Chris Sacca, one of the world’s most renowned tech investors, recently suggested that venture capitalists are often very wrong. To be fair, he also said that when they are right, they are very, very right, and so this is what should be expected of them. However, many venture capital firms are struggling to ever be ‘very, very right.’
According to the Kauffman Foundation’s research, venture capital (VC) investment on the whole has not outperformed public market investment since the 1990s. Even worse, between 1997 and 2012 VC investments failed to return more money than the total sum invested, despite a number of startling successes. So, what can be done to ensure that venture capital investments are more successful? After analyzing their own VC failure to deliver large returns, the Kauffman Foundation made five major recommendations on how to improve VC investment practices.
Recommendation 1: Reject generic growth models as proof a company’s growth potential. The study found that firm growth does not always follow the traditional J-curve or exponential growth model, which VC firms often use to decide whether or not to invest in a company. Committees that decide which companies to invest in should be cautious of claims that a company will follow a traditional growth trajectory. The graphic below shows the small percentage of firms that successfully hit the golden “J curve” in the Kauffman Foundation’s portfolio.
Recommendation 2: Create more transparency in VC firms. Limited partners are often unable to access enough information about the VC firms and general partners in order to make an educated decision about whether or not they should invest. Increasing limited partners’ access to information can help them make more educated decisions as to which firms to back in order to reduce risk.
Recommendation 3: Remove VC Mandates. Requirements by funds into how VCs invest should be removed because they do not increase returns. The report found that it is only financially responsible to invest in the top-performing VC funds.
Recommendation 4: Pay for performance, not percentage of ownership. Currently, VCs are paid more when they raise large funds because of the two percent management fee and the percent profit sharing model that is the VC market standard. The market standards allow VCs to lock in high returns regardless of the individual company’s performance. If limited partners negotiated a compensation structure where they pay general partners for their performance instead of accepting a market standard, which does not encourage good performance, there would be more incentive to choose less risky companies.
Recommendation 5: Use Public Market Equivalent (PME) to benchmark VC fund performance. VC funds should chart firms’ performance by comparing the cash flows to comparable indexes of publicly traded stocks in similar industries. Using PME to assess VC firms would force consultants and investment staff to rely on metrics other than gross returns and internal rates of return that fluctuate rapidly.
To read the full report, please click here.
Contributed by Emily Luepker.