VC success: meteorites and lightning strikes more likely than a unicorn

It has become fashion, as of late, amongst Harvard Business School faculty to share reasons why ventures fail.

Statistics vary by the season, but the rules of thumb are:

• 80% of Ventures fail!

• Of those Ventures that liquidate, nearly 40% of inventors never see any of their cash returned.

• Ventures can survive for over seven years before they fail.

• Private equity (gross) returns are less that 10% pa.

• (The meteorite-lightning /unicorn probability is at the end of the post).

The implications are wide-reaching: inadvertent value transfer, if not destruction (depending on one’s perspective); impact on the functioning of the Venture Capital ecosystem; personal tragedy all round. It is not that every failed entrepreneur can get back up and try again: Arnie-style. Founders are the seeds of success; and hope springs eternal.

To practitioners, this high failure rate is not news. What still remains lacking is an understanding of the critical issues to be resolved or better yet; practical steps that can be taken (by investors, founders, management), in the appropriate time, to increase the chances of success, closer to 50/50.

HBS Lecturer Shikhar Ghosh, in his article, believes the problem lies in the chasm between Financial Reporting and Business Operations. He cites: unrealistic growth expectations; inadequate processes to deliver that growth; inability to build a compelling brand; as well as difficulties to develop “progressive, provable, repeatable results”. The lack of “visibility” between Backers and Founders is the key challenge. His suggestions include:

• Operating Blueprints that tightly knot-together Financial Reporting with Business Operations.

• 360° Enterprise Models to provide a holistic framework.

• Impact Analysis and Scenario planning.

Sadly, none of these comments adds additional insight to the problems of failure.

Probably even more blooded is his HBS colleague, Professor Tom Eisenmann; who takes a different tack in his recent paper. Lack of cash flow and funding are the banes of any start-up, obviously. He suggests looking for 6 patterns of failing behaviour and targeting actions to ameliorate them. Tom Peters-like, they have been badged.

• For true start-ups:

  • Bad bedfellow,

  • False starts

  • False promises

• And for those scaling ventures:

  • Speed traps

  • Help wanted

  • Cascading miracles

Eisenmann suggests that lack of speed to act and unwillingness to cut losses early, a “butcher’s cut” discipline (in Equity Trading parlance) are the two most defining characteristics of catastrophic failure; with its ensuing financial, social and personal damage.

Eisenmann’s reflections may be more useful as they are a call to watchful action and discipline.

In Venture investments, identity becomes wrapped up in the entity. The dynamic balance between subjectivity and objectivity can be disturbed. Furthermore, there are two aspect that are not considered by either professor, and nor much of the academic literature. First, the parasitic nature of the Venture as times turn tough. Second, is the failure (and associated cost) of agents, particularly the fund/portfolio managers, to fully protect principals’ funds. It is rare that their pockets are touched. To the VC professionals it is largely a matter of ‘playing the odds’ and avoiding crystallising that definitive loss/write-off.

It is true that when the VC model works, especially American style, producing that unicorn, then the results are specular. But as with any ‘star’ system, the odds of success are low and highly concentrated. Such as:  banker bonuses; Hollywood stars; Music artists; Lottery winners; etc. For the record, the chance of a start-up becoming a unicorn (at a valuation of USD 1.0 billion) is less than 0.00006% (aka 1/16,667). One is more likely to be: struck by a meteorite (0.0003%); dealt a Royal Flush at poker game (0.00015%) or struck by a bolt of lightning (0.00008%). Is VC a numbers game?

A few observations.

• It is all about the Founder.

• The financier be clear and agreed, as to the objectives (inputs, outcomes, timing).

• Communicate constantly, listen, act!

• Cull early.

VC is an essential aspect of enterprise development and economic growth; but it is not suited to all investors and not all would-be entrepreneurs can run with the unicorns.

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Justin Jenk is business professional with a successful career as a manager, advisor, investor and board member. He is a graduate of Oxford and Harvard universities. Justin can be found at: justinjenk.com ; gate capital; or www.raktas.ee gate or researchgate.

US better than Old-World for VC funds and investor – structure

February 19, 2021 / Leave a comment

IInvesting in Venture Capital (VCs), especially funds, is still considered an attractive asset class. What is interesting to note is the significant differences between American, British and European VCs. The US is just a better place for VC.

Historically, American VCs fund are larger ($282m), and perform better (10.3% over 10 years) vs their Old-World equivalents, specifically the UK ($168m and 4.6%) and EU ($128m, under 4.0%).

While the data is dated and the adage about generalisations remains true; there are some interesting observations that remain valid for those engaged in the sector, as well as alternative asset investors.

Overview

The correct selection of a target as well as constant fund-raising remain evergreen, constant activities across all three geographies: US, UK and EU. Yet there are important structural aspects to consider, as highlighted below

The main structural aspects include the following: the nature of funds, investment strategy, sourcing strategy, differences in due diligence and cultural differences. These structural and operational factors provide possible explanations for the differences in performance (and hence attractiveness, ease of operation) between the geographic funds. These factors will have deep ramifications for fund-raising strategy.

Fund size

Current research suggests that larger fund size does NOT mean better performance. Yet average fund size does provide an indication with regard the ease of accessing capital. For many founders, the fund-raising strategy is aligned to fund size. In most cases, especially for start-ups, founders must demonstrate the potential exit from the company will be 3x the size of the fund.

