{"id":4510,"date":"2014-06-19T11:24:26","date_gmt":"2014-06-19T18:24:26","guid":{"rendered":"http:\/\/canary.kcprod.info/blog\/?p=4510"},"modified":"2022-01-11T17:12:39","modified_gmt":"2022-01-12T01:12:39","slug":"venture-capital-economics","status":"publish","type":"post","link":"https:\/\/canary.kcprod.info/blog\/venture-capital-economics\/","title":{"rendered":"Demystifying Venture Capital Economics, Part 1"},"content":{"rendered":"

T<\/span>he other day my co-founder, Dan Carroll<\/a>, asked me a number of questions about Venture Capital returns because he was stunned by the valuations of some recently announced deals. After I answered the question, Dan and a few colleagues who were within earshot encouraged me to share my perspective on the subject because it is so poorly understood.<\/p>\n

Much has been written about the financial performance of the companies backed by venture capitalists, but very little has been written about the economics of the venture capital industry itself. With this post we open the kimono on who funds VCs, what returns they expect and how the best VCs consistently succeed in outperforming those expectations.<\/p>\n

Who Funds VCs?<\/h2>\n

The primary providers of funding to the venture capital industry are managers of large pools of capital. These entities include pension funds, university endowments, charitable foundations, and, to a much lesser extent, insurance companies, wealthy families and corporations. Venture capital funds are raised in the form of a limited partnership that typically has a mandated 10-year lifespan. VCs typically do not invest in new companies beyond the third year of a partnership\u2019s life to insure their latest investments have a chance to reach liquidation before the partnership legally ends. That means they must raise new partnerships every three years if they don\u2019t want to stop investing in new companies. Taking a hiatus from investing in new companies is usually interpreted by the entrepreneurial community as no longer being in business, which makes it hard to restart one\u2019s deal flow later. As a result there is a huge incentive not to let that happen.<\/p>\n

Why Do Institutions Fund VCs?<\/h2>\n

As we explained in our investment methodology white paper<\/a> and many of our blog posts about diversification, almost every sophisticated large asset pool manager uses modern portfolio theory (the same methodology employed by Wealthfront) to determine its base asset allocation. Because of their size, pensions, endowments and charitable foundations have access to a broader set of asset classes, including hedge funds, private equity (of which VC is a component) and private investments in energy and real estate, than most individuals. Most large asset pool managers would like a 5 \u2013 10% allocation to venture capital because of its past returns and anti-correlation with other asset classes. Unfortunately they can seldom reach their desired allocation because there aren\u2019t enough VC firms that generate returns that justify the risk. That\u2019s because the top 20 firms (out of approximately 1,000 total VC firms) generate approximately 95% of the industry\u2019s returns.<\/p>\n

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These 20 firms don\u2019t change much over time and are so oversubscribed that they are very hard for new limited partners to access. The premier endowments are considered the most desirable limited partners by venture capitalists because they are the most committed to the asset class. Even these endowments, though, have a hard time getting into funds if they weren\u2019t there in the beginning. Occasionally new firms like Benchmark and Andreessen Horowitz emerge and break into the top tier, but they are the exception rather than the rule.<\/p>\n

What Returns Are Expected of VCs?<\/h2>\n

As we have also explained, with greater risk comes an expectation of greater return.  Venture capital has the greatest risk of all the asset classes in which institutions invest, so it must have the highest expected return. I have heard institutions express their required return from venture capital necessary to compensate them for taking the additional risk (i.e. the risk premium) in two ways:<\/p>\n