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Venture Capital Method Is The Madness

As an investor who sees his share of early stage pitches, my associates and I are increasingly of the mind that the method used to evaluate VC pitches and ultimately the pitches themselves and the businesses they spawn need to change. My main complaint is that pitches are usually crafted and deals are funded and the ventures are managed to focus on grand slam potential. This need for the grand slam, as opposed to more home runs or valuable triples, is supposed to make up for the 9 out of 10 deals that don't work out. The focus on grand slams adds risk, skews the mix of available deals, changes how new ventures are presented and managed, and ensures that at least 9 out of 10 deals don't work out. I find it wasteful, time-consuming and under-productive, What do you think? Or am I just having a bad day?

Answers

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Anon, walk in the shoes of 5x to 10x (maybe slightly more) companies with good products/business models that can't get funded. Add to it that VCs dont give the time and day for less than 10B in addressable market potential. Most of the funding goes to "known" personalities and exacerbated by the FOMO mentality. Add another wrinkle that most funded startups (the supposed "grand slams") barely have any resemblance to their original products/business models when presented to the initial funders. So the grand slam "excuse" (reason?) does NOT hold water.

I still have to encounter a VC who invests in startups that can easily do singles, gunning for triples and maybe a homerun.

Initially, scarcity of funds (maybe efficiency) was the main reason for the mindset. However, with the availability of capital, this is no longer applicable.

Rant over.

Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

The mindset was started on the Street where double digit increases are required every year otherwise the company is a dog.

What ever happened to steady and controlled growth allowing for the entire company to not only be in sync, but stay in sync with the demand(s)?

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

I can do miracles given enough money! LOL

As a P.S. to my response, most of the unicorns are still not making money 5 years out. Market share (and arbitrary valuation) is more important...at least to the investors.

Anonymous
(CEO/CFO) |

Dear Anon - you are right on target. As a many time entrepreneur it is forever frustrating that a profitable for all sale to a big public company hardly seems interesting anymore. I'm talking great returns for short-lived investments, but certainly with risk, and no, VCs are not interested.

The VC world top to bottom still says things like "we're in it for the long haul", but almost none are, they are in it for the unicorns and lots of businesses that should get funded don't, and, frankly, lots of sock puppet businesses that should never see another dime end up sucking up a lot of the money.

As a result, 10 year venture returns looking back from 2014 were barely a tick higher than S&P 500 returns. Risk weighted, that doesn't make sense for investors.

So no, you're not having a bad day, the limited partners of many of the ever-dwindling number of VC firms are having a bad day, and the entrepreneurs who deserve the funding for their great ideas are getting turned down for some VC to take a shot at a thirty-seventh social network for tweens.

Robert Honeyman
Title: CFO
Company: Advanced Predictive Analytics
(CFO, Advanced Predictive Analytics) |

VCs are not risk takers. They are far more comfortable with minor shifts in the eco-system than they are in paradigm shifts. That is, unless they can be the last ones in.

David Cowan
Title: Vice President
Company: Proformative, Inc.
LinkedIn Profile
(Vice President, Proformative, Inc.) |

Whether you're an investor or an entrepreneur seeking funding, understanding the valuation methods used by venture capital firms may help you understand the "method behind the madness" of their investment decisions.

Here are two courses that present two different valuation methods for early stage, high risk investments that might help inform this discussion:

Venture Capital Valuation Analysis Method

Pre-Revenue New Venture and New Product Valuation Technique: Part I

Whittington Vara
Title: Director of Operations
Company: Wave Contact Lens System
(Director of Operations, Wave Contact Lens System) |

David,

Thanks for mentioning the "Pre-Revenue New Venture & New Product Valuation Technique Part I" course. I just wanted everyone to know the Part II of this course, which provides spreadsheets and tutorials for implementing the technique, should go live in the next several days.

Anonymous
(Sr. Growth Business Finance Specialist) |

David and Whittington, appreciate the links to the training sessions. However, as a previous VC principal I have to echo others' assessments above regarding the state of early stage (pre-revenue and even very early rev) investment assessment.

Too often today the "MBA Mentality" of valuation techniques is the norm not the exception. Find a concept, assess the potential market size (to which you discount), apply an anticipated market share that the company might gain (again, discount), estimate exit comps, then back into a valuation based on what can get you to a 10x+ return.

Rinse, repeat.

Now that I have moved to the risk-taking (read: entrepreneurial) side, this investment "analysis" seems even more exacerbated (even when investors we talk to know we have all "walked the walk" as VCs!).

My partners and I often dream that if we are lucky enough to have a sucessful exit that we would really love to put together a small fund focused on "old school" VC investing - capital, advisory, even sweat equity as necessary. Almost like merchant banking (a largely defunct US vestige). Realize this is a dream, and haven't explored enough to know if the economics are even tenable enough to do it that way (given time commitments it would be a super concentrated portfolio), but its nice to think about.

