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Early Stage Venture Investing — A New Kind of Philanthropy?

November 9th, 2012 Leave a comment Go to comments

I’ve been busy with a project outside of the mobile/startup world for the past couple of years, but I’ve seen something surprising in the venture industry reports that I find very interesting.  So, I thought I’d post this note to crystallize those observations.

The good folks at Wilson Sonsini just published their Q3 2012 Entrepreneurs Report.  WSGR obviously sees a good fraction of all the venture financings that happen, and are in an ideal position to produce longitudinal data on valuations, amounts raised, and other terms.  Looking at this data over the last eleven quarters, we see some pronounced and significant trends in the data.  These trends seem to reflect a fundamentally new and different early stage venture environment — one with negative expected financial returns for investors.

From the WSGR data, one can calculate Post-Money Series A cost (to the venture investors) per percent of ownership, and see that it has gone up almost two-fold over the eleven quarters of this data series.

From WSGR data, Median Series A post-money valuation per percentage point of ownership now costs investors almost twice what it cost a few years ago.

This would be OK for early stage investors if they were getting rewarded for these increased prices that they are paying.  If they were seeing a commensurate increase in Series B Pre-Money valuations, or there was an increased level of early-ish stage M&A activity.  But, the data seem to indicate that neither of these things are really happening.

From data in the WSGR Entrepreneurs Report, we can construct the chart below, which shows that the Pre-Money Series B value per percent of ownership has come up a few tens of percent, but nowhere near the almost two-fold increase we see in the Series A Pre-Money chart above.

From WSGR, Median Series B pre-money valuation per percentage point of ownership is up a bit over the last few years, but not much.

And, from the NVCA, we get a consistently reported quarterly data set on total venture-backed M&A exit activity.  If there were really an increase in early stage exits, we would expect this number to really be shooting up.  But, it’s not.

NVCA data on total number of (Venture-backed) M&A deals per quarter. There has been no recent increase in transaction pace.

Yes, I understand capital efficiency in modern startups.  It really should take less capital to prove market demand for a new offering.  I truly believe in that.  But, if that was the primary effect driving early stage venture economics, the Series B Pre-Money valuations should’ve come up by now.  Instead, what this data suggests is that there is an increased supply of of Seed/Series A money coming from an increased number of small pools of capital, driving prices up.

My entrepreneur friends may be thinking something like “hooray! the negotiation power has swung toward us; it’s great those venture folks are getting their comeuppance.”  Maybe.  The problem is that early stage venture returns to the LPs (who invest in those venture funds) is already so unattractive that any additional pressure will cause venture investors to deliver negative returns, and drive them out of business.  So, be careful what you cheer for.

Indeed, Cambridge Associates reports early stage returns (as seen by the investors into venture funds) have only been 3.9% per year over the last ten years.  If you subtract out inflation, you’re talking about real returns of about 2.5% per year.  And, those numbers don’t yet reflect the reality captured in the first two plots above.  Barring unforeseen goodness breaking out, one would have to expect significantly negative returns to the LPs for the Median Series A investment done in any of the last four quarters.

For non-professional investors (ie, those that don’t have to answer to anyone but themselves), it may be OK to accept negative expected returns.  For these investors, the non-pecuniary benefit of helping see new ideas get off the ground may justify accepting a negative expected return.  Of course, they should be undertaking these investments fully aware of this philanthropic aspect.

The bottom line is that industry data seems consistent with a new era of early stage venture investing, where philanthropic considerations, and other ego-gratification considerations, have a material impact on the prevailing economics in the industry.


Postscript: Average does not equal Median

Others have noted the likely impact of the Instagram acquisition on early stage investor enthusiasm.  For sure, the few grand-slam home-run outlier cases make up a significant part of the expected return for an early stage venture investment.  They also add something of a lottery ticket like thrill for the non-professional investor.  The fact that many startups “could be the next Instragram” may well be driving valuation thinking for entrepreneurs and investors alike, but I think there are two import facts we have to keep in mind.

  1. It has always been true that the few positive outliers have had a big impact on Average venture returns of early stage venture investing.  But, this is the reality that is baked into those 2.5% per year returns that LPs see.  This is nothing new.
  2. Those big positive outlier outcomes are not evenly distributed among early stage investors.  The top handful of early stage firms have always seen a disproportionately large fraction of the big positive outlier outcomes. If you are an investor who is not sitting at one of those top handful of firms, history suggests that “the next Instagram” is unlikely to happen to you.

This is another way of saying the (anemic) Average returns for early stage venture investing are much higher than its Median returns, and that investors who are not who are not at the top handful of firms should be expecting Median returns, not Average returns.

  • everploeg

    After publishing this post, I spoke with Herb Fockler and Eric Little, who produce some of the WSGR Entrepreneur Report articles and data.

    Herb and Eric identified what is probably the weakest part of my argument: there may not have been enough time elapsed to see the increased value of these capital efficient companies reflected in Series B prices.  It may take longer than used to be the case for venture backed companies to need to raise that Series B financing, because of capital efficiency itself.  I agree there is a chance that this is going on.  It will be very interesting to see what happens with Series B Pre-Money valuations in the coming quarters.