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Comment by andrewchoi | Hacker News Reader

Just some examination of the math:

If the VC firm is taking 15% of your company for $15m, then you've got a valuation of $100m. As far as I know, the "We all know that nine out of ten startups fail" applies to all startups, not the ones that are being valued at $100m. Also, I think very few VCs are investing $15m into a company that they expect to have a 90% chance of failure. You're looking at more of a 3-5x on some of the deals to carry the consistent 1-2x that the rest of the portfolio is returning.

I don't disagree with a lot of the points in the article, but saying that a VC firm with a $150m fund is betting the farm on one $15m investment exiting at $3bn should raise some eyebrows.

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Just looking at YCs returns, the vast majority of the wealth appears to be concentrated into 3 of 600+ starts (Dropbox, AirBnB, and Stripe). Even a Heroku sale for 200M+ is a drop in the bucket compared to $10B private market valuation, say it out loud and it will sound weird. "Dropbox is worth 50 Herokus"

Betting the farm implies that they have no other options, which is not the case with VCs, and it's impossible to know which will be their "super unicorns" when they write the checks, so they write lots of checks.

There's not much reason to believe YC is unlike other angel groups, individuals, or VC firms, and their data should back up that the majority of their returns is 1 or 2 companies every so often with huge wins.

The difference is that YC isn't investing $15m into companies, they're investing $20k. The corresponding valuations for the companies that they invest in is $1m on the high end (20k / 2%), not $100m. The risk profile for different check sizes is vastly different.

The risk profile as you seem to be thinking of it is an irrelevant metric when you're only interested in the return profile. They're optimizing for dollars returned, not % of companies sold for greater than money put in.

Consider a "soft landing" (VC gets their money back), vs complete death (VC gets no money back). When put alongside a $3B acquisition they're both completely irrelevant, even if on paper the 1x money back is not considered a "failure".

Check size doesn't appear to matter, the data for YC and for VC that I've seen suggests a similar power-law-ish distribution of returns.

Nitpick: VCs are optimizing for % return, not on an dollar return basis.

I would say that the risk profile is not irrelevant: if you're betting that 1/10 of your investments are returning your fund, then just one miss is the difference between a good year and "I don't have a VC firm anymore". Compare that to betting that half of your investments are returning your fund: one miss is the difference between a good year and an "ehh" year.[0]

That's true; when you compare both of them to a 30x, the difference between a 1x and 0x is small. But what I'm saying is that at a $15m investment, very few VCs expect to see a 30x, and when you compare it vs. a 3x or a 5x acquisition, the difference between no money back and your 1x liquidation pref paying out is much larger, proportionally.

The same power law may apply, but you see more of the tails in when you have a much larger sample size. If there were just as many $15m investments happening as $20k investments, you'd see the same result, but there aren't.

Off-topic: are you the same Scott Klein I talked to over the summer re: statuspage.io?

[0] Of course, that glosses over different probabilities of success and failure, but what I'm trying to say is that VCs are risk averse.

> if you're betting that 1/10 of your investments are returning your fund, then just one miss is the difference between a good year and "I don't have a VC firm anymore"

To add to this, the top 10 VC firms make up around 85% of all of the returns of VC firms combined, and the top 15 VC firms make up around 95%. (don't quote me on those specific numbers, but I believe they are roughly accurate based on a report from a16z).

Long story short - very very few VC funds see worthwhile returns. The one's that do are absolutely killing it.

The best VCs have basically created a self-fulfilling prophecy: many of these firms do well BECAUSE the top VC firms invested in them. If a16z or KPCB invests in you, it makes it a lot easier to get press and additional rounds of funding from other VCs because one of the top firms "blessed" you.

I get the feeling that YC (and similar incubators) are less about making a profit and more about connecting successful entrepreneurs with up-and-coming entrepreneurs. This isn't bad; it gives the YC partners (most of whom never need to work another day in their lives) a way to give back to their community, and I suspect many of them enjoy it.

It can't be based on pure charity because that's not a sustainable model, so there's got to be an equity component. But I suspect YC barely breaks even.

Regardless, the way VC measures returns is typically at between 70% and 100% of the life of the fund. If after 7 years, you're getting 1x your money back, that's a pretty big loss considering you could have just put it in an S&P index fund and earned ~7%. Even a 2x return after 10 years isn't that great; you're looking at an equivalent annual interest rate of ~7%. Things don't even get interesting till you start talking 5x or more (~17%). The time component of the equation is very important; the only reason people invest in VC is because it has the potential to provide greater returns than other asset classes if you're patient enough to wait 10 years for the payoff.

YC is seed stage; you expect a higher failure rate and higher returns from your successes.

Basically, you can break VC firms down into categories based on the size and timing of their investment. Typically you have the following:

* Seed / angel funds. <$1M investment, 90-99% failure rate (failure rate is higher the less you invest). Astronomical returns because they buy equity when it is at its cheapest; a "home run" here can net you several thousand times your initial investment. Your founders are often very raw and you have to work with them on basic business fundamentals.

* Series A funds. ~$1-3M investment, 70-90% failure rate (though this is dropping as more funds move from Series A to seed funding.) Probably the riskiest of the bunch since you're placing pretty big bets on a lot of companies; this is typically what people think of when they think "VC". Returns for a "home run" are 10-100x initial investment. Your founders think they know what they're doing but they don't; good VCs will help the founders through their network and by letting them make enough mistakes to learn from.

