The Math Behind Venture Capital, and the Need for Home Runs

Recently, I discussed how venture capital in the tech sectors is weird: every investor is swinging for the fences. Rachel Chalmers describes the financial incentives (boldface mine):

Besides being custodians of the fund and therefore honor-bound to seek the best outcomes, investment managers are compensated in part by carried interest. Carried interest is a cut of returns to the fund after (a) all capital has been returned and (b) the fund has met an agreed-upon rate of return. Let’s say the VC firm has a $150m fund and a preferred return to investors of 3x, or $450m. The partners in the VC firm don’t even start earning their carry check until that $450m threshold has been reached.

What does this mean for you, everywoman entrepreneur? Let’s assume this firm has offered to invest $15m in your company in exchange for 15% of equity. At that rate, said VC firm can make ten such investments. We all know that nine out of ten startups fail, so the VC is betting that one of the ten of you can return the fund, and then some.

What do you have to do to make the VC’s 15% of equity worth in excess of $450m? We are now talking about a $3bn outcome.

Whatever it is you have to do to earn this – take the company public, somehow impress Mark Zuckerberg – your investor/co-owner is now focused on persuading you to do. That’s why they’re starting to ask if you would consider moving aside to let an experienced public-company CEO take over.

By the way, the odds of achieving a $3bn outcome are so far from being in your favour, it’s absurd. Not winning-the-lottery absurd, but an order of magnitude worse than that old one-in-ten rule of thumb. Let’s leave aside the outliers like WhatsApp and focus on enterprise software, a business I know and one that’s slightly less subject to the whims of wanton Gods than consumer-land. As an industry analyst, I covered 1054 enterprise software companies over a 13-year span. Of these, 75 were incumbents or enterprise end users of other vendors’ software, so let’s say 1000-odd were venture-backed startups. Where did they all end up?

Well, 188 of them were acquired, in deals that ranged from the sublime (Citrix paid $500m for XenSource, which had trailing 12-month revenues in the $1m range) to the ridiculous (many, many face-saving exits of failed firms consisting of a nominal fee in exchange for their patent portfolio.) Note that an exit in the tens of millions, which is a champagne-and-confetti Retirement Level Event for the owners of a bootstrapped company (like Sleepycat Software or Platform Computing), can be a disaster for a venture-backed firm. In particular, since the investors own preferred shares (which means they get paid first) and the employees own common stock (which means they only get paid if there’s anything left over), the people who actually did the work can walk away from a multi-million dollar acquisition with nothing to show for it but sadder and wiser hearts.

Back to my cast of one thousand: 28 of them failed so hard they don’t even fog a mirror any more. Google their corporate site and get domain-squatter linkspam. No face-saving exits for them. I won’t name names. Eight went public: eight out of a thousand. Their names are Opsware, Rackspace,, ServiceNow, SolarWinds, Splunk, VMware and WorkDay.

What this means is that you are more than three times as likely to crash your startup as you are to ring the Nasdaq opening bell. Your chance of utter failure is around 3%.

Your chance of going IPO is just under 1%.

The key part, other than the dismal success rate (you would be better off opening a restaurant which isn’t exactly a low-risk proposition), is that many companies that would be successful turn out to be failures–at least for the talent–simply because of the hunger of the VC firms. There has to be a better way to mobilize capital than this.

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