One of the first things I did when I joined the venture asset class as a lowly institutional LP analyst in 2001 was to build the VC fund cashflow model. Just about every analyst who looks at fund investing has built one. You incorporate expected company returns, mortality rates, and fee structures to try to predict how a venture capital fund works from a cash in, cash out, and NAV standpoint.
It's basically the unifying theory behind all your assumptions about 10% of the investments driving most of the returns, needing certain multiples of return, and the basics of how many deals you do a year, with fees layered on.
Let's be clear about this exercise. It's not perfect. There are all sorts of wacky cludges and hacks in it, like the idea that every company performs exactly the same over time, because you don't know *when* the winners and losers happen. You wind up with a Schroedinger's Cat type model where you invest in a company and it partially dies and partially exits over time. This way, you smooth out all the lumpiness of time when multiplied out across 30 or so deals. And no, the numbers don't exactly add up--but they're more than close enough for venture capital.
It's also not the "average fund". You don't want the "average" fund, because average funds don't do well--just like you don't want to model the average startup, because you might as well draw a big flaming hole in the ground. Venture capital is all about finding the extraordinary. It's about building the exceptions.
On the other hand, you can't exactly model out being in Accel Facebook fund, the First Round Uber fund, or the Lowercase Twitter fund. So when you think about returns, what should you expect.
What I tried to model out is "institutional quality" funds--funds that have access to winners--those winners being "normal", however. Not unicorns necessarily, which require the suspension of reality to believe you can consistently pick them.
The average VC-backed exit is somewhere around $250mm... so that's what I said my exits would be as a seed stage fund.
And those exits would be roughly 10% of the portfolio--about 3 out of every 30ish deals.
On top of that, maybe you get another 3 that have good but not so great exits at $50mm.
Perhaps 2-3 more exit for $20mm or so after a Series A.
Toss in a few acqui-hires in the $6-8mm post seed... like 3 or 4, and there you have it. Thirty deals, 13 exits, 17 wipeouts--and roughly a billion dollars of total enterprise value generated. For my fund, an $8mm seed fund, without even following on, you wind up with a 26.67% return and a 2.88x cash on cash return.
If you could return investors nearly triple their money and mid 20's returns consistently, compared to the 8% long term return in the public equities market, they'd more than accept that. Comparatively, if you look at long term private equity results, I think most investors are winding up with high teens returns.
Without complicating the model at first, so what does that actually look like in terms of committing to a VC fund?
It's what you'd expect... You're putting money in over the first 3-4 years, but you're not really seeing most of it back until years 7, 8, and 9, if not longer. Distributions can actually be drawn out over an extended period of time, but for the purposes of this exercise, I just kept the fund to 11 years.
That's if you're not following on. If you're following on, not only do you have a bigger fund, but the requirements to continue putting in money last a lot longer. Obviously, you get more back as well. A fund that follows on would look more like this:
You've probably been sitting there thinking, "What is with this bullshit no follow on strategy you keep talking about? Don't you double down on your winners? Everyone knows that."
Yes, that's conventional wisdom, but my question has always been, "When do you know something is a winner?"
Just because my seed bet raises a Series A, I don't think that automatically think that's a winner. What if we took that as our sole criteria? Then, wouldn't it suggest that Series A funds in general vastly outperform seed funds as a whole? They're only investing in the ones that make it past seed, so isn't that a better bet?
That hasn't been shown to be the case, for a few reasons. First, seed funds tend to be smaller, and smaller funds do generally outperform larger ones. Second, their dollars dollar cost average at cheaper entry prices. Even if you lose a bunch of the seeds, your multiples on the seed exits should more than make up for the ones you lose.
Here's another way to look at it--the cost of capital argument. Do seed investors have Limited Partners with different return expectations than Series A and beyond investors? I'd say no--they're taking money from the same endowments, high net worths and pension funds as everyone else. I've never heard any limited partner ask me if I can generate a better return than their Series A funds. So, if that was the case, and the market was competitive, why wouldn't each VC be bidding up a round up until the point where they could get the return that matches their own cost of capital?
So, whether you're doing Seed, Series A, or Series B, each round would get its net 25% to LPs, no? After factoring in price and mortality rate (risk), every stage's investor would be trying to get a return that satisfies their LPs--and I think that's the same across all early stages.
Where I don't actually think that's the case is in growth rounds, which seem hyper competitive right now--and where the ability to differentiate yourself as an investor is limited. I honestly don't think the investors who are going into Uber are underwriting that bet to a 25% net return to investors. I think it's closer to 15%, and maybe that's justified because they're very unlikely to go out of business at that point.
