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