Archive for August 2011
In spreading the word about RSCM, I recently encountered a question that led to some interesting findings. A VC from a respected firm, known for its innovative approach, brought up the issue of “homeruns”. In his experience, every successful fund had at least one monster exit. He was concerned that RSCM would never get into those deals and therefore, have trouble generating good returns.
My initial response was that we’ll get into those deals before they are monsters. We don’t need the reputation of a name firm because the guys we want to fund don’t have any of the proof points name firms look for. They’ll attract the big firms some time after they take our money. Of course, this answer is open to debate. Maybe there is some magical personal characteristics that allows the founders of Google, Facebook, and Groupon to get top-tier interest before having proof points.
So I went and looked at the data to answer the question, “What if we don’t get any homeruns at all?” The answer was surprising.
I started with our formal backtest, which I produced using the general procedure described in a previous post. It used the criteria of no follow-on and stage <= 2, as well as eliminating any company in a non-technology sector or capital-intensive one such as manufacturing and biotechnology.
Now, the AIPP data does not provide the valuation of the company at exit. However, I figured that I could apply increasingly stringent criteria to weed out any homeruns:
- The payout to the investor was < $5M.
- The payout to the investor was < $2.5M
- The payout to the investor was < $2.5M AND the payout multiple was < 25X.
It’s hard to imagine an investment in any big winner that wouldn’t hit at least the third threshold. In fact, even scenarios (1) and (2) are actually pretty unfair to us because they exclude outcomes where we invest $100K for 20% of a startup, get diluted to 5-10%, and then the company has a modest $50M exit. That’s actually our target investment! But I wanted to be as conservative as possible.
The base case was 42% IRR and a 3.7x payout multiple. The results for the three scenarios are:
- 42% IRR, 2.7x multiple
- 36% IRR, 2.4x multiple
- 29% IRR, 2.1x multiple
Holy crap! Even if you exclude anything that could be remotely considered a homerun, you’d still get a 29% IRR!
As you can see, the multiple goes down more quickly than the IRR. Large exits take longer than small exits so when you exclude the large exits, you get lower hold times, which helps maintain IRR. But that also means you could turn around and reinvest your profits earlier. So IRR is what you care about from an asset class perspective.
For comparison, the top-quartile VC funds currently have 10-year returns of less than 10% IRR, according to Cambridge Associates. So investing in an index of non-homerun startups is better than investing in the funds that are the best at picking homeruns. (Of course, VC returns could pick up if you believe that the IPO and large acquisition market is going to finally make a comeback after 10 years.)
I’ve got to admit that the clarity of these results surprised even me. So in the words of Adam Savage and Jamie Hyneman, “I think we’ve got to call this myth BUSTED.”