But what does the model say?
Well, funny enough, the model pretty much agrees with me, even though I wasn't putting that cost of capital in as an implicit assumption. Things change, however, if you have different mortality timing expectations.
So here goes...
I assumed the following:
Seeds are done as a $1mm round on a pre-money valuation of $5mm.
Series A's are done as a $5mm round on a pre-money valuation of $15mm.
Series B's are done as a $10mm round on a pre-money valuation of $40mm.
Series C's are done as a $25mm round on a pre-money valuation of $100mm.
Exits are $250mm.
Mortality rates dictate that half the seeds don't make it to A, then 30% of those don't make it to B, then 10% of those don't make it to C. Along the way, you've got some early, smaller exits as well... 20% of the Seeds get acqu-hired at the 6 post. 25% of the A's sell for $20mm. 50% of the Bs sell for $50mm.
So here's what the charts say for follow on strategies:
If you run down the first column, what it says is that it basically doesn't matter if you follow on from an IRR perspective--a percent won't kill you here or there. You are, however, leaving cash on the table, obviously, b/c you put money to work at the same level of return.
If, however, you assume that companies die later on, here's where you start to lose return. What if most of your seeds are making it to A, but then half of them die between the A and the B round? If you're following on in the A round, then you shed a full 500 basis points on your IRR. You don't really gain it back after that regardless if you follow on in your B's and Cs.
It gets even worse if things just hit a wall at the end--where companies just keep getting funded until they crash, Fab style. If your deaths don't occur until Series C or later, then you're literally talking about a mid teens return--10% less than what you would get if you didn't follow on.
Me personally, I'm happy to keep my fund small, to not have to worry about staying close enough to each company forever to make good follow on decisions, and to not worry about whether the market is artificially propping up companies.
How about price? Does price have an effect on returns?
You bet your tookus it does.
Let's just say that instead of the 5, 15, 40, and 100 pre-money valuations we were paying before, everything was 50% higher. That's going to cut our returns by about 400-500 basis points and much worse if you're following on. This makes sense because you're paying higher and higher prices along the way for the same deals, but your exits aren't getting any better.
If prices are 2x higher, then we're looking at high teens returns for just the seed round's returns, and mid for the whole ball of wax if you follow on.
Seed round returns are particularly sensitive to exit valuation--because what might seem like a million bucks here and there is actually a lot on a percentage basis.
So, if I can get everyone down from $5mm pre-money to $3mm pre-money, now I'm netting my LPs above a 40% return. If I'm forced to pay $7mm pre-money for all the same deals, we're looking at sub 20% returns. Don't even talk to me about paying $9mm pre.
Ok, I know what you're saying. What's with these paltry $250mm exits? Bring on the unicorns!
Fine, fine, what if exits are better than I'm expecting?
Returns obviously get much better in the seed when the outcomes are larger, but it's not really as crazy as you'd think--mostly because exits still take a long time. So, a billion dollars is obviously much better than a quarter billion, but 6-8 years out the effect gets a little muted.
What if you keep following on in your winners AND you get some unicorns. Well, clearly the dollars are much better--which is nice for VCs who get a cut of the dollar profits (as opposed to being paid on IRR). You'd need a bigger fund to maintain your ownership (although in this model, we're still keeping the simplistic A, B, C round approach at the same prices). The fact remains though that the key to getting outsized IRRs is to be in the winners, almost regardless of what you do with them after.
How does time play into this?
Time is the enemy of IRR. No surprises there.
If it normally takes 5-7 years to exit at $250mm, what happens if it takes longer. For every year, you're looking at about a 300 basis point drop in return. Or, to look at it another way, you'd need roughly $75mm in enterprise value gain on exit to keep up with a $25mm net return.... so if you choose not to sell for another two years, you better be exiting at around $400mm.
Obviously, this model isn't perfect, and neither is venture capital--but at least it gives you a ballpark sense of how these funds perform, and what moves the needle on them.
Admittedly, it was fun to pretend that I was a 25 year old analyst again.
I'm excited to be able to finally announce Brooklyn Bridge Ventures' investment in Clubhouse, a company I agreed to back before I even knew what it was.
In 2010, a bunch of techies got together to do the next year's NYC Triathlon. I had already done two and was looking forward to joining people from the tech community.
