Startup community news from Houston, Texas, USA

Don’t Let the Numbers Fool You

So today I got a nice little note from the guys at DFJ Mercury letting me know that they made Entrepreneur Magazine’s VC100 list of Top 100 venture capital firms for a second straight year. The guys did 4 “first time fundings” last year (Phurnace, Marval, Illumitex and Glycos Bio) which was as many as our friends to the west of us did. Congratulations to the guys for a heckuva year and continued success.

As part of the note, DFJ Mercury founder and Startup Houston supporter, Blair Garrou was quoted as saying:

“Although we appreciate the recognition, it’s not a numbers game for us. We are excited about playing our role in the Texas startup eco-system and look at every deal, one at a time. We only wish more VCs were funding seed and early-stage Texas companies.”

First of all, G-d love Blair’s humility. For those of you who have never spent quality time with him, you are missing out on his wisdom and passion for Houston’s technology eco-system. But my digression is not to lay praise on DFJ and Blair as much as broaden the discussion about the venture market’s current temperature.

Jeff Cornwall (I love this guy…it’s a forum, not a blog) addressed some interesting points that came out of a recent report from the National Venture Capital Association (NVCA). It is no secret that the IPO market has all but dried up and strategic sales will also be under pressure with expensive oil and a cheap dollar. With all of that plus global unrest shoved in our faces by the media, I can imagine startups are quaking in their boots.

Don’t.

Let me explain venture investing once again: money goes where it can earn a return high enough to compensate for the level of risk involved in the investment. Higher risks require higher potential returns. Luis Villalobos and Bill Payne, Managing Director, Angel Venture Partners wrote about this in a piece for Kauffman eVenturing:

“In a typical angel investor’s portfolio of ten investments in seed/startup companies, half the companies perish with no return to investors, and an additional three or four companies return some capital or provide a modest return on investment. Investors hope these three or four companies will at least return the capital for the entire portfolio-all ten investments. Ultimately, only one or two of ten investments will strike it big and bring virtually all of the return on investment to the portfolio.”

What this tells me is that venture investing is a numbers game and that the numbers need to be big for it to make any sense to play the game. Think about this, venture capital funds sustain themselves until the fund returns back to the limited partners (which could be 5-10 years) anywere from 1-3% in the form of a management fee. To make that number material enough for you to quit your high paying job and start a fund requires a large enough fund to keep you out of the poorhouse. So now you’ve got $100 million dollars and the average indicates that 50% or more of your bets will fail miserably. That leaves you with 30%-40% that may make the partners money back for them. Since the fund managers did not get into this crazy business to breakeven, that leaves you with 10%-20% that are potential black swans that might generate the >35% return that venture investors look for at a minimum. And don’t even get me started about dilution.

So ignore what you read…stats are not gospel. Venture capitalists need to keep laying bets all over the place just to make the returns happen. Without volume, they will succumb to the bell curve and be back looking for work in no time. And just because for 3 months out of the last 60 some odd years there were no venture backed IPOs does not harken the apocolypse. Come up with a disruptive technology or business model and funding will fall like manna from the heavens…or maybe from a guy named Blair.

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