Bigger isn’t better Part 1: Size considerations for Venture Capital Funds

September 29, 2009 at 9:29 am 3 comments

What is the right size for venture funds?

Veteran investor Alan Patrikof is musing in a recent piece in The New York Times about the “good old times” when venture funds were $100 million at most.

So why should VC-Firms be smaller?

1. It takes longer for VCs to reap their profits:

The time from VC-financing to M&A exit has grown substantially. From about 2 years in 2001 to over 7 years in 2007. And the time value of money comes at a high price to VCs: In order to realize a 50% IRR on an individual investment, it would have to yield a 17-fold return after 7 years, versus a 2 ½ -fold return after two years. Not that such returns aren’t possible, but given the substantial investments of large VC firms, those need to be some hefty exits, and:

2. There aren’t that many supersized exits out there:

The average (disclosed) M&A deal size has shrunk to about $50 million in the US in Q1 2009 (with Q2 faring somewhat better) according to Thomson Reuters and NVCA reports. Most M&A deals are not disclosed. Most undisclosed M&A deals are much smaller.

So if venture investors owned 50% of a company at the time of the M&A transaction, the proceeds would yield them $25 million. Which is exactly the average amount of VC investment prior to an M&A exit in Q1 2008. That doesn’t leave much room for any return on investment. And although there are some encouraging signs for technology IPOs, the vast majority of exits are currently in the form of M&A. Even discounting the financial crisis: IPOs these days are a large-bank affair: a company will need to provide sufficient float to attract an active market in its shares; in the order of at least $50 million; at valuations of north of $250 million.

Will any of this change?

We will certainly see more exit activity and better valuations at some point. But a return to the “small IPO” is unlikely. And to build a company with an exit value of $50 – $100 million, it shouldn’t take more than $5 million for the math to make sense – which would call for venture capital firms that can deploy these relatively small amounts of money efficiently.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is a Member of the Board of the German American Business Association (GABA).

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Entry filed under: Financial Advisory, Interim Management, Restructurings, Shareholder Services.

So You Bought a Copy of QuickBooks, Now What? Bigger isn’t better Part 2: The right size for the Venture Capital Industry

3 Comments Add your own

  • 1. Jeff Rosner  |  October 14, 2009 at 7:41 am

    The math is correct, but there is a dilemma here. Effectively, VCs are attempting to skim only the most cash-efficient business plans from the entrepeneur community; of course, software development has a history of being the best at this and has come to dominate much of the VC landscape. The other alternative is to fund a high-visibility technology startup to a news-worthy demonstration point and then try to cash out on ‘promise’.

  • 2. Gunther Hofmann  |  October 20, 2009 at 4:33 pm

    I would agree that VCs are always looking for the most cash-efficient business plans.

    But that can mean different things in different industries:

    Software has traditionally been very cash-efficient. Now being overtaken by Web 2.0 online endeavors.

    Other industries have figured out their own way of cash-efficient financial strucutre during the development stage: Biotech companies are usually acquired before productization, as the amounts neccessary for drug marketing exceed what VCs can provide; and there’s still a lot of risk involved at that stage. So much risk actually that even pharma-companies need to take a portfolio-approach for new drugs; whereas software companies are usually one-product companies.

    It gets interesting – as you point out – in emerging technologies where there’s no clear financial industry structure, such as clean-tech. A lot of the manufacturing facilities were financed with venture capital, whereas in more traditional industries this would be financed through debt.

    And that can only work if there’s an assumption about sustainable growth of cash flows at some point. I.e. “promise”.

  • 3. circuit diagrams  |  November 11, 2009 at 5:19 am

    i really appreciate this your good article
    from there i get something that i want to know
    thanks for this usefull informations

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