Written by Brian Bernstein, Chairman of the Miami Venture Capital Association.
With Herwig Konings, Waylon Chin, Sebastian Gomez-Puerto, and Philip Mershon.
Miami will never be a great startup ecosystem unless we dramatically change the way that the venture capital business works in our city.
In our last article by Mike Lingle, we discussed how Miami was on its way to becoming a top entrepreneurial ecosystem in the country. The city has many factors that are currently working in its favour. But we are missing a critical piece: A venture capital industry specifically tailored and intentionally designed to meet our city’s needs.
This is why Miami leads the country in startup formation, but has a huge series A gap and as a result is second to last when it comes to startup growth.
What is at stake? If we don’t restructure our practice of entrepreneurial finance, we fail the bigger mission. Miami entrepreneurs go unfunded, leave the city, fail to build great businesses and change the world. We don’t create jobs, attract talent to our city, and become the great metropolis that we ultimately can be.
HOW TRADITIONAL VC FALLS SHORT FOR MIAMI
Let’s be honest, the reason the venture capital business isn’t working here is that it almost never works anywhere. There is a huge cognitive dissonance between what people believe about the venture capital business, and what is actually true. By taking a hard look at entrepreneurial finance today, without our presuppositions of “common knowledge,” we can correctly identify the issues that must be addressed if we are to create a productive venture capital industry in this city, a commensurate boom in entrepreneurial activity, and success in the form of exits.
The traditional VC model is broken for all but the best funds. This point becomes obvious when one examines outcome for two key stakeholders in the VC ecosystem; Limited Partners and Founders/Entrepreneurs.
WHY VCs GENERATE POOR OUTCOMES FOR LPs
The traditional early-stage VC model is broken for all but the best funds for the following reasons:
- The strategy that most venture funds follow does not produce acceptable returns to investors.
- This results in most funds going into the asset management business as opposed to the performance business.
- That investment managers have too small of a percentage of their net worth in their funds.
Today, a majority of venture capital funds make a lot of small bets on hundreds of companies, where they get minority positions with little control. For the purposes of our conversation, we will call this the “spray and pray” method. These professional investors make these bets with the full expectation that 99% or so of them will fail, and that 1% will return a multi-billion dollar exponential payoff, bail out all the losing positions, and maybe give them a nice cut of the backend profits. It’s like playing the lottery with your money hoping the winning ticket is Uber or Facebook.
Note, not all venture funds follow a spray and pray methodology, as funds have gotten larger, some function more as a bridge to public markets. Some industry-specific funds or value-based strategies have much lower loss ratios. Yet the industry level returns will still tell the story, that we need specific innovation for capital formation for our city.
This creates some weird behaviour. Imagine for a second that you are a venture capitalist. Your job, every time you meet with a company, is to ask yourself if there is a one percent chance that it will be a billion-dollar business. If it is, you write a check. Not only that, but you need to write a check every week or two, and you meet with ten new startups a day. So if you are a partner at this hypothetical VC firm, and you buy into the logic of getting very few exponential winners, your negotiating and structuring your deals will take a perverse deviation from what is common business sense. Namely, you will waste LP money and overpay on the way in, because if the deal exits for billions the entry price shouldn’t theoretically matter. Second, you absolutely will not exit a deal for a reasonable multiple of 2x, 5x, or even10x, because you need a 30x to pay for the other losing deals. So chances are, any one of your deals, considered severally and not jointly will be a poorly negotiated and structured investment.
In our example above, the best theoretical argument the GPs have for their strategy is that venture capital returns obey power laws – simply stated, the more companies you invest in, the greater the odds that one will be a massive winner. Thus, someone who writes 1,000 checks has a better chance of getting into a massive winner than someone who writes 10 checks. Indeed this strategy works well for probably the top 30 or so funds in the world. Yet power laws alone don’t explain the top thirty funds returns, and they don’t explain why everyone else doesn’t succeed on the same strategy.
Benchmark Capital’s Andy Radcliffe explains:
“Cambridge Associates, an advisor to institutions that invest in venture capital, says that only about 20 firms – or about 3 percent of the universe of venture capital firms – generate 95 percent of the industry’s returns, and the composition of the top 3 percent doesn’t change very much over time.”