Whittington Vara
Title: Director of Operations
Company: Wave Contact Lens System
(Director of Operations, Wave Contact Lens System) |

Anon,

I agree the MBA mentality fostered in the VC valuation method may assign unreasonable values to non-revenue producing new ventures. I think this is due in part because the transitory nature of commercialization risks are not adequately taken into consideration.

All new ventures do not share the same overall risks because the overall risk depends on which stage in the commercialization process the most risk currently resides (development, customer acceptance or marketing & sales). The overall commercialization risk is reduced as the company overcomes the high risk in each of these areas until the venture reaches the point in time when commercialization risk is minimized and the business is dominated by "normal business risk."

The concept of reducing risk by learning is a fundamental concept of "real-options" valuation and should be incorporated in any high risk valuation process.

The Pre-Revenue New Venture & New Product Valuation Technique Part I and II expand on these concepts to provide the background and tools necessary to apply this process.

Topic Expert
Keith Perry
Title: Consulting CFO and Business Operations A..
Company: Growth Accelerator
(Consulting CFO and Business Operations Advisor, Growth Accelerator) |

Anon,

I'd agree if we overlay the assertion with the clause "...when inappropriately applied." Premise: a good VC isn't a passive investor. There are a flurry of activities: board work; leadership coaching; recruiting; customer and partner intros; pivot support; etc etc. You also have a tighter filter on the front end which means more time for research, analysis, feedback, and bigger but fewer deals coming out of the back end.

I do a lot of work both in Silicon Valley and in emerging markets. Addressing the latter first, we simply don't apply the VC valuation or management method because it doesn't fit in an emerging markets scenario. We know in this market that a) we're not looking for unicorns, and b) we can't afford to pay someone $250K/yr in an MD role when unicorns simply don't exist. In this environment we're looking explicitly at base-hits. Low risk, extant teams, known or ported products and business models (shaped to fit the different environment of the target market). 1337 Ventures is a good example of a group evolving this model (note, they're pretty high-touch in all fairness, but aren't nearly so as a unicorn-focused firm).

On a more local basis, certainly not every investment firm (VC or otherwise) always hits their numbers, and in aggregate the returns are paltry. Granted all of that, there is certainly room here for "home-run" investing. There may be some structural issues (eg over-priced seed rounds that end up as down-rounds at exit), but I don't see that as the greatest issue. One is a simple reality issue. Allow, if you will, there there can only be so many unicorn-class exits, only so much displacement of business or consumer spending, etc; run that across the number of deals done, and *no matter the quality of the deals you're investing in*, if you (as a community) invest in too many deals, you must fail. Invest in too few, and you're leaving money on the table. That's a balancing act that the invisible hand seems to be playing.

Whittington Vara
Title: Director of Operations
Company: Wave Contact Lens System
(Director of Operations, Wave Contact Lens System) |

Keith,

Although I am an avid proponent of the lean entrepreneurship process of "hypothesis, test, pivot" to validate a minimum viable product (MVP), I also believe that JUST validating a MVP is insufficient for success.

The market economics to deliver the MVP must also be validated through modeling. My experience with the "lean startup" movement is this needed aspect is simply replaced by a "canvas" suggesting that a business model has been perfected.

Achieving a validated MVP is merely the breakthrough event that should be followed by modeling the business model to determine its financial viability. I also suggest the process of performing a risk-based valuation using the financial model can, in fact, provide market validation to the financial model.

A financial professional's modeling skills can provide immeasurable to the success of a new venture using lean startup techniques.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Maybe a rhetorical question/s......How do you account for "known" founders in valuation methodology? When VCs have admitted giving funds (some even without a business model) to startups just because a founder is "known" to them? Heck I even know of a case where the 19 year old just exited and VCs are already lined up and gave him a $45m commitment...without even an idea!

Gary Honig
Title: President
Company: Creative Capital Associates Factoring Co..
LinkedIn Profile
(President, Creative Capital Associates Factoring Company) |

Capital strategies evolve during economic conditions. Lessons learned from previous cycles are incorporated in current environments.

Currently we are seeing way too much capital with little or no places to go. Some of the activity is really nibbling around the edges, but the pack is waiting.

Computations and pedigrees are risk tolerance methodologies for the most part.

Topic Expert
Peter Freeman
Title: Chairperson - Clean Tech Committee
Company: Keiretsu Forum - Angel Investors
(Chairperson - Clean Tech Committee, Keiretsu Forum - Angel Investors) |

I found this conversation quite interesting. Full disclosure, I am the instructor for the VC method course in the Proformative learning platform, as well as an entrepreneur and angel investor.

I agree with many of the concerns expressed about the challenges of funding innovation and start-ups, and share the jaundiced view of the VC community eloquently stated by others. A large deal and market fixation, lack of long term perspective, and also a herd mentality. I focus primarily on clean-tech, which is very much out of favor in Silicon Valle these days, so that will impact my views and objectivity.

The VC method is, in my view, a decision analysis tool addressing a simple but important question - how much of an ownership share to I get from my investment? Judgments and assumptions about risks, returns, market position, potential profitability as all relevant and need to be included. The VC method, if properly done, takes this into consideration.

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