It was also right around that time when I started CTO School--a small five session series on how to go from being a developer to a technical leader, which blossomed into a not only a very active meetup, but also gave birth to a great conference series as well.
Of course, I had no business starting such a group, so I enlisted the help of some people I had met through the community--like my fellow triathlete Kurt Schrader, who was, at the time, leading tech for Intent Media.
Kurt is a no-nonsense guy with fantastic experience growing and managing technical teams. He's direct, focused, and he gave me great feedback on what to teach about how to get teams working together at scale--so great that I roped him into giving the talk, and eventually co-founding the meetup group that CTO School became.
We stayed in touch, doing a couple of tris together, chatting about startups, and venture, life, etc. I was really impressed with his ability to distill things down to what was really important--and his constructively critical eye when it came to the buzz around products that most people just didn't need.
So when we grabbed dinner about a year ago and he told me he gave notice, and that he had a guy working on a thing (that guy was his co-founder Andrew Childs), I just said "I'm in."
I didn't even know what he was working on--but Kurt isn't the kind of guy that wastes his time on some Uber for moustache grooming app. For him to leave a great job at a growing company where he had become CTO, it had to be real. Kurt is the kind of founder you back whenever they're working on something, and I've had a lot of success backing pre-product founders like Raul from Tinybop, Adam and Chris at Canary, and Chantel from chloe + isabel. All had enough experience that led them to being the absolutely right founder for the products they were working on.
Eventually, he told me the premise--creating product management software that development teams would actually want to use. He spoke of why developer teams outgrew Trello and didn't love Jira. When I started to float the idea by product managers I knew, they couldn't wait to talk to Clubhouse.
We closed the round with some great co-investors, but what's striking is how little of it they spent to actually get to a product that teams loved. I introduced them as "product management software that doesn't suck" to tech team at my portfolio company Orchard, their CTO wrote:
"Thanks for the intro! We're actually vetting alternatives to our current toolset for suckage reasons."
Less than three weeks later, he wrote:
"Just wanted to thank you for the intro to Kurt at Clubhouse. The product is exceptional. Home run."
One of their developers wrote in separately:
"This tool is incredible. Absolute best PM tool I've used."
Basically, just a couple of developers built a better tool than what people have been using for years. Even potential employees are excited. At one of the Stackup Talks that Brooklyn Bridge Ventures runs, a developer from the hedge fund world who had been making quite a fair amount of cash just walked up to the team and said that he's excited about what they're working on and wants to join.
So why is Clubhouse different? First and foremost, Clubhouse aimed to help developers do their jobs without creating an extra layer of administrative overhead. They did that by integrating with the tools that devs are already using, like Github. When you do things in Github, they're reflected in Clubhouse.
Another hugely successful software company with that design philosophy was Salesforce. They realized that salespeople lived in their e-mail--and the last thing they wanted to do was to log e-mails into a database. By creating Outlook plugins and bcc tools that ingested e-mails, attaching them to clients, they made the lives of a salesperson so much easier.
But that's not all. When everyone is actually using a tool correctly, you can start quantifying productivity, and optimizing for it. The way we now have deep insight into salesperson productivity is exactly the way we *don't* have it during the development process. What PM knows exactly how long everyone accomplished their tasks when the team is updating the product management software during the standup? Jordan Crook's comparison to Clubhouse as Salesforce for developers is spot on.
I can't wait to see how things develop for the company now that they're out there in the world.
Late last year, Adam Price opened by eyes to a group invisible to most New Yorkers--bicycling food delivery guys. He told me about how they get their jobs, what they make, how they make it, and about all of the various problems that come with being a 1099 worker--or being completely off the books.
He told me months and months ago, before anything came out about Uber's workforce, how it was never going to work in a world of increased "on demand" services. He outlined some of the issues in a recent blog post:
- Using 1099 workers--people who, by definition, you can't tell where and when to be at a certain spot, is inherently inefficient.
- The explosion in on demand apps and services meant that any retailer or restaurant didn't just have one firehose of demand to drink from--they had eight. These small businesses needed a single delivery solution in order to focus on what they do best--whether it's making food or curating products to sell in a store.
That's what Homer is. It's not a B2C company. You order from Seamless or wherever the way you normally do, and the restaurant turns the delicious meal over to Homer, the delivery experts. This way, Homer doesn't have to raise hundreds of millions of venture capital dollars to change consumer ordering behavior.
