How do top performing venture capitalists succeed when historical data shows that most venture capital investments lose?
The private investments database from Cambridge Associates (CA) includes conventional private equity and venture capital with historical performance records from over 2,000 fund managers and 7,400+ funds. Besides showing venture capital’s returns advantage on average relative to the public equity market, the table below also shows just how different the returns are from the top half of VC over the total of the venture capital industry (which includes the top half.)
|Comparison of Average Annual % Rates of Return*||15 Year||10 Year||5 Year|
|Global Venture Capital (Top Half Only)||18.0||22.1||21.3|
|Global Venture Capital (All)||11.8||15.0||14.9|
The Winning Formula
How do the better performing venture capitalists do it, especially since the risk of each individual investment is so great? Success is based on a combination of art and science, with their right and left brains working in powerful unison. Both sides of the brain collaborate in a process of visualization, pattern recognition, elimination, and optimization.
- Visualization is the ability to see the possibilities when they never have been seen before or at least never been clearly understood. Visualization may be conscious or sometimes a combination of the conscious and unconscious. It is recognizing the potential of an entrepreneur thinking outside of a box or even not seeing or feeling constrained by any box at all.
- Pattern recognition calls for organizing known facts into patterns, thereby uncovering underlying relationships. This leads ultimately to seeing the possible paths to success.
- Elimination is about recognizing when no promising patterns are seen, and even looking hard for fatal flaws that would likely preclude success. When a potential winning pattern is not seen, consideration of the venture is quickly eliminated. There is no FOMO (Fear of Missing Out).
- Optimization entails acting on recognized patterns and the resulting potential paths to success. As the large number of potential paths to success narrows, the VC works with the entrepreneur, combining left and right brains, to optimize the elements most important to ultimate success.
Sorting out the Wheat from the Chaff
Venture capital is expected to deliver returns greater than other asset classes in order to justify its risks and the long timeframe to ultimate returns. Top performing firms shoot for an overall multiple on invested capital of 3x to 5x and average annualized return or IRR of 20%+.
The average VC in a typical year may review over 300 potential investments and fund just two or three of those companies. A large venture capital firm may see over 3,000 deals per year and invest in just ten to twenty of them.
As they sift through the deal opportunities, choosing just a select few, they recognize that their batting average, while expected to be above industry average, will still be well under 50%. Their quest therefore is to find the few golden nuggets that they believe could become home runs returning 10x+ on the capital invested. To deliver consistently an IRR of 20%+ requires both a better batting average (i.e. a greater percentage of investments with positive returns) as well as a number of home runs in order to deliver those 10x+ returns on invested capital.
The experienced, successful VC sorts out the wheat from the chaff through an almost unconscious process of pattern recognition, looking for the elements of a repeating model as an initial guide to early elimination or retention for more in-depth due diligence before an ultimate invest-or-reject decision. Those patterns may be positive or negative, resembling prior investments that delivered rich returns or investments that didn’t pan out. The pattern most sought is one that features a good jockey, riding a fast horse, on a smooth track – i.e. a proven entrepreneur, with a product or service that is expected to deliver valued new benefits that will result in strong market demand, ideally without much projected competition or extraordinary business environment hurdles that could get in the way and block or retard progress.
After Selecting the Right Companies, an Ongoing Push for Their Optimization is Required
As if there isn’t already enough challenge, the VC’s mission challenge is heightened further by the need to push for optimization of the funded company. Remember, the VC must swing for home runs ... even better, grand slam home runs... when the opportunity presents itself. That requires a chess player’s awareness of the almost infinite number of possible move sequences, the repeated mental search for the best routes to ultimate success, and the ongoing push to optimize key elements as the array of possible routes to marketplace success narrows.
That chess game doesn’t end until the venture exits from venture capital funding and the VC and his or her investors collect their prize. Until then, as potent and unique as the venture may be, the threat of competition is always there, and so the need to continue to innovate – to stay enough steps ahead of any competition – remains.
To sum it up, success often boils down to one key two-part question that the VC and the entrepreneur must constantly consider: “What opportunity am I seeing that nobody else has thought of, and what I am doing about it?” That question confronts the conscious and the unconscious, the intuition to recognize without consciously seeing. It may be thinking outside the box or ignoring all boxes and thinking in the open sky. That’s what we mean by “to see and not see.”
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