With the stock market leaking a lot of oil and interest rates rising, spillover effects are starting to happen in other adjacent markets. One that I have watched and participated in for a while is the venture capital market.
Venture capital ebbs and flows. It falls into favor, and out of favor. Sometimes it’s just a flavor.
In the 70s and 80s, it was an oddity. An oddball market. It wasn’t until the 1990s that VC started to build steam. Fortunes were made then because investors could get a huge edge. There was not a large supply of capital, but there was demand.
When the internet happened, it increased the demand since it became easier to start a company than it was before. Companies could grow faster since you could scale electronically a lot faster than brick and mortar.
I remember my friend Sam Guren telling me about their investment analysis for Staples. It wasn’t a lot different than a chain of restaurants.
That electronic scaling enticed more capital to come in the market. The IPO of Google in 1998 really set the tone. We had the run up to 2001, then the crash.
The years from 2001-2006 were tough years in the VC business. It was tough to raise a fund and it was looked upon by other capital markets as the “I told ya so” market.
But, the persistence of scaling electronically remained and so did the ease of starting a company to create value. As a matter of fact, starting up got easier and cheaper. Great companies were created then and by the end of the decade despite the crash of 2008, venture capital became a respected asset class.
Here we are today.
A lot of us that had feet in the traditional capital markets and venture capital noticed that valuations crept up. This was a function of the easy money policy of the Federal Reserve since 2009 which changed risk preferences. People put money in riskier assets looking for greater returns. It was also a function of more money coming into the venture capital market looking for deals.
The supply and demand curves of the market were the opposite of the early days of VC. Now there was too much money chasing too few deals. Celebrities got into the mix. That drove up valuations.
The problem in the VC business is the math.
The rule of thumb benchmark return in venture capital funds is 3x the fund after fees. Cash on cash return. Hence, a $100MM fund will have fees of 2/20. Can it return more than $300MM plus fees?
Long ago New York City angel David Rose did some math on his portfolio. He found 50% fail. 1-4 companies return 1x-4x. That means the 10th company needs to return 30x. That gave him a 27% IRR and a better than 3X cash on cash return. This assumes equal investments at the same valuations with the same length of company life.
Most companies outright fail. They usually fail in the first two years of their existence. In our West Loop Ventures portfolio, no one has gone out of business. We aren’t investing anymore. We started investing in 2016. Some have gone on to raise succeeding rounds of capital at pretty high valuations compared to where we invested. However, you can’t eat percentage gains. You only celebrate when you ring the cash register.
We led all but one of the deals we participated in.
In the years since I started Hyde Park Angels, I have seen a lot of changes in the VC business. What I have noticed is that firms who lead deals generally are pot-committed to companies even after they don’t assume a leading role on the capitalization table.
In floor trading, we called that “being a stand up guy”.
My angel returns were very good. Some companies I invested in are still operating. A few went under. Many exited.
I have seen a flood of family offices and corporations get into VC. We have seen a lot of venture firms startup but they rarely lead. Solo angels got into the game but go along for the ride. In downturns you see what people look like naked since the ocean tide has gone out.
I know one corporation that dipped its toe into VC. The company didn’t do a search to find someone with VC experience to run their fund. They just hired internally and found someone who wanted to do it. There was a bureaucratic process to get deals done and a check written. The person who ran the fund never led deals, but just tried to network to get into deals. There also wasn’t a strategy around investing. Instead, the corporation put limits around investing so investments didn’t blow up cherished parts of their business.
The effort failed 100% and they wound up getting out of the venture business.
How many companies will do that in this downturn since committing capital, and committing the kind of capital they need to generate returns that Wall Street analysts find acceptable, will stay with it?
When it comes to family offices, they say they are “patient capital”. Always there. Bedrocks of stability. They are for the families they serve. But, how about for startups?
Family offices don’t typically lead rounds. They come into rounds and might add credibility, especially if the family made its money in the business sector being invested in. Sometimes, you assume there is some “local knowledge”, which isn’t always true.
We will see down rounds, bridge rounds, cramdowns, and other creative financing rounds happen in the downturn. Will the families be anxious to write a check? Will they be supportive?
For a family office to act like a leading venture fund, it actually needs to build a venture fund inside its office and make it hew to the operating metrics of a typical venture fund.
I also wonder about individual angels. It’s super hard to be a lone wolf. I know. I have done it. As they see asset values decrease across the spectrum, will they engage? I don’t know.
