5 ms·

Why VCs Will Block Good Exits

22 points by prakash 18y ago

cx01 18y ago
I read that argument several times, but always wonder: Shouldn't VCs factor in the subjective risk of the individual venture, like banks do (by requiring higher premiums for riskier credits)? So for example, if a venture has a (subjective) 10% chance of success, the VC should require at least a 10x payoff, but if it has a 50% chance, a 2x payoff would suffice. Or am I missing something here?
- gravitycop 18y ago
  the VC should require [...] if it has a 50% chance, a 2x payoff VC's do not invest in ventures with high (e.g. 50%) chances of success. A high chance of success impies a low return multiple. See: http://www.youtube.com/watch?v=HaeWyLuJsJ4 http://www.youtube.com/watch?v=HaeWyLuJsJ4 Investors in Startup companies are not interested in hearing about conservative startups.
- prakash 18y ago
  So for example, if a venture has a (subjective) 10% chance of success I recently asked a VC on how they evaluate risk in their portfolio, and do they bucket investments into low, medium & high risk and how they identify & classify each of these investments into various buckets -- his answer was simple, they would invest in any company that could potentially get them a 10x return -- as simple as that.
  - gravitycop 18y ago
    they would invest in any company that could potentially get them a 10x return It's like an SAT score, though. If 10x is borderline, to be competitive against other funding-seekers you should be approaching VC's with much-riskier (e.g. higher-return) opportunities (100x; 1000x; etc.).
mattmaroon 18y ago
This seems, to some extent, like a self-fulfilling prophecy. Part of the reason that VCs need a 10x return is that they block a 3x return. Clearly if every investment was a 3x return in a fund lasting 10 years, they'd be incredibly successful. Mathematically speaking, a good VC should aim to get the most value out of every individual startup. To pass on a 3x return, if it consigned the startup to failure, because they need a 10x return is idiotic. Either the VC was a moron, or he thought the company could do better. He didn't block it because he needed 10x, he blocked it because he thought his expected value was higher than 3x by doing so.
- gravitycop 18y ago
  The invisible-hand of the market selects the good strategies, Matt. If your strategy worked, it would be used by the VC's that did not fail. To pass on a 3x return, if it consigned the startup to failure, because they need a 10x return is idiotic. Paasing on a 3x return does not consign a startup to any given thing. However, it does allow a startup to continue to have a potential to provide a 10x return. Cashing out at 3x ruins that potential.
  - pmjordan 18y ago
    Well, the article makes it pretty clear that at least the founders thought things were going to get worse, not better, due to the situation in that market at the time, unless they got bought out. Assuming this was an accurate assessment, I fail to follow your reasoning. And I suspect Matt made the same assumption. (and why not? the article is all we have to go on, and was written by an investor who has seen both sides of the story) Just because there is a simple strategy or "rule" doesn't mean there aren't cases where it isn't optimal.
    - gravitycop 18y ago
      the founders thought things were going to get worse, not better This is speculation about the future. The market has tested its value, and the value must have been found to be poor, otherwise exit decisions would be based upon it. In other words, what the market tends to weed out is micro-management. If a consistent strategy of blocking 3x exits -- -- rather than an inconsistent micro-management strategy involving speculating on the value of speculation -- works, then it works. The critical question remains: Why are there no successful VC's that follow your and Matt's "founders can reliably predict the future" strategy?
RiderOfGiraffes 18y ago
There is a link to some math from the references article, but here's an independent calculation. Suppose the VCs expect 10% of their investments to succeed wildly, 10% to mostly succeed, 30% to limp along and 50% to fail. Suppose also they want 50% profit, which is a complete guess, but seems plausible. For 100 investments of $10,000 each (total outlay $1m) they want a $1.5m return. Some of that might come from the moderate successes, so let's say that $1m needs to come from the 10 wild successes. That's $100,000 each, a factor of 10 on the original investment. This suggests that the factor of 10 is driven by the numbers, and not (purely) by greed.
gojomo 18y ago
Note that even YC's 'Series AA' model documents [1] give them effective veto power over exits. (See the term sheet 'Protective Provisions', (iii).) Their power may in practice be wielded benevolently, but I point it out so people realize even fairly entrepreneur-friendly venture deals include this sort of provision. [1] http://ycombinator.com/seriesaa.html http://ycombinator.com/seriesaa.html
sgman 18y ago
This post clearly shows the market white-space that is being filled by YC and other similar funds.
miked 18y ago
I'm very surprised by some of the comments here, as I think many of them are missing the key point: NEVER use a sunk cost as a factor in making a decision. What the VC paid for its investment is gone forever. All that is relevant is how they can maximize their investment at decision time. What multiple that works out to should be utterly irrelevant.

