Episode Transcript:

ADAM MCGOWAN: Welcome to episode five of Ventures in Tech, brought to you by Firefield. This is Adam McGowan and on today’s show we’re going to discuss the economics of venture funding and the forces that can hurt the alignment of interests between entrepreneurs and their investors. I’m again being joined by my colleague from Firefield, Henry Reohr, who’ll be guiding today’s chat. And with that, I’ll let Henry take it away.

HENRY REOHR [00:36]: Adam, I’ve heard numerous investors talk about the alignment between their interests and those of the founding teams in their portfolios. It’d seem that both investors and entrepreneurs want to see the company succeed but I’ve heard you describe cases where investors and founders don’t see eye to eye. Can you explain?

ADAM MCGOWAN [00:56]: Sure. I think the key element here is the fact that investors can come in many different shapes and sizes. And I’m talking about institutional investment from the likes of venture capitalists. The common trait with those investors is that they are investing other people’s money.

HENRY REOHR [01:16]: Why is that distinction of other people’s money important?

ADAM MCGOWAN [01:20]: Well, let’s assume you’re a VC who wants to make early stage investments in a bunch of startups. To do that, you are going to need to raise a fund and you are going to need to sell that fund and find your own investors that are called limited partners or LPs. Funds need to make commitments to those LPs to get them interested in participating. And most importantly, these investors want to know, when are they going to get their money back and how much are they ultimately going to get back?

HENRY REOHR [01:51]: Can we talk a little more about that? What are the typical expectations of investors in an early stage venture capital fund?

ADAM MCGOWAN [01:58]: Well, this is going to be hypothetical and certainly won’t apply to everybody, but let’s assume an investor in a fund assesses the level of risk and says, “I’m interested in a 15% annualized return.” So, better than the stock market and it’s something that they think compensates them for the risk. And let’s also assume that one of these venture capital funds has roughly a 10 year maturity. Also, to make the math simple, let’s assume that the whole payout of the fund, back to the investor, happens at the end. So you put up your money on day one, you wait 10 years and at the end of the tenure is when you get your money back. That’s not true for every fund but it makes the math a little bit simpler. In that scenario, in order to generate an annualized rate of return of 15% over 10 years, an investor who put up $100 on day one needs to get $400 back at the end, in year 10. So that’s ultimately the original investment plus $300 worth of return on top of that.

HENRY REOHR [03:06]: Okay. So a fund needs to generate four times the money invested to be considered successful?

ADAM MCGOWAN [03:14]: Well, not exactly and not an in every case because we can’t forget the fact that funds actually have fees. So these funds typically take a management fee of 2% as well as performance fees. You may often hear that referred to as what’s called “carry” which is short for carried interest and that is a 20% typical fee on the returns above and beyond the original investment made by the LP into the fund.

Let me start with the math around this carry. So using the example we just went through, we talked about needing a $300 return on top of the original investment. So to get $300 back to the investor, the fund actually has to create $375 worth of returns. Because when you take 20% off of that, you’re left with the $300 and the $75 is ultimately the carry the fund gets. So adding that back to the $100 investment, that’s $475 that has to come back. And just to round it off, let’s use the 2% annualized management fee over 10 years and now we’re talking about something much closer to five times the original investment.

HENRY REOHR [04:33]: How attainable is that five times return for a successful startup?

ADAM MCGOWAN [04:39]: I think, for a successful startup, it’s extremely attainable and that’s actually quite a low estimate. If you think about someone who really wins, when they start from a very-very early stage, the number could be quite larger than that. But the problem is that even a really good fund, the large majority of the investments that they make, may return little or no capital whatsoever.

So even if a deal isn’t a total loss, those outcomes would all be considered failures by the fund. They don’t help or really contribute or move the needle when it comes to trying to reach that ultimate five times return. So in order to account for this and to make good on their commitments to the investors, VCs really need to take what I’d consider a portfolio based approach or mentality when making investments.

HENRY REOHR [05:32]: What do you mean by a portfolio based mentality?