The top 30 or so funds in the world are oversubscribed with potential investors, as you would expect. You can’t get into them, and they aren’t doing deals in Miami. Therefore they don’t matter in determining an optimal investment strategy for funds in Miami. So let’s discuss all of the rest of the funds in existence, specifically the ones that are likely to operate or already operate here. If we strip out the top 30 funds from our industry-level analysis, we find that venture investors consistently lose money in the aggregate. At the end of the day, the one number you have to focus on is how much do you invest in a fund (paid in capital) and how much do you get back (distributed capital).
From How Venture Capital is Borken on Reuters:
“If you look at the performance of VC funds during the golden years of 1996-1999 it turns out that once you strip out the top – performing 29 funds, the rest, more than 500 collectively invested 160 billion, and managed to return 85 to investors. If you can’t get into one of the best funds – and everyone knows who those funds are – then there’s really no point investing in venture capital at all ”
From the 2011 technology review’s What’s Wrong with Venture Capital:
“But of late it also seems like the difference between the historical image of venture capital and the harsh reality of the current business….In recent years, however, the industry has seemed less magical than mundane. Since 2004, the average 5-year return has oscillated around zero. High priced IPOs have become rare events, even as VCs have continued to pour tens of billions of dollars into new companies every year. As Fred Wilson, principal of union square ventures bluntly puts it “venture capital funds, as a whole, basically made no money the entire decade.”
The problem is, venture funds today show paper profits on unrealized positions. They claim that Uber is worth x billion, and they have y shares, so their position is worth z. These valuations are not set on a public market, and there are no buyers for those shares at the inflated prices. What’s more, VC firms use a term called a liquidation preference, which deals with how proceeds from a sale of a company are handled. If you have a company that has raised ten rounds of venture money, knowing how many shares a VC firm owns is nearly useless in calculating their return, you need to know the preference stack of all other positions in a liquidation. Now, if you add on Dodd-Frank, Sarbanes Oxley, and the ever-shrinking IPO window, we realize that VC’s aren’t selling their positions on public markets because in most cases their paper profits would evaporate.
“What do LP’s think of VC markets for 2016. “LPs have been feeling great about venture capital due to holding valuable paper positions in companies like Uber and Airbnb that they feel confident will drive large cash distributions in the future. But they have been sending VCs way more investment checks in the last ten years than they’ve gotten back as distributions. In fact, if you add up capital flows of the past ten years, there has been just shy of 50 billion in cash outlays.”
So we know that the spray and pray method doesn’t work anywhere, and definitely won’t work in Miami. People think it works because they look at industry level returns, but when we strip out the top 30 funds, we get a more accurate picture.
If venture funds aren’t making their investors’ money, why are they in this business? The answers is fees…
So how do venture capitalists make money? Historically, Venture Capitalists were paid 2% of the capital their fund raised every year in order to cover the management expenses and salaries of the fund. Given what we know about industry returns above, this creates the following problems:
“This fixed 2% fee structure creates the incentive to accumulate and manage more assets. The larger the fund, the larger the fee stream. Raising bigger subsequent funds allows VCs to lock in larger, and cumulative, fixed cash compensation. The 20% carry, in contrast, is paid sporadically (if there’s any generated), not until several years after the fund is raised, and is directly tied to investment performance (or lack thereof).
Given the persistent poor performance of the industry, there are many VCs who haven’t received a carry check in a decade, or if they are newer to the industry, ever. These VCs live entirely on the fee stream. Fees, it turns out, are the lifeblood of the VC industry, not the blockbuster returns and carry that the traditional VC narrative suggests.”
VCs are paid very well when they underperform. VCs have a great gig. They raise a fund, and lock in a minimum of 10 years of fixed, fee-based compensation. Three or four years later they raise a second fund, based largely on unrealized returns of the existing fund. Usually, the subsequent fund is larger, so the VC locks in another 10 years of larger, fixed, fee-based compensation in addition to the remaining fees from the current fund. And so on. Assume it takes three or four funds for poor returns to start catching up with a VC firm. By then, investors have already paid for nearly two decades of high levels of fixed, fee-based compensation, regardless of investment returns. And the fee-based compensation isn’t trivial – in all but the smallest funds, the partners make high six, and more often seven, figures in fixed cash compensation.
