Monthly Archives: February 2014

Past Performance as an Indicator of Future Performance

Performance ChartMany fund prospectuses, after disclosing strong past returns, contain the statement “past performance is not indicative of future performance.”  Of course, the fund manager wants you to believe the opposite, and in venture there is a demonstrated persistence in returns:  better fund managers produce consistently better results.

When it comes to entrepreneurs, the warning should read “past performance is often determinative of future performance.”  However, I’m not talking about success or failure:  there are many entrepreneurs who have both success and failure on their resumes.  Rather, I’m talking about human nature:  how people behave, work, interrelate, etc. in the workplace is indicative of how they will so behave in the future.

In my experience, many personality types can be successful in the workplace.  Success comes from a combination of hard work, good ideas, careful planning, market timing and a little luck, and that success is not concentrated in entrepreneurs with only certain skill sets, certain personality traits, certain management styles, certain interpersonal relationship methods, etc.  Some of the greatest entrepreneurs of our time (e.g. Steve Jobs) are not people I’d hold up as the quintessential managers to bet on for a start-up.

So, when reviewing past performance of an entrepreneur or executive, what can we learn?

I find that if someone micromanaged at his last company, he’ll micromanage in his next one.  If someone built a great culture once, she’ll want to build a great culture again.  If someone thought job 1 for the CEO was marketing, that person will probably find job 1 remains marketing in the next gig.  The key then is determining not whether the entrepreneur succeeded or failed with those traits at the last company; instead, the focus should be whether those traits will properly serve the next organization at that moment in time.  Sometimes a micromanager hinders progress; other times, a micromanager is necessary to complete the job.

Determining a company’s needs, and then making sure the fundamental characteristics and traits of the team meets those needs, can further a company down the path of success.

Venture Mathematics: Why VCs Need Homeruns (and only Homeruns)

HomerunWe turn down many great deals brought to us by great entrepreneurs offering to double or triple our money.  Most investors would kill for such opportunities, yet venture routinely turns those down in favor of going after high risk “grand slam homeruns” offering 10, 20 or more times our investment (but far more often than not flame out).  Why do VCs pursue such a high risk strategy?  Venture math demonstrates why.

In order to make their investors happy, VCs target 20-25% annual returns.  The average dollar invested by a VC will be invested for 5-7 years in portfolio companies before being returned.  If you do the math, you can calculate that for a VC to achieve 20% annualized returns over that period of time, the VC has to produce roughly 3x the amount invested (ignoring the VC’s profit interest for sake simplicity).  So, at first blush, it seems like a sure 3x opportunity should be attractive to a VC.

The problem comes when you look at a VC fund at the fund-level rather than at the portfolio company level.  If a VC raises and invests a $300 million fund (a good mid-sized fund), that VC needs to produce 3x = $900 million in returns for its investors to reach 20% rates of return.  As you may know, VCs typically buy minority stakes in companies; many target owning 20% in portfolio companies.  Thus, if a VC wants to produce $900 million in returns while owning an average of 20% of companies, the VC must invest in companies that sell or go public with a total value of $4.5 billion (so the VC’s 20% stake equals $900 million).

A VC might invest in many companies with its $300 million fund—maybe 20-40 companies.  Let’s assume a VC invests in 30 companies with its $300 million fund.   To be part of $4.5 billion in exits, the 30 companies must exit at an average value of $150 million.  The good news is that the average value of a successful VC exit (as reported by the National Venture Capital Association) is right around that $150 million mark; the bad news is that a minority of VC-backed deals are successful VC exits (maybe 10-30% depending on who you listen to).  Thus, a VC going after average exits will need to “bat 1,000” when the industry average is in the 200’s.  Good luck with that.

Instead, VCs try to go after huge exits that will take care of the returns in one exit. A good rule of thumb is VCs like to invest in companies that will “return the fund”—that will produce returns for the VC at least equal to the size of the fund on exit.  So, in our $300 million fund example, a good “homerun” exit should produce $300 million for the fund.  Since that will represent 20% of the exit (given that the VC probably holds around 20% of the company), a VC running a $300 million fund will focus on investing in companies that can exit for $1.5 billion or more.

There are many solid projects that we see that can be built into great companies, but don’t have the potential for explosive growth.  A disciplined VC needs to say “pass” on many great companies that don’t fit the narrow model driven by venture math.