22 points by prakash 18y ago

cx01 18y ago

I read that argument several times, but always wonder: Shouldn't VCs factor in the subjective risk of the individual venture, like banks do (by requiring higher premiums for riskier credits)? So for example, if a venture has a (subjective) 10% chance of success, the VC should require at least a 10x payoff, but if it has a 50% chance, a 2x payoff would suffice. Or am I missing something here?

gravitycop 18y ago
the VC should require [...] if it has a 50% chance, a 2x payoff VC's do not invest in ventures with high (e.g. 50%) chances of success. A high chance of success impies a low return multiple. See: http://www.youtube.com/watch?v=HaeWyLuJsJ4 http://www.youtube.com/watch?v=HaeWyLuJsJ4 Investors in Startup companies are not interested in hearing about conservative startups.
prakash 18y ago
So for example, if a venture has a (subjective) 10% chance of success I recently asked a VC on how they evaluate risk in their portfolio, and do they bucket investments into low, medium & high risk and how they identify & classify each of these investments into various buckets -- his answer was simple, they would invest in any company that could potentially get them a 10x return -- as simple as that.
- gravitycop 18y ago
  they would invest in any company that could potentially get them a 10x return It's like an SAT score, though. If 10x is borderline, to be competitive against other funding-seekers you should be approaching VC's with much-riskier (e.g. higher-return) opportunities (100x; 1000x; etc.).

mattmaroon 18y ago

This seems, to some extent, like a self-fulfilling prophecy. Part of the reason that VCs need a 10x return is that they block a 3x return. Clearly if every investment was a 3x return in a fund lasting 10 years, they'd be incredibly successful. Mathematically speaking, a good VC should aim to get the most value out of every individual startup. To pass on a 3x return, if it consigned the startup to failure, because they need a 10x return is idiotic. Either the VC was a moron, or he thought the company could do better. He didn't block it because he needed 10x, he blocked it because he thought his expected value was higher than 3x by doing so.

gravitycop 18y ago
The invisible-hand of the market selects the good strategies, Matt. If your strategy worked, it would be used by the VC's that did not fail. To pass on a 3x return, if it consigned the startup to failure, because they need a 10x return is idiotic. Paasing on a 3x return does not consign a startup to any given thing. However, it does allow a startup to continue to have a potential to provide a 10x return. Cashing out at 3x ruins that potential.
- pmjordan 18y ago
  Well, the article makes it pretty clear that at least the founders thought things were going to get worse, not better, due to the situation in that market at the time, unless they got bought out. Assuming this was an accurate assessment, I fail to follow your reasoning. And I suspect Matt made the same assumption. (and why not? the article is all we have to go on, and was written by an investor who has seen both sides of the story) Just because there is a simple strategy or "rule" doesn't mean there aren't cases where it isn't optimal.
  - gravitycop 18y ago
    the founders thought things were going to get worse, not better This is speculation about the future. The market has tested its value, and the value must have been found to be poor, otherwise exit decisions would be based upon it. In other words, what the market tends to weed out is micro-management. If a consistent strategy of blocking 3x exits -- -- rather than an inconsistent micro-management strategy involving speculating on the value of speculation -- works, then it works. The critical question remains: Why are there no successful VC's that follow your and Matt's "founders can reliably predict the future" strategy?

RiderOfGiraffes 18y ago

There is a link to some math from the references article, but here's an independent calculation. Suppose the VCs expect 10% of their investments to succeed wildly, 10% to mostly succeed, 30% to limp along and 50% to fail. Suppose also they want 50% profit, which is a complete guess, but seems plausible. For 100 investments of $10,000 each (total outlay $1m) they want a $1.5m return. Some of that might come from the moderate successes, so let's say that $1m needs to come from the 10 wild successes. That's $100,000 each, a factor of 10 on the original investment. This suggests that the factor of 10 is driven by the numbers, and not (purely) by greed.

gojomo 18y ago

Note that even YC's 'Series AA' model documents [1] give them effective veto power over exits. (See the term sheet 'Protective Provisions', (iii).) Their power may in practice be wielded benevolently, but I point it out so people realize even fairly entrepreneur-friendly venture deals include this sort of provision. [1] http://ycombinator.com/seriesaa.html http://ycombinator.com/seriesaa.html

sgman 18y ago

This post clearly shows the market white-space that is being filled by YC and other similar funds.

miked 18y ago

I'm very surprised by some of the comments here, as I think many of them are missing the key point: NEVER use a sunk cost as a factor in making a decision. What the VC paid for its investment is gone forever. All that is relevant is how they can maximize their investment at decision time. What multiple that works out to should be utterly irrelevant.