On January 13, we shared our letter with ZUZ Partners. We are happy to share the public part here today.
Dear Partner,
Over the years, I’ve been asked many times about investing in the startup ecosystem, through Venture Capital funds or direct investment in startup companies. This is a complex question, that impacts both personal pocketbooks and social progress. In this letter, I lay out my thoughts on the topic.
What are startups?
If you ask 10 people what startups are, you’ll get 11 different answers. When you try to differentiate the startups from other new businesses there are several ways to do it. Some may say that startups are businesses based on a technological idea that can capture large markets. Others may say that startups are defined by innovation. To me, a good definition of what a startup is, has to do both with the entrepreneurs’ goals and with the ways of funding the business, not by the nature of their product.
Non-startup businesses are usually started by people who aim to make an honest living from their business. They may want to grow steadily and if 20 years down the line they’re doing a few millions in business, they are very happy. In order to create a stable company like this, the entrepreneurs will generally use savings and maybe a bank loan.
Startups want to grow and fast. Growth of 20% per month is often a minimum requirement. They want to be billion-dollar companies in a matter of a few years. Growth comes at a cost, and startups often fund themselves from external capital in exchange for part of this new venture.
The bottom line is that defining a startup is sort of like defining art, it is characterized by the viewers and by the creator.
What is Venture capital?
The first venture capital activity started after WWII in order to fund returning soldiers’ entrepreneurship. Those were good days to be in venture capital. Many companies were chasing a small amount of money with an even smaller number of investors, meaning that companies were willing to give a lot to get an investment. In addition, while they didn’t know it at the time, the US was at the precipice of an economic and demographic explosion with the first baby boomers to provide a tailwind for new business.
The VC industry grew all the way from a few tens of millions of dollars, to a few hundred billion dollars currently. There were, of course, hiccups along the way like the dot-com bubble around the turn of the century. As of 2018, the global VC industry stands at $254B-$341B and the 2019 numbers (not out yet) should be similar.
How do Venture capital funds work?
Anyone can start a new VC fund, but some background is always welcome. Usually, VCs are started by angel investors (private startup investors who had seen some success), people with VC experience (high ranking VC employees who want to start their own VC), or successful startup founders after an exit. The founder of NewVC sets a target fund size, say $100M, and sets out to raise these funds. At this point, the VC is in the fundraising stage. Usually the VC manager will collect commitments, but not take the cash until the target amount is reached.
Once the full amount is raised, the VC moves into the investment stage. In this stage, the VC will sort through many companies looking to make an investment. VCs tend to be very proud of how they generate deals. Anyone can put up a sign saying, “we invest a lot of money in very new companies”, they will have a line around the corner. Most VCs will tout a special source of dealflow, like a college alumni network, an untapped geographic location or a unique founder demographic.
Even with the slightly smaller pool to fish in, the VC will have people knocking down the door. A typical VC will have thousands of meetings over the investment stage. Some companies will get a second meeting and fewer will get to the due diligence stage. There isn’t much information available in the early stages of the company, so due diligence includes getting to know the founding team and other qualitative factors. Eventually, a select few companies will get the coveted investment.
Investing in a company in the VC space is different than investments done in ZUZ Capital. Generally speaking, ZUZ will buy companies in a secondary market, like the stock exchange. Stock is purchased from previous owners, who decided that they are not interested in this holding any longer. The target company is oblivious to the fact that ownership has changed, and the company sees no cash when the deal is made. ZUZ can then sell these assets to someone else with relative ease.
In the VC space, stock is purchased in a primary transaction, where the seller of the stock is the company itself, usually represented by an enthusiastic company founder. The cash in a VC deal is paid into the company and is used to fund the growth that is expected of a startup.
The VC gets a decent stake in the business, usually 10%-30%, a seat on the board, voting rights and more. The VC manager is expected to provide not only capital but also contacts, advice, experience and much more. This dynamic prevents the VC from making too many investments, since you can only sit on so many boards. During the investment stage, that usually lasts 3-5 years, the VC collects a management fee of around 2% of the fund per year.
The next stage is the management stage. By this time the fund is mostly depleted. During the management stage the VC has relatively less work and they continue to sit on the companies’ boards and continue to monitor the investments. This stage usually lasts 5-7 years. In parallel, the fund manager will probably start another fund, NewVC2, and start the fundraising stage again in parallel.
