Are VCs Bad at Math?

November 12, 2009 at 10:29 am Leave a comment

Pepperdine University recently published its first Private Capital Markets Report, and it is chock full of useful information for entrepreneurs and investors alike.

It is based on an exhaustive survey of commercial bankers, asset-based lenders, mezzanine capital investors, private equity sponsors and venture capitalists. It provides insights into everything from the critical ratios commercial banks expect when extending credit to the average closing fees charged by mezzanine investors.

Rates of Return – what VCs want

What caught my attention and gave this post its title is the calculation of implied expected rates of return of venture investments.

Investors were asked about their expected sales multiple (target sales prices to total venture investment ratio). As can be expected, the average ratio decreases from 8.2x for a “Stage 1” company (Two guys in a garage, or more formally according to AICPA: “No product revenue, limited expense history, incomplete management team with an idea, plan, and possibly some initial product development”) to 3.9x for a “Stage 6” company (“Established financial history of profitable operations or generation of positive cash flows”).

So far so good.

Respondents were then asked about their anticipated time to a liquidity event. Again, as expected, the timeline shortens from an average of 6.2 years for a Stage 1 company to 3.8 years for a Stage 6 company.

With both numbers in hand, the authors then calculated the implied rate of return.

The average implied expected rate of return actually increases from 40.5% for a Stage 1 company to 43.3% for a Stage 6 company.

In other words, this would mean that VCs require a higher rate of return from an investment in a company with lower risk. This does not quite conform to financial theory.

How come?

1. Black Swan Hunting

First, VCs aren’t really going for an average return, but they are looking for the outlier that will carry the return for the portfolio. In essence, they’re “black swan hunting”. The 6.2 year estimate for the time to exit of a Stage 1 company may be a realistic average. But the 8.2x exit multiple might be better understood as a hurdle ratio for a base case: An Early Stage VC investor is unlikely to invest in any company (or at a valuation) that does not have the potential to return such a multiple. In the end, of course, most investments don’t pan out that way. But hopefully, a select few in the portfolio will outpace that number by far.

2. No incentive to invest in early stage deals

Secondly, and questioning the viability of Early Stage Venture Capital investing on a more fundamental level: If above estimates are correct in reflecting the current reality that the expected returns from Early Stage investments aren’t significantly higher than Late Stage investments, who would want to invest in Early Stage deals? And indeed, for the second quarter 2009, an analysis of 89 financings conducted by law firm Fenwick and West pegs the percentage of Series A and Series B rounds at 35% of all financings, down from more than 50% in the third quarter of 2007.

And finally – coming back to the title of this post – I believe that respondents are underestimating the detrimental effect that compounding has on their rate of return: The additional time to exit chips away from a healthy return. I would yet want to meet the Early Stage VC who invests with an expected IRR as low as 40% on an individual investment.

The authors of the Private Capital Markets Report are planning to include actual return estimates for the different stages of investment in future editions of the survey. At that point we will be able to quantify exactly how bad VCs are at their math.

In the meantime, I encourage any investor to participate in the survey.

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 (CFA) designation and an Accredited Valuation Analyst (AVA/NACVA). Gunther is a Member of the Board of the German American Business Association (GABA).

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Entry filed under: Financial Advisory.

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