Monday, July 29, 2013

The Point When VC Will Never Be The Same Again

Albert has a nice post this morning on the intersection of technology and openness in the VC landscape and how disruption of VC is starting to spin.

I don’t want to be redundant to his post, and I agree with much of it. But, I’ve long thought the disruption of VC will hinge on one simple change (that has yet to occur), and so I want to elaborate on that thought here.

But first, my assumptions: VC is about access.  Knowing which companies are interesting and worth investment when they are fundraising is no where near as hard as actually getting access to those top quality deals.  The problem is exacerbated by the fact that nearly all the returns in VC are generated by the top decile of deals in a given year.  For certain fund vintages in the 90s, the only profitable VC funds were the ones that got access to one or two deals that broke out during the years of the investment period of the vintage… everyone else was left out in the cold.  Given the explosion of new startups in the last 4 years (really… since The Social Network hit theaters), this problem of highly concentrated successful deals is less true, but it still exists.

Don’t believe me?  Well… I can’t really talk about performance, but thanks to FOIA of public pension funds, much of the data is public.  It’s no coincidence that Spark, USV and Foundry co-invest quite frequently, and they also are each in the top 3 managers in UTIMCO’s portfolio of 100+ VC/PE managers.  This is the concentration I’m describing at work.

If you believe now that VC is largely about access to the best deals, then the next part will make more sense.  The firm offering the best terms often doesn’t win.  Founders choose their VC partner based on a couple criteria:

A) Economic terms (read: highest pre money valuation),

B) Control terms (read: control of the board… voting power), and

C) Value-add (read: how can this VC help make my company more value, beyond just the equity capital provided)

Getting access to the best deals is a careful balance of these three variables.  If you give away the farm on terms (ie, you’re the best term sheet), you can easily still loose due to insufficient points in category C.

So, stack-tracing back up to the purpose of this post. When will VC be disrupted? When value-add and deal terms get evaluated and transacted separately.  Imagine a clean layer of abstraction where the board member you add to a company in a financing round is a decision that is wholly separate from the terms of the deal you accept.

Picture a Series A round of investment that is crowdsourced capital from hundreds of investors, where the founders are accepting money strictly on their own terms.  Once the funding is in place, the company then recruits a board member using the equity they saved by accepting the best possible deal terms.  

Here’s a hypothetical: The “standard” series A VC deal might involve selling 25% of the company for a couple million dollars.  Of that 25% the VC now owns, 20-30% of that will become carried interest if the VC fund is successful and will go to the general partners.  The general partners will split that up amongst themselves, somewhat equally or otherwise.  So:

25% of the company * 20% carry * 33% of the carry in a flat partnership of 3 partners = 1.65% of the company goes to the VC board member (assuming everything goes well for the fund… which is a tough assumption for the average VC firm). So, roughly 1.65% of a company is the cost to recruit a *great* board member by this logic.

So, you could take 2% of your company (to use a round number) and go out and recruit Dick Costolo to your board, and then accept a crowdsourced VC round from hundreds of angels on economic terms and control terms much better than the 25% of your company for a couple million dollars.  

This strategy might only work for the hottest deals, but as I already stated, that’s where all the returns are regardless… So, that’s when VC gets disrupted: when “value-add” and terms get separated.

Notes

  1. caterpillarcowboy reblogged this from thegongshow and added:
    Reminds me of Paul Graham’s post from 2010 on how convertible notes could shift funding rounds from discrete step...
  2. thegongshow posted this