Fund-raising

In the US, it is fair to say that fund-raising has become a science, if not an industrialised process: mainly from private/non-government sources.

Yet the Old-World profile reveals a much larger reliance on government support and funding – about 45%. Are governments the best investors in such risk ventures? The motives of Old-World owners accepting such funds can also be challenged.

This difference raises the chicken-and-egg dichotomy: whether lower performance is the cause or the result of a lack of appeal to the private investor.

A further knock-on effect is the time taken to secure funding. Relying on government sources naturally slows down or elongates the period of investment and return. Also, there is a time allocation conflict created. Time (a vital resource) is expended on extended fund-money as opposed to the business of investment.

Thus, the net overall effect is that Old-World (UK or EU) based VC funds do not seem as attractive at the outset. This attribute further influences the stages of development (investment) as well as the nature of investors.

Stage of Investing:

There are several stages of investment. The critical ones are at the earlier stages of the cycle.

The American VC market has a fully developed range of expertise to facilitate investments at all stages, particularly at the growth stage. Any venture needs multiple funding rounds. Such a context in the US provides a balanced and supportive environment for firms to grow and develop.

In contrast, over 60% of British and European funds are focused on seed funding. There is a significant lack of Series A focused funds. Statistics reveal that the main risk for Old- World start-ups is that less than 20% receive further financing from the same investors. Few of these VC’s have sufficient finance available to follow on with their initial investments. The impediment is not only stage; another limitation is the insufficient scale of Risk Capital. In the US the pool of growth stage capital available is 8x larger than in Britain and EU; and support from the same sponsor for a venture across all its funding stages.

Investment Strategy

Investment strategy is another structural difference.

The American approach is much more projected. In the US, VC funds tend to adopt a ‘home run’ investment strategy. It can be summarised as a “1 in 10” approach; whereby one investment’s success will provide the return for the whole size of the fund. This approach reflects the more developed, broader, deeper and hence competitive nature of the US sector. As a result, American VC firms aim for a 60% internal rate of return. Also, they have a well thought out and deeply researched investment thesis. US VC firms are very specific about what they looking for, and base their decision criteria accordingly. They place much greater emphasis on a company’s ability to establish a commercially viable product-market fit, as opposed to revenue.

The Old-World approach is more cautious. Lower IRRs. There is a weaker top down investment thesis approach. A greater emphasis is placed on the finance soundness and profitability of the company.

Deal Sourcing

The ability to source deals/targets primarily relies on the brand strength of a VC fund.

US VCs have better, in the sense of recognised and managed, brands. As a result, they are able to use a more frontline marketing approach (deal sourcing and financing), due to strong networks and track records to build robust pipelines and convince incumbent owners and management. US funds rely extensively on frontline conversations and networks to understand what is happening in the market.

British and EU brands are relatively weaker. It seems that more effort and resources are required to manage their poorer network and weaker track records. The increased competition in the American market means VC

Exits

‘Exits’ are places in the Promised Land.

US VCs have strong relations with corporates, other funds and exchanges for exits. This allows them to wait for a more optimal time and valuations for an exit. A deeper market suggests better considerations.

In contrast, both EU and UK venture capitals have inadequate relations with corporates. This situation is often reflected in sub-optimal exits. It can lead to firm facing a difficult position of being restricted to ‘taking’ offers, or just one; rather than proactively negotiating the best terms.

Culture

Culture is such a fecund phrase and concept. Generalisations abound, some are relevant, and what can be observed are the following aspects.

American VCs are more organised, structured, determined, optimistic, flexible, faster pace and less reliant on State assistance (in whatever form) and higher risk tolerance. In the VC sector this cultural has moulded: fund size, stage focus, investment strategy and sourcing.

VCs in the EU and UK seem unable to emulate the same process due to factors such as: The EU and UK having a less productive process that reflects a more sclerotic and sceptical cultural milieu. Decision-times are attenuated.

A vitally important aspect is scale and connectivity. This physical cluster reflects and reinforces behaviours. The creche for the American VCs has been the development of Silicon Valley in the US. It has developed to provide easier and more experience with regard to access to capital. The cluster’s legal and regulated systems have helped entrepreneurs. Silicon Valley has set the parameters and standard that other loci seek to emulate; elsewhere in the US and well as the rest of World.

The Old-World lacks such a concentration. Its fragmented market structure, made more complex by language and national practices has made it extremely difficult to create or at least emulate the American clusters. Furthermore, the partners of US funds are usually former successful entrepreneurs. While in the Britain and Europe, partners tend to come from either operations, consulting or finance. The former has ‘walked the talk’, the latter group, rarely.

In summary

The US remains the home and centre of the VC world. It is clear that the US is the ideal destination for any start-up. The combination of its: risk-orientated culture as well as expertise helps founders and their ventures grow from a more premature concept state to a more sustainable and established state. While the marketers of Britain and EU proudly promote their skills and successes, there remains an experience and expertise gap.

Be you an VC investor, founder or entrepreneur, the US is a safer bet; unless the proposition is a top-of-class winner, and it may attract the VC.

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Do read my other blog entries!

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Justin Jenk is business professional with a successful career as a manager, advisor, investor and board member. He is a graduate of Oxford and Harvard universities. Justin can be found at justinjenk.com or www.raktas.ee or www.gatecapitalgroup.com or researchgate