The Fiction of 20%
It’s a “given” in the venture business that in order to compensate a venture firm for all the time and energy they are going to put into a particular investment, they need to own at least 20% of the company and ideally 30%.
I hear it all the time.
“We won’t do a deal unless we can own 20%”
“This term sheet has us at 22% which is well below our target ownership of 25%”
“I can’t make a venture return owning just 15% of the business”
To which I say RUBBISH. Just because you WANT to own 20-30% of a business doesn’t mean you NEED to own 20-30% of the business.
The Flatiron program that I still manage owned about 14% of comScore when it went public. 14% of comScore is worth about $120 million today. I don’t want to get into confidential data about how much we invested and how much we took out, but I will say that it was a fantastic investment. I think that is fair compensation for the eight years I put into that investment. And let me tell you, I worked as hard on comScore as any deal I have ever worked on.
Union Square Ventures owned about 14% of TACODA when it was sold to AOL. We returned more money to our investors on that one single investment than they had invested to date in our entire fund at the time of the sale. That sounds like a venture return to me.
Those are two recent examples. But I could go on and on. I have made vastly more money on companies where our firm owned 15% than on companies where our firm owned 20% or more.
To some extent the desire to own large chunks of companies is related to the size of the funds that many venture firms manage. A $120 million position in a recently IPO’d company might not be that interesting to a fund that is managing billions of dollars of investor’s capital. But it sure is interesting to me.
One of the things we are doing in the venture capital business by raising ever larger fund sizes and amassing larger pools of capital under management is creating problems and then making them the entrepreneur’s problem.
And so we tell the entrepreneur that we need 20% of his or her company to solve our problem. I don’t think that’s right. I’ve said this before and I am going to say it again. The scarce resource in the venture capital business is great entrepreneurs with cutting edge ideas willing to work 100 hour weeks turning the ideas into businesses. The scarce resource is not capital and yet we are optimizing our businesses to be able to manage ever larger sums of capital.
I want to optimize our businesss to be able to back more and better entrepreneurs. And so I think its fine to start with significantly less than 20%. We often start our investments off with 10% or less and build our ownerships over time. We have one company in our portfolio where we started with about 5% ownership and are now close to 20% and if we do our job right, we will end up with close to 25%. But we earned the right to get there by investing early and often and scaling our investment with the entrepreneur’s capital needs.
Don’t get me wrong, I would love to own 25% of a company or more. But we don’t make it a requirement. Our requirement is being able to get into the best deals, work with the best entrepreneurs, and be able to generate $40-50mm in proceeds when a deal works and return the fund, $125mm in our case, on the very best deal in the fund.
And you don’t need to own 20%+ of a company to do that. I have 21 years of venture capital investment data to prove it.
Comments (Archived):
Fred, this is so refreshing. As an entrepreneur, I thank you for writing this. What you said about ever larger fund sizes reminds me of what Warren Buffet said about the growing size of Berkshire Hathaway. He warned his shareholders that the bigger Berkshire becomes, the harder it is to get above market returns because he can no longer do many attractive deals that are simply too small. It seems that only the most astute investors recognize this.
Fred,There may be 100 or more other VC’s out there who are better for me to work with…BUT, the /way/ that you write and /what/ you choose to write about certainly makes me want to work with YOU.Keep up the good job, tell it like you see it, write fresh content often (btw, that is the secret to SEO).
Excellent post – and we can see why you’re making money and most of the other VC’s are losing it. They’ve forgotten how to work in alignment with the entrepreneur.
Do you think it is possible that you end up owning more of your home runs for one of the following two reasons?1. The company was a hot investment (so to speak) to start with and therefore the founders were able to command a reasonable (i.e. high) valuation at the beginning and did not need a lot of capital? or2. As the company grew and became successful – the risk reward of continuing to take your anti-dilutive rights became tilted toward the risk side – and you were happy to let later stage venture firms in the door at 4X your original pre money price – diluting you down?Or is it just that all winners look alike – good market, good execution, capital efficient?
