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Re-matching expectations

Every time there are new venture capital performance statistics announced, lots of people, including me, decry how over-funded the segment is and claim that it has to shrink.  And, over time, it will shrink.  But, what does this environment mean to entrepreneurs?

The fundamental problem with the venture capital business is that the VC investor's expectations are no longer aligned with that of an entrepreneur.  According to the latest statistics on exits from venture-capital backed companies, the average merger exit this year is $92M (and that's only for the ~25% of the deals where the transaction size is announced).  I'm willing to bet that the unnanounced transactions average a much lower price, although there are always some significant deals where the value isn't announced for various reasons.  Let's be optimistic and assume that the average for ALL venture M&A exits this year is something like $70M.

Now, if you and your co-founders could start a company from scratch and make it worth $70M, you'd think of yourself as being pretty successful.  But, to a VC, that's a marginal return.  Assuming that the VCs own 75% of the company by the time of the exit, they would take $52.5M of your $70M exit.  If the total investment in your company was $25M, the VC's profit would be $27.5M.  20% of this goes toward the VC's carried interest (assuming that their overall fund was in the black), leaving $22M for the LPs (the VC's investors).  That's a 1.88x multiple for the LPs.  Not what the VCs are shooting for, but not a disaster.

If you look at the historical returns I linked to above, you'll see that, on average, the VC industry has delivered a less than 1x return to LPs year after year from 1999 on.  They've lost money for a decade, so the average deal is worse than what I described above.  It's worse because there has probably been more money poured into the deal.  Maybe the real average exit is less than $70M.  And, my analysis above doesn't include the VC's 2%/year fee which also drags down returns.

What most VCs do to combat this is either 1) raise a lot less money and invest only in very capital efficient deals or 2) take really big risks that have a chance to deliver gigantic returns.  One huge return can overcome the losses of many deals.  But, if you aren't lucky enough to be part of one of those big wins, your returns (as a VC and an entrepreneur) suffer.

As an entrepreneur, your interests are more directly aligned with the VC that raises less money and is careful about the capital that they invest.  When your revenue-stage company gets to the point where it needs some additional capital to get over the 'cash flow break even finish line', you won't want to take that in as equity capital.  That's what pushes you into the overfunded category and lowers your return.  Instead, you may want to consider some venture debt that is tailored to meet the needs of companies at this stage.

The benefit of this type of debt is that it doesn't really change your share (or the VC's share) of the upside proceeds when your company achieves its exit.  The venture debt typically includes some warrants (or options to purchase shares in the company upon exit), but not a large stake.  If your company grows as planned, you should make more after repaying this venture debt then if you sub-optimized your growth without the debt.  The downside is that you have to service this debt which adds to the short-term cash burn.  As long as your company is growing faster than the added burden of the debt service, you should be able to repay the debt and capture the upside.

Of course, if you've never raised venture capital money, this type of debt instrument is just as applicable.  You may not want or have the option of taking additional equity investment to finance your last stage of growth.  Venture debt gives you the capital you need while allowing you to maintain control of your company.

In another case of mismatched expectations, most venture debt firms don't want to invest in revenue stage companies.  They prefer to invest as early as possible when the top-tier VCs invest.  Essentially, they are loaning money to the VCs, not to the company.  That can make sense if you have a new company with top-tier venture backing.  But, for the other 99% of the private companies out there, venture debt isn't really available.

There's clearly a nice opportunity here for both the private companies and the right venture debt investor.  More to come soon.


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