He created Homer in order to solve those logistics problems, but he was especially proud of another problem that he solved:
These delivery workers were highly underpaid--because they were working off of tips and were highly underutilized. When you have a single shop that has varied demand throughout the day, the amount of money you can make delivering is really low. Sometimes, you'll get zero orders in an hour and you'll just be stuck with the $5 wage you're being paid--if that.
What happens when you start batching all of these orders across restaurants is that now you're getting two, three, four, or even five orders, not just in peak orders--but every hour--and sometimes more. Now you're pushing hourly wages for these hardworking people into the teens, and you're doing it while classifying them as W2 employees with worker's comp protection. I can say as a NYC cyclist myself that's particularly important.
Adam told me the story of one of the members of his delivery team who enjoyed riding for Homer so much that he started dropping leaflets at the restaurants he used to drive for--and marketing wasn't even his job. It was a much better setup to be classified as a W2 employee, with all its protections, as well as obviously making more money, more consistently.
Homer didn't need to get sued to classify its employees as employees. It found a better business model that solves doing right by customers and doing right by its staff. That's why I'm proud to have led their $2mm round of financing. I'm joined by Two Sigma Ventures, VaynerRSE, and, importantly, some of the largest delivery restaurant owners in the city--the founders of Chop't, Dig Inn, Melt Shop, Dos Toros, etc.
Urban logistics and delivery is a huge market and in high demand by customers. There's enough money here to both make a huge business and compensate people appropriately.
Mayor Bill DeBlasio is on the verge of making NYC one of the most unfriendly cities in the world for technology companies to operate.
It first started with Airbnb, which got caught in a crackdown aimed at people who turn "affordable" residential housing into full time hotel space. Don't concern yourself with the fact that Airbnb is simply an outgrowth of the lack of affordable housing--where no one would ever bother renting out their place if they didn't have to struggle to afford to live here. Don't concern yourself with the fact that it's the city that green lights all of the luxury condos going up all over the city in place of reasonable housing.
They could have created a reasonable, nuanced set of rules that allows me to rent my place out when I'm not there, like the four times a year I'm out in San Francisco trying to convince valley VCs to invest here, to someone who needs it. Most of these renters are tourists who contribute to the NYC economy and who can't afford $450 a night for a hotel--people we should be aiming to attract. Instead, the baby got thrown out with the bathwater here and renting your whole place is illegal.
And now, our anti-tech progress Mayor is helping NYC join an exclusive list of cities that have stood in the way of Uber providing an innovative consumer service that is in high demand.
Regardless of how you feel about Uber as a company or their management, it's really hard to argue that New Yorkers don't want this service. It's also hard to argue that anyone who supports NYC's tech community wouldn't have rather had Uber build their company here versus in San Francisco. Uber employs 3000 people, more than most startups in NYC do, and is only six years old. Same with Airbnb. Imagine what the NYC tech community would be like had Uber and Airbnb grown up here.
Well, what are the chances of that given our anti-innovation policies regarding these two companies?
Would NYC rather be on the side of innovation, or the side of the taxi lobby, who donated over $550,000 to the Mayor's campaign?
In LA, it has made getting around the city transformationally easier. I've spoken to at least ten LA residents in the last year who have said they no longer need a car because of services like Uber and Lyft.
Similarly, Uber makes getting around in the outer boroughs of NYC much much easier, as well as to and from the airports. I don't think I would have ever been able to find a green cab had it not been for Uber. Remember, this is the Mayor who initially wanted to curb green cabs--a program that quadrupled the number of outer borough taxi fares picked up--because the yellow cab lobby was against it.
It may or may not be necessary to have Uber in Manhattan, but then again, it's not totally clear to me that *any* cabs are necessary in Manhattan--or cars in general. That's why I was a big fan of the congestion pricing setup that Mike Bloomberg proposed a few years ago.
If DiBlasio really wants to prevent traffic fatalities and improve the air quality, as well as make it faster to get around here, he should take a look at plans to limit driving across the board instead of targeting one company.
Has Car2Go, in my opinion one of the best things to happen to outer borough transportation, undergone the same governmental scrutiny for taking up 400 Brooklyn parking spaces (or half spaces, since they're little Smart cars)?
Has Via, the new bus service come under fire?
What about WeWork? While smaller startups benefit from the coworking company's great facilities, larger companies looking to expand are fighting with the multi-billion dollar real estate behemoth for already expensive larger commercial space.
Not yet, because it seems like the NYC government picks and chooses which startups it wants to go after depending on which lobby being disrupted complains the most.
Given that kind of environment, what's the likelihood that the next Uber or Airbnb will want to set up shop in New York City?