* Growth funds. $10-25M investment, 50% failure rate. These guys go after companies that have proven a market exists and there's an opportunity for huge growth if only they can scale. Still risky because scaling a business is hard. Returns for a "home run" are closer to 10x, but these guys can pull their funding if things are starting to circle the drain so a "failure" doesn't always mean a loss. Good founders here are starting to realize they are in way over their head and ask their VCs for help.

* Pre-IPO funds. $25M+ investment, very low failure rate. Returns are relatively low but also much safer: investors here are basically funding you pending an inevitable IPO. This is basically your traditional private equity firms at this point. Founders here need guidance on how to take their company public (legal, cultural, etc.) -- hence why PE guys who are often ex-investment bankers play in this space.

Partially true; practically not.

Most VC funds do have exit dates and specific life spans (typically 7-10 years). The way it was explained to me that if you have 10 companies in your portfolio, by year 7 you will have:

* 3 total busts. Out of business; zero return on investment.

* 4 "walking dead". Still in business, but just barely breaking even. Might as well be zero return because these investments are not liquid (who wants to buy a 7-year-old risky business with no profit?) Anymore these end up as acqui-hires with the VC getting pennies on the dollar.

* 2 minor successes. Good, profitable companies that will probably never produce a hockey-stick graph. 2x-3x return.

* 1 home run. If you're lucky. 10x return (though usually closer to 5x).

Her example was bad, but it was just an example. VC is a tough industry to actually make any money in. VCs don't pressure founders to do things because they are greedy, it's because they're scared of losing their shirts.

Some actual numbers from Fred Wilson are here: http://www.usv.com/posts/why-early-stage-venture-investments...

He makes the interesting point that 2/3rds of his successful investments made major changes along the way.

Big changes in approach are inevitable in early-stage companies: things become apparent after 1-2 years that weren't initially. Early stage companies involve so much uncertainty that trying to stick to a plan for the sake of sticking to a plan is folly.

His numbers are in a different context; but I get his point. Venture investing is a portfolio business; you fully expect a high failure rate.

The way I interpreted it was more, failure in VC terms is "not blowing up".

That $15 mil investment might be acquihired, or continue to be unexcitingly profitable, or put up on the chopping block for its patent portfolio. They might not even lose money, but.

Also keep in mind that VC funds as an asset class are historically a bad investment: http://www.slate.com/blogs/moneybox/2012/05/07/most_venture_... http://avc.com/2013/02/venture-capital-returns/

It's not just that the VC expects the average startup to fail; it's also expected that the average VC fails - or at least underperforms the S&P500.

I agree, especially in light of the preference structures that she mentions (and that I believe are industry-standard). But these arguments seem to lead to the conclusion that you shouldn't be an LP, not that you shouldn't take venture money. The only way that this becomes an issue is if the VC has enough of a stake to run their own decision making and executing process, and that (as I understand it) is the line between VC and PE.

>But these arguments seem to lead to the conclusion that you shouldn't be an LP, not that you shouldn't take venture money.

I have a very limited understanding, but the impression I got is that VCs typically have short maturity dates and thus are riskier in nature, whereas PE funds typically have the luxury of biding their time. How this is structured, or why exactly is beyond my ken.

So upside being, VCs are incentivized to encourage larger risk taking than what would be otherwise optimal from the perspective of a bootstrapped founder.

I can't speak for the PE side, but VCs aren't investing their own money. They have limited partners (LPs) that provide the money, and expect returns on it. This LP money goes into funds (vehicles to make investments out of). Each fund has a limited lifespan (the company I work for has fund lifetimes of around 8-10 years). This means that all of the money should be returned to investors over that time period. Since VCs can't make all of their investments at the beginning of the fund (for many reasons, chief among them scarcity) they need to show returns in an even shorter timeframe.

The bootstrapped founder, on the other hand, doesn't necessarily need to exit the investment in those 8-10 (or shorter) years. There are, of course, serial entrepreneurs for whom that is their goal, and for them (as the article points out) their incentives are aligned. For "lifestyle company" founders (not meant to be disparaging), an exit may not be necessary at all. The key differences are time horizon and exit.

FYI: The carry distribution schedule mentioned in the article (carry after 3x) is way off market for a VC GP-LP relationship.

The most typical arrangement is 20% after 1x in LP distributions, with some variation in what are called hurdle rates (that is, different percent carried interest at different multiples or IRRs).

Thanks for the info, I knew something was a bit off!

Maybe the numbers could have been better chosen, but the message is correct: when you raise money, you're raising the bar for what will be called success.

This is especially important now that infrastructure is close to free, it's easier now to bootstrap your company or even start it as a week-end hobby. That wasn't true in the 90s or early 2000s when you had to buy costly servers and hosting just to get started.

So it is very important to know what your goal is. You want to get a slight chance to be the next Google or Facebook? You'd better raise money. You want to build a sustainable company for you and a small number of employees? Maybe raising is not the best thing to do.

So the numbers are simplified to make it easy to follow the general point. If they line up _that_ neatly, they usually are.

What I'm saying is that there are very few VCs that are hoping for a 30x on one investment to make up for 9 failures. It's an order of magnitude difference, which I think is nontrivial.

If it was a general point, it would have been fine, but the difference between a $100m --> $300m company and a $100m --> $3000m company are huge.

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