The final stage is the exit stage. This is where the founders, the VCs and the investors collect on their investment. Exits come either from selling the company to a large, well established company or by way of IPO that turns a private company into a public company. For example, the Dollar Shave Club exited by being sold to Unilever, while Beyond Meat, Uber, Spotify and Snap (Snapchat) exited in an IPO. Upon exit, the VC will take 20% of the exit value and the VC investors will get 80%, representing a 20% success fee the VC takes.
The social impact
Before we drill down into what a VC fund aims to achieve, what the numbers look like and the likelihood of hitting those numbers, we need to discuss the social role that VCs hold.
We live in a capitalistic society. One of the tenants of this type of this economic system is the outsourcing of many functions from the government to private individuals and institutions. Under capitalism, individuals make a lot of different experiments and are rewarded if the experiment succeeds. When you think of a mall or street full of stores over a decade, there are constantly stores closing and others opening in their place. Each store that goes out of business is a failed experiment, paid for with private money, telling us that a coffeeshop / clothing store / sporting goods store is not a good enough use of that piece of real estate. When a business is open for several years or decades, this tells you that they are using of their resources efficiently enough to turn a profit.
As a society, we advance by constant experimenting where the successful experiments are rewarded, until something better comes along. At any point in time, there are a set of business owners that seem invincible. Railroad barons, steel makers, car makers, and current tech giants to name a few over the years. While they enjoy the fruit of their labor and business acumen, a new generation of entrepreneurs is out saying “there’s a better way to do that”. When the newcomers show they can compete with the incumbents, they get the spoils of success, for a while. Remember, before Facebook there was MySpace, but Facebook is the king, for now. Voltaire said it beautifully: History is filled with the sound of silken slippers going downstairs and wooden shoes coming up.
In the past, innovation was done by large corporations. Some of their relatively large and stable income was devoted to growth capital expenditure (CapEx) which is just a complicated term for R&D of future developments. For example, the digital camera was invented by Kodak. Kodak invested in this development, but later failed to bring it to market. One could also mention the jolly old days of Xerox PARC and Bell labs where the technology and research that a lot of the large companies we know today was based on.
Since the financial crash of 2007-2008, corporate appetite for spending on anything that isn’t profitable in a couple of quarters has greatly diminished. This means opening a new store, developing the next iPhone or next car is fine, developing a VR system, moving into electric cars and other innovations that might be profitable several years down the line are hardly occurring in the corporate setting.
Someone needs to take the risk of developing something that might fail. Over the last decade, most of this innovation has been happening in the VC/startup realm - funded by wealthy individuals and institutions. When a company or technology looks promising, a large corporation will go out and buy it. The large corporation may overpay for a given startup, but they also avoid funding failed innovations.
In a very real sense, the realm of startups and VCs is saving lives. It’s easy to think about autonomous vehicles becoming much safer than human drivers, cutting-edge drugs and medical procedures that are reducing fatalities, etc. It doesn’t have to stop there, your Ubers, Airbnbs, and PayPals help us do more with less. They allow us to better utilize our limited resources – like time or money. They are quite literally squeezing the tube just a bit more.
A final note before we dive into the VC business model and the attractiveness of putting your money to work there. The statements above are positive, not normative, statements. That’s to say, they describe the world as it is, not how it should be. You may have your own opinions about the role of government, corporation, innovation, wealth accrual with those who succeed, and other topics covered here. I certainly have my own opinions. Regardless of our opinions, we deal with the current reality.
VC arithmetic
The average VC has a predetermined lifespan of about 10 years. A VC fund aims to return about 3 time the initial investment over that time, meaning about 11% a year. The actual annual return is slightly higher because the VC doesn’t take all the money at once, rather they call the money in as they need it to make investments. Let’s attach an example to make it more concrete.
NewVC just launched its 1st fund with $100M to be invested. After considering the 2% annual management fee over the life of the fund, there is about $90M to invest. NewVC finds 10 companies to invest in, and for simplicity's sake, the investments are equal at $9M per company.
NewVC wants to return 3X to the investors, or $300M. The return to investors needs to be net of the success fee that can be calculated in 2 ways. One way takes 20% of the return on the whole portfolio, the other way takes 20% of the return per individual investment (regardless of losses on other investments in the portfolio). Depending on the way the fund calculates the return, the NewVC would need actual returns of $350M-$375M in order to deliver $300M to investors.
VC Odds
I’m going to figure out the chances for those investing through a VC. Note that those investing directly in startups, don’t need to clear the extra 20% carry or success fee that VCs do. On the other hand, VCs are the best at what they do, and this is their full-time job. They also have access to deals individuals don’t. The description below applies to both VC and direct startup investing.
