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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 inve

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?
    - pmjordan 18y ago
      Why are there no successful VC's that follow your and Matt's "founders can reliably predict the future" strategy? Because you're assuming that I'm saying that all 3x valuation situations are the same. Obviously the founders (especially first-timers) will usually be much keener to exit at 3x than risk crashing and burning, because there's more on the line for them personally than for the VCs. And it's understandable that VCs (need to) protect against that, as it probably happens a lot. However, the author (an investor himself) deemed this case sufficiently noteworthy to write about it. The impression I got wasn't that this was as clear cut a case as the usual "hold out until 10x valuation". But I suppose it comes down to the fact that we know very little about this specific case.
      - gravitycop 18y ago
        However, the author (an investor himself) deemed this case sufficiently noteworthy to write about it. No he didn't. He explicitly said that there was nothing noteworthy about the case. My friend couldn’t understand why his board was blocking the sale. He asked me why the VCs on his board couldn’t see the situation they were in and appreciate the opportunity for a great exit that was right in front of them. I explained that it wasn’t the VCs who were missing something; it was my founder friend who didn’t get it. This is not an isolated event. It happens all the time.
    - mattmaroon 18y ago
      I never said founders can reliably predict the future. I never even said they could do so better than VCs. I simply said the author was missing the point. It wasn't that the VC just won't accept anything less than 10x. They do it all the time. It was that in this particular case, he probably felt that by not exiting he would, on average, get more than 3x. I have no opinion whether or not that's true. But I know for a fact that VCs (at least ones with a clue) don't just categorically reject every exit below 10x.
- mattmaroon 18y ago
  The invisible hand of the market only works when there is a market. If you learn anything about the way VCs work, you'll know that it's a less a market and more a good old boys network. There is a ton of collusion. It's a lot more like a market would be without anti-trust protections. I said "if it consigned the startup to failure" because the entrepreneur in question seemed to feel that way, and the writer seemed to not disagree. My sense is that the VC did disagree.
- mlinsey 18y ago
  You have too much faith in the efficiency of the market in a field with: a) lots of players making decisions based on very imperfect and very incomplete information. b) very large consequences for random events. Yes, there are many important contributing factors to the success of a company besides luck, but the difference between a mere success and a multi-billion dollar homerun involves a large degree of luck. These sorts of exits are often associated with winner-take-all markets where randomness is more important. Example: I play a competitive game against you where you beat me 60% of the time because you are more skilled. Given the option, I would much rather play one game against you for $100 than one hundred games with $1 on the line each time. I contend that the one-game option is more analogous to to businesses with lots of "lock-in" or "network effects". c) a relatively short history - if a funding cycle for a VC is several years, and most venture firms haven't been around no more than a couple decades, that's not a lot of generations for funding strategies to prove themselves, especially in the presence of randomness (see b).
  - mattmaroon 18y ago
    d) high barriers to entry e) well-known collusion
pmjordan 18y ago
I had the same thought, especially after reading this part: The management team was eager to sell because much bigger players were moving into their space and they had concluded that it would be much harder to win new contracts in the future. They also believed that because the big players were getting excited about their space, they would probably get the best valuation now. I know VCs talk about the 3 buckets (big winners, getting investment back, belly-up) but it seems crazy they'd turn this down that just happened to fall somewhere in between. It's possible (probable!) that we don't have all the information available to them at the time. Maybe they foresaw some opportunity for it turning into a big winner.
tlb 18y ago
Actually, not. A 3x return over 10 years is 11% annually. Subtracting VC fees (say 2% management and 30% take) brings that down to about 6% for the LPs. VCs have to deliver much better returns than that. Also, don't underestimate the cost of an acquisition. Not just the few $100k in legal fees. Generally it means they have to distribute proceeds to the LPs, and they're exposed to various liabilities if the acquisition goes badly. Assuming they get restricted stock in a public company, selling it is a complex procedure. They may be prohibited in trading in that acquirer's stock while the acquisition is pending, which complicates other deals. Sad to say, but you really can't run a fund with only 3x returns.
- mattmaroon 18y ago
  That's not true because of the way the money comes in and out. They don't bring in the money for the entire fund in the beginning, or wait and pay it out at the end. The actual time period over which that 3x would be realized is considerably shorter than 10 years. The 10 year mark is just where any going concerns that still haven't exited are purchased by a new fund or dealt with in some other way. Also, it's closer to 12% annually. And VCs don't take 30%. It's generally 20-25. For a detailed explanation, see this article which shows that a fund that returned 3x would net investors about 30% annually: http://www.vator.tv/news/show/2008-08-03-venture-capital-economics http://www.vator.tv/news/show/2008-08-03-venture-capital-eco...
netcan 18y ago
It might be rational. Supposedly, they are looking for 10X-30X. If they expect a >20% chance at a 15X return or some variation of that. Also their strategy may be to not make decisions 'as they go'. That eliminates the need to actually be able to make the above estimate, something that probably requires a bit of an understanding of the specific business. They might not expect to do much better by making decisions on the fly then they would by following a simple rule, not enough to justify all of the analysis time. They might expect to do better this way, like rule based stock market investing. When it comes down to it, it's not really an issue with 'the VCs are dumb.' They may have been. But if so, only slightly. They also may not have been. The bigger issue is the discrepancy in risk tolerance. That's not really news.