ADAM MCGOWAN [05:36]: By that I mean that there are really two components to consider. The first one would be the composition of the actual investments in the fund. Literally, what are the investments, what are their sizes, what are the attributes of them? And the second is the time horizon over which those investments might pay off. It’s also really important to keep in mind, and this may sound obvious and silly, but investors need to get paid back in cash. They do not want to get stock in the portfolio companies within the fund. And really, the only way to generate a meaningful amount of cash is one of two things. The first would be an IPO, initial public offering, going public, and the second would be an acquisition of a portfolio company by some other company. So then across the entire portfolio, VCs really need to make typically dozens of investments and then drive as many of those to these “exits” typically the IPO or the acquisition. And so, even a company that might appear successful by most measures, profitable, throwing off some cash, it might not be attractive or deemed a success to investors in one of these funds if it can’t generate an exit like the one I described. And also, don’t forget that a very large percentage of investments really have no chance for an exit at all.

HENRY REOHR [06:56]: So what does all this mean for a founder?

ADAM MCGOWAN [06:59]: I think it means that to account for the high risk and this volatility, they need to be prepared for the fact that investors are not looking for investments that will meet this average return profile; we’re using this 5 times number.

To make it much simpler, let’s use examples that have some pretty binary circumstance. So let’s assume all investments in a fund are either winners or losers. This means they exit with and generate a multiple of their investment that’s meaningful that would be a winner or then a total loss, that’s a loser. Let’s assume for the sake of making it simple a portfolio’s half winners half losers. In that case, the winners need to generate not five times, they need to generate 10 times return to build an average of five over the course of the whole portfolio. But by the way, a portfolio that’s half winners is extremely successful in the terms of venture capital funds. So what if the returns weren’t as good? What if two-thirds of the portfolio were losers? Well then that means only a third are winners and now they need a 15 times return to average out to 5 over the course of the whole fund.

So the reason I mention that is because founders should really be keeping those sort of multiples in their mind when they start thinking about what their investors’ expectations are and what they expect from their investment in their company and they should not forget that this all is contingent upon those exits or those multiples being generated through effectively or circumstances ripe for a timely exit.

HENRY REOHR [08:35]: What makes an investment good for this kind of timely exit that you just mentioned?

ADAM MCGOWAN [08:41]: There could be many attributes but they all really boil down to the same thing. You’ve got to show early and pretty exponential growth. That doesn’t necessarily need to be in revenue. It could be in, for some industries, it could be users or traction, but you need to show early exponential growth.

Startups that have more moderate growth, they could mature into really large and valuable enterprises over time and they might meet those target return multiples that we talked about, but if that growth doesn’t warrant a relatively early exit, then that startup likely wouldn’t be a suitable investment for an early stage venture capital fund.

HENRY REOHR [09:22]: I can understand the theory behind why investors and founders interests may get misaligned. But how does this all play out in real life?

ADAM MCGOWAN[09:30]: I think a classic example would be the case when an investor wants to pump a lot of cash into a startup and wants to get those founders to spend it quickly. This could be a case where an investor asked for a certain amount or I should say the founders asked for a certain amount and the investors are willing to give them actually even more than they asked for. In that case, the amount of cash and the rate of spend might both be higher than the founders actually intended and it’s also really important to remember that these founders have a portfolio of one company. They’re putting all their eggs in that basket. That’s it.

So you’ve got investors caring about this overall portfolio mentality. The blended performance across many-many companies. For that to play out effectively, they really need all their investments to go big or go home. Some moderate growth, steady earner that might not get to an exit and might not generate a quick big multiple is just not interesting from a portfolio perspective but might be really attractive to an individual founder given that they have their portfolio of one. So I think that’s something that’s really important to keep in mind particularly because for investors, if this “success” isn’t large enough, it’s just not interesting and they’d rather spend more money and take bigger risks in order to make a bigger return a possibility in a timeframe that makes sense for their fund.

HENRY REOHR [11:01]: So in a case like this, what can the founders do?

ADAM MCGOWAN [11:06]: The reality is once you take an investment or moving down this path, it’s pretty tough for founders to truly change course. My advice then is simply to ensure that founders go into these deals with their eyes wide open. For many of them, this high risk high return, go big go home approach, could be exactly what they’re looking for but not every founder I’ve met agrees with that mentality.

And for the rest, I would argue that they really take a deep breath before entering or engaging or agreeing to a term sheet. And as we’ll talk about in future episodes, there could be a variety of alternative funding options available that don’t involve this same “other people’s money problem.” There’s a lot to cover there, too much for today’s episode, we’ll definitely dive into it in the future, but the moral of the story is that when and if those sorts of alternatives are available, it could make that crazy idea of turning down the money suddenly seem pretty compelling.

HENRY REOHR [12:16]: And that’s all we’ve got for today. I’m Henry Reohr from Firefield and you’ve been listening to another episode of Ventures in Tech.