February 12 2015
by Todd Hixon

There Are No Base Hits For Startups Today

[This post first appeared at on February 12, 2015.]

Once upon a time, like ten years ago, entrepreneurs could make decent money building a business that hit milestones but never got big and sold for $10 – $20 million. These exits would pay entrepreneurs enough to sends kids to college and return 1x-2x capital for venture capitalists. They are scarcer than rotary dial telephones now.

Entrepreneurs and venture capitalists (“VCs”) have long known that a few winners get most of the spoils. The classic rule in early stage venture capital is: 10%-20% of companies provide 2/3 of the return in a fund (about 2x invested capital), another 30%-40% provide substantial return (about 1x capital), and the remaining 40%-50% are zeros.

We saw this in our last fund. Three of 18 companies were real winners that together returned ~10x the capital they received. Seven were base hits, returning 0.5x – 2.0x their capital. The other eight were near/total write-offs. The fund did well overall.

The distribution of outcomes has become far more skewed. We’ve seen a sharp rise in the number of venture-funded companies with valuations over $1 billion (“Unicorns”). But the Unicorns are a small percentage of outcomes: CB Insights estimates that about 1% of start-ups have unicorn exits. The University of New Hampshire’s broader database of funded start-ups puts that percentage close to 0.1%.

The biggest change is the hollowing of the middle of the outcomes distribution. If companies fail to achieve “escape velocity”, i.e. scale, revenue momentum, category leadership, and/or profitability, they are worth little. The idea that acqui-hires are lucrative is bogus: many amount to a pay-off for the bank and a hiring bonus for the engineers.

Data sources: Seed fund data via Shai Goldman; early stage data from Pitchbook and Atelier via Mark Suster; total investment via NVCA.

Data sources: Seed fund data via Shai Goldman; early stage data from Pitchbook and Atelier via Mark Suster; non-fund via CB Insights; total investment via NVCA.

Why is this?

•  The boom in seed investing and micro-VCs has created a lot of companies. The supply of classic early stage capital has not recovered from the halving caused by the financial crisis, however (see chart above). So a lot of start-ups raise seed funding, go aground looking for A or B rounds, and put themselves up for sale. Corp Dev officers are often deluged with small companies looking for an exit.

•  The social/local/mobile space that has dominated recent venture exits inherently has one winner in each category: Facebook to connect with friends, Twitter to build your persona, LinkedIn to find business connections, etc. That means there are only a few category winners and only a few buyers for businesses extend the category winners’ platforms.

•  Most of today’s start-ups don’t have deep technology: they are applications and business models built on standard technology platforms. Their patents are worth little, if they bother to file any. Value is built by creating a user base and network effect. So there is little to sell if the company never gets to scale.

•  Tens of billions of dollars of venture capital has concentrated in the hands of a couple of the few dozen late/growth stage venture investors plus the non-fund investors, like Fidelity and hedge funds that come into growth rounds. They dominate financing growth of start-ups from $300 million of market cap to the $ billions market cap at which the biggest exits now occur. This small group is effectively anointing winners, probably with more selectivity and discipline than the public investors who financed this stage of growth in the past.

What does this tell me want to do or not do? First, it reinforces the rule that start-ups are all about the big winners, and all else is forgotten when the fund winds up. If a given company does not have the potential to be a big winner, it’s a mistake to get involved, for both entrepreneurs and investors. But, big winners are all relative to ownership percentage and fund size: exits in the $200 million to $1 billion range can be a great outcome for entrepreneurs and small funds alike. And Unicorns often don’t do much for many of their investors.

Second, we need to build companies, business plans, teams, and syndicates that can accelerate rapidly, emerge as category leaders, and attract the attention of the “king-maker” later stage investors. Skillful and charismatic business leadership is key to success. A small industry (Mattermark, etc.) has grown up around measuring and reporting start-up momentum.

We need to hold our winners until they achieve full potential, because that’s where the money is. Company cycles and fund cycles will be longer, because private companies grow longer and bigger before they exit. Leaving all the money in the pot longer will increase risk.

We need to evolve fund models to account for this reality. Seed funds have emerged because you can start companies cheaply, a few of them have spectacular success, and seed investors do well if they are great company pickers. There are celebrated successes here, but time will tell how well seeds funds work as a strategy.

Classic early stage funds face big challenges: they need more capital to capture the appreciation potential that their pro-rata rights create in winners as they scale further before exit. Longer time to liquidity tests limited partner patience. Early stage has fallen out of favor, as the chart shows: money has flowed to faster payback later-stage investments and the shiny new seed fund thing. GPs are adapting, particularly developing companion “Opportunity Funds” that invest in their companies at later stages and provide faster returns to their investors. Look for interesting developments here.

So the going gets even tougher. Of course, entrepreneurs and VCs love the big game: they get energy from the challenge and keep their eyes on the big prize.

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