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?
  - pmjordan 18y ago
    Why are there no successful VC's that follow your and Matt's "founders can reliably predict the future" strategy? Because you're assuming that I'm saying that all 3x valuation situations are the same. Obviously the founders (especially first-timers) will usually be much keener to exit at 3x than risk crashing and burning, because there's more on the line for them personally than for the VCs. And it's understandable that VCs (need to) protect against that, as it probably happens a lot. However, the author (an investor himself) deemed this case sufficiently noteworthy to write about it. The impression I got wasn't that this was as clear cut a case as the usual "hold out until 10x valuation". But I suppose it comes down to the fact that we know very little about this specific case.
    - gravitycop 18y ago
      However, the author (an investor himself) deemed this case sufficiently noteworthy to write about it. No he didn't. He explicitly said that there was nothing noteworthy about the case. My friend couldn’t understand why his board was blocking the sale. He asked me why the VCs on his board couldn’t see the situation they were in and appreciate the opportunity for a great exit that was right in front of them. I explained that it wasn’t the VCs who were missing something; it was my founder friend who didn’t get it. This is not an isolated event. It happens all the time.
  - mattmaroon 18y ago
    I never said founders can reliably predict the future. I never even said they could do so better than VCs. I simply said the author was missing the point. It wasn't that the VC just won't accept anything less than 10x. They do it all the time. It was that in this particular case, he probably felt that by not exiting he would, on average, get more than 3x. I have no opinion whether or not that's true. But I know for a fact that VCs (at least ones with a clue) don't just categorically reject every exit below 10x.
mattmaroon 18y ago
The invisible hand of the market only works when there is a market. If you learn anything about the way VCs work, you'll know that it's a less a market and more a good old boys network. There is a ton of collusion. It's a lot more like a market would be without anti-trust protections. I said "if it consigned the startup to failure" because the entrepreneur in question seemed to feel that way, and the writer seemed to not disagree. My sense is that the VC did disagree.
mlinsey 18y ago
You have too much faith in the efficiency of the market in a field with: a) lots of players making decisions based on very imperfect and very incomplete information. b) very large consequences for random events. Yes, there are many important contributing factors to the success of a company besides luck, but the difference between a mere success and a multi-billion dollar homerun involves a large degree of luck. These sorts of exits are often associated with winner-take-all markets where randomness is more important. Example: I play a competitive game against you where you beat me 60% of the time because you are more skilled. Given the option, I would much rather play one game against you for $100 than one hundred games with $1 on the line each time. I contend that the one-game option is more analogous to to businesses with lots of "lock-in" or "network effects". c) a relatively short history - if a funding cycle for a VC is several years, and most venture firms haven't been around no more than a couple decades, that's not a lot of generations for funding strategies to prove themselves, especially in the presence of randomness (see b).
- mattmaroon 18y ago
  d) high barriers to entry e) well-known collusion

pmjordan 18y ago

I had the same thought, especially after reading this part: The management team was eager to sell because much bigger players were moving into their space and they had concluded that it would be much harder to win new contracts in the future. They also believed that because the big players were getting excited about their space, they would probably get the best valuation now. I know VCs talk about the 3 buckets (big winners, getting investment back, belly-up) but it seems crazy they'd turn this down that just happened to fall somewhere in between. It's possible (probable!) that we don't have all the information available to them at the time. Maybe they foresaw some opportunity for it turning into a big winner.

tlb 18y ago

Actually, not. A 3x return over 10 years is 11% annually. Subtracting VC fees (say 2% management and 30% take) brings that down to about 6% for the LPs. VCs have to deliver much better returns than that. Also, don't underestimate the cost of an acquisition. Not just the few $100k in legal fees. Generally it means they have to distribute proceeds to the LPs, and they're exposed to various liabilities if the acquisition goes badly. Assuming they get restricted stock in a public company, selling it is a complex procedure. They may be prohibited in trading in that acquirer's stock while the acquisition is pending, which complicates other deals. Sad to say, but you really can't run a fund with only 3x returns.

mattmaroon 18y ago
That's not true because of the way the money comes in and out. They don't bring in the money for the entire fund in the beginning, or wait and pay it out at the end. The actual time period over which that 3x would be realized is considerably shorter than 10 years. The 10 year mark is just where any going concerns that still haven't exited are purchased by a new fund or dealt with in some other way. Also, it's closer to 12% annually. And VCs don't take 30%. It's generally 20-25. For a detailed explanation, see this article which shows that a fund that returned 3x would net investors about 30% annually: http://www.vator.tv/news/show/2008-08-03-venture-capital-economics http://www.vator.tv/news/show/2008-08-03-venture-capital-eco...

netcan 18y ago

It might be rational. Supposedly, they are looking for 10X-30X. If they expect a >20% chance at a 15X return or some variation of that. Also their strategy may be to not make decisions 'as they go'. That eliminates the need to actually be able to make the above estimate, something that probably requires a bit of an understanding of the specific business. They might not expect to do much better by making decisions on the fly then they would by following a simple rule, not enough to justify all of the analysis time. They might expect to do better this way, like rule based stock market investing. When it comes down to it, it's not really an issue with 'the VCs are dumb.' They may have been. But if so, only slightly. They also may not have been. The bigger issue is the discrepancy in risk tolerance. That's not really news.