I don’t know harryI think your first hypothesis may be part of the answerWe try to always ‘follow our winners’ so your second hypothesis is not likely to be part of the answerFred
Amen, brother Fred.The dirty little secret (not so secret really) is that as an asset class, venture capital is a bust.Sure some very few funds or firms make great returns but the vast majority suck wind, yet still continue to raise huge amounts from LPs and charge outrageously high management fees.The result? That VCs desperately chase returns in the only place they can — in the common stock. By 1) artfully (sometimes deceptively) convincing entrepreneurs/management to accept conviluted deal terms that seem to be one thing but when it matters are not, and 2) creating the misconception that a) its best to raise as much money as you can (its not — its best to raise as little as you need) and b) its best to stay in the game and shoot for the sky, rather than simply execute well and get out smart.The only thing keeping the current generation of VC funds and partners in business is that the public stock markets, bonds, hedge funds, buyout funds and real estate have all performed so brilliantly the last several years. As the returns from all these asset classes have been so excellent, LPs (pension and endowmnet managers) have had great returns overall, even though VC funds have underperformed their kids’ savings account at the local bank. And because everyone is so flush, asset allocations have not been changed, so the dough keeps piling in to the VCs, who somehow are now taking home truly huge salaries and benefits for losing their investors money.Remember: a painfully conservative plain vanilla investment portfolio earns about 7-8%/year, which means the pot doubles every ten years. Next time you hear a VC brag that his/her fund returned 2X, keep in mind that performnace is less than the most conservative plain vanilla inexpensive, minimally volatile index fund. BFD.
SteveDo you have an opinion why some vc firms/funds do outperform?Fred
luckbetter deal flow based on past performanceplaying for the long termbeing more entrepreneur friendly (jockeys who beat their horses win less races)lower fees (in greylock and venrock’s cases)timing (thru smarts or luck, VC as an asset class has performed when truly substantial changes are taking place in technology, e.g. emergence of steam engine, emergence of electricity, emergence of the transistor and semiconductor, emergence of PC, emergence of internet). likewise VC performs poorly when tech is merely iterating in small incremements, like now, i’d argue)luck—this doesn’t mean technology/innovation isn’t a great place to work and to invest, it just means that between major paradigm shifts true “VC returns” are difficult maybe impossible — as an asset class, not as isolated individual deals or companies or products — particularly in an environment of huge fees and oversupply of capital…
GREAT Post Fred. Yeah, I’m biased ’cause I already believed this…you know ’cause we often talked about it. But you said it well. RUBBISH (although being from Brooklyn I’m more inclined to use a slightly more vulgar synonym for rubbish).
I learned most of what I know from my partners in the business over the past 20 yearsI have been blessed by great partners like youFred
Amen. Entrepreneurs should only take money from funds under $250 million in size in the A round! Otherwise incentives get too far out of alignment. Large funds have a perverse incentive to ramp burn too soon; to create a top-heavy org structure, and “go corporate” before any repeatable sales process emerges.
Although I’ve been a long time reader I’ve never felt compelled to comment until now. As an entrepreneur going through our first significant round of funding I wanted to praise you on such a refreshing view.
Fred, this is a big one – thanks so much for this!My further thoughts:http://blog.adaptiveblue.co…
Fred, I think your dirty little secret is that you’re an entrepreneur at heart 😉 The market has changed and some folks still haven’t noticed, or if they have noticed, they react by pushing harder in the same direction they’ve always gone in. But you, as an entrepreneur, are able to see that the market has changed and have come up with an effective response.I’m envious of any company that gets to interact with you on a regular basis…
whoops, that last click went before its time…what I was about to say in my comment was that this question comes up all the time — so I’m going to send this post to every new Web 2.0 entrepreneur I know!bless you for blogging it,Graeme
One of your best posts that I can remember. Thanks.
Fred,I totally agree with your comments. Your numbers really highlight the problems that big funds cause. More comments here:http://www.thefeinline.com/…
Thank you. I’m carrying this in my wallet, right next to notes from old boyfriends. Mary Trigiani
If only more investors understood that…Any way you can make that mandatory reading for your peers??Thank you Fred. I agree with what everyone else had to say…this is one of the better post I have read on your blog. It’s inspiring and timely to entrepreneurs like myself. I’m determined to stick to our guns until the right investor comes along that understand that exact point. You can invest early in the right team and concept and get a much larger return because the package is HOT, not because you own a big piece of a mediocre business.Entrepreneurs with hot ideas will bootstrap for as long as they can…because they want to avoid sharing their treasure with investors, but for the big leaps they will still need investors; the kind of investors that understand vision in it’s clearest sense of the word.
Sounds like the venture capital firms that place these percentage floors are really just wanting to place more money in the companies – why invest in 40 companies when you can invest in 20? Sounds a bit lazy…!
Wouldn’t it be more diverse to own less, depending on the size of the VC Firm’s capital pool? Depending on how you allocate that money, you could raise the return with a little diversity, so yeah, you’re right.
