Feb 27 2006

Q&A: VC Economics – Web 2.0

I received the following question last week. It’s a good one – very chewy – and my answer is given from my frame of reference (e.g. a managing partner in a large VC fund).  Consequently, I’m not sure that my answer is either generally correct or abstractable to all situations. How’s that for a hedge? The question is:

Do you agree or disagree with the following scenario as a firm basis for Web 2.0 ventures: Raise $2 to $6 million to be spent over a two to three year period, with an exit of a $20 to $50 million sale to one of the GEMAYANI’s. Would you adjust those numbers significantly, as a general thesis? Is such a venture model an attractive VC proposition, by definition, or maybe merely acceptable in the absence of a more traditional, larger-scale exit (say, raising $4 to $16 million with a $80 to $300 million exit after 4 to 7 years)? What model has the most appeal to you these days? Ultimately, it’s a question of what entrepreneurs should be shooting for. Implicit here is the question of whether Web 2.0 is a short-term window which may close in less than two to three years.

Let’s assume an median case where the $2m – $6m raised gets 50% of the company. In this situation, the VC firm gets half of the exit, which would result in a 5x return in the best success case and a 1.5x return in the worst success case. Of course, both of these assume the exit will occur – this only happens a small percentage of the time, so you have to risk adjust these numbers down by this amount (say 1 in 100 success case, although I’d assert given the number of startups in this domain, it’s probably 1 in 1000 right now.)  So – while the “invest $2m – $6m and return $20m – $50m is a reasonable thesis”, it’s missing the “how many times does this actually happen” multiplier.

While the exit numbers are ok, they aren’t going to move the meter on most VC funds with > $100m under management. While VCs need these kind of exits, they are typically looking for are both higher multiples and higher absolute returns, especially when you take into consideration the discount associated with the probability of success.  So – investing in this general thesis is limiting in a way that won’t be attractive for many VCs.

Now there’s been plenty of blogosphere chatter about how the VC business needs to be revolutionized, how new fund types that are motivated to invest in these outcomes should appear, and how “Advisory Capital” should play a role in all of this. All that is fine – but the second question that’s asked is the really interesting one.  What model has the most appeal to you these days? Ultimately, it’s a question of what entrepreneurs should be shooting for. Implicit here is the question of whether Web 2.0 is a short-term window which may close in less than two to three years.

I’ve always invested with the idea that I should be trying to build significant companies, rather than invest for a quick flip.  Occasionally I end up with a quick flip (and I’m always happy), but – if I see an opportunity to create something large, I’d rather go down that path.  Of course, everything is circumstantial – there is often great fit with an acquirer early in the life of a company and – when this is the case – it’s often in the best interest of all parties (entrepreneurs, buyer, VC’s, employees) sell the company and for the VC to move on (remember – a VC has a limited number of things that he can handle at any given time.)

So – the invest for a quick but modest return doesn’t appeal to me as an investment thesis.  However, I’m sure it appeals to plenty of other folks, including some VCs.  Subsequently, the real answer (from the entrepreneurs frame of reference) is to understand the investor you are working with, what his underlying economic motivation actually is, and ensure that you (the entrepreneur) are aligned before you take the investment.

As to whether Web 2.0 is a short-term window which may close in less than two to three years, I have no idea.  Ask me again in three years.  However, I expect that in three years there will still be an opportunity to create great Internet-related companies.