovation and therefore does not play a meaningful role.

The argument that venture capital does not facilitate innovation is really not much of an argument at all; aside from the rare cases when VCs start their own companies, entrepreneurs are clearly the innovators - no VC would argue with that. So then the next question is around the role venture capital plays. VCs are not simply “middlemen” as Wadhwa states. It would be ignorant to group VCs into one bucket - some are better than others, but almost all VCs play a role in their portfolio companies’ management and strategy. Wadhwa points to research that shows a company’s innovation decreases after it receives venture capital. This is actually a product of maturation. Most companies far enough along to receive venture capital funding would see a decline in innovation regardless of whether or not they received that venture funding.  Venture investment is meant more to take an innovation to the next level, raising its impact and growing its reach, not to prompt innovation.

The role venture capital plays varies by industry as well. In the more visible internet sector, there is limited need for venture capital investment, particularly because the cost associated with starting and scaling web startups has become so low. Venture capitalists won’t always admit it, but it’s a space most do not understand well, and because of its high visibility they catch the more flack for failures. Other sectors such as biotech and cleantech need venture investment to scale. Innovation can be halted if not for investment by venture capitalist. Wadhwa does not account for this at all.

Looking at the big picture, there’s not necessarily causality between venture investment and innovation, rather the two go hand in hand. Innovation can only have limited impact without scaling which is often made possible by venture investment. At the macro level, as the US is faced with increase competition from abroad from countries like India and China, innovation will be paramount in our global competitiveness. The only way the US can continue to compete and maintain its current standard of living is by creating new jobs through innovation. Entrepreneurs will be at the forefront and VCs will continue to be there to back them. The innovation ecosystem is fragile and the last thing it needs is people like Wadhwa causing an unnecessary break in trust.

As an aside, Wadhwa in his piece also mentions that “VCs are looking for bailout money and tax-breaks.” I’m not sure what the basis for this claim is. Surely anecdotal evidence is not what bears the proof. There’s not a single VC I know of that would want to touch bailout money, given the caveats it would come with. Nor are VCs aggressively looking for tax breaks. The only major activity on that front is resistance against a change in capital gains tax, which is reasonable. The one exception where tax breaks have been asked for by VCs is in the cleantech industry where government subsidies have led to increased investment by not only venture capitalists, but by a wide range of investors. And finally, I’ve written about this earlier, but venture capitalists are sitting on approximately $120 billion of “dry powder,” not a figure that indicates the VC community is looking for handouts.