From here to enternity

Earlier this week at the AlwaysOn Venture Summit East, Harvard Business School Professor Bill Sahlman declared that the "Median rate of return on VC will be 0% for the rest of eternity".  For those of us who have been in the industry for a while, this is not a new statement from Professor Sahlman, although the qualifier "to eternity" certainly is a new time frame for this claim (and for those of you keeping track at home, eternity likely exceeds the length of my investment horizon).  Rather than debate his point of view, when I heard this I sent out a tweet saying simply "I hope he is wrong".  Soon thereafter I got a reply, which I have heard from several entrepreneurs before, that went something like this: "Don't you hope he's right? We want entrepreneurs to get at bats, and the current model makes that possible".  


I was tempted to reply back quickly with the the short answer of No, but thought this topic may deserve more than 140 characters.  So here is the the longer answer.  In the short term, venture capital that is willing to be invested at a 0% expected rate of return is on the margin good for entrepreneurs in that it helps get companies funded and maybe some of these companies will emerge as real businesses and many entrepreneurs will indeed get their at bat.  In the longer term, however, it is unsustainable and bad for entrepreneurs for two reasons.  The first reason is that the abundance of capital leads to too many companies being funded in any given sector, with the net result being that interesting sectors that can support maybe 5 companies now have 20+ companies pursuing the same customers, partners, and employees and each company is weaker as a result of the level of competitive intensity for scarce resources.  The second reason is that venture capital as a "asset class" competes for capital from investors and if the returns are not interesting, capital will go elsewhere where the expected risk adjusted returns are higher.  Further, venture capital is an inherently illiquid investment and, because of the illiquidity, our investors look for a premium return when they can not access their capital for longer periods of time, just as you get (and demand) a higher interest rate from your bank when you commit to a 3 year CD versus the interest rate you get in your always accessible checking account.  The general rule of thumb is that venture capital needs to generate returns that are 500-1000 basis points greater on a per annum basis than a similar equity investment, say the S&P 500 or the Nasdaq 100.  As a result, unless you are expecting the broader public stock markets to decline by 5-10% per year, a 0% rate of return in venture capital is not sustainable and the industry as a whole will contract, resulting in less capital for the industry and entrepreneurial ventures.  So while it may seem appealing on the face of it to have the industry run for the broader good of innovation, in the end we – meaning entrepreneurs and venture capitalists together – need to earn our keep every day to ensure that capital remains available for great people and ideas.

5 thoughts on “From here to enternity

  1. Avi Deitcher June 25, 2010 / 2:08 am

    Chip,
    I think you hit the nail on the head, two points that are often missed by many early-stage entrepreneurs.
    1) Everyone has to make money, or no one does. If VCs, over the medium to long term, do not make money on their investments, then these investments dry up. The return has to be competitive compared to other potential investments. The same is true for the entrepreneurs: they won’t sell their services at a loss, because then they go out of business. Smart buyers – consumers and businesses – get this, and want to pay the best price they can that still allows their provider to remain in business.
    2) Cheap money creates lots of high-risk low-return investments. Return and risk are normally correlated, but too much cheap money creates lots of risk for low return. Reference: Real interest rates last 5 years prior to financial meltdown. Good entrepreneurs not only want to make money for their companies and their investors, they want only good competitors. I never worry about a few good competitors; we will all find target markets we are after, and even if a few compete head-on, with a big enough market, we will all get share. I do worry about 20 or 30 highly funded companies selling services at a loss, run by people who do not know how to make money, making it hard for me to get capital or souring customers on paying good money for good service.
    But now for the downside: VCs share heavily in the responsibility for this mindset. How many poor firms have been funded? How many firms have been pushed to, “not worry about revenues or profits, just scale up, we can worry about the financials later?” This is true even in the decade after the dot-bomb meltdown. Just yesterday, I had a conversation with an entrepreneur friend who regrets following that precise VC advice… in 2008-2009!
    You are right… but we need to keep the investors out of the herd mentality and in this good business sense mode.

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  2. Rob K. June 25, 2010 / 9:04 am

    Chip- If you believe that one big reason for low returns is overfunding, then he has to be wrong. At least with the “eternity” comment. As you point out, low returns will drive LPs elsewhere, leading to smaller VC funds and fewer of them. Less capital produces fewer “me too” companies, raising returns for the VCs as a whole.

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  3. chazard June 25, 2010 / 9:40 am

    Avi – thanks for the thoughtful comments. I agree with the shared responsibility note as well, althought it is scary to hear 1999 advice being doled out in 2009.
    Rob – I agree and is why we are very optimistic looking forward

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  4. Janthonymez June 25, 2010 / 12:25 pm

    The assumption of 0% returns to eternity assumes steady state. A shake out of the VC world would not be a bad thing as it will drive innovation in the VC industry. Having been in VC late 90’s to bust and in P.E. and seed stage since, I think that the VC model has done little to adapt to the new economics of investing. Combined with the fact that many are reaching the end of their 3 year investment period they are actively trying to put money to work in the old way. i think there will be another VC bubble pop but as I wrote in my blog a few weeks ago that might not be a bad thing http://bit.ly/d6FBVk

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  5. dave broadwin June 27, 2010 / 10:11 pm

    Bill Sahlman is just being Bill, but the venture industry is well on its way to being half the size it was in 2007. All in accordance with the laws of supply and demand. Having said that, funds as they currently exist are not well suited to fund the “new” types of businesses that are being created. At one end of the spectrum, many cleantech and renewable energy companies require very large investments and will only pay off over very long investment horizons. Most ten year funds (even with a couple of extensions) can’ carry these investments for these time periods. At the other end of the spectrum, capital efficient start ups (like many communications companies — where a lot of VC investment money is going today) require a lot less capital than “traditional” VC investments. Here is my prediction, exits for these capital efficient companies will be relatively quick and relatively small in absolute dollars (although they may have big multiples). VCs will need to make very many investments to get the returns they need. They are not set up to have 20 or more investments per partner. (Let alone the issued you have raised about multiple entrants for each opportunity.) In the end I have come to the conclusion that many different types of funds (by which I mean funds with different sizes, terms, amounts of carry, level of management fees, and etc.) are needed. The one size fits all ten year fund will not work for every investment any more.

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