Luke Dixon
Venture capital (VC) is a form of investment for early-stage, innovative businesses with strong growth potential. Venture capital provides finance and operational expertise for entrepreneurs and start-up companies, typically, although not exclusively, in technology-based sectors such as ICT, life sciences or fintech.
- British Private Equity & Venture Capital Association (BVCA)
Venture capital firms make minority investments in small, often start-up, companies that frequently lack revenue and do not yet make a profit but have prospects for high growth because they have an innovative, disruptive business idea. Many of today’s best-known technology companies received venture capital investment in their early days: Amazon, PayPal, eBay, Google, Facebook, Snapchat, Spotify, WhatsApp, Alibaba and Zoom all received VC funding as they began their high-growth journeys to market prominence.
Notwithstanding its high-profile successes, venture capital is one of the least understood and hardest to access areas of the private markets, and historically the riskiest. But it also where great innovations are discovered, funded and grown into viable businesses. With access to plentiful capital from a growing number of specialist venture capital and private equity firms, companies are staying private for longer. Venture investing is often the only way to participate in the highest-growth stages of the most innovative companies, but access is limited, the risks are high, and often great patience is required to reap the biggest rewards.
Accessing Innovation
Venture funds are typically small and new launches from the best known and most successful managers are often oversubscribed. Access to the top VC managers is limited and becoming ever more exclusive as they favour granting limited partnerships to the founders of existing portfolio companies and prestigious institutions or family offices.
Moreover, highly regarded founders and their start-ups are also in the enviable position of selecting which VC firms to partner with, and those firms with a great reputation have a comparative advantage. WhatsApp, for example, chose to work with only one VC firm from seed to its acquisition by Facebook, and that’s how Sequoia Capital turned a $60m Series A+B investment into $3bn on exit, a more than 50x return on its original investment.1
In other cases, it is a VC firm’s ability to pro-actively add value to a founder that leads to its success and gives it an advantage in sourcing other high profile investment opportunities. Accel Partners led Facebook’s $12.7m Series A round of investment in 2005 and turned that into $9b for its Accel Partners Fund IX. Similarly, highly respected VC firm Benchmark Capital Partners was the sole Series A investor in Snapchat, a $13.5m stake that turned into $3.2bn 4 years later when Snap Inc. went public at $25bn. 1
When truly inspiring founders have a great idea and surround themselves with the right team to execute their vision, investors line up to get in on the deal. And only those with the best reputations are invited to participate. For this reason, the best VC opportunities are very difficult to access.
Return & Risk
Start-up investing is exciting – even glamorous – when one has backed the latest > $1bn + technology “unicorn”. But the reality is more sobering: 75-90% of start-ups ultimately fail, and 50% do not make it to the end of their 5th year. So, an early-stage VC fund that makes 50 investments will, on average, have 25 failures within its first 5 years, and can expect a further 15-20 failures by the time it reaches 10-years.2 Still – and notwithstanding this high rate of attrition – according to Pitchbook benchmark data, VC funds returned on average over 14% annually over the 5- and 10-year periods ending 31 December, 2020, demonstrating that a few big wins can more than make up for the substantial number of small losses that most VC funds experience.
Depending on when you invest, primary private equity funds (including venture capital) can be blind pools, at least to a significant degree. Unlike when one invests in a traditional open-ended public equity fund where the underlying holdings are known, Limited Partners (LPs) commit their capital to a primary private equity fund based on the management team, the strategy, and the perceived strength of the investment opportunity. Primary funds are “blind pools” because at the time an LP commits to a fund it may have very few, if any, investments. You are investing in a vision, the experience of the manager, and in hope.
As one might expect given the foregoing, early-stage VC investments are the riskiest because you invest “blind” and can expect most of the underlying companies into which your fund invests to fail. Late-stage primary VC funds and VC secondary funds, on the other hand, are less risky because you are investing into the more established young companies, those that have introduced their product or service to the market, begun generating revenue, and survived their first 5+ years. By investing later one can avoid the high attrition associated with the earliest years and instead focus on scaling the surviving – and successful – start-ups.
Long Horizons
In contrast to the fast money Benchmark made on its stake in Snap (235x MOIC, 4-years), most start-ups take years to become successful and patience can be very rewarding. Apax Partners bought a 45% stake in King Digital Entertainment in 2005, 7 years before it introduced the hugely popular Candy Crush Saga game to the market in 2012. In 2015, Apax orchestrated King Digital’s buyout by Activision for $5.9bn, achieving a 100x MOIC after 10 years of patient investing. 1
In 2000, SoftBank acquired a 34% stake in Chinese internet start-up Alibaba for $20m, before it even had a business plan. Softbank founder Masayoshi Son used his experience as an early-stage investor in Yahoo! to imagine the potential of the internet in China and backed Alibaba founder Jack Ma as the visionary entrepreneur to build the dominant Chinese internet company. Softbank finally began realising its investment in Alibaba after it went public in 2014, having turned its $20m stake into $60bn after 14 years. 1 Today, SoftBank’s remaining 24.9% stake in Alibaba is worth an estimated $140bn.
Concluding thoughts
Venture capital funds are one of the only ways to invest in the next generation of global market leaders during their most explosive stages of growth. But there can be vast divergence in performance between the top and bottom quartile VC managers; between those with the best access to deals and those on the outside looking in. And access to the leading venture capital managers, whose funds are always oversubscribed, is nearly impossible without deep connections within the VC world. VC secondaries are a terrific way to both access leading VC managers, reduce risk and uncertainty by buying into fully invested funds and later-stage start-ups, and reduce the usually long holding period.
References
- CB Insights. From Alibaba To Zygna: 45 Of The Best VC Bets Of All Time And What We Can Learn From Them. 9 June 2021
- Cerdeira, Nicolas & Kotashev, Kyril (25 March 2021). Startup Failure Rate: Ultimate Report + Infographic (2021). www.failory.com
- Pitchbook Benchmarks (as of Q4 2020). Pichbook Data, Inc.
- McGrath, Charlie (28 April 2021). Venture Capital Investors Go For The Sure Bet. Preqin.
