Every once in a while, you read something and you agree with what the author is saying. As you read, you can hear the resounding “yes” that accompanies the comprehension of the text. What doesn’t happen as often is the experience of where you find yourself physically nodding your head in agreement. Well, that is exactly the experience I had when I read Alan Patricof‘s piece in the NY Times DealBook: Another View: V.C. Investing Not Dead, Just Different.
Alan is the founder and managing director of Greycroft Partners, and he clearly has a lot of years of experience to make this analysis. In meeting and chatting with some of the veterans of the venture industry the one thing that I’ve consistently noticed is that there are a lot of smart people in the business. I haven’t had the pleasure of meeting Alan, but his column certainly resonated with me.
In essence, Alan’s column gets to the core of why I started K9 Ventures, and does a wonderful job of explaining why and how Venture Capital needs to change. He makes the case that because of the changes in the public markets and what it takes to take a company public, those exits are going to be far and few. Therefore, venture capitalists need to change their models. The change can be one of two things, either you focus in the early stage and in that case you have to have a smaller fund and expect to get smaller exits (my strategy) or you can move upstream and go for the later stage opportunity (which is where I would argue most of the well known funds are headed, for example, KP is raising a total of $1.25B).
Though the whole article is well worth the read, I took the liberty of excerpting the key paragraphs here:
… I believe that the paradigm has changed for the venture business. We can no longer realistically expect the same kinds of absolute returns that were achieved in the past through a quick turnaround from start-up to liquidity through an I.P.O. Rather, I believe that most of the companies that venture capitalists are funding today will find an exit through merger or acquisition. And if we expect to achieve a return in a reasonable time frame of three to five years, we are probably looking at a sale price of $20 million to $100 million. This is the valuation range where most young companies are being acquired.
To compensate for these lower gross return expectations, we must establish initial valuations, usually in the single digits, that can provide an adequate multiple return and internal rate of return. Inevitably, this suggests that a true venture capital firm should be reverting to smaller-scale funds and restricting individual investments in early-stage companies to accommodate the realities of the exit opportunity. Larger funds can focus on later-stage growth opportunities that can absorb greater amounts of capital where there still exists the possibility of taking companies public in a timely manner.
I’ve bolded the key statements in the excerpt that had me nodding along as I read Alan’s article.