Fred Wilson from Union Square Ventures, had a recent post on his blog that I thought deserved a comment of my own, about ‘Venture Fund Economics.’  What Wilson said in his post is a much more aptly worded way of what I was trying to say in this previous post about venture investing.  From that post a few months ago …

… [T]he investment strategy is very simple.  The managers will put the $250mm to work in let’s just say an average of $5mm investments.  This means they will do a total of 50 deals for the fund in efforts to allocate all of the capital. 

With an exit strategy of either an acquisition or IPO, you assume a 10-15% (many times higher, but also lower) success rate of your portfolio companies.  Let’s just say 10% of your portfolio companies make it to a successful IPO priced in the $2.5 billion range.  Investing $5 million in the company, you probably came in at a series A and you could have retained about 10% equity ownership in the company after being dilluted from subsequent rounds of financing.  Ultimately, you own roughly 10% of five companies that have a market cap of greater than $2.5 billion and are priced as much when hitting the public capital markets.  That turns out to be pretty nice returns on your original $250 million worth of capital.  What happens to the other companies you’ve been spending all that time with for the past few years.  Nothing.  They’re an afterthought. 

I think this is an appropriate topic for anyone aspiring to get into venture capital investing, because if you will read many of the blogs and material out there from VC’s and mainstream media, they will undoubtedly attempt to overcomplicate this process, ultimately trying to make it appear much more complex than it really is. 

I don’t want to minimize the level of complication that can go into venture deals.  Indeed, some deals become very complicated, many times to the detriment of the entrepreneur and investors.  However, the macro view of the venture investment landscape is very straightforward, and this should be understood. 

The reason I am pointing this out now is because I have been reading and thinking a lot lately about the attitude that people outside the VC community, as well as many people within this space, have towards venture investing in general.  It is gravely misunderstood, the primary reason for which is due to peoples’ attempts to overcomplicate the processes and structure involved in venture capital.

Another reason this is relevant is because I believe some of the dynamics are changing.  As we have already seen the number of venture deals and IPO’s decline, allegedly as a result of the credit crunch, I believe the boom of venture deals, and thus the returns, will continue to see some declines in the next few years.  Again, this is very simple.  Institutional investors’ capital is across the board lower.  Therefore, the allocations that will go to private equity, and specifically to venture stage deals, will decrease.  So, those billions of dollars that were almost wantonly being allocated to venture firms in the past three to five years will inevitably go down.

Will this hurt venture capital?  I do not believe so.  Many of the VC’s out there today are more concerned with managing their current funds and LP’s, making sure their active investments do not go bust.  Raising capital for new funds has become a bottom of the list item for now. 

A more important question to consider, though, is how this will effect the abililty of new ventures to raise capital and thus grow to become competitive firms, eventually launching into the public markets?  I have argued before that I think we will see the number of venture-backed IPO’s come back around as the economy and markets rebound over the next few years.  This is a cyclical thing.  However, there’s a simple process here, thus a potentially simple cause and effect relationship between the lower amounts of venture capital leading to declines in the amount of new ventures funded, ultimately resulting in the number of venture-backed IPO’s remaining low. 

So, venture capitalists can attempt to make the process complicated and they can come up with all kinds of speculation as to why and how the VC space will evolve over the next couple of years.  However, what the markets need to understand is that the true ‘economics’ of venture capital can tell us a lot about where VC is going and what the future will look like for the major VC players.  My hypothesis:  we will see a lot of the old players bow out and new players come up to take advantage of a new stage in this evolving marketplace.