Investors have perpetuated a compensation structure where VCs can generate significant personal income over their career, even when they make no money for their LPs. This payment structure perpetuates the economic misalignment between VCs and LPs, fails to create strong incentives to generate outsized returns, and most importantly, insulates VCs economically from their own investment underperformance.”
The author continues – and this is an important point for our analysis – VC’s rarely invest material portions of their own net worth in their own funds:
“VCs barely invest in their own funds. The “market standard” is for VCs to personally invest 1% of the fund size, and for investors to contribute the remaining 99%. It’s an interesting split, considering that, to hear VCs tell it in a pitch meeting, there is no better place to invest your money than in their fund. Pick up any pitch deck, slide presentation or private placement memorandum and read about the optimistic projections about the VC industry, the fund’s unique strategy, the incredible market and technology trends that support the strategy, and the impressive team of investors that generates “top quartile” returns. The future has really never looked better! Yet, when it comes time to close the fund, there’s hardly a VC checkbook in sight. In fact, many VCs don’t even invest in their fund from their personal assets, instead contributing their investment via their share of the management fees.”
This is probably the most material point so far. If you are an investor, you want your fund manager to be as dependent on a successful outcome as you are. Imagine if an entrepreneur with several million dollars in savings came to you asking you to invest a few hundred thousand dollars into their seed round, but wasn’t putting in any of their own money. You would run, not walk away, from that deal. Alternatively, if you are an entrepreneur, it should greatly anger you that your VC expects you to have all of your net worth in your business, and do have your livelihood dependent on a successful outcome, but not see the same from them. If a deal or fund is really great, why aren’t the promoters taking as much of it as they can for themselves? Once they know they are truly great investment managers, why do they keep raising more money instead of just running their own? For those who are not emerging managers, do they have a real audited track record of positive returns on a distributed capital basis?
At the end of the day, any private equity investment is very illiquid and very risky. Therefore, most investors want to be compensated for the increased risk and lack of liquidity versus a public market benchmark. This has been said to be 3-500 basis points above public market equivalents, or 18 % IRR, depending on who you are asking. Let’s remember that what matters is returned capital, not paper asset values.
VC OUTCOMES FOR ENTREPRENEURS AND FOUNDERS
From a founder’s perspective, it’s best to think of VC money as debt with an exceedingly high cost of capital. As an entrepreneur, you are paying an incredible price for this money over time. VC is senior in the capital stack to the founder’s equity, has an extremely high cost of capital, and is covenant heavy. Because a VC expects you to fail 80+ percent of the time, they have no problem increasing the operating risk of your business far higher than it needs to be. While mid-market exits can make founders millionaires and change their lives, if one of a spray and pray portfolio’s few big winners exits early, it would doom the portfolio. The way to think about it is VC money is like a loan that over-leverages a business, increases its risk of bankruptcy materially, and lowers the odds of survival and success. Not to mention the high-pressure environment this demand for insatiable growth creates for the entrepreneur. To be fair, some markets truly are winner take all, and an entrepreneur needs to take as much risk as possible to be the number one company in the marketplace. That being said, should an entrepreneur really risk their livelihood in such a risky industry vertical when only one out of dozens of startups will become the company with dominant market share and positive economics?
Let’s put in some concrete numbers. Brandon Evans writes:
“As founders, we are essentially forced to play the lottery. The odds of a venture backed startup becoming a unicorn is less than 1%. Factor in that less than 50% of startups even raise venture capital and you are looking at less than a .5% chance from Day 1. So less than five out of every 1,000 founders “win” by today’s rules.”
But what happens to the other founders? Depending on how much the company has raised and the preference they’ve given to their investors, it will often take $100M+ exits for the founders to see any significant money. Those exits are also rare. Approximately 57 out of 2,196 founders of startups will achieve those, or 2.6%. For the other nearly 98%, things look quite different.