I do know this. The way to make big money in inflationary times is to be investing in private companies. They can grow faster than inflation. However, you have to have incredible intestinal fortitude and commitment to do it. The opportunity has increased because capital will leak out of the system, but the risk is higher.
Personally, I am trying to figure out the best way to structure that at this stage of my life. I am not ready to do it yet but cogitating and thinking through the permutations. The rehab I am doing is taking a lot longer than I had planned and has been more expensive than I planned so that is also a constraint.
I have seen a lot of people my age exit the venture business. It’s just time for them. I think the tumult of the last two years plus Covid factors into the decision. I think that will happen a lot now too for people in their late fifties and up. If you think about the math of venture returns along with the time to achieve them, many people don’t want to plunk down a check at age 60 hoping to see a return at age 70. Especially when you see friends dying at those ages.
If you are a corporate or family office, you are better off looking at top-tier venture funds and organizing your venture capital efforts similarly. It often means outsourcing them. The company I talked about earlier in the post should have done that. They’d still be in the VC business today with good returns and a good handle on innovation. But, no one in the board room truly understood the VC business to begin with.
Given the amount of information that is floating around the internet, it is also harder to find an edge to invest in. What is the next big thing? It most likely isn’t the “current thing”. I was thinking about this while walking with my family down the streets of Louisville. Remember when motorized scooters were the current thing?
I am reminded of that when looking at the cryptocurrency meltdown across the board. It’s way overdue. No one has built anything of lasting value in crypto or something that everyone in even one business vertical has adopted and uses every day. I wrote about it last December. Personally, I had only a pittance in crypto and stopped buying. I didn’t sell some of the ones I had bought because I didn’t buy on the speculative value of the coin going up, but on the long-term viability of the company building a business. Since it is not a significant part of my portfolio, the meltdown doesn’t matter.
One of the tests of a sustainable business is thinking about if there are substitutes for that business. Ask, “If this business didn’t exist, could what I am doing be made significantly more arduous?” If that’s the case, customers will pay for the solution. In the first and second phases of the internet, if PayPal didn’t exist, what was the alternative?
The other phenomenon that has happened over the last 15 years is that a lot of younger people have entered the VC business. They haven’t seen big downturns ever in their lives. This will affect them.
When you invested in a firm and it’s going well you might have done the math on how much money you will make at projected exits. When the company does a down round, or you get a cramdown, or worse it goes belly up, that imagined money goes away. That will affect your psychology as an investor if it happens more than once. Ask people that went through 1999-2001. They have scars.
I hear younger people tell me about their “scars” and I am not sure they are deep enough to leave a mark.
On the demand side, with an iffy economy, there will be less desire for people to take a risk on working for a startup. It will be harder to recruit. At the same time, there will be people who pitch ideas for startups to investors but they have no intention of actually building a blowout startup. They just want money to tide them over until the economy improves and they can do something else.
With what is going on at the Fed, and in the market, preferences are going to change. That will affect the supply and demand curves for venture capital. We are going to see who is committed to it, and who isn’t.
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While not VC, I spent many years in the mid-market LBO world. It will be interesting to see how family offices that have been focused on direct investments, wanting to pretend they are actual PE and VC firms, fare during the downturn.
I was primarily on the debt side of the market but learned a great deal about the sponsors that had a reputation for tossing the keys to the banks vs those willing to invest more cash along side the lenders with the understanding that the only way to avoid a complete wipeout sometimes meant keeping a business liquid through a downturn to ensure it could be sold at the other end.
Those who understood this and acted prudently never had problems accessing debt capital to finance future deals. Those who were more likely to give the keys to the banks often became persona non grata to certain lenders. Will the rush of family offices that have piled into this world since 2009 understand what they need to do when the family’s money is on the line?
What a great article! Thanks Jeff!
I am on the other side of the equation -- the startup side. I have found it to not be easy, but not difficult to raise dollars in the past couple years. I also think it's because the business I am raising/starting up has cash flow in year one (and it's a hard, manufactured product), whereas most tech concepts take quite a few years and need scale to do it. I have also benefited from investors who saw big returns in the large caps stock market, and then used their returns to do more speculative stuff like my startup.
With the broader market nosediving, I wonder how that will affect us at the startup end. I also wonder if startups that demonstrate early cash flow will now be king, or if the mix will remain the same.
Very interesting to me! Thanks again for sharing, Jeff!