Thank you for sharing this information. I’ve seen many investors follow the ‘herd’ mentality and just because one person says it they believe they have to buy into it. As an entrepreneur I’ve always bought into the notion that a smaller % of a larger pie is much better than 90% of a very small pie or as they say no pie at all. VCs will say that with a smile to many entrepreneurs but until this very post I’ve never seen one see that the same holds true for them as well.
Hi Fred,naturally, as a VC your duty is to get the best ROI for your LP. That should come before any other consideration, am I right?”We´ll not take less than 20%” is often simply an hardball negotiation, where VCs try to scare company founders into giving them a bigger slice of the pie, implying they will drop their offer otherwise. In that respect, isn´t it totally aligned with the LPs goals, especially if you keep yourself flexible and are willing to take less at the end, if it makes sense?I mean, I see it simply as one of the negotiating tools in a VC´s arsenal, and therefore I don´t see why it should not be used.Cheers, Giordano
GiordanoI think honesty is better than posturing.Would you negotiate with your wife before getting married?The vc/entrepreneur relationship should start out with frank, honest, and open discussionToo often it starts out with a high stakes negotiation insteadFred
Hi Fred,what about pre-nups? :)Cheers, Giordano
Type your comment here.
Great Post Fred. Gives all of us entrepreneurs more hope that we don’t have to give away the farm.
I am not sure that you should come to that conclusion.The best way to keep as much equity as possible is to limit the cash you need to raiseFred
Thanks Fred, great insights to the world of VC funding. A friend who attended GSB Chicago once told me that VCs normally want to take more than 50% of the company and that just make me wonder.. how true can that be. I think the “norm” is around 33% .. as in 1 for 3.
Amen, Fred…while few of any of us have had the success you’ve had making some of these smaller investments into home runs, many of us I’m sure have experienced the scenario in which the generally large(r) fund falls back on the ersatz requirement of a % ownership threshold when proposing to lead a follow-on round. Generally, this seems to mask the desire to squeeze out participation by other venture players, not just entrepreneurs, who have taken the larger risk early on…and while it can be fun, but generally unproductive, to call their bluff pointing to examples of investments they’ve made below this supposedly immutable threshold, now at least we’ll have the permalink to this blog post to help buttress our argument…
I think this is mostly a function of VC firm internal political dynamics.My experience is that the ownership thresholds come from VC firms that have large and/or political partnerships.Large firms and smaller firms that have political partnership typically set investing guidelines, and one of the easiest ones to set is the ownership threshold. The partners at a firm who make the home runs can do whatever they want, but the other 80% of the partners at a firm spend a lot of time reading the political winds and are hesitant to advocate a deal that violates the investment guidelines. With respect to the ownership threshold, the advocating partner doesn’t want to look weak in front of his partners by not being able to get the required X% of ownership from the mgmt team and/or the investing syndicate. It shows that they are not the “leaders” of the syndicate. Or another common analysis is that the prospective portfolio company “doesn’t value us as a partner”, which is a not so subtle way of telling the advocating partner that he has failed in convincing the management team or investing syndicate of the firm’s value as a partner.No one knows in advance which deal is the next Google, and therefore no one knows which deal they should stomach looking weak on the way in so they will look like heroes on the way out, so therefore partners are very hesitant to violate the ownership threshold, no matter how illogical it is.In small firms where each partner gets to know each opportunity and the whole firm can sit around the table and be fully conversant in all the trade-offs (like Union Square) then no one is worried about looking weak and taking a smaller “non-leadership” position in a good opportunity is fine.
Amen!
Fred:I realize that this is an older post. I did read it when originally posted, and liked what I read, but I have a question, I think that most early stage entrepreneurs who need other peoples money to get their business up and running wrestle with this area. When you say your firm owned 14-15%, how many other early stage investors were also in the deal and what was the total amount the company had to give up?Thanks.
Generally speaking we invest all the money to half the moneySo the total dilution might be 15-25%fred
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I agree that VC funds have made piles of cash over the last few years by investing in conventional stocks – but I wonder if this attitude will change after the crash in global share markets.I have met VC fund managers who have not found a good investment in 6 months, and it must be difficult to justify the fat fees when nothing is happening in the investor’s fund.What are the chances that VCs will start backing new, innovative ventures again?
NiviWe encourage all of our portfolio companies to test the market in each round. Then if they want to take more from us, it will be at ‘market’. But the thing is when you know a company well as an insider, a third party market value may be a bargain in your eyesFred