Implications for entrepreneurs and venture capital ecosystems

by The Insights

In a great article on early-stage venture capital (VC), former VC Andy Rachleff notes that the top 20 VCs, or about 2%, earn about 95% of the VC profits. Is it true? For what? What are the implications?

Here is Why few VCs earn most of the benefits of VC:

Home runs are key to VC returns, as VCs fail on about 80% of their investments. Only about 19 are hits and one is a home run, and these profitable businesses have to pay for the misses and offer a return. Venture capital portfolios that do not have home runs will not appear in the Top 20 (Designing Effective Venture Capital Funds for Regional Development: Bridging the Hierarchical and Equity Gaps Dileep Rao, Applied Research in Economic Development, 2006. Volume 3. Number 2).

· Due to the high level of losses in its fund, Y-Combinator (a well-known Silicon Valley incubator) reportedly performed poorly in its fund which included an investment in Google.

· Rated VC Netscape’s Marc Andreessen and Andreessen Horowitz note that around 15 companies are expected to account for around 97% of VC returns. VCs that fund these companies are likely to be in the Top 20.

So whether it’s 20 VCs or 40, and 15 home runs or 30, the reality is that there are very few home runs, and VCs have to invest in those few VC home runs if they want to be in the Top 20.

Here is how the top 20 VCs invest in potential circuits and earn the most returns:

· They hunt where the home runs roam. VCs do not start shopping at home. Entrepreneur-unicorns do. And unicorn entrepreneurs have mostly been in Silicon Valley. That’s why VCs have mostly succeeded in Silicon Valley.

· Importantly, the top 20 VCs are investing at the best stage of the business for VCs. VCs need to see evidence of potential, i.e. Aha, to achieve high returns and lower risk. Rachleff notes that the top 20 VCs fund after the value model (Strategy Aha) and before the growth model (Leadership Aha) for better value and reasonable risk. After the Aha strategy, business leadership is the key objective. This is one of the main reasons why top 20 VCs often replace the entrepreneur, like Pierre Omidyar (eBay) with a professional CEO, in order to grow faster and increase the chances of leading the emerging industry. Risk-averse VCs (an oxymoron) invest after Leadership Aha. But then, the potential of the business is obvious to all VCs and the high interest of VCs in investing puts entrepreneurs in control. Entrepreneurs such as Jan Koum (WhatsApp) and Mark Zuckerberg were able to select their VCs and dictate terms. Strong demand is also increasing valuations and reducing annual returns.

Implications for VC-based ecosystems outside of Silicon Valley

The belief that there is a shortage of venture capital because so many “deserving” entrepreneurs are being rejected, and the assumption that anyone can succeed in venture capital simply by setting up a fund, has led the launch of numerous targeted venture capital funds. Few seem to be asking the right question: if there was such a shortage, why do so few venture capitalists succeed and why do so many venture-backed companies fail? To get high returns outside of Silicon Valley, venture capital-based ecosystems need to develop unicorn entrepreneurs to start potential unicorns.

· Without home runs that can be made public, VCs cannot earn the huge returns that public valuations offer in times of euphoria. This means that VCs outside of Silicon Valley must primarily exit via strategic sales, but few of those strategic sales yield returns.

Regions outside of Silicon Valley that are launching venture capital funds should instead focus on developing ecosystems based on the unicorn entrepreneur if they want lasting success.

Implications for entrepreneurs and entrepreneurial ecosystems outside of Silicon Valley:

· Entrepreneurial (EE) ecosystems outside of Silicon Valley need more Unicorn entrepreneurs who have the skills to start and launch VC-free home runs. They can learn from the 94% of Unicorn entrepreneurs who avoided or delayed VC.

· Regions that use VC to develop high-growth businesses have another problem. For their businesses that are hits, but not home runs, the most likely exit will be via strategic sales where the business is sold to an acquiring business that can move the business and its potential growth elsewhere. The zone does not win.

Implications for sustainable development

· All the additional constraints on business development reduce the range of investment options. This means that VCs that fund “sustainability” have a smaller universe to fund, with a lower probability of home runs. It also means that sustainable developers must reduce risk and increase potential by developing Unicorn-Entrepreneurs who can grow more with less. .

MY OPINION: Few VCs outside of Silicon Valley succeed because they try to build unicorns using venture capital ecosystems, which is a frontal assault on Silicon Valley. They would do better by building the entrepreneurial ecosystem and launching a guerrilla war.

Wealthfront BlogDemystifying the economics of venture capital, part 1 | wealth front
NY TimesOnce Low-key Venture Capital Firms Learn the Promotional Game (published 2012)
Tech CrunchWhy Angel Investors Don’t Make Money…and Advice for People Who Are Going to Become Angels Anyway
MORE FORBESFlips, flops and unicorns: where will you fit in the VC portfolio?
Wealthfront BlogDemystifying the economics of venture capital, part 1 | wealth front

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