note: the article below was first published yesterday in BusinessWeek -- please check it out.
Troubled VCs need to rethink how long they invest in startups; many
should fund early and then sell to a secondary firm after a few years
There's plenty of fretting in Silicon Valley and beyond over the
venture capital industry, how broken it has become, and what needs to
be done about it. Proposed solutions abound, with some favoring a
government bailout, others saying the ranks of venture capitalists need
to be slashed dramatically, and some proposing the creation of a market
where equity in startups is bought or sold like shares of publicly
traded companies. Each has its merits and weaknesses.
But in my view, what's needed is a fundamental rethink in the way
startups get backing. VCs need to take a fresh look at when they
invest, and for how long. VCs and other investors that have expertise
in early-stage companies ought to invest at the outset for a few years,
but then sell to companies that specialize in—and have more to
offer—more mature companies. To understand why this approach makes
sense, consider the shortcomings of the existing model.
Currently, many investors buy stakes early on and then add to those
investments in later years. For instance, a typical early-stage firm
might invest $3 million to $5 million in what's known as an A or B
round. Then over the life of a startup, they'll put in another $3
million to $5 million to maintain their share of ownership and the
rights that come with it. The model has been sacrosanct for the past 30
years.
A 10-Year Life But the wait for an exit, through an
initial share sale or a buyout, can take a decade from the time of the
A round. Remember that most VCs have a "life" of about 10 years. And
if, say, a VC invests in a company in year three of its fund, there's a
good chance the firm will be managing the investment past the life of
the fund.
What's more, the time to exit is getting longer, not shorter. Companies like YouTube, purchased by Google (GOOG) for $1.65 billion less than two years after it was founded, are rare. In the future, big wins will more closely resemble Zappos,
an online apparel retailer. Zappos is incredibly well run, and all VCs
wish it were in their portfolio. But Zappos is having its 10-year
anniversary this year, and it might be another few years before its
exit.
Longer waits are bad not just for the VC calculating the return on
investment (ROI). They also result in impatience on the part of limited
partners such as university endowments that invest in venture firms.
It's also demoralizing for individual venture capitalists. There are
many well-regarded VC partners that have never had an exit. Some
venture capitalists are leaving the profession altogether and firms are shrinking.
Here's where secondary VCs can play a vital role. These firms, most of
which did not exist 10 years ago, specialize in buying stakes in
private companies from VC firms. Some examples include Saints Ventures and W Capital Partners,
which are among the most successful firms this decade. Secondary firms
now account for roughly 3% of the VC market, but their clout is
increasing as they do more deals. San Francisco-based Saints now has
more A-list portfolio companies than most traditional VC firms. Its
investments include Facebook, eHarmony, and QuinStreet.
Increased Return It helps that increasingly, many VCs are open to
selling their positions to secondary firms. While selling early will
lessen the long-term value of investments that become hits, it could
increase a VC's actual return on investment by letting them realize
returns much faster—say, three years rather than 10 years.
What's more, increased dependence on secondary investors will let VC
partners focus on what they do best. Different skills are required for
an A-round investor than for a late-stage investor. A venture capital
firm should deliver and focus on its core competency and move on. Just
like startups change CEOs as they mature, shouldn't companies change
VCs as they mature? If there is a good startup CEO, shouldn't there
also be good startup VCs? Some people can take a company from startup
idea to billion-dollar business, but most need to be replaced along the
way—this is true for both management teams and board members.
Early-stage VCs could focus on early-stage issues and later-stage
VCs could focus on later-stage issues. Their investing timelines could
be shorter, they can better plan for the future, and they'll need to
keep less undeployed capital, or "dry powder," on reserve. They'll
probably also do more deals.
My guess is that firms that invest in an A round might not
necessarily invest in the B round. Instead, they might look to unload
some or all of their shares in the C round.
Take Gains Early
I know a few angels who already follow this model. One sold half his
interest to a particular VC in the C round and later sold the rest of
his interest to that same VC. He made about 250% in three years. That's
not bad—especially when compared with the current market. Sure, he may
miss a big pop in share price. But he's become a very successful
investor through his strategy of taking gains early.
Why don't more VCs and angels follow this strategy? As an angel, I
have a lot of good advice for a company that's just getting off the
ground, but if I'm intellectually honest, I don't usually add much
value after the second venture round. Still, I haven't followed the
model I outline here. Maybe it's time I should.
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