So failure rates for entrepreneurs are high, VC’s make safe six to eight figure incomes on the fee stream, and the entrepreneurs? Close to minimum wage…
• “50% of founders make an average of $5.61 an hour. This accounts for the founders who bootstrap but fail before raising institutional funding or reaching independent profitability. The assumption was that this group of founders bootstrap for the first six months and raise some friends and family money over the next six months.”
• “20% make an average of $14.12 an hour. This group raised seed capital but failed to raise a Series A or exit. At this point they’ve clocked 32 months well below the living wage for family of four with two working adults.”
• “5.4% make an average of $21.23 an hour. This group raised a Series A but failed to raise additional capital or exit. They’ve spent an average of 53 months building their startups while just getting by.”
• “4.4% make an average of $28.31 an hour. This group raised a Series B but failed to raise additional capital or exit. They’ve worked hard for six years at wages in line with a good administrative assistant.”
• “That leaves 20%. That 20% likely reached higher average hourly rates by raising further rounds of capital and/or exiting. But as discussed earlier, only about 2.7% of them likely had a significant windfall. The others still capped out at wages a fraction of what their talent likely would have garnered in the open market.”
The author then goes on to add that venture capital should come with a warning label, and that new paradigms should include metrics for founder survival and success as a percentage of total portfolio companies in a fund. The spray and pray and grow at all costs paradigms hurt the city, because for all of our startup formation, we never get anywhere. If we change to a grow slowly mentality, and build true value, startup survival rates would take off, and we would end up with sustainable entrepreneurship year over year. More importantly, founders would have the ability to get early exits, and recycle their capital through the ecosystem.
THE FUTURE OF FINANCE FOR MIAMI STARTUPS
The VC business doesn’t work for most investors, and certainly not those in Miami. If it did we would have a venture industry that was substantially larger in proportion to all of the massive wealth in the city. It doesn’t work for most entrepreneurs here, as they often complain about the lack of good funding options, and minus an outlier here or there, there is a lack of publicized and disclosed exits making anyone rich.
So why do startups and funds continue to advocate an excessively high-risk high failure strategy, when it clearly fails most stakeholders? In my opinion, I believe it comes from the fallacy that most people think they are special, above average, and destined to defy the odds and beat the house in the casino.
“Venture-funded companies attract talented people by appealing to a “lottery” mentality. Despite the high risk of failure in new ventures, engineers and businesspeople leave their jobs because they are unable or unwilling to perceive how risky a start-up can be. Their situation may be compared to that of hopeful high school basketball players, devoting hours to their sport despite the overwhelming odds against turning professional and earning million-dollar incomes.”
If we are objective, we know that most investments earn market returns for the strategy and asset class over time. We know that if executing a spray and pray strategy is likely to lead to failure, it must be abandoned or modified to something that will produce acceptable returns, and help businesses grow.
Over the course of this year, the Miami Venture Capital Review will be giving you our cutting-edge thinking on new paradigms of investment best practices and company building. Our intention in this article is not to indict or condemn, but to show why the current way venture investment has been practiced has not resulted in a robust entrepreneurial ecosystem in Miami.
People are profit motivated. If investing in startups actually makes them money, they will do a lot of startup investing. If investing in venture funds makes them money, they will allocate more capital to the asset class. If they do both of these things, entrepreneurship will thrive in our city. Let’s stop talking about how great startup investing is, and prove it with real results.
The final idea I want to leave you with is that startup investing is a double-sided marketplace. Your work doesn’t end when you put money into a deal, you have to get it out. That requires active work by fund managers with their M&A advisors, investment bankers, lenders, and strategic acquirers. If anyone talks to you about a fund and all of the discussion is about putting money to work, and none is on selling and getting it back; or if you hear vague words placed together like “Facebook” “Uber” “IPO” “billionaire,” or “unicorn”, run away from that meeting. At the end of the day money talks, and we need our city to be one with results.
Brian Bernstein is the Founder and Chairman of the Miami Venture Capital Association. He is also a principal at Harris Bernstein & Co., a venture investment firm, M&A advisory practice, and fund formation consultant.
