Most people with an interest in Venture Capital know that the returns in the asset class are extremely skewed: a small minority of VC funds make most of the money. A handful of VC firms seem adept at replicating this success across fund vintages. How do they do it?
Note: this blog post was updated in October 2020 with Morgan Stanley data on VC returns
Even people unfamiliar with VC understand that it’s a high-risk industry. Most startups go bankrupt, even – maybe chiefly – VC-backed ones, who play the Go Big or Go Home game.
What is often more surprising is that these statistics are the same for the best VC firms. The top firms don’t lose less money. They make considerably more returns from a tiny fraction of their investments.
In early-stage VC, you don’t get to the top by playing it safe. If anything, elite firms such as Sequoia, Benchmark, and Andreessen Horowitz take more risk than others.
The Power Law In Venture Capital Returns
Most longitudinal analyses of VC funds’ returns bring the same conclusions: a minority of the funds make most of the money in the asset class (the power-law distribution); and the firms who own these funds tend to be the same.
As the graph below shows, two-thirds of investments made in 30,000 startups globally over 1995-2018 returned less than the money injected.
However, as the same report points out, the long tail of VC investments make more returns in total than the other asset classes.
The Issue of Persistence
Another feature of Venture Capital is that the top firms tend to remain at the top. Most of the elite early-stage VC firms today have been around for decades. Think of Sequoia Capital (1972), Accel (1983), Benchmark (1995), and Index Ventures (1996). One notable exception is Andreessen Horowitz (2009), which has paved the way for the Founder-CEO approach.
Data backs this characteristic of Venture Capital.
What the table above shows is that, on average, the successor of a top-quartile fund is likely to be followed by another top-quartile fund by the same VC firm – and conversely:
- When a VC firm’s first fund was in the top quartile compared to other funds of the same vintage, it had a 49% probability to have its second fund in the top quartile (green box);
- If the first fund was in the 4th quartile, the following fund was more likely to perform similarly (red box).
This trait remains valid across time periods, by and large.
A Higher Dispersion
Another characteristic worth noting is that returns vary highly by VC firms. Although average returns for the asset class have been poor over the long term (most estimates place it at close to 0), the very best funds are making a lot of money, and the worst ones are losing a lot of money.
One way to look at it is that a handful of VC firms make all the returns in the asset class.
Roughly half of venture capital investments lose money – about 5% generate 3/4 of the returns. And the average exit for a VC deal is eight years – it’s the longest term capital there is— Benedict Evans (@benedictevans) May 3, 2020
One explanation often given for the characteristics highlighted above is access to better deal flow: the best VC firms attract the best Founders, who produce the best returns.
We believe that another explanation can be added: the approach to risk and failure of the best money managers in VC has a lot to do with their continued success, which tends to last across generations of General Partners.
Elite VC Firms’ Secret: Taking More, Not Less, Risk
Many Silicon Valley Venture Capitalists like sports.
If you follow them on Twitter, you will quickly realize they often tweet about Trump, their daily lives, startups, and favorite football or basketball teams. (You can follow our list of Top VCs on Twitter.)
But the sport that is closest to their business model is baseball. Just like baseball hitters, financial investors are thrown a lot of balls (i.e., investment opportunities) but very rarely hit a home run – that one deal that returns an entire fund.
Hall of Fame hitters and Midas-List VCs share another characteristic: they repeatedly make big bets that pay off. Persistence seems to be true also at the partner’s level.
Recent examples include Jim Goetz (Sequoia), who topped the Midas List four years in a row, or Neil Shen (also Sequoia), who’s been the number 1 for the last three years. Since the list exists, many VCs have been in the ranking consistently, such as John Doerr (Kleiner Perkins, 15 years), Michael Moritz (Sequoia, 15 years), and Jim Breyer (formerly at Accel, 14 years).
Measuring VC Partners’ Performance
How do they do it? It seems that the best VCs often pass on deals that others take.
They are looking for above-average returns, not a safe bet. Such performance can only be achieved by taking more risks than their fellow investors.
Another way to put it is that top VCs favor efficiency over activity.
