A slightly dated (in internet terms) – but still a hugely insightful article on the economics of a VC firm and why VCs behave the way they do. As good friend Sumanth Raghavendra (CEO of Instacoll) put it: “definitely guffaw-worthy!”
David Gammon, a Cambridge, UK based angel investor, posted an addendum to the article which is also very readable:
a) The client of a VC is not the investee company but the LPs whose money the VC manages. This is the first fundamental flaw made by all companies seeking money from a VC. Viewed from this angle VC behaviors are very understandable. Entrepreneurs should take the trouble to try and understand the VC model before seeking funds from them and VCs might help this by explaining their model more clearly.
b) VCs do not undertake a shoot gun approach to investment – typified by public market investors who typically get a spread, invest in 50 or more companies and maintain a watching brief. VCs have to adopt the rifle shot approach to investment – i.e. concentrate the fund in a few well selected thoroughly researched opportunities. The prime reason, in my view, this happens is because information and data about private companies is so difficult of obtain. I think this is going to change in the not too distant future as providers of granular information, updated on a regular cycle, on private companies becomes more available.
c) Public markets operate through intermediaries – stockbrokers – who do a large part of the work which VCs have to do themselves. Private equity in the venture field is not intermediated. Stockbrokers make the information available to public market fund managers, disseminate it, arrange the deal, decide the terms, do the research, conduct the references, do the due diligence. All the public market fund manager has to do is make a decision – buy or sell. VCs have the entire onus placed on themselves. Personally I view this as an inefficiency (and opportunity) in the industry.
d) There are many more arsehole companies seeking money from VCs than arsehole VCs. When I established the private equity advisory business at Credit
Lyonnais it staggered me how many rotten, sometimes fraudulent and hopeless propositions came past my desk. VCs have to be cautious because many have learnt the lesson the hard way.
e) When it comes to exit you have the financial asset cycle. Equities as an asset class experience PE value ranges from 5x to 30x for the same asset at different points in the financial cycle. In my experience neither VCs nor entrepreneurs have any understanding of this cycle, how it works, where it comes from. A VC can make just as much money playing this cycle as public fund investors but none of them seem to strategically do so. In about 2000 Durlacher almost came in the FTSE100 entrant with a market cap in excess if £1bn. Thus a company without a jot of substance can be worth £1bn or £10m depending on the timing of that asset’s valuation in the financial cycle. As a broker who had the responsibility of determining which issues we IPOed or not it was a constant struggle to explain and justify valuations. At the end of the day it is the market and nothing else that makes the valuation. So far no one has come up with a model that can predict this. You can spot and play the trend though. VCs try to understand value by reference to their own set of criteria – the company fundamentals – which sadly have very little bearing on market value in general. Entrepreneurs in this case are just as poor judges of their value as the VC.