Continuing the example from above, NewVC has $90M to invest in startups ($100M net of management fees) and we’ll assume that NewVC invests in 10 companies, $9M per company. NewVC (and all other VCs) assume that 9 out of 10 companies will return 0. This means that one company in the portfolio needs to exit at a price high enough to cover all the losses and triple the portfolio.
Many VCs will tell you that they invest $9M for 20% of the company (implying a $45M valuation). They will also say that all they need is a $350M exit to triple the fund. That sounds like a 8X return (from $45M to $350M) a very very respectable return, and at first blush, it even sounds doable. As a matter of fact, a $350M exit sounds like something that happens every other day, something google would buy a hundred times a year.
The truth is that this is not exactly an apples to apples comparison. NewVC only owns 20% of the company assuming it wasn’t diluted in more recent funding rounds. They need the company to be worth $1.75B in order to net $350M. This means that the company goes from $45M to 1.75B, a 39X return. In order for this company to be the holy grail, the company needs to (a) not raise any more capital, (b) exit at a minimum of $1.75B and (c) exit within 7-9 years from initial investment.
Let’s zoom out to the industry level. There are close to 3,000 VC firms with fund sizes of over $100M. In order to make it easier, let’s assume that all those funds are only $100M funds (there are several billion-dollar funds and at least one, Softbank’s Vision fund1, with $100B under management). Let’s further assume that every fund has one winner and they own 20% of the company (that is 2 VCs per company assuming that VC own 40% of companies upon exit). This means that the industry assumes that there are 1,500 private companies that will be valued at least at $1.75B. Just for reference, the smallest market cap company in the Russell 1,000 (the largest 1,000 US companies) stands at the sub billion-dollar level.
What about dollar value? The numbers are striking. 2018 saw global VC investments of $251B-$341B. Even using the lowest number of that range, they would need to return $810B to the fund in order to return $753B to investors. Remember that on average, the VCs only get 40% from the exit. The actual exit needs to be a bit over $2T. A number like $2 trillion is tough to understand. That’s larger than the whole Canadian economy or the Brazilian economy. Its right around the size of the Italian economy. You could buy the NBA, NFL, MLB and NASCAR organizations and teams and not break a quarter trillion.
The $2T is just for the 2018 investment crop. 2019 numbers aren’t out yet, but it looks like they will be similar. That’s another $2T that needs to be made. For $4T you can buy Apple Inc. (est. 1976), Microsoft (est. 1975), Amazon (est. 1994) and Google (est. 1998). Not only is there an assumption that the 2018 investment will return that, they assume it will happen by 2027. It could happen, but the chances seem slim. As value investors we look down before we look up, but even when I look up here, I find it hard to see how venture capital investment will even show a positive return on average. Once you consider the fact that a small number of VCs will have an outsized return, most others will lose a lot.
From yet another angle, the VC industry assumes that elbow grease + $25B (remember, all exits come from 10% of the money) invested in 2018 will be worth $2T in less than a decade. That’s an impressive rate of compounding and elbow grease. To an unnamed IRS auditor, “The trick is to stop thinking of it as ‘your’ money.”
The paradox
Consider the terms “buyers’ market” and “sellers’ market”. The former indicates many sellers and few buyers while the latter indicates the opposite. When you make an investment, you always want to be in a buyers’ market. Since 2007-2008, as corporate appetite to invest in real growth has declined, the public was forced into riskier investments to find that extra growth. In the past, you could make 5%-10% a year with safe government bonds. This is no longer true. In the last decade, as the safe return has all but disappeared, investors let risk creep into the safer parts of the portfolio. Many people have their bond allocation littered with junk bonds and long duration bonds and their stock allocation loaded with VC and PE investments. That is the backdrop to recent appreciation in art, collector cars, Venture Capital, Private Equity and others.
Sure, prices rose immensely but the underlying reality cannot be ignored forever. In a past letter I wrote that I see no value in bitcoin, just as it was at the top and seemed like in would never stop. I wrote a long piece on cannabis investing at the peak of that market (that market has declined more than 70% since). I wouldn’t be surprised if the meatless trend (BeyondMeat and others) will suffer the same fate.
The paradox is that investors try to make up for lost safe investments by taking on more risk at the worst time. When you buy expensive assets, the chance of making money is lower than usual.
We must consider that VC profits overall will be lower than expected and yet there will be some outsize winners. It follows that most money in this space will make not only a subpar return, it will make a significantly negative return.