In baseball, the measure for a batter’s activity is called the ‘batting average’. It’s calculated by dividing the number of hits by the number of times the hitter was “at bat”, i.e., in front of the pitcher (1).
Batting Average = Hits / “At Bats”
A comparable statistic in VC would be the number of times the investment returns at least the money divided by the number of deals closed.
VC Batting Average = Deals Returning Money / Deals Closed
Since most VC investments end up losing money, a good batting average would mean the VC partner is playing it relatively safe.
As Fred Wilson outlined in a post already ten years old, maximizing batting average is fine for late-stage VC firms. They get their money back and change, in line with the “lower risks / lower returns” principle.
However, early-stage VC firms promise 25%-30% IRR to their Limited Partners, which translates into a 4x gross / 3x net multiple on cash. (If you want to know more about how VC funds work, we run an Excel-based live webinar as part of our VC Investing track.)
Since half of the portfolio will burn to ashes (strikeouts), and a large proportion of what remains will make 2-4x the money invested (second- or third-base hits); then, the last couple of bets need to return the entire fund at least 1x (home run).
Bill Gurley, one of Benchmark’s star partners with early investments in Uber, Stitch Fix, and Zillow, takes a tennis analogy to describe how VC funds’ performance is measured.
The Best VC Partners Favor Productivity Over Activity
The kinds of returns Fred Wilson and Bill Gurley are talking about can’t be achieved by playing it safe.
Investors are limited both by the capital they have at their disposal but also their time and attention. They need to carefully pick which startups they invest in and which ones will receive follow-up financing. That’s why it is said Venture Capital is “narrow but deep.”
Firms like Andreessen Horowitz are known for their ‘all-in’ approach, to take a poker analogy.
Focusing On The Slugging Percentage
Just like the Hall of Fame hitters, the top Venture Capitalists are patient and disciplined enough to let a good (but not great) investment opportunity pass by.
They want to make sure they wait for the potential home run.
In baseball, the statistic that best captures this ability to take risks that pay off is called the slugging percentage. It is calculated by multiplying the number of base positions by that position and dividing the total by the at-bats.
Slugging Percentage = (Singles + 2x Doubles + 3x Triples + 4x Home Runs) / At Bats
Contrary to the batting average, the slugging percentage doesn’t capture activity but efficiency: when they hit the ball, they hit it big.
According to baseball experts, a high slugging percentage requires more than hitting mastery. The critical qualities are patience, the willingness to take huge risks, and the capacity to absorb strikeouts.
These are not typical traits in VCs. Many feel they need to invest in as many deals as they can to tip the probability scale in their favor. In an industry where losing money is part of the job, many professionals believe they should go for quantity over quality.
Jules Maltz compares the experienced hitter, who carefully studies the opposing pitcher’s style to gain an edge, to the experienced investor who learns about a specific market’s trends and dynamics before investing in it.
What Baseball Data Tells Us
To push the baseball analogy to its limits, we analyzed a thorough set of statistics for the five MLB players with the highest levels of strikeouts.
Common belief would expect them to be average players. Their batting average seems to confirm this sentiment. Four of them are close to rank #1,000 or below.
But look at their slugging percentages. They are all below #150. As a matter of fact, two of these players are Hall of Famers (one is none other than Reggie Jackson), and two more hold MVP titles.
This analysis shows that the willingness to make big bets pays off over the long term, even though you end up hitting less than others.
A New Method To Calculate VC Performance?
Instead of ranking investors based on the amount of money they return, why not look at their investing efficiency?
The formula could be adapted from the slugging percentage calculation in baseball.
VC Efficiency = (a*1 + b*2 + c*3 + … + j*10) / Deals Closed
Where ‘a’ is the number of times an investment makes a 1x return, ‘b’ the number of times an investment makes a 2x return, and so on.
Such an approach should normalize for luck and expose the play-it-safe approaches.
One last word: if you like baseball and statistics, watch Moneyball. The Brad Pitt-Jonah Hill duo demonstrates another similarity between VC and baseball: you don’t need a roster of all-stars to win but players who are complementary to each other.
(1) Diehard baseball fans will object that “at bat” is not the same as “at plate”. They are right, and the difference is explained here.